Does Air Pollution Harm Business Ethics?

The harm air pollution causes to one's heath is well documented. The effect it has on the integrity of business practice is less so. This paper asks if businesses in high pollution areas are more likely to engage in unethical practice.

Air pollution is one of the greatest challenges faced by business and society today. According to the World Health Organisation, air pollution kills millions worldwide every year. Many countries - including China - are determined to improve the quality of air we breathe. However, our knowledge of the consequences of air pollution has been limited to its effects on physical and psychological health; it is less clear whether and how air pollution induces ethical, economic, and social costs. The study Contaminated Heart: Does Air Pollution Harm Business Ethics? Evidence from Earnings Manipulation examines how air pollution affects business ethics, specifically those relating to earnings manipulation.

Earnings manipulation is the purposeful intervention by managers in the financial reporting process, with the intention of infuencing stakeholders about the true performance of the firm or to alter contractual outcomes that depend on financial reports. It can increase social transactional costs, and negatively impact capital allocation and social welfare. It is widely regarded as unethical in the accounting and business ethics literature.

Research has generally found that firms which are poorer environmental performers tend to engage in “greenwashing” - unethical activities that aim to deceive stakeholders with misleading information about their environmental performance. Psychology research shows that air pollution would increase the effective discount rate used by individuals in decision-making. Accounting research finds that manipulation is increasing with the discount rate used by managers to discount the costs of earnings management. Prior studies have also shown that air pollution leads to elevated aggression, and that it can lead to lower firm performance, as managers become less productive and suffer from lower cognitive performance after exposure to elevated air pollution. Therefore, the researchers began their study with the prediction that managers who are exposed to higher levels of air pollution are morely likely to engage in earnings manipulation.

Using a large sample and a comprehensive air quality index in China, they found that firms located in cities with more severe air pollution exhibit higher levels of discretionary accruals and are more likely to restate their fnancial statements, consistent with exposure to air pollution leading to more earnings manipulation. 

Further causal evidence is provided using propensity score matching, and a discontinuity regression design (RDD) exploiting the Qinling Mountain–Huai River Heating Policy Line, which exogenously leads to more air pollution to cities located immediately to its north. These findings are robust to controlling for weather conditions, and alternative samples and measures of air pollution and earnings management.

Overall, this study unveils how the ecological environment shapes business ethics. Future research to explore the efects of air pollution on economic and social costs, and the specific mechanisms that bridge air pollution and such costs is highly warranted.

A copy of the paper Contaminated Heart: Does Air Pollution Harm Business Ethics? Evidence from Earnings Manipulation can be requested at City Research Online. It has been published in Journal of Business Ethics.