Toxic chemical releases and idiosyncratic return volatility: A prospect theory perspective

We investigated whether and how firms’ toxic chemical releases (TCRs) affect idiosyncratic return volatility (IRV) using a prospect theory lens. Utilising a large sample of US public listed firms over the period 2001–2018, we find a significant and positive association between TCRs and IRV, suggesting that firms releasing more toxic chemicals have higher IRV. Additional analyses show that a positive association between TCR and IRV is more evident among firms with (i) high revenue, (ii) lower financial constraints and (iii) fewer environmental violations. A further test also suggests that a positive association between TCRs and IRV is contingent on political leadership ideology and market states. Our results remain consistent with weighted TCRs, IRV based on the Fama–French three‐factor model, fixed‐effect two‐stage least square estimator (FE‐2SLS), and other robustness checks. These findings shed light on the role of equity markets as a driver for capital‐intensive pollution abatement activities and enhanced compliance with environmental laws, standards and best practices.