What Gets Measured Gets Managed: Climate Reporting Mandate for Publicly Traded Companies 

This is a paper written for a public sector economics course at Davidson College taught by Dr. O’Keefe. Written on December 2, 2021.

The US is the second-largest emitter of carbon emissions in the world. Businesses are significant contributors to US’s Greenhouse Gas (GHG) emissions, but they are not currently mandated to report those emissions. Investors increasingly recognize the risk that climate change poses to their portfolio. Requiring reporting would allow investors to assess risk more efficiently, potentially impacting their investment decisions, and thereby incentivize companies to reduce their carbon footprint. The question I aim to answer in this paper is will mandating climate/greenhouse gas emission reporting for public companies reduce gross emissions in the US?

Introduction 

Investors are critical financial stakeholders of corporations, and they are critically worried about the economic impact of climate change. One estimate suggests that climate change-induced disasters could induce over $1 trillion in losses in a single year by 2040 (Sullivan, Russell, Robins, 2008). Public and private risk discourse is becoming more popular as investors recognize that climate change represents a material risk for portfolio management. Thus, since businesses are the leading producers of GHG, they are being asked to account for any environmental harm related to their business processes. Companies in the US are starting to publish public climate change reports, but they are primarily stand-alone sustainability reports with no standardization or verifiable auditing referee. 

For these reasons, governments across the globe are being urged to mandate climate-change reporting. For example, the Companies Act passed in 2006 in the UK required GHG reporting in 2013. There’s no equivalent law in the US, but there is public pressure to adopt one. For example, in 2018, institutional investors with $5 trillion in assets petitioned the US Securities and Exchange Commission (SEC) to mandate standardized sustainability disclosure by public companies (SEC 2020). Most recently, in March of 2021, the Climate Risk Disclosure Act of 2021 was a bill introduced in the United States Senate to require any securities issuers to “report their direct and indirect greenhouse gas emissions and disclose their fossil fuel-related assets” (Climate Risk Disclosure Act of 2021). Currently, the Environmental Protection Agency (EPA) does have the Mandatory Reporting of Greenhouse Gases Rule. Still, this rule only accounts for direct carbon emissions, is industry-specific, and doesn’t require standardized data to be disclosed publicly to investors (US Environmental Protection Agency 2009).

Firms face mounting pressure from various stakeholder groups, including investors, employees, consumers, communities, and regulators, to disclose Environmental Social Government (ESG) related risks. Mandated reporting corrects the economic externality that arises when firms do not internalize the total social cost of their GHG emissions. This rift between the private and social costs of GHG emissions leads to large-scale global market failure. Disclosures have been used successfully in the past to correct for other market failures such as corporate tax avoidance, workers-safety violations, and restaurant hygiene, so they may be helpful in environmental externalities as well. Public GHG reporting could incentivize firms to improve the sustainability of their business — even if it is costly — because of pressure from investors. 

The critical assumption for mandated reporting to be effective is that investors will change their behavior when given more information on companies’ GHG emissions—further, transparency pressures firms to change their behavior to maintain investment. Even though companies are not obligated to put any resources towards sustainability, mandated reporting may incentivize firms to adjust their behavior and force them to internalize their carbon emissions and generate positive social benefits. Requiring reporting is a unique solution to climate change that does not involve direct government management but reduces information asymmetries and allows for the more efficient private allocation of resources. 

Literature Review

Carbon Emissions Impact

In a UK-based study, Downar, Ernstberger, Reichelstein, Schwenen, and Zaklan examined the impact of a disclosure mandate for GHG emissions on firms’ emission levels and financial operating performance. They used a difference-in-difference method and found that firms required to report GHG emissions by the mandate reduced their emissions by about 8%, with no significant changes in their gross margins (Downar, Ernstberger, Reichelstein, Schwenen, Zaklan 2021). Similarly, Jouvenot and Krueger observed how a firm-level carbon disclosure law in the UK affected corporate GHG emissions. They found that firms reduced their absolute GHG emissions by 16% more than other European firms not subject to disclosure requirements. Their results indicated that standardized, prescriptive carbon disclosure mandates lead to more considerable reductions in carbon emissions than voluntary reporting (Jouvenot, Krueger 2019). These two UK studies suggest that mandated reporting effectively reduces emissions without heavy government interference and minimal cost to firms.

In the US, Yang, Muller, and Liang examine the Greenhouse Gas Reporting Program (GHGRP) on electric power plants in the United States. Their working paper uses a difference-in-difference research design and finds that power plants subject to the GHGRP reduced carbon dioxide emission rates by 7%. The effect is more substantial for plants owned by publicly traded firms, indicating that the firms were internalizing their carbon emissions and may have felt pressured by their investors to cut emissions. However, the researchers also found firms would reallocate emissions from GHGRP plants to their non-GHGRP plants, which they interpret as evidence that the program is costly and points to a severe concern for effective implementation of GHG mandates (Yang, Muller, Liang 2021). Overall, their results indicate positive effects on GHG reductions after introducing a mandate. However, because the mandate was not ubiquitous, companies could find loopholes by diverting their emissions rather than reducing them. This form of greenwashing is a concern. Another reason mandated reporting for all publicly traded companies would be more effective is by preventing companies from hiding their actual emissions.

