The Unintended Consequences of Mandatory ESG Disclosures

Introduction

The corporate social responsibility (“CSR”) debate asks the fundamental question: what is the role of corporations in society? The debate over CSR has proceeded since at least 1932, when two attorneys, Adolf A. Berle, Jr. and E. Merrick Dodd, Jr., publicly debated the following question: to whom are corporations accountable? Berle argued that corporations are accountable only to shareholders, who are a corporation’s owners. Berle’s position was adopted by economist Milton Friedman in 1970, who argued in a New York Times article that “The Social Responsibility of Business Is to Increase Its Profits.” The Friedman Doctrine, as it came to be known, is also known as stockholder wealth maximization (“SWM”) theory or simply stockholder theory. Fifty years later, Richard A. Epstein continues to assert that anything but SWM theory would be untenable in practice.

Dodd, on the other hand, argued that corporations are also accountable to society. This position favors CSR and is also known as stakeholder theory. CSR scholars responded immediately to the Friedman Doctrine. In 1971, Hein Kroos and Klaus Schwab argued that corporations must serve all stakeholders. Fifty years later, Lynn A. Stout continued to contest the SWM theory, writing, among other things, a book entitled The Shareholder Value Myth, in which she argued that shareholders are diverse groups who cannot have but one value, making SWM theory just an untenable as Epstein claims CSR to be.

The Berle-Dodd SWM-CSR debate still frames today’s ongoing discussion about the proper function of corporations. And now, the discussion includes the concept of mandatory environmental, social, and governance (“ESG”) disclosure. Mandatory ESG disclosure would require corporations to publicly address ecology, culture, politics, and economics. Proponents believe that mandatory ESG disclosure will make corporations more accountable to society, and thus increase CSR. SWM proponents counter that corporations already are accountable to society, through consumer and supplier reputation and the stock market; moreover, ESG imposes a uniform view of what corporations should do about social issues, which destroys business diversity and may not focus efforts on the right issues.

This paper does not contribute to the great debate of whether corporations should engage in CSR or SWM. Rather, it offers a narrower and more technical focus. Proponents of ESG believe that mandating ESG disclosures will result in more ESG activity. This theory is based on the notion that you get what you measure. However, mandating more disclosures about ESG activities may not lead to more ESG activities. Mandating ESG disclosures could actually lead to less CSR, at great cost to society. This paper aims to prevent such an expensive regulatory blunder by cautioning against mandatory ESG disclosures.

This is not necessarily an anti-ESG or pro-CSR position. As this paper will show, opposing mandatory ESG disclosures makes sense from both a CSR and an SWM perspective. CSR proponents want more CSR. For the CSR proponents, this paper’s theorical and empirical analysis of how mandatory ESG disclosures have unintended consequences that lower CSR activities might give CSR proponents pause before pushing on with mandatory ESG disclosure proposals.

SWM proponents generally want less CSR. For most SWM proponents, mandatory ESG disclosures make no sense already, because their goal is not to incentivize CSR anyway. Ironically, they may flip and support ESG mandates after reading this article. However, ESG mandates are costly. Such costs may exceed their benefits, contrary to the preferences of SWM and ESG proponents.

If neither side of this ninety-year war finds it gets what it wants through mandatory ESG disclosures, then the battle on mandatory ESG disclosures could end in a mutual surrender, with both sides abandoning the mandatory ESG disclosure regime. Efforts could then be spent elsewhere in a grand battle to define corporations under capitalism.

This paper proceeds in three parts. Part I explains the theoretical mechanism for the counterintuitive result that more ESG disclosure may yield less CSR activity. Part II analyzes the recent empirical studies on the effect of ESG disclosures on CSR activity, which tend to show that ESG-related mandatory disclosures are not associated with beneficial real-world outcomes. Part III considers the cost of mandating ESG disclosures. The conclusion casts doubt upon that argument that the Securities and Exchange Commission (“SEC”) should mandate ESG disclosures from public corporations.

I. Theoretical Model

A corporation takes actions to attract investors. These actions include disclosing to the investor certain material facts about the corporation that help the investor decide whether to invest in the corporation. For example, a corporation could disclose its quarterly earnings reports or how many trees it planted in Sri Lanka. Investors who care only about SWM might disregard the disclosures regarding the trees, while investors who care about CSR might find this information helps them decide to invest in the firm.

At the outset, it must be clear that disclosures from public corporations, whether about earnings or trees, must be made publicly. Regulation Fair Disclosure (“Reg FD”) saw to this in 2000. Consequently, a company cannot selectively disclose earnings to SWM investors, then make a different selective disclosure about the trees to CSR investors. Both disclosures must be publicly filed where all can see and evaluate them.

