Institutional Investors’ Views and Preferences on Climate Risk Disclosure
Financial market efficiency relies on timely and accurate information regarding firms’ risk exposures. An increasingly important and pertinent risk exposure relates to climate change, which can originate from natural disasters, government regulation to combat a rise in temperature, or climate-related innovations that disrupt existing business models. Consequently, high-quality information on firms’ climate risk exposures has become a significant component of informed investment decisions and of correct market pricing of the risks and opportunities related to climate change. Furthermore, with climate change being increasingly considered as a danger to the financial system, sound disclosure on climate risks is also essential for regulatory efforts to protect financial stability. However, many regulators and investors argue that climate risk disclosure is currently insufficient.
To address potential shortcomings in current disclosures, regulators, governments, and NGOs have been taking actions to improve firm-level reporting on climate risks. While these initiatives suggest that many investors increasingly require climate-related information for their investment decision making, little systematic evidence exists regarding how institutional investors think about such disclosures. In our paper, we directly survey institutional investors about their views and preferences with respect to climate-related disclosures.
We find that the survey respondents share a strong general belief that climate disclosure is important. In fact, 51% of respondents believe that climate risk reporting is as important as traditional financial reporting, and almost one-third considers it to be more important. Only 22% of respondents regard climate reporting as less (or much less) important compared to financial reporting. Climate disclosure is perceived as more important among those investors who also believe more strongly that climate risks matter, and among those who expect larger temperature increases due to climate change.
Climate change affects portfolio firms through three channels. Physical climate risks arise because of adverse effects of changes in the physical climate (e.g., sea level rises, natural disasters). Technological climate risks originate from climate-related innovations that disrupt traditional producers, and regulatory risks result from costs associated with changes in policies or regulations to combat climate change. With regard to these various types of climate risk, our survey reveals that climate disclosure is deemed most important by those investors that worry most strongly about the financial consequences of the risks for their portfolios. In terms of their relative importance, concerns about physical climate risks matter the most for the perceived importance of climate reporting, while regulatory risks matter the least. An implication of this finding is that disclosure is likely to be most valuable when it enables investors to better evaluate the physical climate risks of firms, which tend to be less visible to investors than the regulatory risks. One reason is that physical risks are generally firm and location specific, thus requiring precise information about a firm’s exposure to evaluate them correctly. Regulatory risks, on the other hand, tend to be firm independent and regulator dependent, and information on such risks is easier to obtain from sources outside of the firm.
The vast majority of our respondents believe that current quantitative and qualitative disclosures on climate risks are uninformative and imprecise. Many investors, especially those that worry more about the financial effects of climate risks, share the view that climate risk reporting should be mandatory and standardized, as is currently the case with financial reporting. They generally believe that the situation could be improved if investors actively pressure firms to disclose more information about their climate risks.
Next, we build on recent work that predicts a link between climate mispricing and disclosure. We find that investors’ opinions on the availability and quality of current climate reporting are strongly related to the perceived underpricing of climate risks in equity markets (i.e., climate-related overvaluation of firms). Notably, respondents who believe that current reporting is lacking also judge there to be more mispricing in current equity valuations. An important consequence of this finding is that better disclosure may contribute to the more efficient pricing of climate risks. This implication is consistent with the view expressed by Michael R. Bloomberg, Chair of the TCFD, that “increasing transparency makes markets more efficient, and economies more stable and resilient.”
The majority of the respondents appear to embrace current developments in climate disclosure as they engage (or plan to engage) their portfolio firms regarding reporting that follows the recommendations of the TCFD. Further, our respondents indicate support for the recent French approach requiring institutional investors to report on the carbon footprints of their portfolios (60% either already disclose or plan to disclose their portfolios’ footprints). This result indicates support for ongoing European Union policy efforts to broaden the French approach to other member states.
To complement our survey analysis, we employ observational data whether the propensity to voluntarily disclose carbon emissions should be greater among firms with higher institutional ownership. Using an international sample of firms, we find that a one-standard deviation increase in institutional ownership increases the probability to disclose emissions to the CDP by 14% (about 83% relative to the unconditional probability). The positive relation between disclosure and institutional ownership is driven by institutions from countries with high social and environmental norms. Higher ownership by institutions from high-norm countries also increases the propensity that firms ask third parties to audit and verify the emissions data they disclosed.