In a different US study, Tomar focused on the EPA’s Mandatory Reporting of Greenhouse Gases Rule enacted in 2010, requiring manufacturing facilities to report GHG emissions. Tomar uses a difference-in-difference study and finds a 7.9% emissions reduction following disclosure. Tomar emphasizes the effect of firms to self-regulate as companies compare their GHG performance to their peers. Interestingly, Tomar finds that disclosure leads to relatively more significant reductions for firms where state senators have progressive voting records on climate change policies. Tomar interprets this evidence to mean that firms are responding to fear of future regulation. At the same time, he finds little evidence of an effect from external stakeholders such as capital markets or the general public. While Tomar’s results show optimistic carbon emission reductions, his research on political pressure suggests that the government is intervening in the market, leading to efficient production.

Private Vs. Public Solutions

Moreover, Christensen, Serafeim, and Sikochi examined how disagreement on environmental, social, and governance (ESG) rating standards can lead to market inefficiency. Using firm fixed effects in a difference-in-differences test, they find that greater ESG disclosure leads to more significant ESG rating disagreement. Greater ESG disagreement is associated with higher return volatility, more significant absolute price movements, and a lower likelihood of issuing external financing. (Christensen, Serafeim, Sikochi 2021). Both Tomar’s findings, along with Christensen, Serafeim, and Sikochi’s results, expose important market issues that could arise from mandating GHG reporting.

Enforced reporting has certain pitfalls. However, voluntary reporting may not effectively hold companies accountable for the environmental externality they create. Crawford and Williams examined whether a government entity should enforce reporting or if private, voluntary reporting is enough. They tested whether countries with higher regulative pressures, such as France, lead to a “minimum‐requirement” type of disclosure or if the free-market systems in the US foment more thorough disclosure. They find that French firms exhibit higher quality disclosure than US firms on average (Crawford, Williams 2010). Similarly, Allman and Won found that after the Non-Financial Reporting Directive (NFRD) was put in place in 2014 in the EU, US firms with activities in the EU mandated by NFRD increased the quality of disclosure by 10%. They are also more likely to comply with the Global Reporting Initiative (GRI) framework, thereby increasing the credibility and comparability of their ESG disclosures (Allman, Won 2021). These two studies measure the quality of reporting and not the GHG impact, but we could assume that the two are highly related. Thus, although there are severe concerns with public mandating, private voluntary reporting may not be robust enough to protect investors from climate-change-related risk effectively. However, it is still unclear whether requiring reporting will elicit a response from investors and firms.

Reporting is an essential means to account for information asymmetries between firms and investors to improve their externalities cost. Indeed, Eccles, Ioannou, and Serafeim studied the effect of corporate sustainability practices on company performance using a matched sample of 180 US companies. They find sustainability-oriented companies significantly outperform non-sustainable firms over the long term, both in the stock market and accounting performance (Eccles, Ioannou, Serafeim, 2014). Their evidence suggests that sustainability-related issues can materially affect a company’s long-term performance. 

Institutional investors are paying close attention to the risks that climate change poses to the financial performance of their investments. Flammer, Toffel, and Viswanathan observe an increasing trend of shareholders voting for climate-related proposals and asset managers asking for greater sustainability disclosure. They found that environmental shareholder activism increases voluntary disclosure for companies not mandated to disclose climate change risks in the US. Further, they find that reporting companies receive higher valuations after disclosing (Flammer, Toffel, Viswanathan, 2019). Flammer, Toffel, and Viswanathan’s findings, in addition to Eccles, Ioannou, Serafeim’s results, indicate that investors do care about the sustainability of the companies they invest in. If the government-mandated reporting, it will likely alter their investment behavior to reward firms that are doing an excellent job at reducing carbon emissions while also forcing companies to invest in sustainability to keep investors interested. 

Lastly, a key concern with public mandated reporting is the impact of a firm’s financial performance. Allman and Won empirically examine the effects of ESG disclosure on investment efficiency. They used a difference-in-difference experimental design using a unique data set of US firms with EU activities that the NFRD forced to report ESG disclosures publicly. They found a reduction in underinvestment for US firms under the NFRD mandate. Without the mandate, firms with small carbon footprints are more likely undervalued by investors. When affected by the NFRD, those firms saw an increase in external investment by 6.3% of total assets compared to US firms not mandated by the NFRD who would have benefited from disclosures. These results are most robust for the firms with initially low levels of ESG disclosure (Allman and Won 2021).

Further, Allman and Won found evidence of the increased quality of disclosures. As discussed previously, that increase in quality leads to the firm’s more efficient issuance of new debt by reducing information asymmetries in the debt market. However, they find no effect of ESG disclosures in the equity market (Allman and Won 2021). Overall, their results suggest that reporting can mitigate adverse selection issues for institutional investors and increase investment efficiency in the market.

