Mandatory vs. Voluntary ESG Disclosure, Efficiency, and Real Effects

In recent years, several countries have imposed disclosure requirements on public firms for environmental, social, and governance (ESG) performance. These mandates have also been accompanied by the European Union’s wide-reaching Non-Financial Reporting Directive, effective in 2018 (Directive 2014/95/EU). Similar legislative attempts to impose mandatory ESG disclosure have been made in the U.S. For example, in June 2021, the U.S. House passed the Corporate Governance Improvement and Investor Protection Act (HR 1187), which includes ESG-metrics disclosure requirements for public companies and allows enforcement of these requirements by the SEC. At the same time, a sizable portion of public firms in the U.S. voluntarily release information related to their ESG activities and social responsibility.

The rising prevalence of ESG disclosure and the laws that mandate it point to a few natural questions. First, it’s important to understand how mandatory or voluntary disclosure affects the investment decision of firms. That is, what are the real investment effects of either voluntary or mandatory ESG disclosure? Second, how do these two separate disclosure regimes compare in terms of efficiency? In other words, when is mandatory ESG disclosure better for shareholders, and vice versa?

We explore the above and related questions in our recent paper “Mandatory vs. Voluntary ESG Disclosure, Efficiency, and Real Effects.” In particular, we develop a simple economic model to investigate the interdependence of investment decisions and ESG disclosure under two different disclosure regimes, voluntary and mandatory (we discuss the distinction shortly). Our model has the following intuitive components. A firm manager (“she”) makes a project decision that is not observable to investors. She can invest in a traditional (non-renewable) project, which produces high expected future flows and also produces a high negative social externality (such as carbon emissions). Conversely, the manager can invest in a sustainable (clean) project that produces a low negative social externality but is met with lower future expected cash flows. Following the project decision, the manager with some probability receives information regarding the project’s success along each dimension – ESG performance and future cash flows. Under the voluntary regime, she can disclose both pieces of information, or either or neither piece, as she sees fit. In the mandatory regime, the manager must disclose ESG quality, but she continues to have discretion over the disclosure of future cash flows. Finally, the firm’s shareholders have heterogeneous preferences: Some investors (“financial investors”) care only about financial performance of the firm, while other investors (“social investors”) care about both the firm’s social and financial performance. The manager seeks to maximize aggregate shareholder welfare based on the proportion of each kind of investor in the firm’s shareholder base.

We solve for the manager’s optimal investment and disclosure strategy under each regime and then provide efficiency and welfare analyses. Among our efficiency results, we find that mandatory disclosure is met with greater over-investment in the sustainable technology relative to the first-best efficient level. Put differently, under mandatory disclosure, the manager often adopts the clean project even if this is the overall less-preferred project among shareholders, and thus results in lower aggregate shareholder welfare. Under voluntary disclosure, we find that either over- or under-investment in the clean technology can occur, depending on the likelihood that the manager receives information and the relative portion of social investors. Hence, both regimes carry inefficiency in the manager’s investment decision, however the type of inefficiency varies by regime.

To better understand the implications for shareholder welfare, we examine when one disclosure regime enhances efficiency more than the other does. The results show that voluntary ESG disclosure can be efficiency enhancing for shareholders under certain conditions. Specifically, when the fraction of social investors among the firm’s shareholders is sufficiently low, the voluntary regime minimizes investment distortions. However, when the fraction of social investors is sufficiently high, the mandatory regime is efficiency enhancing. An additional important result we find is that mandatory ESG disclosure results in a greater prevalence of sustainable investing. This result implies that a within-country or within-region shift from a voluntary ESG disclosure regime to a mandatory disclosure regime should increase sustainable investments among firms, on average. A number of recent papers have documented that firms produce less-negative externality (such as carbon emissions) following ESG disclosure mandates; our results provide theoretical underpinnings for this recently documented empirical regularity.

Our framework also provides a number of novel empirical predictions that may help to guide future research. These include predictions regarding cross-industry (or cross-firm) variation in clean technology adoption, likelihood of disclosure, and level of investment distortion. Additionally, our efficiency results suggest that shifts in the disclosure regime may have differential (i.e., non-monotone) effects on firms in terms of efficiency, based on the composition of their shareholder bases.

The recent rise in ESG considerations among institutional and retail investors has led to heightened demand for ESG information. Some firms have met this demand by voluntarily disclosing ESG information. Likewise, legislative bodies around the world have implemented disclosure mandates. Our study helps us to better understand the economic effects of ESG reporting under both kinds of disclosure regimes.

This post comes to us from professors Cyrus Aghamolla at the University of Minnesota – Twin Cities and Byeong-Je An at Nanyang Business School, Nanyang Technological University. It is based on their recent paper, “Mandatory vs. Voluntary ESG Disclosure, Efficiency, and Real Effects,” available here.

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