Conventional business and economic theory suggest that private enterprises exist for one sole purpose, profit. They seek to maximize profits through strong growth which is reflected in stock prices. Yet there are agency costs where management’s myopia is hurting the owners and the societies in which they are present. Firms are willing to give up long term growth in search of short-term profits with a vague promise of eventually righting the ship.
Before ESG principles, voluntary disclosures were signals from management of the robustness of their growth and the persistence of profits. It seems logical that a public firm will not release data which will seriously damage their equity value. Thus, voluntary disclosures act as a signal of efficiency.
The new demand for ESG stems from a societal demand for voluntary disclosures from firms to show their participation in fighting climate change. While progressive regulation is being designed by the European Union as part of their commitment to be carbon neutral by 2050, ESG voluntary disclosures will play a large role to obtain access to European private and public capital as they will directly affect the bottom line via the cost of capital. Firms which are more sustainable with national and regional political goals will benefit from being better adapted to the shifting paradigm and state support in interventionist states such as Germany and France.
What the Theory is Saying
Voluntary disclosures are a well-researched topic and have been used to resolve problems such as agency costs. Disclosing more information than required on environmental issues can be beneficial to the firm and is supported by 3 theories on voluntary disclosures: signaling theory, stakeholder theory and legitimacy theory.
Disclosing the firm’s environmental initiative for transitioning to a net-zero model can be a signal of efficiency which helps the firm distinguish itself from its competitors. By being more transparent on the status of its environmental endeavors, the firm is also building goodwill between management and its shareholders. Disclosing positive developments are inherently beneficial as they reflect positively for the firm and neutral news can avert rumors of a poor environmental performance. The fear of negative news can be paralyzing for firms. Markets have proven unforgiving to negative surprises with losses being generally bigger than gains on positive news of similar scale.
Firms may prefer avoiding this risk altogether by avoiding voluntary disclosures, but reporting on negative performances can help avoid reputational costs and litigation which could be more disastrous to a company’s equity value. Signals work best if they’re not easily copied by the firm’s competitors. Best adapted firms will distinguish themselves from the pack by showing their lead at mitigating environmental costs and the inability of competitors to disclose progress on their sustainability program, if it even exists.
Signaling your good behavior on environmental issues may be a good intention but what’s suggesting that shareholders or even customers care about firms’ environmental impact? From political economy, we have the stakeholder and legitimacy theory which argue that firms exist in a social system containing various stakeholders with their own interests. Climate change is the most salient environmental issue which is causing many big firms to address their environmental impact and formulate transition plans, as is predicted by stakeholder theory. Beyond their fiduciary duty to shareholders, firms have to incorporate stakeholders’ interest in societies in which they produce or sell goods because their reputation is tied to their equity value.
Legitimacy theory explains how firms have a social contract between themselves and society by which they have to comply with the society’s value system. The pursuit of legitimacy is the observable part of voluntary disclosures as many firms are proudly displaying certifications such as Fair Trade, Rainforest Alliance, or B Corp. Firms operating in western societies are compelled to change by societal demand for environmental responsibility or risk their legitimacy. Firms have to balance their transition strategy with their business strategy in such a manner to avoid the cardinal sin of the Net-Zero Agenda: Greenwashing. An intentional attempt to deceive stakeholders is a far greater risk to equity value than negative disclosures.
Saving the World has its Benefits
These 3 theories support decisions made by management teams at tech giants like Apple or Alphabet to include ESG disclosures or Consumer goods firms like Danone or Ben & Jerry’s to externally certify their impact by B Corp. These are concrete steps from giants to realign their values with environmental interests, but they are also beneficial to shareholders.
The European Union is at the forefront of reducing its carbon footprint as it reduced greenhouse gas emissions by 24% and increased GDP by 60% from 1990 to 2018. A large part of the reduction is due to the European Commission’s innovative green regulations and the Brussels Effect which has led to the unilateral adoption of EU regulation outside of the common market. The commission has made clear its commitment to make the single market climate-neutral by 2050 through their heavy investment in green energy technologies, de-risking of green infrastructure projects and developing a taxonomy for sustainable finance.
Strong institutional support for fighting climate change is pushing firms to venture beyond environmental regulations to gain a first-mover advantage in the new European order and prepare itself for any new environmental regulation. The Brussels Effect can be costly if a firm doubles-down against the commission, as we’re seeing Apple contesting its right to their proprietary charging port. Voluntary disclosures can act as a catalyst for attracting institutional investment into green transition projects with de-risking from various institutions (EC, Member-States, institutional investors).
Green credentials benefit from preferential financing in markets. According to research by MSCI, firms with stronger ESG credentials are benefiting from lower cost of capital in developed and emerging markets. Additionally, firms with poor ESG credentials in developed markets saw better cost of capital as their ESG performance improved. Markets rewarding green initiatives by firms are also visible through the Greenium in corporate issued green bonds. First time issuers tend to experience larger abnormal returns on equity upon first issuance of green debt. Voluntary disclosures can play a critical role in transparency for use of proceeds as third party environmental certification would show tangible impact of the project.
Lastly, firms benefit from the prestige of being compliant with the climate agenda. Younger generations, especially in the Global North, are showing a growing preference for environmentally friendly consumption and production. Eco-friendly products can be a class of products which are climate neutral but appeal to both green or indifferent consumers.
Writer: Mikail Durrani
References
Tzouvanas et al., Environmental disclosure and idiosyncratic risk in the European manufacturing risk (2020), Energy Economics Vol. 87
Cotter et al., Voluntary Disclosure Research: Which Theory Is Relevant? (Spring 16, 2011). Journal of Theoretical Accounting Research, 2011
OECD (2021), "De-risking institutional investment in green infrastructure: 2021 progress update", OECD Environment Policy Papers, No. 28, OECD Publishing, Paris
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