Several recent studies (Jayachandran, 2006; Knight, 2006; Shelton, 2005; and Snowberg, Wolfers, and Zitzewitz, 2006a, 2006b) report partisan effects of presidential elections and changes in congressional majorities on financial market outcomes. For instance, Jayachandran (2006) uses the surprise switch of Senator Jim Jeffords from the Republican Party to Independent to estimate the impact of changes in congressional control on equity values. She finds that firms making large donations to the Republican Party lost market value in the announcement week of the switch. Jayachandran explains the relationship between donations and stock returns as reflecting how well a party's policy agenda matches a firm's interests and the perceived support of the party in achieving the firm's objectives.
In another study, Knight (2006) tests whether the market capitalized party platforms into the equity values of 70 firms favored under either the Bush or Gore agendas in the 2000 election campaign. Event-study analysis shows that campaign platforms matters in the valuation of politically-sensitive firms. Snowberg, Wolfers, and Zitzewitz (2006a, 2006b) analyze the impact of election outcomes and changes in congressional majorities on three stock price indices (S&P, DJA, and Nasdaq). They find a Republican-Democrat differential not only in recent elections but also extending back for many decades.
These results suggest that financial markets recognize the intrinsic policy goals of the major political parties and react to changes in political regimes. The purpose of the present paper is to take the analysis one step further by examining the impact of changes in political regimes on the market's reaction to specific agency decisions. (1) The paper focuses on the enforcement activities of the Environmental Protection Agency (EPA).
Previous studies (Jones and Rubin, 2001; Karpoff, Lott, and Rankine, 1998; Muroghalu, Robinson, and Glasscock, 1990) of environmental enforcement actions have found that the market's reaction to announced violations is a function of the form of legal action taken, the type of toxins involved in the citation, and special circumstances such as firm size. The hypothesis tested in this paper is that in addition to these factors, the market reacts differently to announced environmental infractions depending on which political party controls the presidency and/or Congress. (2) Testing this hypothesis is important because studies that do not recognize the impact of the political environment on agency decisions run the risk of obtaining biased estimates of the other factors in their models. For example, an omitted political regime measure could be correlated with the types of legal action and/or toxin(s) involved in the violation. Such an omission could confound a model's interpretation by attributing the impact of political regime changes to other regressors. Thus, the true market effect of an announced environmental violation could be overestimated or underestimated depending on the sign of the coefficient of the excluded regime variable and its correlation to the other determinants. The event-study model specified in this paper endeavors to determine whether announced violations of EPA statutes and rulings elicit different market responses depending on the political regimes in which they occur.
Several studies (Hamilton, 1995; Harper and Adams, 1996; Jones and Rubin, 2001; Karpoff, Lott, and Rankine, 1998; Muoghalu, Robinson, and Glasscock, 1990; Laplante and Lanoie, 1994; and Lanoie, Laplante, and Roy, 1997) have analyzed the direct impact of environmental damage lawsuits and case settlements on shareholder wealth, but few studies have considered the political environment in which this impact occurred. It is important to study this effect because different policy decisions are forthcoming from different intrinsic party platforms. This section summarizes the results of five studies that have recognized the potential influence of political regimes on the behavior of the EPA and places the conclusions of these studies in the context of the present paper. …