Should climate disclosures be more like financial disclosures? 

Financial market efficiency relies on the disclosure of timely and accurate information regarding firms’ risk exposures. However, research suggests that many institutional investors believe that publicly listed firms currently provide insufficient information regarding an increasingly relevant risk: climate risk. For instance, in a co-authored paper in which we surveyed institutional investors worldwide, we found that the large majority of responding institutions believed that current management discussions of climate risks were insufficient and that the available quantitative information regarding firms’ exposure to climate risks was also lacking. Furthermore, about three quarters of the surveyed institutions held the belief that more information regarding firms’ climate risk exposure was required and that standardization and mandatory reporting was a necessary step forward.

Current firm-level climate disclosures are provided in inadequate quantity, are of insufficient quality, and also lack much needed standardization

Perhaps as a result of the recognition that current firm-level climate disclosures are provided in inadequate quantity, are of insufficient quality, and also lack much needed standardization, several proposals have been made recently to improve the state of climate-related disclosures. For instance, the Securities and Exchange Commission has released a draft proposal that would mandate and standardize climate disclosures for publicly listed firms in the United States. In parallel, the European Financial Reporting Advisory Group (EFRAG) issued the first draft of the European Sustainability Reporting Standards, which--if adopted--would introduce requirements for many firms to disclose climate-related information in a standardized way. In a similar spirit, the International Sustainability Standards Board (ISSB), the body of the IFRS Foundation tasked with the development of sustainability-related financial reporting standards, has also proposed a set of climate-related disclosure standards.

While the abovementioned proposals differ in many respects, they also share a common element in that they aim to improve and standardize firms’ disclosures of climate-related information by means of prescription. An important concern surrounding any change to existing reporting requirements is a proper understanding of the potential effects that these changes could entail. It is difficult to predict the exact effects of introducing mandatory, prescriptive, and standardized climate disclosure requirements. However, we can try to gauge the potential effects of such requirements by learning from the experiences of countries that have already introduced such disclosure requirements in the past.

Standardized disclosures allow firms to better assess their own GHG emissions relative to that of their peers, pushing firms to reduce GHG emissions.

A point in case is the United Kingdom, which--through the Companies Act 2006 Regulations 2013--made the standardized disclosure of greenhouse gas (GHG) emissions a mandatory requirement for UK firms listed on the Main Market of the London Stock Exchange. Because of the uniqueness of the regulation, the UK experience has been widely studied in both accounting and finance. Using slightly different approaches, samples, and settings the research generally suggests that the law caused a stronger reduction of GHG emissions among UK firms relative to firms that were not affected by the disclosure requirement. The research also suggests that the disclosure regulation facilitated across firm comparisons through standardization, thereby leading to emissions reductions. Specifically, standardized disclosures allow firms to better assess their own GHG emissions relative to that of their peers, pushing firms to reduce GHG emissions. The role of ‘benchmarking’ and peer effects in driving GHG emissions reductions is confirmed by other research focusing more on mandatory GHG requirements at the plant-level.

When it comes to the financial effects of the UK regulation, the conclusions differ across studies. Some research suggests that the mandatory disclosure requirement did not lead to changes in the operating performance of the concerned firms. However, other research points to a regulation induced reduction in operating performance for the most highly emitting firms. The latter is consistent with the view that the most GHG emitting UK firms reduced emissions through costly operational adjustments after mandatory disclosure requirements were introduced. The differences in the conclusions regarding the financial implications of the regulation could be--at least partially--due to the slightly different study designs.

Beneficial effects such as higher liquidity and lower bid-ask spreads as well as lower volatility for the firms most affected by the regulation.

While most of the research studying the financial effects of the regulation have focused on accounting based measures of financial performance, other research has evaluated possible capital markets implications. These studies also generally document beneficial effects such as higher liquidity and lower bid-ask spreads as well as lower volatility for the firms most affected by the regulation.

So what can be concluded regarding the initial question of whether introducing mandatory climate-related disclosure requirements for firms was a good idea or not? In a sense, such regulation aims to apply principles that typically govern financial disclosures to the realm of non-financial disclosures. In general, financial disclosures of publicly listed firms meet several requirements: they are mandatory, standardized, available in regulated disclosure documents, and audited. Nobody would disagree that these requirements are critical for the functioning of efficient capital markets. In contrast, when it comes to climate-related information, firm-level disclosures rarely meet these requirements. Studying a unique legal change in the United Kingdom that essentially introduced mandatory, standardized, and prescriptive carbon disclosure for listed firms, several research papers document beneficial effects such as reductions in firm-level GHG emissions or lower volatility, suggesting that introducing mandatory carbon disclosure for firms is probably a good idea. The alternative would simply leave us with a soup of selective and questionable voluntary disclosures, on which we could determine very little from future research regarding its efficacy in combatting climate change.