Signaling Through Carbon Disclosure

Patrick Bolton is Barbara and David Zalaznick Professor of Business at Columbia Business School, and Marcin T. Kacperczyk is Professor of Finance at Imperial College London. This post is based on their recent paper.

Twenty years ago, a few visionary NGOs (most prominently the Carbon Disclosure Project (CDP)) started tracking corporate carbon emissions, the main cause of global warming. By now over 1700 publicly traded companies around the world (more than 15% of all listed companies) are disclosing their carbon emissions, and investors are better informed than ever about the climate change transition risks they are exposed to. Yet, the role and effects of carbon disclosure are still not fully understood. In this study, we take a systematic look at carbon disclosure by studying the (stock) market effects of firm-level carbon emission disclosures.

Whether and how carbon disclosures matter is not fully known, but many prominent commentators agree that reporting of carbon emissions is a crucial step in combatting climate change. Michael Bloomberg, the first chairman of the Task Force on Climate-Related Financial Disclosures (TCFD) has stated that: “Without reliable climate-related financial information, financial markets cannot price climate-related risks and opportunities correctly and may potentially face a rocky transition to a low-carbon economy…” Yet, a recent HSBC study found that even though “A key goal [of disclosure] is to give investors more information about which companies are prepared for the shift to a low-carbon economy, and which are not… in practice, investors have shown more muted interest in the data that is generated. An HSBC survey of 2,000 investors found that just 10 percent viewed the disclosures as a relevant source of information.”

Why are most firms reluctant to disclose their carbon emissions? Could it be that for most firms, carbon disclosure is just an irritant without visible benefits? And for those firms that do disclose, what benefits do they obtain from providing this information to investors? Are they able to lower their cost of capital by disclosing their emissions? These are some of the basic questions we address. Other questions suggest themselves depending on the answer to the previous question: if firms aren’t able to lower their cost of capital, why do they still choose to disclose their carbon emissions, and if they are able to lower their cost of capital, why aren’t more firms choosing to disclose their emissions?

Common sense suggests that firms voluntarily disclose information only if they benefit from revealing what they know. This logic has powerful implications and can set free revelation dynamics that eventually bring about the revelation of all relevant information to investors (this is known as the unravelling result). Of course, this striking result only holds under some assumptions, the most important being common knowledge, the absence of any disclosure costs, no agency conflicts at the issuing firm, and an equal ability to process the disclosed information by investors.

Even though some (or all) of these assumptions are unlikely to hold all the time in practice, the accounting literature has struggled to explain why firms withhold so much information, even information that would shed a good light on their operations (in particular, favorable information about their carbon emissions). Disclosure of carbon emissions could be motivated by firms’ desire to act in a socially responsible manner. By disclosing their emissions firms may seek to shape social perceptions about their environmental impact more than signal a stronger financial performance. By this social-perceptions motive, one would expect firms with lower emissions to be more likely to disclose other things equal. On the other hand, disclosing carbon emissions may possibly involve higher costs, as emissions must be tracked, measured, and aggregated. The fixed costs of implementing the processes of measuring and reporting emissions may be deemed to be too high at many small and medium-size firms. There are also potentially indirect costs specific to the disclosure of carbon emissions, such as giving investors a ready variable on which to base their exclusionary screening policies, or possibly attracting unwelcome political attention.

Another effect of disclosure is greater financial market efficiency. When there is more publicly disclosed information there is by implication less private information available that informed traders could trade on. Also, more standardized disclosed information could facilitate relative performance evaluation. These considerations lead to the general prediction that the cost of capital will be lower when more information is disclosed, since (uninformed) investors will face lower uncertainty and therefore demand lower returns. Does this prediction also hold for carbon disclosures? Does carbon disclosure reduce uncertainty and the cost of capital?

We test whether voluntary carbon disclosure affects stock returns (our proxy for the cost of equity) on a large panel of over 14,400 listed companies in 77 countries over a long time period, 2005 to 2018. It is important to explore this question over both a long and recent time-interval because investor awareness about carbon transition risk has evolved over time, so that the effects of carbon disclosure may be different over different time periods. Similarly, there is substantial variation across countries in financial market development, disclosure regulations, and underlying carbon transition risk, that the effects of carbon disclosure are likely to vary substantially across all countries in our data. One important aspect we explore is whether carbon disclosures in one country has spillover effects in other countries.

