Here is the first in a series of regular articles on current academic research into a range of sustainable investment topics. The papers discussed were presented at the latest annual GRASFI conference.
Compelling academic papers
The Global Research Alliance for Sustainable Finance and Investment is a collaboration of universities committed to producing high-quality interdisciplinary research and teaching curricula on sustainable finance and investment. In this series, we highlight compelling papers presented at the latest GRASFI conference, with a comment from a ‘practitioner’ at BNP Paribas Asset Management.
As the sustainable investor for a changing world, BNP Paribas Asset Management sponsors GRASFI’s efforts to bring academic rigour to the challenges of sustainable finance and investment. Through its sponsorship, BNPP AM is able to access leading academic research into sustainable finance and investment, helping to inform the broader debate. Our goal is to share these reflections with clients and the industry. Visit the GRASFI Conference website.
The conference’s winning paper – The effects of mandatory ESG disclosure around the world
As the dangers of environmental, social and governance (ESG) risks have been broadly explored and acknowledged, many countries have imposed mandatory rules on companies to report more information on these issues in their financial disclosures or standalone sustainability reports.
One driving factor is the need to improve the supply of information by companies to investors and other stakeholders, whose demands for more disclosure on ESG risks have grown both considerably and rapidly. However, has mandatory ESG disclosure really made any difference?
‘The Effects of Mandatory ESG Disclosure around the World’, the research paper rated the best submission and awarded the BNPP AM sponsored Best Paper Prize, found that mandatory disclosure of ESG information improves the level of reporting and has numerous informational and real effects, while the average quality of ESG reports stays roughly the same.
The analysis by Philipp Krueger, Zacharias Sautner, Dragon Yongjun Tang and Rui Zhong is based on an international dataset of mandatory ESG disclosure regulations between 2000 and 2017 that were introduced in 25 countries including Australia, China, and the UK.
The research also looked at how mandatory ESG disclosure affects the information set that key market participants use when evaluating firms.
Mandatory ESG reporting – More, but not necessarily better
According to the study, the percentage of companies that file ESG reports in the Global Reporting Initiative (GRI) database, which allows investors to easily access and bulk-download ESG reports, increases by 56% after ESG disclosure is made mandatory.
However, the authors found that, on average, such regulation has no effect on the quality of ESG disclosure reports. They measured this by checking if the reports adhered to the GRI’s reporting guidelines.
While they could not find a strong reason to explain why this was the case, they noted that firms with lower ESG reporting quality made significant improvements after ESG disclosure was required.
The level of reporting depends on several factors. Mandatory disclosure will have a bigger effect on smaller firms as they are less likely than their larger peers to have voluntarily disclosed ESG information before. The authors found that smaller firms – as well as those with lower ESG quality – are more likely to file ESG reports after mandatory disclosure is introduced.
Conversely, larger firms – as well as those smaller companies with better ESG policies – may have already voluntarily disclosed ESG information before the introduction of rules. This is also the case for international firms. This may be because they have stronger motives to disclose on ESG to a wider audience and are more exposed to stakeholder scrutiny.
Benefits for market participants
Even if mandatory disclosure increases the availability of ESG reports, does it improve the information used by financial market participants to value firms?
The author’s findings indicate that ESG disclosure regulation is beneficial.
Mandatory ESG disclosure has positive informational effects on market participants because it increases “the availability and quality of firm-specific non-financial information”, thereby improving the information used to forecast earnings, the report said. Also, the mandatory nature of the disclosures “could reduce ambiguity about the fundamentals of a firm.”
The authors said the accuracy of earnings per share forecasts by financial analysts improves significantly after disclosure becomes mandatory, and forecasts become less dispersed.
Fewer ESG disasters
Meanwhile, negative ESG incidents, such as the 2010 spill in the Gulf of Mexico, become less likely after ESG disclosure is introduced. The researchers measured such incidents using a proxy constructed by RepRisk based on media reporting about negative ESG events.
A reduction in negative ESG events can lower the risk of stock price crashes, according to the report. Indeed, after mandatory ESG disclosure is introduced, the likelihood of stock price crashes decreases by about 26%, the authors found.
The significance of these events falls after mandatory disclosure because news about them is transmitted faster to markets. “When accumulated bad ESG news reaches a tipping point and [is] released to the market all at once, such batch-releases can result in sharp stock price declines,” said the authors.
Since mandatory disclosure regulations accelerates ESG information disclosure through ESG reports, crash risk may decline after mandatory disclosure.
The authors conclude that mandatory ESG disclosure regulation improves the corporate information environment and lead to real effects.
Given the numerous benefits that mandatory ESG disclosure regulation brings, this supports the argument for changes in countries that do not have mandatory ESG disclosure regimes.
The authors’ evidence shows that the gap between supply of and demand for ESG information may be bigger for firms headquartered in common law countries, suggesting a greater need for mandatory ESG disclosure regulation in those countries.
“This important research confirms that enhanced disclosure of ESG information can inform idiosyncratic or company-specific price discovery for investors. But it also importantly demonstrates that information access can reduce systemic risk by reducing the likelihood of market crashes. While some regulatory jurisdictions are already moving to enhance ESG disclosure requirements, hopefully this new research will help bring those on the fence onto the other side, particularly regulators with systemic risk management in their mandates.”