Companies are typically not compelled to disclose environmental and social (E&S) information because this information does not meet the materiality standard used in many jurisdictions. However, some shareholders have an explicit mandate to screen potential investments based on E&S criteria. The growing popularity of socially responsible investing, which accounts for more than one in four dollars under professional management in the United States (US SIF 2018), has raised questions about the optimal standard of materiality for E&S information. Recent statements by the SEC’s Investor Advisory Committee indicate that the environmental and social information provided by firms lacks the materiality, comparability, and consistency required by shareholders to make informed investment and voting decisions (SEC Investor Advisory Committee 2020).
Even so, complaints from investors suggest that inadequate E&S disclosure creates information asymmetries between shareholders and managers. Information asymmetries give rise to moral hazard (i.e., incomplete contracting), as managers can more easily renege on commitments to E&S goals. Likewise, information asymmetry creates adverse selection problems in both primary and secondary markets. With insufficient public disclosure, the cost of acquiring E&S information falls on investors, which advantages those with deeper pockets, resulting in an uneven playing field among market participants. These information-based frictions cause investors to ration capital, which leads to a higher cost of raising external equity for firms.
In my new working paper, “Does Environmental and Social Disclosure Affect Firm-Level Innovation? Evidence from Around the World,” I measure how improved E&S disclosure affects firm-level innovation in the context of this information asymmetry problem, as investment in innovation is information-sensitive and is often financed with external equity (Hall 2002, Brown et al. 2009). Improved E&S disclosure could alleviate capital market frictions from information asymmetry, thereby facilitating innovation. On the other hand, mandatory E&S disclosure could reveal information to competitors or lead to new compliance costs or pressure on managers to meet short-term E&S benchmarks, all which could give firms incentives to curb innovative activity.
Outside of the United States, many jurisdictions have adopted regulations that compel firms to report specific environmental or social information publicly. Using data on disclosure regulations from the “Carrots & Sticks” report (Bartels et al. 2016) – a joint project of KPMG, Global Reporting Initiative (GRI), the United Nations Environment Programme (UNEP), and The Centre for Corporate Governance in Africa (University of Stellenbosch) – I identify 87 such regulations in 39 countries that are both mandatory and apply broadly to firms within the country . I use these changes in firms’ disclosure standards around the world to quantify the effect of E&S disclosure on innovation and investigate the extent of financing frictions related to E&S disclosure.
I find that these shocks to E&S disclosure standards have a net positive impact on corporate innovation. Following the adoption of an E&S disclosure regulation, affected firms increase both their “inputs” and “outputs” of innovation. The economic magnitude of the effect is significant. I show that firms affected by mandatory E&S disclosure regulations increase R&D expenditures by 5 percent, relative to the sample mean, in the years following a shock to E&S disclosure. Likewise, I find that patent applications increase by 60 percent, and patent citations increase by 24 percent. Relative to the sample mean, these results represent an increase of three additional patent filings and 10 additional citations, respectively.
The implication is that E&S disclosure mitigates information asymmetry, which eases external financing frictions, enabling a firm to increase innovation. In support of this inference, I document an 11.2 percent increase in seasoned equity issuance in the years after a shock to disclosure. In the cross-section, the effect of disclosure on innovation should be naturally stronger for firms or industries that rely more on external equity to finance investments in innovation. After combining the disclosure shock with various measures of dependence on external equity, I find that the increase in innovation is significantly higher for equity-dependent firms.
Finally, I demonstrate the impact of E&S disclosure on specific adverse selection and moral hazard problems. First, I show that increased E&S disclosure mitigates moral hazard through improved contracting – firms are more likely to adopt an executive compensation contract explicitly linked to E&S measures following a shock to E&S disclosure. This effect is strongest for affected firms that had less E&S disclosure before the adoption of the disclosure regulation. Second, I show that bid-ask spreads, a proxy for information asymmetry between traders, fall after the adoption of mandatory E&S regulation. Thus, E&S disclosure lowers adverse selection costs in the secondary market, resulting in a more level playing field between informed and uninformed traders.
The key insight of this study is that information asymmetries related to a firm’s E&S activities result in less investment in innovation and reduce the use of external equity. Mandatory disclosure of E&S information helps smooth frictions, including incomplete contracting on E&S information and adverse selection among traders, thereby alleviating capital rationing and facilitating innovation. These findings add a new and important dimension for policymakers to consider when debating the merits of adopting or expanding a compulsory E&S disclosure regime.
Bartels W, Fogelberg T, Hoballah A, van der Lugt CT (2016) Carrots & Sticks Report
Brown JR, Fazzari SM, Petersen BC (2009) Financing Innovation and Growth: Cash Flow, External Equity, and the 1990s R&D Boom. J. Finance 64(1):151–185.
Hall BH (2002) The Financing of Research and Development. Oxford Rev. Econ. Policy 18(1):35–51.
SEC Investor Advisory Committee (2020) Recommendation of the SEC Investor Advisory Committee Relating to ESG Disclosure. :1–10.
US SIF (2018) Report on US Sustainable, Responsible and Impact Investing Trends 2018
 An example is Australia’s National Greenhouse and Energy Reporting Act of 2007. This scheme “is a single national framework for reporting and disseminating company information about greenhouse gas emissions, energy production, energy consumption and other information specified under NGER legislation” and requires all corporate groups producing 50 kt or more of greenhouse gases, producing 200TJ or more of energy, or consuming 200TJ or more of energy to disclose (See Appendix B in the paper for a full list of regulatory instruments).
This post comes to us from Brian Gibbons, a PhD candidate in finance at Pennsylvania State University. It is based on his recent paper, “Does Environmental and Social Disclosure Affect Firm-Level Innovation? Evidence from Around the World,” available here.