Discussion

Overall, I think that mandating Climate/Greenhouse Gas Emission Reporting for Public Companies will reduce gross emissions in the US. Based on solid empirical evidence in the UK and Europe, reporting appears to affect GHG emissions with minimal cost to the company. Isolated studies in the US also indicate a positive impact on reductions in emissions after mandating disclosures. Estimates of the effect indicate anywhere on average from a 7-16% reduction in GHG. A drop in emissions of that magnitude for publicly-traded companies in the US would make a meaningful impact. 

Reporting climate change risks does not inherently reduce emissions, but the effect of making emission performance salient for a company may induce the firm to change its behavior. This is a self-regulating process if the company has environmentally conscious values or possibly believes that its clients care about sustainability — in which case the firm will work to reduce emissions so that they do not lose valuable customers. A firm might also alter its practices due to external pressure from investors who prefer sustainable businesses because they are a less risky investment in the long term. Currently, in the US, there are no mandated climate-change reporting rules in place. However, based on the research presented in this paper, I believe that requiring climate-related disclosure for publicly-traded companies will incentivize firms to reduce their GHG emissions.

Many companies and investors already recognize the benefits of reporting climate-change risk, leading many firms to report ESG disclosures voluntarily. However, these voluntary disclosures are often stand-alone, not standardized, and lack thorough auditing. Mandated reporting enforced by the SEC or other government agencies would allow more comparable and consistent climate-related disclosures. Mandated reporting would enable firms to compare their emissions performance against their peers, encouraging them to invest in sustainable practices if they think it will give them a comparative advantage. Further, with standardized reporting, investors can operate with more transparency of the financial risk of their investments and better account for externalities by reducing information asymmetries. 

In conclusion, mandated climate-change reporting in the US has a high potential to reduce emissions and improve investment efficiency. Businesses are critical players in the transition towards a more sustainable economy. Reporting is an essential first step for firms to internalize their environmental externality.

References

Allman, E., & Won, J. (2021). The Effect of ESG Disclosure on Corporate Investment Efficiency. Available at SSRN 3816592.

Bonnefon, J. F., Landier, A., Sastry, P., & Thesmar, D. (2019). Do investors care about corporate externalities? Experimental evidence. HEC Paris Research Paper No. FIN-2019-1350.

Christensen, D. M., Serafeim, G., & Sikochi, S. (2021). Why Is Corporate Virtue In The Eye Of The Beholder? The Case Of Esg Ratings. The Accounting Review, https://doi. org/10.2308/TAR-2019-0506.

Crawford, E. P., & Williams, C. C. (2010). Should Corporate Social Reporting Be Voluntary Or Mandatory? Evidence From The Banking Sector In France And The United States. Corporate Governance: The International Journal Of Business In Society.

Downar, B., Ernstberger, J., Reichelstein, S., Schwenen, S., & Zaklan, A. (2021). The Impact Of Carbon Disclosure Mandates On Emissions And Financial Operating Performance. Review of Accounting Studies, 26(3), 1137-1175.

Eccles, R. G., Ioannou, I., & Serafeim, G. (2014). The impact of corporate sustainability on organizational processes and performance. Management Science, 60(11), 2835-2857.

Flammer, C., Toffel, M. W., & Viswanathan, K. (2019). Shareholder activism and firms’ voluntary disclosure of climate change risks. Strategic Management Journal.

H.R.2570 – 117th Congress (2021-2022): Climate Risk Disclosure Act of 2021. (2021, May 20). https://www.congress.gov/bill/117th-congress/house-bill/2570

Jouvenot, V., & Krueger, P. (2019). Reduction In Corporate Greenhouse Gas Emissions Under Prescriptive Disclosure Requirements. Available at SSRN.

SEC 2020, May. Recommendation From The Investor-As-Owner Subcommittee Of The Sec Investor Advisory Committee Relating To ESG Disclosure. Securities and Exchange Commission. Available at https : / / www. sec . gov / spotlight / investor – advisory – committee – 2012/recommendation-of-the-investor-as-owner-subcommittee-on-esg-disclosure.pdf.

Sullivan, R., Russell, D. and Robins, N. (2008), Managing the Unavoidable: Understanding the Investment Implications of Adapting to Climate Change. Henderson Global Investors, USS, Railpen Investments and Insight Investment.

Tomar, S. (2019). CSR Disclosure And Benchmarking-Learning: Emissions Responses To Mandatory Greenhouse Gas Disclosure. SMU Cox School of Business Research Paper, (19-17).

US Environmental Protection Agency. (2009). Mandatory Reporting Of Greenhouse Gases; Final Rule. Federal Register, 74(209), 56259-56519.

Yang, L., Muller, N. Z., & Liang, P. J. (2021). The Real Effects of Mandatory CSR Disclosure on Emissions: Evidence from the Greenhouse Gas Reporting Program (No. w28984). National Bureau of Economic Research.

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