Regulation on Environmental Risk Needed by Companies for Investors

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Illustration of company cooperation with investors. (Source: Giga Device)

Industrial pollution can take many forms. For example, polluting drinking water sources, releasing unwanted toxins into the air, and reducing soil quality. Environmental disasters especially those caused by industrial accidents must be controlled. This condition encourages companies to carry out social and environmental responsibility, which is often referred to as CSR (corporate social responsibility). Green companies have higher market value and stock returns, because green companies are considered to have lower risks.

This research was conducted at companies included in the high profile industry because the industry is very vulnerable to the possibility of environmental damage. Companies from environmentally sensitive industries tend to disclose more environmental information than other industries.

There is an underlying assumption that the industries sensitive to the environment are usually subject to various environmental regulations, and as a result they face greater pressure. In this industry, information on performance and environmental risk should be used by investors in decision making, as it will determine the cost of share capital and stock liquidity.

Voluntary disclosure has a large impact on company liquidity and value. It justifies the company to voluntarily disclose more information than is required, while proving that managers can form stock liquidity, at least to a certain extent. Disclosures are made to reduce information asymmetry, because it creates costs due to adverse selection in transactions between buyers and sellers of company shares.

To avoid potential investor reluctance to include their capital in illiquid markets, companies must spend capital at discount prices. This discount makes capital costs higher. If disclosure of risk increases investor predictions, there is greater confidence and thus increases trading volume.

In the sustainability literature, there is a statement saying environmental risk management will provide many benefits. Investors make the transactions and determine the cost of capital of a company by evaluating the risk of its cash flow relative to other investment opportunities available to them. The company carries out emission and pollution reductions to reduce the risk of litigation either from government regulators or from non-government. It will reduce both current and potential risks. Every environmental activity is likely to be valued by the market in terms of increasing the company’s risk perception from an investment perspective.

The sample of this study is companies listed on the Indonesian stock exchange in 2013-2015 and assessed in the Trucost Database. It is the only database that provides data on the magnitude of potential environmental impacts for the benefit of investment to investors in various countries, including Indonesia. Trucost has become part of the Dow Jones S & P Index, so it can be said to be a reliable source of data. Secondly, companies make disclosures or reports on the environment in sustainability reports. However, if it does not publish a sustainability report, an annual report will be used.

The test results show that disclosure on environmental performance is used by investors to determine the value of the company, and disclosure of environmental risk is not used. Furthermore, companies that disclose more environmental risks will have higher stock liquidity. Although disclosure of environmental risk does not result in changes in the value of the company, the disclosure can increase trading volume.

The sample is categorized into two groups, namely high risk and low risk. In the high risk group, companies face more potential environmental damage, disclosure of performance and risk will be responded more by investors. While in the low risk category, this information is not used by investors in decision making.

The practical implications of this study advise the policy and regulatory bodies that companies with high risk of environmental damage, need more detailed regulations regarding environmental activities, because investors need this information. (*)

Author : Rizky Eriandani, I Made Narsa

Details of this research available at:  https://doi.org/10.24914/jeb.v22i2.2356

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