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Inducing Environmental Disclosures: A Dynamic Mechanism Design Approach

Author

Listed:
  • Shouqiang Wang

    (Naveen Jindal School of Management, The University of Texas at Dallas, Richardson, Texas 75080)

  • Peng Sun

    (Fuqua School of Business, Duke University, Durham, North Carolina 27708)

  • Francis de Véricourt

    (ESMT European School of Management and Technology, 10178 Berlin, Germany)

Abstract
This paper studies the design of voluntary disclosure regulations for a firm that faces a stochastic environmental hazard. The occurrence of such a hazard is known only to the firm. The regulator, if finding a hazard, collects a fine and mandates the firm to perform costly remediation that reduces the environmental damage. The regulator may inspect the firm at any time to uncover the hazard. However, because inspections are costly, the regulator also offers a reward to the firm for voluntarily disclosing the hazard. The reward corresponds to either a subsidy or a reduced fine, depending on whether it is positive or negative. Thus, the regulator needs to dynamically determine the reward and inspection policy that minimizes expected societal cost in the long run. We model this problem as a dynamic adverse selection problem with costly state verification in continuous time. Despite the complexity and generality of this setup, we show that the optimal regulation policy follows a very simple cyclic structure, which we fully characterize in closed form. Specifically, the regulator runs scheduled inspections periodically. After each inspection, the reward level decreases over time until a subsequent inspection takes place. If a hazard is not revealed, the reward level is reset to a high level, restarting the cycle. In contrast to the reward level, the mandated remediation level is constant over time. Nonetheless, when subsidies are not allowed in the industry, we show that the regulator should dynamically adjust this remediation level, which then acts as a substitute for a subsidy. Our analysis further reveals that optimal inspection frequency increases not only when the inspection accuracy decreases, but also when the penalty for not disclosing the hazard increases.

Suggested Citation

  • Shouqiang Wang & Peng Sun & Francis de Véricourt, 2016. "Inducing Environmental Disclosures: A Dynamic Mechanism Design Approach," Operations Research, INFORMS, vol. 64(2), pages 371-389, April.
    • Handle: RePEc:inm:oropre:v:64:y:2016:i:2:p:371-389
    DOI: 10.1287/opre.2016.1476
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    References listed on IDEAS

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    12. Ratul Lahkar & Vinay Ramani, 2021. "An Evolutionary Approach to Pollution Control in Competitive Markets," Working Papers 68, Ashoka University, Department of Economics.
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