Grantee Research Project Results
Final Report: Pollution Prevention: The Role of Environmental Management and Information
EPA Grant Number: R830870Title: Pollution Prevention: The Role of Environmental Management and Information
Investigators: Khanna, Madhu , Deltas, George , Joshi, Satish
Institution: University of Illinois Urbana-Champaign
EPA Project Officer: Hahn, Intaek
Project Period: May 30, 2003 through May 29, 2006 (Extended to May 29, 2007)
Project Amount: $286,539
RFA: Corporate Environmental Behavior: Examining the Effectiveness of Government Interventions and Voluntary Initiatives (2002) RFA Text | Recipients Lists
Research Category: Environmental Justice , Pollution Prevention/Sustainable Development
Objective:
The purpose of this research is to examine whether and to what extent the adoption of TQEM is fostering pollution prevention (P2) activities and the implications of P2 activities for the environmental performance and economic performance of firms. These issues are investigated using a sample of S&P 500 firms that emit toxic releases. More specifically, this research:
(a) Develops a theoretical framework to examine the incentives provided by the market for firms to produce greener products and its implications for the ability of the market to achieve social optimality. We examine the implications of consumer preferences for product quality and social welfare and the supplementary regulatory policies needed to achieve social optimality.
(b) Empirically examines the extent to which TQEM has been effective in motivating the adoption of P2 activities and whether P2 adoption is improving environmental performance. We analyze the effect of TQEM on the types of P2 activities being adopted. This analysis controls for differences in various firm and industry specific attributes and direct regulatory and market pressures to adopt P2.
(c) Examines the implications of adopting management practices and or P2 for the economic performance of firms. We examine the sources of economic benefits such as, higher market share, higher price earnings ratio, abnormal changes in stock market returns for firms that adopt management systems and/or P2 and whether stock market reactions to the environmental information in the Toxics Release Inventory (TRI) are influenced by information about toxicity of releases and about TQEM and P2 activities.
Summary/Accomplishments (Outputs/Outcomes):
The theoretical analysis undertaken here addresses the following issues. First we examine whether firms with high intrinsic quality products would choose to produce more or less environmentally friendly products than their competitors. Second, we investigate how the environmental quality for the firms’ products responds to (a) increased consumer awareness of the negative environmental externality generated by these products and (b) to a cost-sharing of the development costs for improving the greenness of a firm’s product (or, equivalently, to secular technical change that reduces the development costs of green products). Third, we examine the effect of the above two changes in the market environment on equilibrium prices and firm profits, which would determine whether the firms would welcome or oppose such changes. Fourth, we examine whether consumer preferences for environmental quality would be sufficient by themselves to lead to the socially optimal provision of green products when consumers were to fully internalize the environmental externality. Finally, we examine the scope for and the effects of regulatory policy, either through taxes or minimum quality standards, in markets in which consumers fully internalize the environmental externality. The sequence of moves is as follows. First, firms choose the degree of product greenness. Second, the firms choose prices. Third, consumers purchase the product that yields the highest surplus.
Our paper is related to the literature on product quality and minimum quality standards. The early literature focused on quality choice by a monopolist and showed conditions under which there would be underprovision of quality. Subsequent literature focused on purely vertically differentiated duopolies. Generally this literature finds that there will be over-provision of quality by one of the firms and under-provision by the other firm in order to reduce price competition. Studies show that a minimum quality standard would enhance welfare by narrowing the quality gap between firms and intensifying competition. The standard lowers the profits of the high quality firm but it increases profits of the low quality firm. They find that the high quality firm will exceed the minimum quality standard. Consumer welfare increases because the quality adjusted prices for both firms fall and social welfare increases. A recent study considers asymmetric firms that differ in the investment costs of quality provision. It shows that if these costs are lower for the high quality firm than for the low quality then even the high quality firm may underprovide quality. Unlike this literature, our paper assumes that products differ not only vertically but also horizontally. Moreover, it assumes that firms are not identical in initial quality and seeks to explain further changes in product quality. Finally, our paper incorporates consumption externalities explicitly and analyzes the effects of the degree of internalization by consumers on quality provision by firms.
