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The Financially Material Effects of Mandatory Non-Financial Disclosure

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Institutional investors argue that principles-based disclosure regimes lack adequate non-financial E&S information. Brian Gibbons finds that disclosing E&S info attracts long-term investors and impacts firms’ decisions.

Image courtesy of interviewee. December 14, 2023

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This video video discusses a study on Environmental and Social (ENS) disclosure, which refers to non-financial reporting by companies to external stakeholders about issues such as climate change impacts, greenhouse gas emissions, and workforce composition. While the U.S. currently lacks mandatory non-financial disclosure requirements, many countries have enacted such regulations, prompting debate on their necessity and effectiveness in providing critical information to investors.

The primary argument is that ENS disclosures can be financially material. The study notes that while companies in the U.S. are only mandated to disclose information that could impact short-term financial performance, there is a significant call for more comprehensive disclosures to help investors make informed long-term decisions.

The research uses data from countries with mandatory ENS disclosure to analyze its effects on institutional investment and firm behaviors. Key findings include:
1. **Increased Institutional Ownership**: Following the introduction of disclosure regulations, institutional ownership in firms rises by about 1%. This video video suggests that institutional investors do indeed prioritize companies with better transparency regarding ENS matters.
2. **Shifts in Firm Investment Policies**: Firms also adjust their investment strategies, with a notable 5% increase in research and development expenditures on innovative projects post-disclosure. This video video indicates a pivot toward longer-term investment without decreasing overall spending.
3. **Increased Equity Issuance**: There is a 15% increase in equity issuance among firms mandated to disclose, suggesting that better disclosure reduces adverse selection problems in financing.

Overall, the study concludes that ENS disclosures are financially material, address information asymmetry in markets, and help attract a specific type of environmentally and socially conscious investor. It argues for the importance of standardized disclosure regulations to mitigate these issues and enhance market efficiency. The insights highlight the transformative potential of non-financial disclosures for both investors and companies.

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X-TIMESTAMP-MAP:LOCAL=00:00:00.000,MPEGTS=900000

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So the study first, let's perhaps define,

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ENS disclosure.

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So, ENS disclosures cover companies reporting to

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outside stakeholders, on a number of topics.

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So these can include how climate change can affect sort

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of assets in place, perhaps the reporting

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of greenhouse gas emission outputs or, or targets

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or reporting on workforce

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composition, these types of things.

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Um, so in, in the study, I refer to this, this type

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of disclosure as, non-financial disclosure

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because it's not the type of information

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that you usually find in standard accounting statements.

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So sort of the backdrop, the context is

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that over the past few years, there's been a big

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ongoing debate, both in the US and worldwide,

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but especially among policymakers here in the US at the SEC,

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on whether the current set

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of financial disclosure requirements,

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in the US provides adequate disclosure on companies

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environmental and social policies.

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So although we don't have mandatory non-financial disclosure

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here in the us, dozens of

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of countries do in some shape or form.

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So, for example, since 2010,

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listed companies in South Africa have been required

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to create an annual report detailing non-financial

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information on greenhouse gas emissions, energy consumption,

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labor practices,

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and how all this information relates

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to financial information that they're reporting.

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So, so currently here in the US we rely on this financial

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materiality standard that says if there's something

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that a air quotes reasonable investor would consider

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important in their investment decision making,

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then a company should disclose it.

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And most of the time, this is just taken to mean anything

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that might affect the company's near term

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financial performance.

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So one school

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of thought in this debate on making non-financial disclosure

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mandatory says, Hey, if it matters to investors,

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then this material materiality standard requires

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that companies should already be disclosing it.

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So nothing really needs to change.

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Like we don't need to burden companies

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with any more disclosure mandates to expand access

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to this type of information.

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And you can understand this concern

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because disclosure costs are real, and,

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and they can be large, especially for,

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for smaller companies.

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But then on the flip flip side,

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major institutional investors are, are,

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have been raising the red flag.

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They're arguing what companies are disclosing out there in

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terms of this environmental

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and social information lacks consistency.

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It's not comparable,

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and maybe most importantly, it's not really enforceable.

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And so they don't have the information needed

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to really assess risks

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and make smart decisions for the long run.

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And, and some policy makers are sympathetic

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to these, to these complaints.

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So the crux of this debate hangs on the issue of whether

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ENS disclosures are financially material.

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And the key here is that even though this info doesn't need

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to necessarily meet the standard

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of directly impacting financial earnings

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of a company in the short term, it could still sway

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Investor behavior, especially those investing

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with environmental and social goals in mind.

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So if that's the case, what I argue in the paper is

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that such an outcomes should be considered

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to be financially material as well when they get

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that information, if their,

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if their decisions are being changed.

