Many investors, regulators, and policy makers complain that we have too little firm-level information on firms’ environmental, social, and governance (ESG) profiles to make informed investment decisions. In response, several countries have initiated mandatory ESG disclosure regulations that force firms to disclose information on ESG issues. On top of these country-level initiatives, there are significant efforts at the global level to design, harmonize, and eventually mandate international ESG disclosure standards. Most relevant are probably the initiatives by the International Sustainability Standards Board (ISSB), which has launched a first set of proposals on ESG reporting standards. But what can we expect from these ESG disclosure mandates? Are they worth the costs associated with political processes and administration that were set up? Will there be any benefits for firms or are they left with large implementation and disclosure costs and no tangible benefits?
Answering these questions is hard, and we will only have a comprehensive and definite answer in a few years. However, we can gauge some answers by examining what has happened in those countries that did introduce some form of ESG disclosure mandates in the past years. Hopefully, these insights provide some guidance on what to expect in those countries that will introduce ESG disclosure mandates in the future, and possibly also on the potential effects of global ESG disclosure mandates as drafted by the ISSB.
To address these questions, my co-authors Philipp Krueger, Dragon Tang, and Rui Zhong and I have compiled a dataset on mandatory ESG disclosure regulations around the world. We analyze in this paper how such disclosure mandates affect firm-level stock liquidity. Why stock liquidity rather than other outcomes? There are several reasons. For example, liquidity is of importance as it affects the valuation of real and financial assets. Moreover, measures of stock liquidity are easily available and comparable across countries. Our measures include the bid-ask spread, the price impact measure developed by Amihud , the fraction of trading days with zero returns, and a summary measure derived from the common factor of the individual proxies. On top of this, stock liquidity is a prime outcome variable in the literature on financial disclosure mandates, which allows us to compare the relative magnitudes of the effects of financial and nonfinancial disclosure rules.
Regulation may improve liquidity by reducing information asymmetry about firm fundamentals, which should mitigate adverse selection problems and improve liquidity.
What makes our analysis interesting is that the effect of mandatory ESG disclosure on stock liquidity is unclear ex ante. On the one hand, such regulation may improve liquidity by reducing information asymmetry about firm fundamentals, which should mitigate adverse selection problems and improve liquidity. On the other hand, one could argue that disclosure mandates covering ESG topics do not have such effects, either because nonfinancial information is too complex, broad, unstructured, and qualitative, or because it is financially immaterial. In addition, there may be a lack of standardized reporting structures and little guidance on the ESG metrics that firms need to disclose. Firms may take advantage of this vacuum by adopting minimum disclosure criteria to just superficially meet regulatory requirements, especially on those disclosure items that make firms look good.
So what do we find? Our data analysis delivers consistent and robust evidence that the introduction of ESG disclosure mandates does have beneficial liquidity effects. The estimated magnitudes are sizeable; for example, bid-ask spreads decrease by 8.4% once a country requires ESG disclosure. Importantly, we reveal substantial heterogeneity across countries beyond these average effects.
In a first step, we examine variation in how countries implemented the disclosure mandates. We find that ESG disclosure mandates improve liquidity almost three times more when implemented by governments rather than stock exchanges. Moreover, the liquidity improvements are about 40% stronger in countries where firms cannot evade full compliance through a comply-or-explain option. That said, our estimates still suggest that it is better to have some form of ESG disclosure mandates—even if issued by stock exchanges or implemented on a comply-or-explain basis—rather than not requiring such disclosures at all.
A large literature demonstrates that enforcement by formal institutions is critical to reap any real or capital market benefits of disclosure mandates.
In a second step, we examine heterogeneity related to disclosure enforcement. Mandatory ESG disclosure is unlikely to have a meaningful impact if the disclosure requirements are not enforced properly. We consider enforcement effects stemming from formal and informal institutions. A large literature demonstrates that enforcement by formal institutions is critical to reap any real or capital market benefits of disclosure mandates. Informal institutions, that is, societal norms or values, may also matter for the enforcement of ESG disclosure mandates. Given that ESG disclosure mandates in part cover societal externalities, social and environmental norms may affect how strictly firms apply ESG disclosure rules. These arguments imply that the liquidity benefits of ESG disclosure rules may be strengthened if enforcement pressure related to a country’s formal or informal institutions is stricter.
We find that stricter informal enforcement increases the liquidity benefits of ESG disclosure mandates, while there is no such evidence for formal enforcement mechanisms. Together with prior evidence in the literature, it appears that informal mechanisms are critical for enforcing nonfinancial disclosure mandates, while formal enforcement channels drive the benefits of financial reporting mandates (such as IFRS).
Overall, mandatory ESG disclosure seems to have beneficial effects by improving stock liquidity, but it also becomes clear that such mandates need to be implemented and enforced well. Our findings encourage and support more regulatory changes for other countries that have not required mandatory ESG disclosure yet.
By Prof. Zacharias Sautner, Professor of Finance at Frankfurt School of Finance & Management and ECGI.
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