The Deterrence Effect of Direct Monitoring: Evidence from a Centralized Environmental Supervision Program in China

• In Event: Regulating the Environment in China and the US: Complexity, Monitoring, and Frameworks

Abstract

    The economics of crime and enforcement suggests that firm compliance is a function of the probability of detection and the penalty severity by regulator. In practice, this theory is challenged: firms’ compliance remains high although the frequency of detective enforcement and the penalties set by regulators are much lower than the theoretical optimal level. For this, one of the explanations is that regulation may causes a general deterrence effect, which induces non-targeted firms’ compliance.
    In environmental regulation, empirical evidence also shows that environmental enforcement and penalties against non-compliant firms can reduce other firms' emissions. However, existing studies mainly focus on the deterrence effect of traditional administrative tools such as inspections and penalties. Little is known about the deterrence effects of information-based regulatory tools, such as direct monitoring, even though they are increasingly being adopted and promoted in environmental regulation practice. As a policy tool aimed at improving the quality of data available to central governments, direct monitoring is particularly valuable for developing countries with widespread data manipulation and local government-business collusion. Examining the deterrence effect of direct monitoring, its magnitude, and mechanism is vital to our understanding of the comprehensive costs and benefits of this emerging tool for better environmental policy design in developing countries.
    This article exploits the deterrence effect of direct monitoring by focusing on China’s National Specially Monitored Firms (NSMF) program. In 2007, the NSMF program started in response to the lax environmental policy implementation of local governments. The program established a list of largest polluters to be monitored directly by the central government, and the list was updated annually based on pollution levels. Central government collected real-time reliable firm emissions data of all these NSM firms through technical devices and on-site inspections. But this program does not directly impose any enforcement and penalties.
    Using a firm-level geocoded emissions dataset and a difference-in-differences estimator,  we find strong empirical evidence that COD emissions from non-targeted firms within 4km rim of NSM firms are significantly reduced by 10.25% after the NSMF program. This magnitude of this deterrence effect roughly amounts to 9% of annual national COD emission reductions.
    Next, we demonstrate the main driving mechanism for the deterrence effect is the cost learning mechanism, where non-targeted firms observe and learn about the additional compliance costs of NSM firms and avoid entering the central direct monitoring horizon by reducing emission. The effect is more salient for firms with higher probability of entering NSM lists, firms with more information about the additional costs for NSM firms, and low original compliance cost regions with weak environmental enforcement capacity and strong local protectionism. 
    Finally, we find that firms’ compliance strategy towards direct monitoring’ deterrence is to reduce emissions intensity rather than industrial output. Specifically, firms are more likely to switch on installed pollution abatement equipment to reduce COD emissions without losing output. Overall, the direct monitoring has a sizeable deterrence effect and thus is more cost-effective than previously expected.

  

Authors

• Hengrui Yang, Tsinghua University
  Presenting Author

• Junming Zhu, Tsinghua University
  Non-Presenting Co-Author