Columbia Law School
Sky Blog
The Financial Economist Roundtable (“FER”) met in July 2021 to discuss current efforts to measure and require disclosure of firms’ ESG activities.[1] The views of individual FER members about specific issues often differ, but the consensus was that financial regulators should be cautious in mandating disclosures.
Public comments by the current SEC commissioners suggest two opposing views: (1) increase disclosure substantially to include disclosure of environmental outcomes or (2) maintain the status quo because current rules for disclosing material risks cover environmental and social (E&S) activities. We recommend increased disclosure, but we also recommend that the SEC not mandate disclosure of the firm’s impacts on E&S outcomes. The SEC should instead mandate disclosures on cash flows and cash flow risks related to E&S activities.
Existing calls for ESG reporting often fail to distinguish between two goals: (1) understanding the impact of E&S activities on the firm’s cash flows and (2) understanding how the firm’s activities affect the environment and society. Distinguishing between the two is essential because the SEC’s mandate covers only the first.
The second goal – helping readers understand how firms’ activities affect society – results, at least in part, from frustration with the lack of legislative and regulatory action on E&S issues. In the absence of legislative action, proponents of SEC disclosure mandates want the SEC to enter the arena. They assume, without widely-accepted evidence, that the registrants’ disclosures would empower consumers, workers, and investors to pressure firms and lead to positive changes in firms’ E&S-related activities. The SEC should not yield to pressure from proponents of mandated disclosures about firms’ E&S-related societal impacts, and the U.S. Congress should not require the SEC to mandate such disclosures.
Using the SEC as a tool to promote environmental and social change creates significant potential costs, with questionable benefit. First, any product and capital market pressures for firms to change their behaviors that arise from mandated disclosures impose a cost on firms. The burden of this cost would likely fall unequally on firms and among the different stakeholders of most firms. Second, what gets measured gets managed. By setting requirements for firms to disclose specific E&S outcomes, the SEC would involve itself in setting E&S priorities, potentially making the SEC a political tool. Third, burdensome disclosure requirements will drive some public companies to become private and limit other firms’ willingness to go public. This incentive could inhibit capital formation, contrary to the SEC’s mandates to facilitate capital formation and efficient markets.
In summary, we see no clear benefits resulting from the SEC’s involvement with societal impact disclosures, yet such disclosures create significant costs. Agencies such as the EPA, Labor Department, and EEOC are better equipped to set reporting requirements for outcomes such as carbon emissions or workforce diversity, and their regulations apply to a broader set of firms.
So much for what the SEC should not require. The SEC should require a registrant to disclose its E&S-related cash-flow impacts in its 10-K (or 10-KSB). We encourage the SEC to encourage the use of quantitative disclosures and to require well-defined language, either by creating its own glossary of terms or requiring that firms define terms.
We distinguish two sources of E&S-related cash-flow impacts. The first is events or activities by parties or forces outside a firm. For example, the firm’s assets in place may be subject to increased frequency and severity of natural disasters due to climate change. Consumer preferences for “green” products may affect sales. Current rules require disclosing these sorts of valuation-relevant risk factors. Thus, the incremental cost of separately disclosing the cash-flow impacts of material E&S risk factors is minimal, and most FER members believe the benefits for investors are large.
The second source of E&S-related cash-flow impacts comes from a firm’s internal decisions to decrease its adverse societal impacts or to enhance its positive impacts. For example, the firm can invest in greener technology or forgo investments in brown assets. The firm can maintain its equipment more frequently, reducing its impact on the environment. Such investments and expenditures decrease the firm’s current cash flows and are therefore relevant to investors, but current SEC disclosure rules do not require their separate reporting. E&S expenditures require special monitoring because the benefit does not accrue to the firm in terms of net cash inflows. Rather, the value of the investment benefits society. If the firm makes these sorts of investments, investors will find the information relevant whether they support such investments or want to avoid firms that make them.
Separately, we recommend that the SEC require reporting entities that refer to ESG ratings also disclose the rater, the factors in the rating, and the weights given to rating factors. If an entity uses a proprietary ESG rating system and objects to disclosing the inputs and weights, it should disclose to investors that the system is proprietary. Investors can then decide whether to invest in a fund with hidden ESG rating attributes. This mandate would cover the use of ratings in any SEC filing, including by corporate issuers who highlight their own ratings, perhaps selectively, and by asset managers, including ESG mutual funds and ETFs that market themselves based on their ESG status. The FER believes full disclosure of rater, factors used in rating, and factor weights is superior to regulator certification of ESG rating agencies or methods.
Taken together, these recommendations will result in disclosures that are more verifiable, comparable, and informative.
ENDNOTE
[1] One of the first decisions of the group was to focus only on environmental and social (E&S) disclosures. E&S activities, which involve actions taken by the firm, are different from the governance, or “G,” component of ESG, which reflects the standards by which the firm oversees and monitors.
This post comes to us from Jonathan M. Karpoff at the University of Washington’s Michael G. Foster School of Business, Robert Litan at the Brookings Institution, Catherine M. Schrand at the University of Pennsylvania, and Roman L. Weil at the University of Chicago. It is based on their recent article, “What ESG-Related Disclosures Should the SEC Mandate?” available here.
There is an underlying assumption in this argument, that the issuers’ impact on the social and environmental systems is of general public interest, but not of interest to investors.
Yet, 75-94% of return to a diversified investor is related to non-diversifiable systematic risk (depending on which academic study you’d like to cite), not the risk of the individual security. So the health of the capital markets matters. A major source of systematic, non-diversifiable risk to the capital markets stems from risks to the environmental and social systems.
What the authors fail to consider is that that the way investors invest has changed since the SEC was established. The majority of investors today invest in a diversified manner, so the health of the overall market matters. The assumption — which goes unexamined by the authors — is that investors care about various things that affect cash flows of an individual company, because they invest in that company. Certainly, we do. But we also care about the company’s impact on the social and environmental systems. because we are diversified.
There is a legitimate question of which metrics would help investors understand how an issuer affects the health of the overall market and which would be a significant burden on an issuer without commensurate benefit to investors, but that is not their argument. Instead, they dismiss the possibility that a company’s “inside-out” impact on the market could be relevant. Indeed, they never even consider that what a “reasonable investor” (to use the Supreme Court phrasing) wants in terms of disclosure has changed, because the nature of being a reasonable investor has changed.
It seems that you have ignored how investors and cash flows may be impacted by customer, supplier, and lender choices.
If a company was required to disclose that it was perhaps entirely legally — and without giving rise to any liability — dumping toxic waste in another country that was injuring people, its customers could say — for reputational, moral, or other reasons — “we don’t want to do business with them.”
That would, of course, impact cash flows.
However, ithe disclosure itself that would be triggering the customers’ decisions to change behavior.
And yet, it seems you argue that the SEC authority could not mandate such a disclosure. This would be despite the fact that the disclosure would be informing market participants to make more informed decisions about where and how to engage in commerce.
Let’s take it out of the abstract and make it more political. Are you saying that the SEC couldn’t require disclosure of political spending, even though companies are facing direct revenue impacts based on their political spending choices and affiliations?
Can’t an investor be interested in his company being boycotted over a political spending choice? Or is that another area where the SEC has to pretend that investors don’t have to worry about the suppliers, customers, lenders or others who do business with the companies they own.
Cash flows depend on all of them, too.