Environmental Regulatory Risk

Peter Boswijk, Cees Diks, Simon Trimborn and Matteo Valle
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Peter Boswijk: University of Amsterdam
Cees Diks: University of Amsterdam
Simon Trimborn: University of Amsterdam
Matteo Valle: University of Amsterdam

No 26-044/III, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: The aim of this paper is to determine from market expectations how firms are affected by risks arising from environmental regulation. We use a text-based measure of environmental regulatory stringency derived from U.S. EPA legal documents and industry-level relevance scores to capture time-varying regulatory stringency exposure. We find that environmental regulatory stringency carries a positive and statistically significant return compensation, especially for firms with high cash holdings. For firms with low cash holdings, the effect is highly volatile, showing investors are uncertain about a firm's future when faced with stricter regulation. Firms’ environmental profiles further matter, as high-emission firms' returns are negatively affected when regulatory stringency increases. Because regulatory text is released infrequently, challenging real-time risk analysis, we utilise our studies insights to derive a high-frequency, market-expectation capturing Environmental Regulatory Risk Index (ERRI). We show that ERRI captures shifts in investors’ expectations of environmental regulatory stringency and how ERRI reacts during environmental policy and political developments.

Date: 2026-07-15
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