Monitoring, Transparency, and Strategic Substitution: Evidence from China’s Air Pollution Reform

Governments increasingly deploy monitoring technologies to improve regulatory transparency and enforcement, yet less is known about how firms adjust across other dimensions of behavior. We study this question using China’s introduction of an automatic air pollutant monitoring system, which substantially increased the accuracy and visibility of environmental performance. We argue that when monitoring constrains firms’ ability to manage outcomes in one domain, they may reallocate strategic behavior toward less observable dimensions. Using a difference-in-differences framework, we compare polluting and non-polluting firms before and after the reform and find that polluting firms exhibit systematic changes in financial reporting behavior, including higher discretionary accruals, lower earnings informativeness, and a greater likelihood of income-decreasing adjustments. These effects are strongest among firms with greater regulatory exposure and weaker external monitoring. We interpret these findings as evidence of cross-domain strategic substitution: as environmental transparency increases, firms shift opacity toward financial reporting. Our results highlight an unintended consequence of monitoring-based regulation and suggest that improving transparency in one domain may reallocate, rather than eliminate, strategic opacity, underscoring the importance of coordinated oversight across regulatory domains.

Working paper

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