Not just a regulatory burden

I don’t think there is a single corporate executive out there who doesn’t bemoan the increasing demands by regulators and stock exchanges for disclosure. In the EU, listed companies with more than 500 employees have to comply with the Non-financial Reporting directive (NFRD) that requires companies to disclose nonfinancial risks including ESG risks. In the UK, similar regulations apply and are constantly expanded. For example, every company listed on the main board of the London Stock Exchange must already or will soon have to disclose its climate-related financial risks along the TCFD guidelines. Only in the United States are there no or very few such nonfinancial disclosure regulations in place.

Notably, though, regulators in Europe only demand disclosure, not action. A company can choose to have huge exposure to nonfinancial risks and terrible risk management, as long as the company is transparent about it, it is all good.

This is why some corporate executives consider these rules as purely an exercise in creating additional admin work for businesses without any real impact. And they’d be wrong about that.

Philipp Krueger and his colleagues have investigated the effects of mandatory ESG disclosures in 53 countries and found some important real life effects of these disclosure requirements. You see, we all want to look good in the eyes of our peers and the public, so very few corporate leaders are willing to have terrible nonfinancial disclosures and don’t do anything about it. Instead, if they know they have large nonfinancial risks, they at least want to improve a little bit and mitigate the worst risks. At least, that is what regulators hope will happen when they introduce these transparency requirements.

And indeed, after the introduction of ESG disclosure regulations, the number of ESG incidents drops. On average, the number of ESG incidents drops by 4.8% after the introduction of these regulations while the number of widely reported severe incidents drops by 6.1%. That may not sound like much, but it is a material reduction of risks that can have a significant impact on the profitability of a company. Consequently, the risk of a share price crash in the aftermath drops by about 2.8%.

Last week, I wrote about how ESG news is able to improve the forecasts of equity analysts. After a regulatory change that forces companies to disclose more ESG data and ESG-related nonfinancial risks, more analysts will read about these risks in company reports and as a result, more analysts will start to incorporate these risks into their analysis. And indeed, with the introduction of nonfinancial disclosure regulations analyst accuracy increases and the dispersion between analyst forecasts decreases. Assume you have a stock that costs $100 and trades at a multiple of 10 times earnings then the accuracy in estimating the $10 earnings per share increases by about $0.25 and the dispersion amongst analyst forecast declines by $0.08. Not much, but it does make a difference.