Our findings can be summarized as follows. Regardless of the degree of asymmetry in intrinsic quality, the firm with the higher intrinsic quality product will have a greater market share than its competitor, charge a higher price, and have a greener product. The last result is driven by the assumption that product greenness affects the fixed cost of production, but not the marginal cost: Since firms with relatively high market shares benefit more from the price premium associated with producing a greener product, they will have stronger incentives to produce such products. Moreover, when the degree of asymmetry is not too large, we find that both firms would oppose campaigns to enhance consumer awareness of the pollution externality caused by their consumption decisions and would also oppose any government cost-sharing of pollution reduction investments. This result is ensured by the absence of aggregate demand effects from increasing environmental quality and that development costs are a convex function of product greenness. Thus, a government development subsidy ends up leading to increased firm expenditures on developing greener products without yielding any benefits in terms of higher prices or sales. To put it another way, pollution reduction has features of a Prisoners’ Dilemma: both firms would prefer that it was so prohibitively expensive that neither would do much or any of it, but given that it is not prohibitively expensive, both find it privately optimal to engage in it. When firms differ in their intrinsic quality, a government subsidy (or secular technical change) that reduces the development costs of producing a greener product also reduces the incentives for the low quality firm to produce a greener product. The intuition for this perverse finding becomes clear once one realizes that government subsidy is more valuable to the high quality firm because it produces the greener product and incurs a higher fixed cost. Thus, this firm will increase its product greenness by more than the low quality firm, leading to a reduction in the low quality firm’s market share. Since low market shares reduce incentives for investing in green products, the net effect of a government subsidy and an increase in the environmental quality of the high quality firm is that the low quality firm produces an even less green product. When asymmetries in intrinsic product quality are large, the high quality firm also prefers campaigns to enhance consumer awareness because it benefits more from such programs, as its market share expands to the detriment of its low quality competitor. Thus, it is possible for a market leader to find it privately optimal to “educate” consumers and increase their willingness to pay for greener products.
Lastly we find that educating the public and instilling them with sufficient altruism so that they fully internalize the externality results in a sub-optimal provision of product greenness. The intuition for this surprising result is as follows. When a firm increases the greenness of its product, it causes its competitor to decrease its price to prevent a large erosion of his market share. This adverse competitive response partially nullifies the benefits of increasing greenness. Thus, market pressure needs to be supplemented by regulatory intervention to achieve environmental quality levels closer to the social optimum. We briefly consider the effects of such regulatory intervention in the form of a minimum quality standard. We show that such a standard is able to increase welfare, but only if firms are not too asymmetric. The reason why a minimum quality standard is not guaranteed to increase welfare is because, somewhat paradoxically, it lowers the environmental quality of the high quality firm. Simply put, increasing the greenness of the low quality firm’s product makes the firms more symmetric, thus reducing the incentives for the market leader to maintain high environmental quality. The high quality firm would oppose such a standard, even though it would not be binding on it, while the low quality firm would support it despite the fact that it would be binding on it. This is because given that the low quality firm has to meet the standard, the high quality firm has less incentive to raise environmental quality, resulting in a smaller competitive advantage for that firm. Effectively, the standard converts a simultaneous quality choice game into a sequential one. Even though the regulator’s action is not optimal from the point of view of the low quality firm, the regulator’s choice of environmental quality is in the direction of the optimal choice of that firm in a sequential game.
We extend the framework described above to consider the design and effectiveness of environmental regulations to improve the environmental quality of the products of heterogeneous duopolistic firms. As described above, firms differ in their intrinsic quality (in terms of overall appeal of their products to consumers) and costs, (which stem from differences in their technological capabilities to improve the environmental quality of their products). In the presence of both types of heterogeneity regulators can subsidize the firms’ R&D investment costs in making their products and production more environmentally friendly or it can set a quality standard. Regulators can also either distinguish among heterogeneous firms and impose different subsidies depending on firm’s intrinsic quality and/or costs, or ignore firm asymmetries and impose a uniform subsidy and a uniform quality standard. We investigate how firm asymmetries, and duopolistic interaction affect optimal regulation under a variety of different policy regimes in a horizontally differentiated market when environmental quality is only one of the many product attributes which include intrinsic quality (product reliability and durability) and other horizontal product features (size, color, or model).
