1. THE IMPACT OF AIR POLLUTION EMISSIONS AND RELATED HUMAN HEALTH RISKS ON THE CROSS-SECTION OF STOCK RETURNS Dinah A. Koehler EPA Bernell K. Stone BYU

2. CONCERN For a cross section of companies/industries, does air pollution, especially health damaging air pollution, have a systematic effect on valuation?

3. HYPOTHESES Null: no effect Alternative l: Positive effect, i.e.: More pollution greater value Alternative 2: Negative effect, i.e.: More pollution lower value

4. Comments: 1.In equilibrium, value and return realization are inversely related. 2.Revaluation from new information and/or from changes in how stocks are valued can be source of noise, possibly distortion. Null HYPOTHESES Positive Negative

5. ASSESSMENT ISSUES Fair return for time and risk Other cross-sectional return dependency variables Interpretative complexities

6. FAIR RETURN MODELS CAPM (Capital Asset Pricing Model) 2 return factors: - time (short-term riskless interest rate) - systematic market risk (beta) R s = R f + (R M - R f )β s Multifactor - Endogenous Factors (APT) - Exogenous Factors (specified variables) Example: “Fama-French 3 Factor”

7. OTHER CROSS SECTIONAL RETURN DEPENDENCY VARIABLES Other so-called anomaly variables Taxes and financial structure Growth, profitability, and other performance attributes Industry

8. Summary of Return Impacting Variables VARIABLE NAME SYMBOLVARIABLE DEFINITION Beta  = Cov(R s -R o, RM – R o ) / Var(RM – R o ) measured over 3 years of past monthly returns, where R o is the riskless rate and RM is the market index. Book-to-Market ratioB2MRatio of BV/MV where BV is accounting book value (total common equity) and MV is market value of common stock Market Cap (Market Value) MVThe market value of common stock at a point in time Earnings YieldEYThe ratio of Net Income to market value, the reciprocal of the price-earnings ratio Dividend YieldDYThe ratio of Annual Dividends to Market Value Financial StructureFSThe fraction of Total Investment provided by debt and preferred stock Effective Tax RateETThe ratio of Tax Payments to Net Income Return on InvestmentROIThe ratio of Operating Income (before extraordinary income and expenses) to Total Investment Return on EquityROEThe ratio of Net Income to Book Value Sales IntensitySIThe ratio of Sales to Total Investment Sales GrowthSAGFive-year average sales growth Average MarginAMThe Ratio of Operating Income to Sales Sustainable GrowthSUGThe growth of common equity from retained earnings

9. INTERPRETATIVE COMPLEXITIES The usual specification problems –Measurement error –Omitted variables –Improperly specified functional dependencies –Correlation distortion State of the economy State of the market –Changing level of interest rates –Changing term structure –Changing currency values –Hot and cold styles (e.g., growth vs value) Industry-specific effects Arrival of new value changing information

10. STUDY LOGIC DATA 1.Rank Order into Industry Portfolios 2.Step-Wise use of MAP Scatter Plots Regression Fits Hypothesis Tests

11. STUDY LOGIC DATA 1.Rank Order into Industry Portfolios 2.Step-Wise use of MAP Model 1: No control restrictions Model 2: CAPM beta Model 3: Fama-French 3-Factor Model 4: 7-Factors: EY, DY, FS, ET Model 5: Add Growth and Profitability

12. STUDY LOGIC DATA 1.Rank Order into Industry Portfolios 2.Step-Wise use of MAP Scatter Plots Regression Fits Hypothesis Tests

13. Measured Cross Section of Returns on Matched Portfolios

16. Linear Regression Results: 1998-2002 LOG [KILOGRAMS DIRECT MASS EMISSIONS] ModelCoefficientT-valueF-valueR2R2 1-0.02-1.281.630.14 2-0.03-1.632.650.21 3-0.03-1.743.030.23 4-0.01-0.320.100.01 5-0.02-1.391.930.16 LOG [DIRECT KG/VA] ModelCoefficientT-valueF-valueR2R2 1-0.0272-1.80423.25520.2656 2-0.0226-1.22581.50260.1431 3-0.0179-1.08641.18030.1159 40.00700.45330.20550.0223 50.00490.35080.12310.0135

17. Linear Regression Results: 1998-2002 LOG [TOTAL TRI RISK/VA] ModelCoefficientT-valueF-valueR2R2 1-0.23-1.983.920.23 2-0.15-1.482.200.14 3-0.17-1.672.800.18 4-0.30-5.01**25.10**0.66 5-0.31-4.08*16.65*0.56 LOG [TOTAL PM2.5 RISK/VA] ModelCoefficientT-valueF-valueR2R2 1-0.21-2.425.840.29 2-0.16-1.843.390.19 3-0.15-1.883.550.20 4-0.27-3.21*10.32*0.42 5-0.31-4.19**17.58**0.56 * p <.01 ** p <.001

18. Linear Regression Results: 1998-2002 LOG [(TOTAL TRI + PM2.5 RISK) / VA] ModelCoefficientT-valueF-valueR2R2 1-0.23-2.546.440.32 2-0.18-2.124.500.24 3-0.14-1.783.180.19 4-0.25-3.07*9.40*0.40 5-0.31-4.50**20.23**0.59 * p <.01 ** p <.001

19. MAJOR CONCLUSIONS Tonnage of air pollution is not significant Cancer health risk is significant Lung health risk is significant

20. INTERPRETATIVE COMPLEXITY: EQUILIBRIUM VS REVALUATION “Equilibrium” (no pollution-related revaluation) -market failure in that companies in industry groups producing more health damaging air pollution are more highly valued than otherwise identical companies -there is a need for pertinent regulation Cross-time revaluation -the market believes that there is the possibility that health-related air pollution will be more regulated (with costs to the polluting companies), and/or -the market becomes concerned with health-related legal liability (as occurred for asbestos and tobacco)

21. METHODOLGY CONCLUSIONS Many variable impacts For pollution, it is crucial to control for –Fair return for time and risk –Taxes and financial structure –Growth and profitability –Industry attributes

22. ON-GOING AND FUTURE RESEARCH Size scaling alternatives Outlier control Industry impacts/distortion More portfolios per cross-section More sensitivity analysis Additional years?