Although consistent with one of the most robust predictions of the accounting theory on disclosure, our first general finding is still remarkable: we find that even when it comes to carbon emissions, disclosure significantly lowers the stock returns investors demand for bearing risk. This effect is most pronounced with respect to reported changes in emissions (what we describe as short-term carbon transition risk), and somewhat less significant for disclosed emission levels (what we describe as long-term carbon transition risk, given that levels of emissions are highly persistent). The fact that disclosure of emissions levels has a smaller effect on the cost of capital is not entirely surprising given that investors can already gain most of the information about long-term carbon risk from estimated emission levels provided by Trucost and other carbon data providers. This effect of carbon disclosure is robust and holds across all countries in our sample. Yet, there is substantial heterogeneity in the cross-section, with the strongest disclosure effects found in North America and Asia, and the weakest in Europe.

What is the effect of carbon disclosure on firms’ subsequent behavior? Does disclosure discipline firms to emit less? Most of the studies on ESG disclosures cannot address this question because ESG performance prior to disclosure is unknown. However, we can evaluate whether there is a difference in effects between estimated and subsequently reported emissions around the first disclosure date. We can also test whether disclosure disciplines companies to reduce their emissions. Interestingly, we find no significant disciplining effect and conclude that the reduced cost of capital following carbon disclosure does not appear to be driven by moral hazard.

Given that carbon disclosures reduce stock returns required by investors, why aren’t all listed companies disclosing their emissions? We mentioned the fixed transaction costs of disclosing emissions, which may discourage the smaller firms. Another possible cost we explore is that carbon disclosure may attract attention and lead institutional investors to divest. Indeed, we find that firms with higher disclosed emissions have lower institutional ownership, which could explain why some firms prefer not to disclose and stay under the radar of institutional investors that apply exclusionary filters based on disclosed carbon emissions.

If only around 12% of listed firms in our sample disclose their emissions, should carbon disclosure be mandated? A prerequisite to address this question is, of course, a welfare framework with which to assess the costs and benefits of mandatory disclosure. If the transaction costs of carbon disclosure could in principle be easily quantified, it is more difficult to determine the benefits. Although there is no general theory of mandatory disclosure, one robust general prediction seems to be that more mandated information disclosure results in lower uncertainty for uninformed investors. Is this also the case for carbon disclosures? We address this question by taking advantage of a quasi-natural experiment, the introduction of mandatory carbon disclosure in the U.K. in October 2013. Before carbon disclosures were mandated a significant fraction of U.K. companies was already voluntarily disclosing carbon emissions.

We find that around 20% more firms disclosed their carbon emissions immediately following the introduction of the new rules and that the effect of disclosure has been to significantly reduce stock returns for these firms. However, an additional striking finding is that the newly disclosing firms with the largest levels of emissions see their stock returns increase. In other words, the worst carbon performers among the newly disclosing firms were penalized by investors, who demanded higher returns after they were surprised to find that these firms had higher than average emissions.

What is the effect of carbon disclosure on other firms? Are there any spillovers? Does disclosure invite disclosure? The quasi-natural experiment of the U.K. mandatory carbon disclosure rules introduced in 2013 allows us to also explore these questions. The more firms disclose, the greater the accuracy of estimated emissions of non-disclosing firms. Another externality operates through investor engagement: the more firms disclose the more investors are likely to demand disclosure of other firms. A first question we look at is whether the introduction of mandatory carbon disclosure in the U.K. has had spillover effects on other countries. We find surprisingly strong spillover effects. The largest effects are on European companies, but even Asian companies are affected. Finally, we explore peer effects of disclosure and whether an individual firm’s disclosure decision is affected by past disclosure decisions by its peers. We find a strong peer effect, particularly for peers within the same industry.

In conclusion, voluntary emission disclosures lead to a significant reduction in the cost of equity capital and thus suggest that there is room for more disclosures by more firms. There are many other benefits from greater disclosure that we are not capturing in this study. With more systematic disclosure asset managers will be in a better position to manage the carbon footprint of their portfolios, banks will be better able to assess their exposure to carbon transition risk, and carbon data providers will be able to estimate more accurately the direct carbon emissions of non-disclosing firms, as well as the indirect emissions firms are exposed to in the supply chain or are generating through the use of their products.

The complete paper is available for download here.

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