Cutting emissions the smart way: How an intensity-based approach drives real change

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Investors' consideration of a firm's environmental performance, along with concerns about future impacts on profit, have led many firms to start trying to reduce their carbon footprint. But such environmental pressure—if not calibrated correctly—may backfire.

In a new study, Tepper School researchers have explored how firms' operational strategies differ depending on the environmental metric used to assess environmental impact. The study, "Greenness and its Discontents: Operational Implications of Investor Pressure," is published as a working paper in the SSRN Electronic Journal.

The researchers found that significantly high environmental pressure from the market may result in different operational strategies under different disclosure regimes, with variations in the erosion of the firm value and environmental outcomes.

"Environmental pressure from both equity and debt investors can influence firms' value, which in turn affects stock prices and the cost of debt," explains Alan Scheller-Wolf, Professor of Operations Management at Carnegie Mellon's Tepper School of Business, who worked on the study, along with Sridhar Tayur, Professor of Operations Management at Tepper, and Tepper doctoral student Nilsu Uzunlar.

The positive impact of investor pressure manifests in its ability to foster sustainable business practices, such as investments to mitigate emissions. But there is evidence that under such pressure, firms may respond by selling their carbon-intensive assets to private companies. This reduces transparency and eliminates investor oversight, potentially leading to worse overall societal outcomes that may include increased pollution, higher unit prices, and lower employment.

Key intermediaries for investor pressure are environmental metrics because different metrics can focus on firms' actions differently. In this study, researchers explored the effect on a manager's operational decisions (production level, investment in emission-reduction technologies, divestment) of two prominent environmental assessment metrics used by institutional investors and regulators to assess firms' environmental performance:

• Under the absolute regime, investors value a firm based on its total net direct greenhouse gas emissions (total output).
• Under the intensity regime, which accounts for the emission intensity of the production process (output per unit) rather than the overall emissions, investors consider a firm's production efficiency level and effort to increase efficiency.

Researchers developed a sequential model to assess the environmental impact of the effect of these metrics on firms' operational decisions, enhancing the traditional operations capacity planning modeling framework to capture the effects of investors' sentiment, and incorporated equity and debt markets into their model.

The study concluded that significantly high environmental pressure from the market results in divestment under both disclosure regimes, but firm value is eroded less under an absolute metric, leading to less frequent divestment.

In contrast, when environmental pressure is not too high, the firm is more likely to invest in corrective action to mitigate emissions under an intensity metric. Thus, using the intensity-based approach may channel investor pressure into more environmentally responsible outcomes, particularly when the pressure from the market is not too intense.

The study also found that using the right metric in certain settings may harmonize divergent public interests (e.g., federal efforts to reduce emissions via the Inflation Reduction Act and state efforts to protect jobs in carbon-intensive industries). In addition, researchers identified a mechanism that might explain "greenhushing," which happens when a firm makes substantive emission-reduction investments but does not take credit for it publicly.

"Our conclusion that using an intensity-based approach may lead to more environmentally responsible outcomes without limiting production may be particularly interesting to policymakers," says co-author Tayur. "Current federal policy prioritizes reducing environmental impact, while states are often more concerned with maintaining local production."

"Our study shows that environmental pressure at a moderate level, combined with the right metric, can harmonize these apparently divergent public interests."

The study was aided by consultations with Nick Muller and Gaoqing Zhang from the Tepper School, and Keishi Hotsuki from Morgan Stanley.

More information: Nilsu Uzunlar et al, Greenness and its Discontents: Operational Implications of Investor Pressure, SSRN Electronic Journal (2024). DOI: 10.2139/ssrn.4729492

Provided by Tepper School of Business, Carnegie Mellon University