In particular, this study attempts to answer the following questions: How should a regulator design welfare-maximizing subsidies that will induce heterogeneous firms to choose the socially desired environmental quality levels? How will firm asymmetries in intrinsic quality and innovation costs affect the welfare-maximizing level of these instruments and how would the policy instrument affect the degree of price competition? Can a combination of uniform instruments achieve welfare-maximizing environmental quality? How would the fiscal implications of a uniform instrument compare to that of differentiated subsidy regime? This paper compares the welfare implications of differentiated subsidies with a combination of two uniform instruments. More precisely, we derive the welfare-maximizing levels of differentiated cost-sharing subsidy rates when price-taking behavior is assumed to be given. We compare these to the welfare levels with a two (uniform) instrument regime that consists of a uniform cost-sharing subsidy and a minimum quality standard and establish their equivalence in achieving a constrained first best level of environmental quality. Next, we analyze how the subsidy rates are affected by various types of firm asymmetries: the intrinsic quality differential between firms, and the relative costs of innovation. Third, we compare total subsidy payments implied by each regime. Our results shed some insights on the impact of each type of firm asymmetry on firm competition, as well as their fiscal implications.
Our results demonstrate the equivalence of a differentiated cost-sharing subsidy regime and the two-part uniform instrument regime in their ability to achieve socially welfare-maximizing environmental quality levels. As the difference between intrinsic quality levels of the two firms increases, the socially desirable level of environmental subsidy increases for the intrinsically high quality firm, and falls for the intrinsically low quality firm. Optimal subsidy levels are lower for the firm with higher costs of innovation, ceteris paribus. We find that the two-part instrument, a minimum quality standard and a cost-sharing uniform subsidy can achieve welfare-maximizing levels; thus a differentiated subsidy regime is not necessary even when firms are asymmetric in their intrinsic quality and costs. Under this two instrument regime, we demonstrate that one firm will always choose to exceed the minimum quality standard to maintain product quality differentiation and ease price competition. Further, the level of the minimum quality standard and level of uniform subsidy depends on the extent of cost heterogeneity and intrinsic quality differential as well. If the cost advantage favors the intrinsically high quality firm, the level of the uniform subsidy will be higher than if the cost advantage favors the intrinsically low quality firm. For moderate levels of cost asymmetry, the quality standard may be set equal to a level that is higher than the quality levels chosen by both firms in an unregulated regime, yet, the firm with the lower private environmental quality will still choose to exceed the standard. The two-part instrument regime will require lower aggregate subsidy payments when the cost-asymmetry is such that it favors the intrinsically low quality firm because the intrinsically high quality firm will require lower subsidy rates to induce it to reach its welfare-maximizing environmental quality level.
Our empirical analysis examine the determinants of the firm’s decision to adopt TQEM, the extent to which TQEM influences the adoption of P2 techniques and the effect of TQEM on the types of P2 techniques adopted by firms (Harrington, Khanna and Deltas, forthcoming). We first investigated the factors that lead to the adoption of TQEM by S&P 500 firms. We hypothesize that the decision of a firm to make environmentally friendly organizational changes could be an outcome of the combined influence of (i) external stakeholder pressures from environmentally aware consumers and public interest groups, (ii) regulatory pressures from environmental agencies, and (iii) internal factors which depend on the production related benefits and costs of making such organizational changes and the capabilities of firms to make them. The internal production-related benefits arise because TQEM emphasizes a systems-based approach towards environmental management. This approach focuses on process management to reduce input waste, which is seen as the cause of pollution, and input use while increasing productivity and value-added activities. These benefits, together with an enhanced potential to respond to external stakeholder and regulatory pressures, constitute the gross gains of TQEM adoption and increase the demand for TQEM by a firm. The adoption of TQEM may also impose production-related and managerial costs, due to a need for process and product modifications, employee training and increased coordination across departments. These costs likely include a large fixed cost component that is unrelated to the level of sales or the level of pollution generated by the firms. These supply-side considerations may reduce the internal ability of firms to adopt TQEM. Throughout the study, we carefully distinguish between demand and supply related factors to obtain a better understanding, at the conceptual level, of the sources of environmentally-related organizational change. We further distinguish between the various components of demand-related factors in order to evaluate whether those of internal origin (i.e., production related benefits) are more important than those of external origin (i.e., those related to stakeholder or regulatory pressure). We find that internal considerations stemming from a firm’s technical capability, size (absolute and relative to competing firms), extent of operations and volume of past emissions are strongly associated with the TQEM adoption decision. The first four factors are proxies for the firm’s costs and capabilities of adopting TQEM while the fifth factor is related to the benefits from increasing efficiency and waste reduction, and thus proxies for internally generated demand for TQEM. The desire to improve a firm’s image with customers, earning good-will with regulators and the anticipation of future regulations do not appear to be associated with the adoption of TQEM. Thus, the paper’s main conclusion is that the adoption of TQEM is associated mostly with internal factors and motives.