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So my research tackles this question of, of materiality,

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both for investors and for companies.

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And as I mentioned before, around 30

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or so countries have mandatory non-financial

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disclosure in some form.

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So I use the implementation

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of those disclosure rules over time

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as a quasi natural experiment

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and look at what happened to both institutional investment

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and firm decision making

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as these rules were rolled out over the past 20 years or so.

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So there's this classic problem in finance

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called adverse selection.

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Uh, probably most listeners are aware of it.

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It's like walking into a market not knowing if the milk

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you're buying is fresh or spoiled.

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'cause you don't have the info about

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how long is it's been sort of sitting there on the shelf.

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So if that's the case, you might just

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skip the milk altogether.

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So this uncertainty causes investors in financial markets

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to also pull back from companies

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and then leads to higher cost of capital,

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higher borrowing costs, higher costs of,

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of issuing equity for companies, which then in turn leads

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to missed investment opportunities.

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So reia back in 2001 talked about

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how disclosure can help alleviate,

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this adverse selection problem.

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So in this setting, we're taking

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what we already know about financial disclosure

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and applying it to non-financial disclosure.

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So we already know that if financial disclosure quality

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improves adverse selection problems are eliminated or,

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or at least mitigated, and firms will then material change

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their financing and investment choices as a consequence.

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So if environmental

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and social disclosures matter to investors

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and help them make better projections

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of a company's cash flows or understand long-term risks,

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or even keep a closer eye on how managers are,

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are managing the firm, then more transparency could actually

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lower the cost of capital for firms,

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by reducing these adverse selection issues.

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So it's, it's all about making investments less

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of a gamble for outside investors.

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Christensen and,

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and others brought up a another angle a few years ago,

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they said, Hey, what if the act of disclosing this type

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of information itself pulls in a certain type of investor,

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firms that are open about their environmental

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and social policies might attract investors

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who care about the same issues.

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Okay, so Fama and French also talked about this back in

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2007, calling this idea sort of a clientele effect.

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It's like changing the crowd

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that's in interested in your company.

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And this isn't really small potatoes we're talking about

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here for investors with these types of preferences.

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Um, for example, iShares has a very large, the name

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of its ESG Aware ETF, that invest in US companies,

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and they don't even invest in any firms

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that don't disclose carbon emissions.

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Okay? So there's big pools of capital

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that you're missing if you're, if you're not disclosing.

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So the impact of ENS disclosure isn't just about reducing

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these information asymmetry or adverse selection problems.

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It could also be about attracting a whole new investor base

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that cares about these type of things.

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Okay? So these, these classic adverse selection problems

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apply to non-financial information has led to some,

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some really, I think, fascinating research

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on ESG disclosures.

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Um, so that's sort of the classical background.

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Now we're applying it to, non-financial information,

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these ESG disclosures.

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So researchers have been looking at

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how voluntary ENS disclosure

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and policies, can affect investors

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and firms for, for really over a decade now.

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So researchers like L Goul and co-authors and

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and Chava, in 2011

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and 2014 observed that better EENS policies are associated

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with a lower cost of equity.

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Um, so what they and others have shown is sort of a big deal

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because it suggests, though it doesn't prove

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that transparency in these matters can make a firm more

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attractive to outside investors.

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Then there's also evidence

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that disclosing ENS information does attract investors

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who have specific ENS preferences.

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So studies by researchers like,

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seraphim in 2015 highlighted

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that better voluntary disclosure policies do in fact

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attract ENS investors.

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However, when disclosures are voluntary,

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when firms are just making them on their own,

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there can be sort of problems with causality.

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So when firms are choosing to disclose voluntarily,

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it's only the firms that expect the benefits of transparency

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to exceed the costs that are gonna choose to disclose,

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or maybe firms that are doing good in the first

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place, right?

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Or perhaps these firms already have, shareholders,

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environmentally minded shareholders that push them

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to disclose, and in fact, the relationship works in,

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in reverse, whereas shareholders pushing for disclosure,

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not disclosures, attracting shareholders.

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So it's problematic

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to draw strong conclusions when disclosure's voluntary,

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and that's part of the advantage of using

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mandatory disclosure regulations

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as a setting like I do in this paper.

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Another recent work that actually focuses on the effects

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of mandatory disclosure regulations.

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Uh, but most of these studies have focused on

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how the disclosure mandate improves the quality

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of the disclosure itself.

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So it does forcing companies

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to disclose on environmental stuff,

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actually make them disclose on environmental stuff.

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Um, INU and Seraphim did this in 2017.

