SHORT‐RUN AND LONG‐RUN IMPLICATIONS OF ENVIRONMENTAL REGULATION ON FINANCIAL PERFORMANCE

Opposing theoretical arguments exist regarding the effect of environmental regulation on financial performance. Some studies argue that environmental regulation constrains firms' abilities to exploit revenue‐enhancing or cost‐reducing opportunities. Other studies, representing the Porter hypothesis, argue that environmental regulation motivates firms to innovate, which ultimately improves financial performance. Although much of the debate focuses on long‐run effects, there are also important short‐run effects. This study provides empirical evidence regarding the short‐run and long‐run effects of Clean Water Act regulation on financial performance. To generate this evidence, we examine the effect of permitted wastewater discharge limits, on the return on sales, using panel data on publicly owned firms in the chemical manufacturing industries. We find that Clean Water Act regulation improves financial performance in both the short run and the long run with a stronger effect in the long run. These results suggest that some net benefits may be realized during a short‐run transition to comply with a tighter permitted discharge limit, with additional benefits accruing to the firm in the long run because the firm has more time to innovate. (JEL K23, L25, L51, L65, Q52)