How Market Efficiency Plays a Role in ESG Disclosure

Proponents of ESG have recently had to contend with several developments that, at first blush, appear inconvenient. Investor support for ESG-focused shareholder proposals seems to have declined year-on-year, and some investors have abandoned ESG-themed funds while others have withdrawn from private sector coalitions promoting action on ESG goals. Is investor demand for ESG – long considered its driving force – on the wane? If so, does that undermine regulators’ case for mandating climate-related and other ESG disclosure?

The answer to both questions is no. As I discussed in a recent article, the indicators of investor demand, murky even under the best of circumstances, are often misunderstood when it comes to ESG. The case for ESG disclosure, moreover, does not hinge on a finding of investor demand. Rather, market efficiency – encompassing both securities-price accuracy and overall capital market allocative efficiency – is a compelling, standalone justification for ESG disclosure. It is supported by finance theory and recent empirical research as well as by the SEC’s rulemaking practice and judicial doctrine. Put simply, ESG disclosure is essential to the market and not contingent on investor demand.

Interpreting Investor Demand for ESG

The high level of investor interest in ESG disclosure, ESG stewardship, and ESG investing has offered a persuasive datapoint in the policy and academic debates over ESG. For example, a 2022 analysis of the positions of 320 investors who collectively own or manage over $50 trillion in assets revealed that 97 percent support requiring climate disclosure on Form 10-K, 99 percent support requiring disclosure of Scope 1 and Scope 2 emissions, 97 percent support the qualified Scope 3 disclosure requirement contained in the SEC’s proposal, and 98 percent support governance disclosures related to board and management oversight of climate risk. Upon the release of the climate proposal, SEC Chair Gary Gensler noted that “investors with $130 trillion in assets under management have requested that companies disclose their climate risks.” This evidence suggests that investor demand is real and near universal, but declining support for ESG shareholder proposals, outflows from ESG funds, and withdrawals from private coalitions seems to provide evidence to the contrary.

ESG Shareholder Proposals. According to ISS data, the median level of support for environmental proposals in 2023 was 16 percent, down from 25.5 percent in 2022, and 49.4 percent in 2021. Another source puts the average level of support for environmental proposals in 2023 at 20 percent, down from 34 percent in 2022. A third sourcenotes that only 3 percent of environmental proposals in 2023 received majority support, down from 32 percent in 2021. Support for social proposals has experienced a similar drop. Unsurprisingly, these declines have been described as “catastrophic” and have served as ammunition for opponents of ESG disclosure.

The reality is more complicated and considerably less gloomy. First, there is substantial heterogeneity in ESG proposals, both at different firms and from year to year, which makes aggregate data on shareholder support and multi-year comparisons suspect. Second, each year some of the most viable shareholder proposals are withdrawn as a result of settlements between management and the proposals’ proponents. According to the Conference Board, 31 percent of all ESG proposals in 2023 were withdrawn – a staggering figure when viewed alongside the very low withdrawal rates, generally less than 5 percent, for proposals in other areas. Finally, in certain cases, pro-ESG and anti-ESG proposals are counted in the same category. The number of anti-ESG proposals has risen, but they receive very little support (generally around 3 percent), and combining them with pro-ESG proposals skews the numbers.

Outflows from ESG Funds. According to data from Morningstar, U.S. investors withdrew $5.1 billion from ESG funds in the fourth quarter of 2023. This amount was offset only partially by net inflows from Europe amounting to $3.3 billion, leading to the first instance of global net outflows in a given quarter. It would be both superficial and premature, however, to interpret this as an indicator of a permanent decline in investor demand for ESG. Here, too, precision is key. Even if the outflows suggest a rebalancing of investors’ interest in ESG-labeled funds, this says nothing about investor demand for ESG disclosure. The relevance of ESG disclosure is not limited only to the firms that find themselves in ESG funds; rather, ESG risks (e.g., climate change) apply to most firms across the economy, and investors seek to understand these risks regardless of their level of investment in ESG funds. Moreover, the scarcity of standardized and accurate ESG information and the resulting greenwashing – at least partly a function of the roadblocks before the SEC – likely contribute to asset managers’ difficulties in formulating active ESG strategies or even assembling passive ESG funds that are truly “ESG.”

Investor Withdrawals from Private “Net Zero” Coalitions. Apart from the push for ESG disclosure, the broad ESG landscape also includes investor-led campaigns to encourage firms to reduce their emissions to zero on a net basis over decades. Three large U.S. asset managers withdrew from one of these initiatives, Climate Action 100+, in February 2024, while another one scaled back its participation. Similarly, several large insurers withdrew from the Net-Zero Insurance Alliance in 2023. Though newsworthy, these actions are neither troubling nor illuminating with respect to investor demand for climate-related disclosure. They indicate only that some financial institutions may be losing their appetite for climate-related activism, in the sense of influencing their portfolio firms’ and counterparties’ emission reduction plans, which tells us nothing about their demand for climate-related disclosure. In both instances, the withdrawals were linked to political pressure and opposition to ESG.

The Market-Essential Role of ESG Disclosure

The discussion above demonstrates that investor preferences on ESG matters are like investor preferences on many other matters – dynamic, heterogeneous, and difficult to divine and aggregate. This need not doom the case for ESG disclosure, however, because market efficiency provides an additional and separate justification.

Finance theory suggests that the more information that is incorporated into the price of a security, the more that price correctly anticipates the future prospects of the company. Price accuracy is important at the level of the individual investor, whether active or passive, and in the aggregate because it ensures that capital will be allocated to its highest-valued users. Empirical evidence about the links between climate information and firm valuations has started to emerge as well. For example, Bolton & Kacperczyk (2021) find that carbon emissions significantly affect stock returns. Bolton, Hale & Kacperczyk (2022) report that “financial markets are beginning to broadly discount companies whose high carbon emissions are viewed as subjecting them to higher levels of political and regulatory risk,” which, in turn, translates into a higher cost of capital. There is also evidence that investors incorporate climate-related information in sophisticated ways when valuing firms.

If securities prices are sensitive to climate-related information, as this evidence suggests, then accurate and comparable information is needed to ensure the accuracy of securities prices and overall allocative efficiency within the economy. It is worth recalling that a number of SEC- and judge-made doctrines in securities law and in state corporation law are premised on the informational efficiency of securities prices. Price accuracy is also a foundational element of investor protection since price is the most significant term of most, if not all, securities transactions.

With the SEC expected to issue final climate-related disclosure rules this month, it is important to focus on the many legitimate justifications for disclosure, understand the complexity of investor demand, and dispel critiques that zero in on what appears to be declining support for ESG shareholder proposals, outflows from ESG funds, and the changing membership of private sector coalitions. And, of course, the debate over climate-related disclosure will not conclude once the  SEC finalizes its much-criticized rules, since the rules are expected to be challenged in court. Moreover, these same critiques will likely be repeated in future disclosure rulemakings, including any potential rulemaking on enhanced human capital management disclosure.

This post comes to us from Professor George S. Georgiev of Emory University School of Law and is based on his recent article, “The Market-Essential Role of Corporate Climate Disclosure,” which appeared in the UC Davis Law Review and is available here

Leave a Reply

Your email address will not be published. Required fields are marked *