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There's also, a strain of the literature that shows

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how these disclosures create positive environmental

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and social outcomes like reduced pollution,

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improve workplace safety,

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or decreased investment in corrupt countries.

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So my work's really building on this foundation

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of adverse selection, disclosure, quality material effects,

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and explores how these dynamics play out in the real world

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across lots of different disclosure regulations when

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disclosure is in fact mandatory.

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But in this paper, I lean on the carrots

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and sticks database for information about

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non-financial reporting standards.

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It's a pretty cool resource.

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It is originally put together from a joint project

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between KPMG, the Global Reporting Initiative,

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or GRI, the United Nations Environmental Program

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and the Center for Corporate Governance in Africa.

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And what it does is it compiles ENS disclosure policies

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and regulations from over 130 countries

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in 40 different languages.

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So you can think about it as an ever, ever-evolving snapshot

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of how different countries

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and institutions are approaching ENS

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reporting around the globe.

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So this is really an excellent resource for researchers.

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I mean, especially I I don't speak 40 languages,

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to read through all these rules.

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So it's super great that they have

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that, compiled for us.

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So from that data set, I narrow in on mandatory

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national disclosure regulations that apply broadly

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to publicly traded companies

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and observe how different outcomes evolve

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after they're implemented.

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Um, there are a few, there are a few caveats

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with using this broad dataset,

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and the biggest challenge is really

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that the dataset doesn't capture every nuance

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of the regulations or the subtle ways

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that companies interpret, these rules.

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So each country has its own approach

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to rolling out ENS disclosure rules,

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including what's covered,

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and enforcement of those rules.

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So some countries might be really detailed in their

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reporting requirements and strict in their enforcement,

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while others may not be all right.

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So this data gives some idea of, of what the rule is,

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but doesn't go into very deep detail.

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So effectively, researchers, including myself,

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treat the rules mostly

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as interchangeable when in reality they can look quite

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different from place to place.

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Um, all across the world.

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However, countries are, are working on new sets

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of more detailed standardized ENS reporting requirements,

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that align with disclosure recommendations by

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institutions like the task force on climate

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related financial disclosure.

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Um, so for example, companies in 27 EU member states will

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have to be compliant with this TFCD standards due

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to the eus new corporate sustainability reporting directive

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that was adopted early in 2023.

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And then the uk, China, the US, are also trying

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to closely align their disclosure frameworks

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to the TFCD standards.

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So I suspect in the next round of research

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that investigates the impact of this new new set

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of disclosure standards, they'll have much more comparable

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and consistent rules to examine.

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So my research, starts by examining

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how ENS disclosure affects institutional ownership.

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Since these are the groups most strongly pushing

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for increased ENS disclosure requirements, I wanted

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to see first whether or not

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mandated changes change their investing decisions.

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Okay, so, so, I find that

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after a new disclosure, rule,

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an ENS disclosure rule kicks in institutional ownership

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increases by around 1% relative to similar firms that are,

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that are not forced to disclose.

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And this is a big deal because it's the first time we've

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seen causal evidence that institutional investors actually

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increase investments in firms with better

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ENS disclosure quality.

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Um, this is the result across all institutional investors,

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by the way, not just investors

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with specific ENS preferences.

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So I'll touch on those results in a second,

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but this result demonstrates that, these types

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of investors, institutional investors,

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aren't just engaging in cheap talk by asking

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for stricter disclosure requirements,

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but not really acting on them.

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They actually do care about the information

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and it materially affects their decision making.

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So next I look at

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how ENS disclosure impacts firm investment policies.

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So here it's hypothetically, sort of a bit of a toss up

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or a tug of war on one side.

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Better disclosure can lower the cost of external financing,

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like I talked about before,

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with this adverse selection problem, enabling the firms

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to take on more profitable, pro profitable projects,

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if they're getting more outside investment for cheaper.

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On the flip side, there's the cost of complying

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with these disclosures, which may limit the cash firms

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actually have on hand to invest in new projects.

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So it's not initially clear,

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how firms will respond in terms of their investments

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after being mandated to disclose.

12:46.525 --> 12:47.825
In, interestingly, I find

12:47.825 --> 12:49.865
that firms ramp up their investments in

12:49.865 --> 12:51.105
innovation post disclosure.

12:51.285 --> 12:52.345
So we're talking about

12:52.345 --> 12:54.865
around a 5% increase in RD expenditures,

12:54.865 --> 12:56.545
which is a pretty significant jump.

12:57.285 --> 12:59.225
Um, overall investment doesn't change.

12:59.225 --> 13:02.225
However, firms are just shifting the mix of their projects,

13:02.285 --> 13:04.985
to more long-term innovative projects without actually

13:04.985 --> 13:08.025
cutting down on total investment spending or increasing.

