Do polluting firms suffer long term? Can government use data‐driven inspection policies to catch polluters?

Do firms suffer from negative long‐term business performance after being exposed for violating environmental regulations? We empirically examine this question using all 1542 environmental incidents committed by 418 public Chinese manufacturers listed on the Shanghai/Shenzhen Stock Exchange from 2004 to 2013. We use the Coarsened Exact Matching to match a sample firm with (exposed) environmental incidents with a control firm that exhibits the same characteristics in our sample. Our comparative analysis reveals that relative to control firms, firms with (exposed) environmental incidents have poor business performance (e.g., sales growth, market share, returns on sales, and returns on assets) over a 5‐year period after being exposed. Using our training samples (data from 2004 to 2012), we also develop a predictive model and a “risk” scoring system to characterize the likelihood of a Chinese manufacturer violating environmental regulations in 2013. Specifically, we use publicly available financial data to identify factors (e.g., firm age, total assets, percentage of government ownership, and past environmental incidents) to predict which firm is more likely to violate environmental regulations. Using our training samples (data from 2004 to 2012), we can expose over 71% of the violations in 2013 by inspecting only 21.5% of the firms with risk scores above the top 80 percentile. Given the long‐term penalty and the potential for the Chinese government to use our predictive model as a building block for developing a more effective inspection policy, the number of environmental incidents in China will decline.