In a second paper (Khanna, Deltas and Harrington, 2007) we examine the determinants of the adoption of P2 technologies by firms and in particular the role that TQEM plays in motivating greater adoption of those technologies. This analysis also examines the influence of a firm’s technical capabilities on the extent to which it adopts P2 technologies. First, regulatory pressure from current and anticipated regulations plays an important role in motivating voluntary behavior. In contrast, market pressures are found to have an insignificant effect on firm behavior. Pressure from existing regulations is found to be more important in motivating the relatively cleaner facilities within firms to adopt P2 practices. Second, adoption of total quality management systems does indeed motivate the adoption of more P2 techniques. Thus, managerial innovations, such as adoption of TQEM, lead firms to be innovative in their approaches towards environmental management. Third, technological capability is an important determinant of a firm’s adoption of P2 techniques. Fourth, firms with a relatively smaller volume of toxic releases face higher costs of abatement using P2 methods. To the extent that this is also the case for facilities within firms, it would explain the finding above that regulatory pressures were more likely to motivate the less toxic release intensive facilities to undertake P2. High toxicity-weighted releases in the past do, however, motivate more P2 activities by firms. This suggests that firms do perceive the benefits from preventing such pollution and reducing potential liabilities and public concern. These results indicate that firms’ adoption of TQEM is not simply a ‘greenwash’ or done only to achieve social legitimacy. Such firms are indeed changing their operations to make them more environmentally friendly. While our study cannot shed light on whether strategies to induce voluntary adoption of P2 techniques are sufficient (or more effective than mandatory approaches requiring P2) for achieving the goals of the Pollution Prevention Act, they do show that efforts to encourage voluntary changes in a firm’s management system while maintaining a strong regulatory framework and a credible threat of mandatory regulations can be effective in moving us towards those goals.
In a third empirical paper (Delts, Harrington and Khanna, 2007), we develop a framework to examine how the effect of TQEM differs across different types of P2 technologies. We postulate that the extent and nature of innovation undertaken by a firm depends on its management system which influences the firm’s organizational structure, the extent of employee involvement in decision making and the internal communication channels for information sharing. We analyze the differential impact of TQEM on different P2 technologies and draw implications about the channels through which a management system affects a firm’s operations. Our framework can also be used to evaluate the effect of adoption of the management system on firms with different pre-adoption innovation profiles. Our findings demonstrate that the effect of TQEM on P2 is non-uniform. TQEM supports the adoption of practices that involve procedural changes or that are customized or otherwise do not fall neatly into well established standard categories. We also find that the visibility to consumers or efficiency enhancement attribute of the practice does not incrementally contribute to the effect of TQEM on the adoption of P2 practices. The stimulus provided by TQEM to the adoption of such practices is essentially determined by their functional attributes, either procedural or unclassified/customized. Moreover, the adoption of practices that involve material or equipment modifications is not statistically significantly responsive to TQEM adoption. Furthermore, we demonstrate that these effects are not driven by secular trends that favor one type of P2 activity over another. Lastly, we also find that the adoption of P2 practices is subject to diminishing returns and inertia.
Our findings provide insight on the extent to which policymakers can rely upon corporate environmental management for inducing voluntary P2 and the types of practices that are likely to be adopted by firms. To the extent that other types of practices, such as those requiring changes in equipment or materials are considered necessary to improve environmental quality, policy makers may need to rely on mandatory regulations rather than on promoting the adoption of TQEM by firms. Moreover, our results show that the benefits in the form of technological innovation from promoting TQEM differ across industries, suggesting the usefulness of targeting policy efforts to promote TQEM adoption to firms in particular industries. In particular, we find that industries such as Petroleum Refining and Chemical Products would gain the most in their count of P2 practices from the adoption of TQEM while industries involved in the manufacturing of metals, machinery and electrical equipment gain less from TQEM adoption. Finally, our analysis shows that firms do experience diminishing returns to P2. While there exist some “low hanging fruit”, the potential for incremental adoption of P2 practices of any type is likely to be increasingly costly; thus extent of adoption of P2 practices is likely to diminish over time in the absence of any regulatory stimulus.
