Costs of mandatory ESG disclosure likely would outweigh benefits

The ESG movement is proliferating across the western world.

In the United States, the Securities and Exchange Commission wants to increase disclosure requirements (with an ESG focus) for investment funds. The European Union has had disclosure mandates for public companies since 2018, tied to the UN’s Sustainable Development Goals. Here in Canada, under current Canadian securities legislation, there are no specific requirements mandating the disclosure of the “environmental, social and governance” practises of public companies, but the idea is gaining steam in some Canadian precincts including the Trudeau government’s latest budget.

Why? According to proponents, expansive and mandatory ESG disclosure regulations will better inform investors about the ESG practises of public companies (their carbon usage, for example) and thus more investment capital will flow to ESG-intensive companies and less will flow to companies lagging in ESG initiatives.

But in reality, an expansive government-mandated ESG reporting regime in Canada will likely have social costs that outweigh any social benefits.

Consider this. If investors are willing to pay more to own stocks and bonds of a company that follows “best practise” ESG activities, that company surely has a strong incentive to inform the investment community about its ESG activities because it would help lower its financing costs, which, from an investor’s perspective, are mirror images of the values of that company’s equity and debt-financing instruments. As such, if companies voluntarily disclose to investors their favourable ESG-related activities, those companies should enjoy a lower cost of financing and a competitive advantage.

So if voluntary ESG disclosure will likely benefit companies, why would government need to impose an ESG disclosure mandate? True, in an environment where ESG disclosures are not mandated and thus less regulated by government, some companies may make false or exaggerated claims about their ESG practises (sometimes known as greenwashing). But these same companies would suffer permanent reputational and financial damage if investors identified this greenwashing. That’s likely a risk few companies would take.

Moreover, some argue that ESG disclosure rules, backed by regulatory penalties against violators, would produce more useful ESG information for investors than a regime of voluntary disclosure. But in reality, it’s unlikely that any standardized ESG disclosure rules would remain relevant across different companies carrying out a wide range of production activities in our modern economy. For example, why mandate the same carbon disclosure rules for petroleum refineries and software developers?

Also, rating companies based on ESG performance remains a subjective exercise. Indeed, different ESG rating services, which sell their corporate rankings to investors, often disagree in their rankings of the same companies. And individual rating services change their rankings of the same companies over short periods of time, sometimes dramatically. In this context, requiring investors to rely on standardized disclosure information consolidated and distributed by rating agencies might actually deprive investors of relevant ESG information that does not fit into the government-mandated disclosure format.

Finally, this debate should include empirical evidence about whether mandating more expansive and standardized ESG disclosures would benefit investors. But unfortunately, methodological and measurement problems plague the empirical tests on that question. Nevertheless, a new study published by the Fraser Institute, which evaluates the available empirical evidence on the financial returns to ESG-themed investment strategies, finds no consistent evidence supporting the claim that highly-ranked (by ESG rating agencies) companies are rewarded with lower costs of capital.

This finding further calls into question whether a more expansive and standardized ESG reporting regime—mandated by government in Ottawa or elsewhere—will produce social benefits. Although there’s no doubt it will impose onerous new costs of doing business, particularly on small and medium-sized enterprises.