Carbon emission trading scheme and earnings smoothness

Abstract

PurposeThe objective of this study is to investigate how the implementation of an Emission Trading Scheme (ETS) influences an ETS-regulated firm’s level of earnings smoothness.Design/methodology/approachUsing a staggered difference-in-differences model based on China’s ETS pilots commencing in 2013, this study investigates how the implementation of ETS pilots affects regulated firms’ earnings smoothing relative to non-regulated firms. The sample period spans from 2008 to 2019. This model incorporates time-invariant firm-specific heterogeneity, time-specific heterogeneity, and a series of firm characteristics to establish causality. Robustness tests justify findings.FindingsThe results show that after implementing an ETS pilot, regulated firms increase their earnings smoothness relative to non-regulated firms. Regulated firms strategically smooth their earnings to obtain additional financial resources and meet compliance costs arising from an ETS. Further analysis reveals that regulated firms’ earnings smoothing activity is a function of environmental regulations, managerial integrity, and capital market incentives.Originality/valueThis study deviates from past research focusing on the environmental consequences of ETS by indicating that an ETS affects regulated firms’ financial reporting decisions. Specifically, regulated firms resort to earnings smoothing as a short-term exit strategy from financing concerns arising from environmental regulations. This finding expands prior literature primarily focusing on the effect of tax and financial reporting regulations on earnings smoothness. This study also indicates that firms utilize earning smoothing to lower their short-term cost of capital, which enables them to access additional financing at a lower cost and reconfigure their operations to meet stakeholder environmental demands.