We also examine the extent to which the adoption of pollution prevention methods by a facility leads to a reduction in its toxic releases. We undertake this analysis at the facility level instead of the parent company level and use a much longer panel of data to capture heterogeneity among facilities even within a parent company while controlling for unobserved facility-specific factors that might influence the effect of P2 activities on its environmental performance.
Our preliminary results show that the effect of P2 activities on toxic releases varies over time. We fail to find a strong association between voluntary P2 practice adoption and toxic releases. Instead we find a transient negative effect between lagged adoption and toxic releases. Contemporaneous P2 activities are found to be positively and statistically significantly associated with current Toxic Release levels. However, one year lagged P2 activities are found to have a statistically significant negative impact on toxic releases while P2 activities undertaken prior to that however have a statistically insignificant impact in some specifications and a positive significant impact in others. Cumulative P2 activities over the past three years have a negative and statistically significant impact on toxic releases. The mixed impact of the new P2 activities could be indicative of omitted variables from these specifications that are affecting toxic releases and are correlated with P2 activities or of the possibility that P2 activities are focused towards a few chemicals that constitute a relatively small share of a facility’s aggregate emissions. These findings suggest a need to supplement this voluntary approach to pollution prevention to reduce toxic releases with other direct incentives.
Lastly, we examine the economic benefits to firms of voluntarily reducing their toxic releases and adopting P2 activities. We examine the immediate reaction on stock market returns of news about toxic releases and P2 activities using an event study method. We also examine the longer run impact when investor reaction could be capitalized in an increase in the price-earning ratio of the stock.
The event study shows that stock markets reacted negatively to the release of TRI data and firms with higher toxic releases had higher abnormal stock market returns. We then examined the association between the magnitude of the cumulative abnormal return of the firm and its weighted and un-weighted toxic releases, and the moderating effects of pollution prevention activities and features of its environmental management system. We find that the coefficient on total unweighted releases has a negative sign and is statistically different from zero showing that the quantity of pollutants released is negatively associated with firms’ stock market returns. The coefficient on toxicity weighted sum of toxic releases is also Inegative and statistically different from zero showing that the toxicity level of the releases is negatively associated with stock market returns. We also find that more P2 activities are positively associated with stock market returns. Among the various features of the firm environmental management system, we find that compensation to employees for environmental improvement and publication of environmental reports has a positive effect on stock market returns. These suggest that stock market reactions to TRI releases were less adverse in the case of firms that used environmental performance in determining employee compensation or regularly published a corporate environmental report.
Our analysis of the impact of P2 activities on a firm’s price earnings ratio, shows that firms that are emitting positive quantities of toxic releases have stocks that are cheaper to hold: their price-earnings ratios are markedly lower than those of other firms, and the effect is strongly statistically significant. However, undertaking pollution prevention raises the willingness of investors to hold these stocks, holding the stream of future payments constant. This effect is also strongly statistically significant. In particular, a polluting firm with no pollution prevention activities in the past two years trades at a staggering 18% discount over firms that are non-emitters. But if this firm has undertaken 45 pollution prevention activities (the average number over all polluting firms) over the past two years, then the corresponding discount is only approximately 12%. Thus, the pollution prevention partially makes up for the polluting firm discount. This effect is likely to be enhanced if one undertakes the full range of environmentally friendly activities that a firm undertakes, and for which pollution prevention now serves as a proxy. All controls are strongly statistically significant, though (somewhat surprisingly) large firms are cheaper to hold than small firms. These results are still preliminary and further econometric analysis will investigate the robustness of these results to the inclusion of additional firm characteristics as explanatory variables.
