Joint Harvard/Georgetown Analysis on Environmental Audits and EPA Audit Policy

Last year, Harvard Business School and the Georgetown University Law Center jointly conducted a detailed statistical analysis to evaluate the effectiveness of EPA’s Self-Audit and Disclosure policy (“Audit Policy”) in the context of two questions:

–       Do the regulators trust self-disclosed audit information enough to reduce inspections at those companies who choose to self-disclose?

–       Are self-audit programs resulting in the reduction of environmental incidents?

The authors, Michael W. Toffel (Harvard Business School) and Jodi L. Short (Georgetown Univesity Law Center) stated that this was the first study to analyze these questions in the context of statistical analysis of outcomes and behavioral analysis of regulator actions.  In summarizing the results of their analysis, the authors stated:

Our results … demonstrate that Audit Policy participants with clean past compliance records improved their environmental performance by reducing their accidental releases of toxic chemicals to the environment.  We also find that regulators rewarded these effective self-policers with an inspection holiday.  By contrast, bad apple self-disclosers did not improve their performance compared with similar non-disclosing firms.  We find no evidence that regulators altered their scrutiny over these ineffective self-policers.

… it turns out that regulators are quite adept at … sorting the good apples from the bad.  We found that regulators had accurately parsed these two groups of self-disclosers, rewarding the former but not the latter with inspection holidays.

… self-disclosing firms on average reduce the number of abnormal events resulting in toxic chemicals being released to the environment.

EPA is now expanding the Audit Policy applicability to mergers and acquisitions.  EPA has stated that “new owners” of companies/sites may also seek penalty mitigation if they conduct self-audits of the newly acquired locations and self-disclose the results in accordance with slightly-modified requirements of the Audit Policy.

Operational environmental compliance is beyond the scope of traditional environmental due diligence (EDD).  Contaminated property determinations are the sole aim of typical EDD reviews known as “Phase I” and “Phase II” studies.  However, operational compliance can drive environmental costs for pollution control equipment that may far outstrip liabilities associated with contaminated property.  Therefore, transactions involving industrial operations –especially those with any type of pollution control equipment – should include a compliance audit as a standard element of the EDD.

In the context of Toffel and Short’s results, should a “new owner” choose to undertake an operational audit and self-disclose the results? The authors’ work indicates that new owners should obtain further information to determine the benefit and regulatory perception of self-reporting the EDD compliance audit information.  It appears important to determine whether the company to be acquired is a “good apple” or a “bad apple” to use the terms from the research paper.

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