New research shows that firms are more likely to break environmental rules when those who control the company finances are overly confident in their abilities.
These environmental violations damage the company’s long-term performance, especially when it comes to credit ratings.
However, the research, which looked at nearly 600 US companies over 17 years, found those in states with laws that require them to consider the interests of all stakeholders - not just shareholders - are better at avoiding these issues and protecting their financial health.
The study was conducted by researchers at the University of East Anglia (UEA) and Heriot-Watt University, together with colleagues at the University of Aberdeen, Coventry and Bangor Universities.
Most previous studies have focused on CEOs, but this one looked at Chief Financial Officers (CFOs), the top financial decision-makers at companies. The findings are published today in the journal European Management Review.
Dr Huong Vu, lecturer in Finance at the University of Aberdeen Business School, said: “Due to their important roles in corporate financial planning, reporting and risk assessment, CFOs are at the heart of the nexus between investment decisions and regulatory compliance.
“Our research brings CFOs into the spotlight, drawing further attention from both shareholders and debtholders to CFOs' cognitive biases, particularly overconfidence bias and to their significance for corporate creditworthiness and value.
"Environmental regulation infringements are, to a great extent, influenced by a firm's top management team members including the Chief Finance Officer. Cognitive biases like overconfidence exhibited by a key TMT member like a CFO, lead to risk-taking behaviour that damages a firm reputation rather than creates value.
“Our research emphasizes the importance of steering these managers toward a multi-stakeholder-oriented approach to leadership, first through legislation and then through future internal corporate governance initiatives.”
Given the important role of senior executives’ overconfidence bias in shaping firms’ environmental actions, the authors say there is a need to strengthen internal control and oversight of high-impact decisions, with the active participation of all stakeholders.
“Constraining managerial overconfidence through regulation can improve investor confidence and trust, as it helps counter the tendency toward short-termism driven by this overconfidence bias,” said Dr Yurtsev Uymaz of UEA’s Norwich Business School. “In particular, firms with overconfident CFOs may benefit more from stakeholder-oriented laws while also incurring higher penalties for environmental violations.
“Our findings are also valuable to stakeholders such as employees, customers, investors, and local communities, whose trust and well-being might be at risk. If the cognitive and psychological biases among management play a critical role in firms’ environmental decisions, addressing these biases can shift managerial and organizational incentives, with far-reaching implications not only for financial markets but for society.”
The findings show that the distinct roles of board members should not be underestimated, as they can amplify firms’ environmental impacts. While managerial overconfidence can drive growth, it can also be detrimental to environmental performance if not properly balanced and controlled. The authors argue this is particularly important at the firm level, as environmental misconduct can lead to significant reputational and litigation costs.
The team looked at financial data, executive behaviour, and records of environmental violations for US firms from 2006 – 2022. The researchers then analysed how these factors were connected and how the introduction of stakeholder laws affected outcomes.
The sample included air transport, manufacturing, petroleum, technology and telecom firms. The researchers found that Brown industries (air transport and petroleum alone) violated environmental rules approximately 62% of the time, compared with 10.6% in green industries (technologies and telecom).
Due to the nature of their business, some industries pose greater risk to environmental degradation than others, which the study controlled for.
‘CFO overconfidence, environmental violations, and firm performance. The moderating role of constituency statutes’, Panagiotis Andrikopoulos, Shee-Yee Khoo, Patrycja Klusak, Yurtsev Uymaz and Huong Vu, is published in European Management Review on June 9.