Policy Implications
Our theoretical framework shows that in imperfectly competitive markets firms will not have incentives to produce the socially optimal levels of green products even when consumers are willing to internalize a part or all of the environmental externalities caused by their consumption decisions. Several policies can be used to induce firms that are heterogeneous in their intrinsic quality and costs of improving the environmental quality of their products to produce greener products. Regulators can subsidize the firms’ R&D investment costs in making their products and production more environmentally friendly or it can set a minimum quality standard. The cost sharing subsidies can differ across heterogeneous firms or regulators can ignore firm asymmetries and impose a uniform subsidy and a uniform quality standard. We find that the socially desirable level of environmental subsidy should be higher for the intrinsically high quality firm and lower for the intrinsically low quality firm. Optimal subsidy levels should be lower for the firm with higher costs of innovation, ceteris paribus. We also find that a two-part instrument consisting of a minimum quality standard and a cost-sharing uniform subsidy can achieve welfare-maximizing levels; thus a differentiated cost-sharing subsidy regime is not necessary even when firms are asymmetric in their intrinsic quality and costs. The level of the minimum quality standard and level of uniform subsidy depends on the extent of cost heterogeneity and intrinsic quality differential.
A key policy implication of the empirical findings of this study is the importance of strong and credible regulatory pressures in inducing voluntary activities by firms. We find that regulatory pressure from current and anticipated regulations play an important role in motivating adoption of P2 technologies while market pressures are found to have an insignificant effect on firm behavior. For example, firms with more facilities located in counties with a non-attainment status were more likely to adopt P2 practices. However, we find that existing P2 programs in some states that impose mandatory reporting requirements for P2 activities adopted, similar to the federal TRI, and provide technical assistance to firms in the state do not have a statistically significant impact on adoption of P2 practices by firms. We do find some evidence that regulatory pressures targeted towards hazardous toxic releases are more effective than those targeted towards the currently regulated pollutants in inducing the pollution intensive firms and facilities within firms to adopt pollution prevention practices to reduce toxic releases. The results obtained here also highlight the importance of providing technical assistance to firms that may not have the capacity to undertake innovative environmental activities. Our finding that the adoption of total quality management systems does indeed motivate the adoption of more P2 techniques particularly of practices that involve procedural changes or have unclassified/customized attributes suggests that public policies could be focused towards encouraging adoption of environmental management systems by firms. We also find that firms that adopt P2 techniques do have higher price earnings ratios and higher stock market returns. This suggests that educating firms about the economic benefits of pollution prevention may create greater incentives to adopt such techniques. However, our preliminary findings fail to find a strong association between voluntary P2 practice adoption and toxic releases, except possibly a transient negative effect between lagged adoption and toxic releases. This suggests a need to supplement this voluntary approach to pollution prevention to reduce toxic releases with other targeted regulatory incentives.
Journal Articles on this Report : 2 Displayed | Download in RIS Format
Other project views: | All 36 publications | 3 publications in selected types | All 2 journal articles |
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Harrington DR, Khanna M, Deltas G. Striving to be green: the adoption of total quality environmental management. Applied Economics 2008;40(23):2995-3007. |
R830870 (Final) |
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Khanna M, Deltas G, Harrington DR. Adoption of pollution prevention techniques: the role of management systems and regulatory pressures. Environmental and Resource Economics 2009;44(1):85-106. |
R830870 (Final) |
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Supplemental Keywords:
Toxic releases; good operating practices, process and product modifications, waste, spill and leak prevention; technological innovativeness; information disclosure; SIC codes 13, 20, 26,28 29,33,34, 36,37, 38, 45,48,49, 50,51,54,59,72,73,, RFA, Economic, Social, & Behavioral Science Research Program, Scientific Discipline, Sustainable Industry/Business, cleaner production/pollution prevention, Corporate Performance, Economics and Business, decision-making, Economics & Decision Making, environmental management systems (EMS), corporate decision making, environmental management systems, toxic release inventory, decision making, pollution prevention assessment, corporate compliance, cost benefit, environmental evaluation, behavior change, outreach and education, pollution prevention, EMS, environmental behavior, benefits assessment, corporate environmental behavior, corporate cultureProgress and Final Reports:
Original AbstractThe perspectives, information and conclusions conveyed in research project abstracts, progress reports, final reports, journal abstracts and journal publications convey the viewpoints of the principal investigator and may not represent the views and policies of ORD and EPA. Conclusions drawn by the principal investigators have not been reviewed by the Agency.