ESG disclosure mandates raise several key questions

In recent years, there’s been more pressure for investment managers and managers of active businesses to increase their reporting of Environmental, Social and Governance (ESG) metrics in their financial and non-financial public disclosures. Regulators and legislators are implementing rules to promote this objective. For example, the European Union has had ESG disclosure mandates on publicly listed companies since 2018, tied to promoting the U.N.’s sustainable development goals, which include poverty relief, gender equality, and affordable and clean energy.

In the United States, the Securities and Exchange Commission (SEC) has indicated that ESG disclosure regulation will be its central focus going forward, with an emphasis on climate change and workforce diversity. And the U.S. Department of Labor has proposed a rule change that would make it easier for retirement plans to add investment options based on environmental and social considerations and make such options the default setting on enrollment.

Under Canadian securities legislation, there are currently no separate specific requirements mandating environmental and social-related disclosures by public companies. However, the Toronto Stock Exchange and the TSX Venture Exchange have adopted policies regarding timely disclosure of ESG metrics alongside reporting obligations for listed public companies. In addition, Bill C-97, which received royal assent in 2019, introduced amendments to the Canada Business Corporations Act that will require corporate boards to disclose information related to diversity on boards and senior management ranks, and the wellbeing of employees, retirees and pensioners. These amendments have not yet come into force.

So, who’s applying the pressure?

Canadian pension plan investment managers are among the most vocal supporters of mandating corporate disclosure of ESG information. In 2020, the CEOs of eight leading plan managers issued a joint statement calling on companies and investors to provide ESG information to strengthen investment decision-making and better assess and manage ESG risk exposures.

The ostensible rationale for mandating more comprehensive ESG reporting is therefore presumably to make capital markets more efficient by providing capital market participants with financially material information that’s currently not being disclosed. More ESG information will presumably enable investment managers to identify companies pursuing “best” ESG practises that supposedly will make those companies more efficient and profitable on a risk-adjusted basis. As a consequence, financial capital will be reallocated from less efficient to more efficient companies with associated benefits for the national economy.

However, this rationale may prompt an obvious objection. If companies implement ESG practises that promise to make them more efficient and profitable, they have incentives to disclose those ESG practises voluntarily. Perhaps mandating standardized ESG reporting makes it easier for investors to compare ESG practises across companies and thereby improves the efficiency of capital markets.

But in fact, the evidence suggests that active portfolio management underperforms passive index investing. And there’s no evidence that active ESG management outperforms other types of active investment management. It’s also very unlikely that standardized mandated ESG metrics would be equally relevant for a diverse group of companies. For example, environmental practises implemented by online gaming companies will have much less relevance for potential investors than the environmental practises of energy companies. Moreover, the correlation of ESG ratings for the same companies reported by ESG rating services is relatively weak.

So, why do investment managers want securities regulators to mandate broader and standardized ESG disclosure by public companies? They may want to mitigate liability risk related to poor investments and avoid being sued for ignoring material information, even if the information is not mandated to be disclosed. If the companies they invest in have disclosed information for all standardized ESG metrics, it reduces the investment manager’s exposure to legally successful claims that they ignored ESG-related risks.

Finally, investors may favour more mandated ESG reporting because it will put indirect pressure on corporate managers to implement unprofitable ESG practises. (Obviously, companies need no outside pressure to implement profitable ESG practises.) In this context, mandated ESG disclosure might be seen as a soft form of regulation that incentivizes changes in corporate behaviour when direct regulation is difficult to implement or enforce.

It may often be easier to shame corporations to implement ESG practises favoured by politicians than it is for politicians to impose unprofitable changes to corporate ESG practises that may, in turn, result in lost jobs and higher prices. In this regard, major regulatory changes to ESG reporting practises should be subject to social benefit-cost analysis as is the case, in principle, with other major regulatory initiatives.