In response to extreme weather events, regulators and standard setters are developing climate-related reporting requirements and standards. The thinking behind making disclosure of firms’ climate-related risks mandatory is that it will allow the market to price these risks, thereby using market discipline to prompt companies to reduce the pollution they create. However, the mandatory nature of these disclosures is controversial  for several reasons.

First, it may have little benefit, given that firms already voluntarily disclose climate-related information in their financial statements. Second, measurements of climate-related risks are unreliable, meaning mandatory disclosures might impede rather than enhance market discipline. Third, disparities in climate reporting across different countries could lead to an unintended consequence – greenhouse gas-emissions leakage – as firms might relocate their production to countries with less stringent reporting policies, resulting in an overall increase in emissions.

In a  recent paper, we establish an economic framework for delving into these issues. Our analysis employs a model where firms have the option of producing domestically or outsourcing to foreign suppliers. Production creates direct greenhouse gas emissions (e.g., Scope 1 emissions) if it occurs domestically and indirect emissions (e.g., Scope 3 emissions) if outsourced. These activities have short-term benefits but long-term environmental costs related to transition and physical climate risks. Transition risks are associated with managing and adapting to change for reducing emissions, while physical risks stem directly from climate change and its acute or gradual impacts.

Our study focuses on the genuine effects of climate-related disclosures. These disclosures allow market participants to accurately price firms’ climate risks, in turn compelling firms to internalize the environmental impact of their production plans and thereby mitigate excessive pollution. Importantly, there are significant global disparities in the quality and consistency of climate-related reporting. Developed countries like the U.S. and the European Union impose stricter reporting standards within their jurisdictions, while emerging markets often lack detailed climate data and quality reporting mechanisms.

The divergence in climate-related reporting becomes a fundamental force behind the analysis, particularly in relation to emissions leakage. Our study compares two regimes: direct emissions reporting, which requires firms to report only their own environmental impacts, and commingled indirect emissions reporting, which requires firms to report both their own impacts and those of their foreign suppliers. The precise measurement of direct emissions is within the domestic regulator’s control, while the measurement of indirect emissions from the foreign supplier is a given.

The results of our analysis indicate that firms tend to over-produce and over-pollute when they fail to internalize environmental impacts, particularly in relation to physical risks. Although firms have an incentive to voluntarily disclose their climate performance, our study asserts that voluntary reporting is insufficient, as firms do not fully internalize the long-term environmental losses caused by climate risks. Consequently, mandatory climate reporting shows greater efficacy in enhancing efficiency compared with voluntary reporting.

However, the effectiveness of mandatory climate reporting in sustaining market discipline depends significantly on the precise measurement of direct and indirect emissions. More precise disclosure of firms’ direct emissions disciplines their domestic production choices, reducing direct emissions. Likewise, more precise disclosure by foreign suppliers of total indirect emissions curbs firms’ indirect emissions. However, more precise disclosure of direct emissions can result in emissions leakage, prompting firms to outsource production to places with less accurate measurement and pricing of environmental impacts.

To counter emissions leakage, our study explores the possibility of mandating the disclosure of information on firms’ indirect emissions. While such disclosures mitigate emissions leakage, they also lead to reverse emissions leakage, prompting firms to shift their production to areas with more lenient disclosure requirements. Our study suggests that requiring indirect emissions disclosures becomes beneficial only if direct emissions disclosure is sufficiently precise. Our analysis emphasizes that direct emissions disclosure complements rather than substitutes for indirect emissions disclosure.

A crucial policy implication is that a domestic regulator should coordinate the precision of direct emissions disclosure with the precision of indirect emissions disclosure across different jurisdictions. Our study advises against unilateral increases in emissions disclosure requirements in developed countries, considering the sparse emissions data in developing countries that are part of the global supply chain. It further asserts that regulators should decide whether to mandate indirect emissions disclosure based on individual cases.

Finally, our analysis compares commingled and separated regimes of indirect emissions reporting, highlighting that the effectiveness of separated reporting depends on the reliability of measuring and allocating emissions to individual firms and their exposure to different climate risks. Industries primarily exposed to transition risks could benefit from separated reporting, while those facing physical risks might find commingled reporting more appropriate.

Our detailed analysis sheds light on the complexities and challenges of climate-related disclosures, revealing the need for a coordinated, global approach in policy decisions to ensure effective and equitable management of environmental impacts across various industries and jurisdictions.

This post comes to us from professors Lucas Mahieux at Tilburg University’s School of Economics and Management, Haresh Sapra at the University of Chicago’s Booth School of Business, and Gaoqing Zhang at the University of Minnesota’s Carlson School of Management. It is based on their recent paper, “Climate-related disclosures: What are the economic trade-offs?’’ available here.