In 2005, Anil Arya, Jonathan Glover, Brian Mittendorf, and Ganapathi Narayanamoorthy published Unintended Consequences of Regulating Disclosures: The Case of Regulation Fair Disclosure. Their analysis concluded that Reg FD inhibited the very disclosures it was intended to widen. It is useful to consider that counterintuitive result and to consider whether other disclosure regulations (such as mandatory ESG disclosures) may also inhibit what those regulations were intended to widen.

In both the case of mandatory Reg FD disclosures and mandatory ESG disclosures, an investor faces a binary choice: to invest or not to invest in a given corporation. To render this decision, the investor obtains information about the corporation in question.

How that investor obtains information depends on how corporate information is disclosed, which in turn depends on whether there is a mandatory disclosure regime. Without a mandatory disclosure regime, corporate information regarding ESG is either disclosed voluntarily or not disclosed at all. Under a mandatory disclosure regime, the corporation has only one choice—disclose the ESG information pursuant to the regulatory mandate.

Even though investors can access and analyze ESG information themselves, most investors generally rely on analyst reports when making investment decisions. Each analyst chooses whether or not to analyze a given company, based on its prediction of how valuable the resulting report will be, and then sells reports to investors. The analyst thus plays a critical role in the dissemination of quality ESG information.

Note that, in the presence of regulatory mandates for ESG disclosures, this collapses the corporate decision matrix into a Hobson’s choice: to make mandatory ESG disclosures, or to face regulatory fines and reputational penalties. To put this another way, there is some lost information (regarding whether a corporation chooses to disclose or not) in the presence of a mandate to disclose, which contravenes some of the information gained from a mandate to disclose. The essential question is: which regime produces higher quality information and better real-world results?

Extrapolating this essential question: How will the presence or absence of a corporate decision impact investor decisions? In particular, will this disclosure regime help investors decide whether to invest in CSR-focused corporations? Is the value of information gained through mandatory disclosure greater than the information lost by allowing corporations to choose whether to disclose?

A. The Information Paradox

Society is awash in information. Human attention spans appear to have dropped in the face of overwhelming streams of constant information. Not all this information is relevant or helpful, or even true. And humans have limited cognitive bandwidth. It becomes harder to discern fake news, and thus harder to trust real news, as the total volume of news increases. The result is an information paradox: A greater quantity of information eventually results in a lower-quality understanding of that information.

This over-information effect is true even where there are a relatively infinite number of people. A rational person will analyze information only if it is likely that doing so will be marginally useful. Either raising the cost of analyzing a given set of information or lowering the value of the analysis will reduce the incentives to analyze that information. When the value is negative, no rational analysts or investors will analyze that information. Thus, by dumping a large quantity of information onto the market, mandatory disclosure regimes can reduce the amount of quality analysis.

In particular, mandating all firms to disclose ESG information may result in a pooling equilibrium where firms with different characteristics regarding actual ESG and CSR behavior will choose the same action: disclosure pursuant to the mandate. When such a pooling equilibrium is efficient, it actually becomes harder to distinguish firms with different characteristics, because all firms are reporting the same information.

Charles Cadsby, Murray Frank, and Vojislav Maksimovic studied this topic empirically in their classic paper, Pooling, Separating, and Semiseparating Equilibria in Financial Markets: Some Experimental Evidence. First, the authors sorted firms as type H (high) or type L (low). Here, we might likewise separate corporations into type H for the “CSR true believers” and type L for the “greenwashers.” The researchers approached the problem theoretically, using only mathematical models, to predict how firms would behave. But, according to their models, all three equilibria were theoretically sustainable. So, the researchers paid a large group of subjects to make disclosure and investment decisions. In these experiments, parties rapidly or immediately converged on a pooling equilibrium strategy. Even when the researchers disrupted the equilibrium by introducing asymmetric information, “[t]he more efficient pooling equilibrium was consistently chosen over both other available equilibria.”

When asked why the pooling equilibrium dominated the players’ choices, the researchers suggested that investors come into markets with different prior expectations. Some expect a pooling equilibrium (meaning, they expect mandatory disclosures to produce low quality or no valuable information), while others expect a separating equilibrium (where “CSG true believer” firms will reveal themselves, while “greenwashing” firms will also show their true nature). This is why, theoretically, all three types of equilibria are sub-game stable. But, in the dynamic real world, the investor who expects pooling is always willing to underpay relative to those who expect separating. In other words, the investors who believe the information is useless negatively price the value of the investment. So long as at least two investors who have prior beliefs in pooling are in the market, they will cooperate to drive the market price lower and lower, until all the separating investors are priced out of the market. Furthermore, in larger markets, where it is very likely that at least two investors have prior beliefs in a pooling equilibrium, the convergence around a pooling equilibrium occurs instantly and reliably.