13:08.765 --> 13:11.785
Um, there's been some work recently, some sort

13:11.785 --> 13:15.825
of follow-up work, by valier and co-authors and Bratton

13:15.825 --> 13:17.545
and co-authors that follow up on these results

13:17.545 --> 13:19.865
and dig even deeper into what types of r

13:19.865 --> 13:21.825
and d companies that are mandated

13:21.825 --> 13:23.105
to disclose actually are undertaking.

13:23.565 --> 13:26.265
And they're showing that a lot of the RD

13:26.265 --> 13:27.585
this effect can be explained

13:27.605 --> 13:29.385
by increases in green innovation.

13:30.085 --> 13:31.665
And I think that's an important finding.

13:31.935 --> 13:34.185
It's sort of in line with both my result here

13:34.605 --> 13:36.545
and probably what you'd expect from companies

13:36.545 --> 13:39.345
who are perhaps lagging behind on green innovation.

13:39.365 --> 13:41.225
The, the disclosure sort of out stem.

13:41.455 --> 13:46.015
Okay, and they have to catch up next, I look at,

13:46.015 --> 13:47.255
firm's financing decisions.

13:47.755 --> 13:49.695
So after disclosing environmental

13:49.715 --> 13:53.015
and social info, I find that firms are issuing more equity,

13:53.515 --> 13:56.775
about 15% more, than average to be,

13:56.795 --> 13:57.815
to be a little bit more precise.

13:58.275 --> 14:01.695
So combined with this previous result showing an average

14:02.135 --> 14:04.935
increase in overall institution institutional investment,

14:05.685 --> 14:07.855
this increased equity issuance suggests

14:07.855 --> 14:11.615
that these disclosures may reduce this general adverse

14:11.855 --> 14:13.535
selection problem that that might be going on.

14:14.635 --> 14:17.215
But when I dive deeper to investigate the mechanism

14:17.215 --> 14:20.175
behind these results, I find that classic measures

14:20.175 --> 14:22.655
of adverse selection, like bid as spreads,

14:22.955 --> 14:24.575
are actually unaffected on average.

14:25.275 --> 14:27.895
Um, instead it seems to be that the change

14:27.955 --> 14:31.255
of the investor base towards investors with environmental

14:31.275 --> 14:34.335
and social preferences, who also by the way, tend

14:34.335 --> 14:36.535
to be longer, longer term oriented investors,

14:36.565 --> 14:39.095
they're not trading in and out of stocks.

14:39.095 --> 14:42.935
They're buying and holding this change in the investor base

14:43.065 --> 14:45.015
leads firms to change their own behavior.

14:45.555 --> 14:48.455
So firms with the largest jumps in these types of investors

14:48.995 --> 14:53.085
pre to post disclosure then also see the largest jumps in

14:53.085 --> 14:55.085
long-term r and d and new share issuance.

14:56.145 --> 14:58.045
So, so we have this sort of trio

14:58.345 --> 15:01.565
of financially material effects in response to disclosure,

15:01.905 --> 15:04.085
one, external investors' preferences and,

15:04.085 --> 15:05.245
and their decision making change.

15:05.865 --> 15:07.765
Two companies are shifting their,

15:07.775 --> 15:09.725
their internal investments,

15:09.805 --> 15:12.005
towards more long-term projects and r and d

15:12.745 --> 15:15.845
and three companies are raising more equity from

15:16.045 --> 15:17.085
external, investors.

15:17.865 --> 15:20.645
So all three of these effects are occurring primarily due

15:20.645 --> 15:24.365
to these shifts in institutional clientele towards ownership

15:24.635 --> 15:27.125
from investors with EENS preferences

15:27.225 --> 15:29.045
and longer term investment horizons.

15:30.025 --> 15:32.285
So I think the takeaway from this is pretty straightforward.

15:32.965 --> 15:35.085
ENS information is financially material.

15:35.465 --> 15:38.525
So despite arguments to the contrary, a lack

15:38.525 --> 15:41.645
of ENS disclosure creates information based frictions.

15:42.265 --> 15:44.205
And the evidence from the impact

15:44.205 --> 15:46.285
of all these disclosure regulations

15:46.345 --> 15:49.005
and rules from around the world supports the view that

15:49.515 --> 15:52.605
more rules based disclosure standards, more prescriptive,

15:53.065 --> 15:55.365
standards, can meaningfully reduce these,

15:55.415 --> 15:57.925
these ENS related information frictions,

15:58.135 --> 16:00.405
which then has material effects on both investors

16:00.745 --> 16:01.485
and companies.

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