In a new paper, we discuss our findings on how ESG disclosure mandates affect IPO underpricing – the tendency of IPO share prices to jump on the first day of trading – which is a substantial cost of going public.

Underpricing stems from the asymmetry of information among participants in the IPO process (Ritter and Welch, 2002; Ljungqvist, 2007). Because IPO firms are young, little information about them is available, and investors require IPO underpricing to help compensate for the risk this lack of information creates. Thus, IPO underpricing should be less when there is a way to provide more and better information about the IPO firm. It is less, for instance, in countries that promote high-quality accounting information (Boulton et al., 2011), practice greater accounting conservatism (Boulton et al., 2017), or have more pre-IPO media coverage (Chen et al., 2020).

If ESG disclosure provides non-financial information that helps investors better to value IPO firms, they will demand less compensation for bearing IPO information risk, thus leading to lower IPO underpricing. Recent research shows that mandatory ESG disclosure increases stock liquidity through mitigating information asymmetry, and investors have incorporated ESG information into their investment decisions (Avramov et al., 2022; Cao et al., 2022; Gibbons, 2023; Krueger et al., 2023). Therefore, it can be argued that ESG disclosure leads to lower IPO underpricing.

Yet, ESG information is complex, and ESG ratings vary widely among the agencies that provide them (Berg et al., 2022). Further, “greenwashing,” falsely claiming that a firm’s ESG performance is strong, is common. As a result, IPO investors may not value such information because it can distort their judgments about IPO firms. Grewal et al. (2019) find that the market reacted negatively to the the European Union’s directive requiring more ESG disclosure. Thomas et al. (2022) finds that firms with higher environmental ratings are more likely to increase pollution levels to meet short-term earnings targets. Therefore, it can be argued that ESG disclosure has no effect on, or even increases, IPO underpricing.

In our paper, we exploit a sample of 17,891 IPOs across 40 countries from 1998 through 2021 to examine the impact on IPO underpricing of ESG disclosure mandates implemented by 26 countries between 1998 and 2021.

We first examine whether mandatory ESG disclosure affects IPO underpricing. We find that IPO underpricing decreases significantly following the implementation of mandatory ESG disclosure. On average, a firm going public in a country with mandatory ESG disclosure (“adopting country”) experiences a decrease of about 23 percent in its first-day IPO return relative to a firm going public in a country without such disclosure (“non-adopting country”). We conclude that mandatory ESG disclosure is associated with lower future IPO underpricing.

We then look at how IPO underpricing has decreased following the adoption of mandatory ESG disclosure. First, we find that mandatory ESG disclosure reduces information asymmetry at both firm and country levels. Specifically, we find that the effect of mandatory ESG disclosure is weaker for IPO firms that have less information asymmetry or are listed in countries where more and better information about companies is available.

We next investigate whether IPO firms listed in adopting countries attract institutional investors with ESG preferences. Because those investors are willing to accept less compensation from firms with strong ESG performance (Barber et al., 2021; Pastor et al., 2021), mandatory ESG disclosure may reduce IPO underpricing through this “institutional investor-clientele” effect. We focus on institutional investors because they have been increasingly pressured to invest in firms with strong ESG performance or avoid firms with poor ESG performance (Azar et al, 2021; Ilhan et al, 2023). We find that IPO firms listed in adopting countries have more institutional investors at the end of the IPO year. Further, institutional ownership at the end of the IPO year is negatively associated with IPO underpricing.

We also investigate the role of country-level institutional characteristics in moderating the relationship between mandatory ESG disclosure and IPO underpricing. First, we focus on climate risk because it affects a firm’s financing choices and ESG disclosure policies (Huang et al., 2022). We find that IPOs in countries with greater climate risk are associated with higher IPO underpricing, and the impact of mandatory ESG disclosure becomes more pronounced for IPO firms from high-climate-risk countries.

Second, we analyze societal secrecy – the tendency to not share information with outsiders (Gray, 1988) – because IPO underpricing is higher in countries that have it. (Chen et al., 2022). We find that the impact of ESG disclosure mandates is stronger in those countries.

Third, we look at country-level governance and ESG performance because those factors affect IPO underpricing (Chen et al., 2022; Baker et al., 2021). We find that the effect of ESG disclosure mandates becomes weaker for IPO firms listed in countries with better corporate governance and stronger ESG performance.

Finally, we look at whether each of the three aspects of ESG disclosure – and whether variations in the regulatory design of ESG disclosure mandates – affects IPO underpricing and find that each is associated with a reduction in IPO underpricing. The impact of mandatory ESG disclosure remains regardless of whether a government authority or a stock exchange mandates an ESG disclosure policy.

Our study shows that mandatory ESG disclosure affects IPO underpricing as it facilitates information flows among IPO participants, leading to lower levels of IPO underpricing. Our findings imply that investors incorporate non-financial information into their equity valuation.

This post comes to us from Lien Duong, Hoang Luong, Lily Nguyen, and Zeyu Wang at Curtin University and the University of Queensland. It is based on their paper, “Mandatory ESG disclosure and IPO underpricing around the world,” available here.