B. Theory of Optional and Mandatory Disclosure

Although it might initially appear that available information will remain the same no matter why it is disclosed, there are reasons to believe that corporations (which we presume to act rationally) will act differently when optionally-versus-mandatorily disclosing information. By mandatorily, I mean by government regulation or some other public fiat, as opposed to private ordering. Do rational entities have different incentives regarding the information to disclose under a mandatory disclosure regime versus a voluntary disclosure regime? Yes. As discussed above, mandatory disclosures tend to create a pooling equilibrium around the choice to disclose. Mandatory disclosures make it costly not to disclose information; after all, the point of a mandatory disclosure regime is to force nearly all corporations to disclose information, and governments have the power to levy fines or shut down operations when corporations fail to comply with their regimes. Faced with this cost, more firms will disclose mandatory information. Knowing this, investors will value corporate information lower on the basis that the regime results in pooling of firms, not separating them. Any firms that continue to engage in separating behavior will find it increasingly costly, and ultimately not beneficial, to do so, until those firms flip to a pooling strategy or exit the market.

Thus, one risk of a mandatory disclosure regime is that, although there may be more information, the quality of that information—as well as the market’s understanding of that information—may be less. Because all firms must disclose ESG information, it is hard to distinguish a “true believer” CSR firm from the many “greenwashing” SWM firms. This is what is meant by a pooling equilibrium. Corporations will find it overly costly to distinguish themselves from the rest of the pool, and therefore, analysts and ultimately investors will likewise be unable to distinguish true belief from greenwashing.

In other words, there is a theoretical risk that mandatory disclosure regimes will incept an information paradox; that is, requiring disclosure might result in more information but less quality information and ultimately less human understanding of that information. Thus, disclosure regimes must be carefully designed to require comparable and measurable information; otherwise, the result may be a net social cost and not overall real-world benefits.

II. Empirical Application

The simple model in Part I highlights a trade-off between the value of information gained from mandatory ESG disclosure and the value of information gained from observing corporations’ choice whether to make ESG disclosures. For purposes of comparison, this Part attempts to quantify the respective values or at least their overall direction.

A. Impact of Mandatory ESG Disclosures on ESG Information

Fortunately, there is some good data regarding the impact of mandatory ESG disclosure rules on the quantity and quality of ESG information. A recent (December 2021) study by the European Corporate Governance Institute (“ECGI”) measured and analyzed The Effects of Mandatory ESG Disclosure Around the World. This study incorporated a massive dataset of all publicly listed firms in the Worldscope database between 2000 and 2017, which included fifty-two sample countries. During the relevant period, twenty-nine out of the fifty-two sample countries required some form of mandatory ESG disclosure, and fifteen of the fifty-two countries required a comprehensive form of mandatory ESG disclosure all at once. This provides some basis for comparison of ESG regimes through both longitudinal and cross-sectional analysis.

The first question regards whether ESG mandates increase ESG information quantity and availability. To measure this, the ECGI study examined the number of ESG reports filed in the Global Reporting Initiative (“GRI”) database and the Asset4 database maintained by Thomson Reuters. GRI, a non-profit organization, pioneered ESG reporting in 1997 and is today’s most comprehensive ESG reporting database. Asset4 is provided by a commercial data vendor that provides ESG reports to investors and analysts on a subscription basis. Both GRI and Asset4 provide value-added services including ranking and indexing of firms along dimensions of ESG activity.

ECGI measured the quantity of ESG reporting in sample countries before and after the introduction of ESG disclosure mandates. Perhaps unsurprisingly, ECGI found an increase in firms’ ESG reporting in all countries after the introduction of ESG disclosure mandates. Thus, there is little doubt that mandating ESG reporting increases the quantity of ESG information. But does it increase the quality and utility of same?

To measure ESG information quality, ECGI examined “GRI compliance,” which is a binary value coded for whether a given firm reports information that GRI can index and rank. Non-compliant reports are difficult to review, compare, analyze, and evaluate. Analysts may choose not to analyze non-compliant reports because it is difficult or impossible to estimate or predict corporate ESG activity via a non-compliant report. Investors, who are generally less equipped than analysts to made such inter-corporate comparisons, are even less able to discern meaningful information from non-compliant reports. The paper employed “GRI compliance” as a proxy for ESG information quality. A corporation can comply with a country’s ESG disclosure mandates while being GRI non-compliant.

