Governments, regulators and stock exchanges worldwide are increasingly introducing compulsory disclosure requirements on companies in respect of sustainability information.

In this study, Ioannis Ioannou (Assistant Professor of Strategy and Entrepreneurship at London Business School) and George Serafeim (Jakurski Family Associate Professor of Business Administration at Harvard Business School) examine the effect of mandatory sustainability reporting by studying the disclosures and market valuation of companies in China, Denmark, Malaysia and South Africa immediately before, during and after the introduction of compulsory reporting legislation.

Their findings suggest that, contrary to popular belief that an increase in disclosure regulation imposes significant costs on companies and, therefore, has a negative impact on shareholders, the reality is that improved disclosure creates value for companies, not destroys it.

The study

The authors compared the levels of disclosure by companies in the four countries over the two years prior to, and the two years following, the introduction of mandatory reporting on environmental, social and governance (ESG) issues. They then mapped this against the valuation of the companies over the same period, using Tobin’s Q (a measure of stock valuation that divides the market value of a company by the replacement value of a company’s assets).

By comparing the results with separate control groups of US and worldwide companies, the authors found that mandatory sustainability reporting:

  • significantly increases the level of ESG disclosure, even if regulations are on a comply or explain basis;
  • increases the likelihood that companies will get their ESG information independently verified;
  • increases the probability that companies will voluntarily adopt ESG reporting guidelines;
  • improves the valuation for companies that respond to the regulation by increasing ESG disclosure.

“[We] did not find any evidence that, on average, the disclosure regulations adversely affected shareholders.”

Using Bloomberg ESG survey data, the authors identified a sample group of 317 companies across the four countries, with an aggregate market capitalisation of US$2,820 billion. Taking account of company size, profitability (return on assets), leverage (total liabilities over total assets), market expectations about growth opportunities (Tobin’s Q), the level of ESG disclosure and industry membership (financial vs. non-financial sectors), they compared against a control group before and after the introduction of disclosure regulation.

Strong responses

Even though the regulations often allowed companies, via comply or explain clauses, to choose not to make greater disclosure, there was a 30%-50% average increase in ESG disclosure as a result of the regulations being introduced (albeit from a low starting base). The greatest increase came in the first year of the regulations coming into force. All three types of disclosure – environmental, social and governance – increased.

Following regulation, companies are significantly more likely to get their disclosures verified (assured) by an external reviewer and adopt the reporting guidelines issued by the Global Reporting Initiative, irrespective of whether regulations instructed them to do so. This shows that companies not only increase disclosure following regulatory change, but also voluntarily look to improve the credibility and comparability of those disclosures.

The authors argue that companies deciding to incur the costs of external verification, even when not prescribed to do so “are more effective in signaling to stakeholders their commitment to sustainability and, therefore, in distinguishing themselves from other firms that may be greenwashing”.

Whilst there was an absolute increase in disclosure across the companies studied, those with already high levels of disclosure were more likely to seek independent verification or adopt reporting guidelines. The authors believe this to be driven by: a commitment to transparency and a desire to distinguish themselves from others once all companies are forced to disclose; and lower cost as they already have experience with ESG reporting so have systems for collecting and collating data already in place.

Leaders and laggards

The level of ESG disclosure prior to regulation varied widely, and the way companies responded when regulation came into effect differed between the three types of disclosure (environmental, social and governance).

Leaders in environmental disclosure further widened the gap over their rivals after regulation. Leaders in social disclosure maintained the existing gap over laggards. Laggards in governance disclosure increased significantly to catch up with the leaders.

This is likely because governance data is easier and cheaper to collect and release. For example, while information on board or compensation levels is readily available, information on environmental impact or employee metrics is more difficult to obtain.

The authors found significant results to indicate an increase in value (measured by Tobin’s Q) for companies that increased disclosure following the regulation.

“By increasing disclosure and potentially affecting ESG management practices, the sustainability disclosure regulation generated longrun benefits for companies that responded by increasing disclosure”.

There is a stronger association with an increase in value for those companies with a lower level of disclosure prior to the regulation than their counterparts that already had high levels of ESG disclosure. This suggests the net benefit from additional ESG disclosure diminishes. However, this is not an excuse for complacency as companies were found to still be disclosing below the levels at which the costs would outweigh the benefits.

Where next?

This paper paves the way for research into understanding how companies change resource allocations and investment decisions as a response to changes in disclosure regulations. While disclosure regulations in some cases increase the supply of such nonfinancial metrics, we still know little about how they affect the demand across different stakeholders.

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    RI Quarterly vol. 7: Unleashing performance through reporting and disclosure

    May 2015