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Environmental Information, Asymmetric Information, and Financial Markets: A Game-Theoretic Approach

Abstract

This paper examines the problem of asymmetric information in financial markets due to a lack of essential environmental information. The literature indicates that asymmetric information generates various problems for the actors of financial markets such as incomplete information for investment decisions and lending procedures, misallocation of financial market funds, the underestimating of stock price securities, and poor environmental risk management choices. To this end, this paper develops a game-theoretic approach to examine both the persistent nature of asymmetric information caused by the absence of accurate environmental information and to indicate how a well-organized, trustworthy, internationally agreed auditing accounting certification scheme could play a critical role in limiting the magnitude of this problem.

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Notes

  1. Many financial institutions may offer the same amount of investment but with better crediting conditions–terms such as lower interests rates. We thank an anonymous referee for pointing this out. In both cases, the ultimate result is a higher value of investment for the recipient firm.

  2. To better visualize this, imagine a checklist that a firm has to complete in order to be considered environmentally responsible. Each tick represents a specific ER action. This way, by breaking down environmentally responsible behavior into a specific series of actions, we simplify and are able to model the complex phenomenon of firm behavior.

  3. In reality, this may be more complicated with different probabilities on different percentages of investment that can be lost. This can be described by an integral containing all possible probabilities for all possible percentages of loss. Without loss of generality and for simplicity reasons, the integral is expressed with the probability of losing the whole investment (firm goes bankrupt).

  4. We thank an anonymous referee for making this point clear.

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Correspondence to Ioannis E. Nikolaou.

Appendix

Appendix

e(i,r,k):

The expected value of investment of FI is assumed to be $150,000.

c er :

A cost for ER action will occur as the average cost of EMS implementation. For instance, Bansal and Bogner [49] estimated the costs of ISO 14001 as $20,000 for SMEs and $200,000 for large firms, while Prakash and Potoski [50] calculated the same cost to range from $25,000 to $100,000 correspondingly. For the purpose of our examples, the cost of ER will be $150,000 (an average value of $100,000 and $200,000 for large firms).

c re :

The lack of an auditing system to assure the reliability of firm’s environmental information could be translated by the financial institution as high loan loss provisions to evade the potential financial risks from a future accident. The height of a provision could range from 0 to 100 % of the expected investment. Even though international accounting standards (e.g., SFAS 5) have compelled the banking sector to acknowledge the likelihood of future financial losses by incorporating bad debt expense into its balance sheet, there are no standard methods and percentages to record it. For the purpose our examples, it is assumed as 60 % of investment, namely $90,000 (0.6 × e(i, r, k)).

u :

The height of remedy costs is related to the strength of the damages, the severity of legislation and ensuing penalties. For instance, Union Carbide India Limited paid $3.3 billion for the clean-up costs after the chemical accident at its plant in Bhopal, India in 1984 [51: p. 876]. For the purpose of these examples, based on the work of Kleindorfer et al. [52], the total cost per chemical industry accident will be estimated approximately up to $600,000 (sum of on-site property damage and of site property damage per accident).

\( p_u^{er } \) :

This probability is estimated by drawing data for the chemical industry from FACTS-Hazardous Materials Accidents Knowledge Base (http://www.factsonline.nl/browse-chemical-accidents-in-database/4). According to the data from the last 5 years, the average probability of an accident taking place in a chemical plant will be approximately 0.161 (as seen in the following table). The lack of information on whether these accidents have occurred by ER chemical firms or not leads to the assumption that the probability for an accident to happen by ER firms should be lower than the average probability (0.161). For the purpose of the examples, the probability is 0.1.

\( p_u^n \) :

Given the limitation of the model (\( p_u^{er } > p_u^n \)) and the above judgment, the probability of a firm which has not taken ER to have an accident is 0.3, higher than the average of 0.161.

\( p_l^{er } \) :

The height of this probability is associated with the intensity of environmental accidents, firms’ environmental performance and subsequent on-site property damage and of site property damage (including penalties). Sharfman and Fernando [53: pp. 773] stated that “undertaking environmental risk management activities by improving environmental performance can reduce the likelihood that firms will encounter extreme environmental events that can require heavy cash flows arising from compensation and clean up costs, and thereby make firms more vulnerable to bankruptcy”. The probability is estimated to be near to 0. For the purpose of the examples, it is assumed to be 0.01.

Years 2005 2006 2007 2008 2009 2010
Number of Accidents 43 60 39 48 33 6
Probabilities (43/365) = 0.117 (60/365) = 0.164 (39/365) = 0.106 (48/365) = 0.131 (33/365) = 0.271 (6/365) = 0.016
Probability mean 0.117 + 0.164 + 0.106 + 0.131 + 0.271 + 0.016 = 0.161
\( p_l^n \) :

This probability will be high when the accident is large scale and accompanied by high penalties. The probability may be close to 1. Nevertheless, for the purpose of the examples, it is assumed to be 0.7.

c c :

This includes the costs for certification by an external auditing certification system. This may be the sum of the costs of certification of ER action (e.g., ISO 14001) as well as the cost for certification for environmental accounting disclosures. Miles et al. [54] estimated certification fees of ER action to be approximately $30,000, while the certification costs for environmental accounting disclosures is considered to be $20,000 as evidenced by the price lists of charter accountants for conventional accounting auditing. Consequently, the total cost is $50,000.

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Nikolaou, I.E., Chymis, A. & Evangelinos, K. Environmental Information, Asymmetric Information, and Financial Markets: A Game-Theoretic Approach. Environ Model Assess 18, 615–628 (2013). https://doi.org/10.1007/s10666-013-9371-5

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Keywords

  • Financial markets
  • Environmental accounting
  • Asymmetric information
  • Accounting audit schemes