The ECGI study found no statistically significant evidence that mandatory ESG disclosure affects GRI compliance. Hence, the study concludes, ECGI cannot detect that mandatory ESG disclosure regimes improve the quality of ESG information. The results are consistent with the interpretation that the average corporation produces ESG reports that superficially comply with minimum standards of mandatory ESG disclosure, but the average corporation does not attempt to produce high-quality results that can be evaluated by analysts or investors. The data, therefore, tend to show that mandatory ESG disclosure regimes do increase the quantity of ESG information, but do not increase the quality of that information, and, most critically, ESG mandates do not increase the availability of useful ESG information.

B. Impact of Optional ESG Disclosure on ESG Information

Optional ESG disclosure is a double-edged sword. On the one hand, optional ESG disclosure could invite greenwashing, which is the corporate practice of pretending to care about CSR while actually engaging in pure SWM. Yet, optional disclosure means disclosure is relatively costly—where some firms are not spending anything on ESG disclosures, a disclosing firm bears a relatively higher cost. This could, in theory, have a positive impact on the quality of the ESG information that is optionally disclosed.

That theory is not supported by available data regarding the impact of optional ESG disclosure on investment information. The ECGI study counted the quantity and measured the quality of 45,281 ESG reports in the United States, which all occurred during a period where the United States did not mandate ESG disclosures. All these disclosures, therefore, could be considered optional ESG disclosures, as they were not mandated by the government but rather incentivized by some other market pressure. The United States reports constituted 17.45 percent of the entire sample, making it the single largest reporting country in the sample, even though it was one of the few countries in the study that does not mandate ESG disclosure. This shows, at least, there may be other factors driving ESG disclosure aside from mandates. However, questions remain. Are optional ESG disclosures higher quality that mandatory ESG disclosures? Is the quality of optional ESG disclosures high enough to avoid a pooling equilibrium?

Unfortunately, there is presently less empirical study regarding the quality of ESG disclosures in the United States. However, some preliminary data provide a basis for further study. First, as mentioned above, the United States, which has no mandatory ESG reporting, produces the highest total number of ESG reports and Japan, which also has no mandatory ESG reporting, produces the second highest number of reports. The simple fact that countries without mandatory ESG disclosure regimes are producing the highest volume of ESG information tends to show that there is some mechanism, other than government fiat, incentivizing the production and disclosure of ESG information. Nonetheless, questions remain: What is that mechanism? And, does that mechanism produce higher quality ESG information? These questions require further empirical research, which is beyond the scope of this paper, but this paper will make some effort to positively distinguish between high- and low-type ESG information. If future studies follow this framework to distinguish these types of ESG information, then those studies could also examine what regime produces better separation between the types.

1. CSR True Believers:  High-Type ESG Information

CSR is perceived where corporations engage in social, environmental, and political actions that go beyond their profit interests. First, it bears mentioning that many scholars believe SWM behavior produces the best outcome for society, as shareholders may redeploy those maximized corporate profits (whether received as dividends or capital gains) to further those social, environmental, and political interests, making CSR a “myth.” On the other hand, some scholars believe that firms can obtain a competitive advantage by engaging in CSR. A primary mechanism for CSR to create a competitive advantage is through a positive brand association.

A recent (2020) study explored firms in Ghana to measure any correlation between CSR activities and positive brand association. The study did indeed find a significant positive relationship between CSR, brand perception, and competitive advantage. However, the study has at least two major flaws. First, the study examined the developing nation of Ghana, and so its results may not be generally applicable to developed economies, like that of the United States. Second, and perhaps more troubling, the Ghana study measured CSR based on CSR reporting. In other words, the study conflated the chicken with the egg. While CSR reporting may result in socially beneficial action, it might also be a rotten egg that results in nothing socially beneficial—greenwashing.

In fact, the problem with many existing CSR studies is one of measurement. How does one identify and measure CSR behavior? How does one distinguish the limits of a firm’s profit interests?

Therefore, even if there are theoretical reasons for firms in a competitive marketplace to engage in CSR, it is not yet clear how to identify and measure CSR contributions by those firms. As discussed above, increasing ESG disclosure does not necessarily increase CSR activity. ESG disclosures are not a proxy for CSR activity, especially where ESG disclosures are mandatory. Any future study that seeks to quantify the relationship between ESG disclosure and CSR activity will first have to establish a credible and reliable method for measuring CSR. Otherwise, the study might conflate true CSR activity with mere greenwashing.

2. Greenwashing:  Low-Type ESG Information

Greenwashing occurs when corporations disclose positive environmental and ecological activities that tend to obscure, mask, or distract from more significant negative activities. As mentioned above, even CSR researchers seem to fall into the trap of conflating ESG disclosure with CSR activity. This is a problem because firms can use ESG disclosure to mask anti-CSR activities. Magali A. Delmas and Vanessa Cuerel Burbano developed the following matrix to explain how communication about CSR does not necessarily relate to CSR activity:

Figure 1. Typology of Firms based on Environmental Performance and Communication