Climate change is undeniably a significant and looming threat, impacting both the global environment and the stability of our economies and financial sector. There is an immediate and pressing need to comprehensively assess and effectively manage this multifaceted risk. Recently, we’ve seen a proactive response from regulatory bodies and standard-setting organizations worldwide, as they’ve taken substantial steps towards combating climate change. They have created guidelines and standards to facilitate transparent and informative reporting on climate-related matters.
The prevailing consensus is that mandatory disclosures related to climate risks can play a pivotal role in enabling market participants to make informed decisions. These disclosures are expected to empower investors and stakeholders to better factor in these risks when making financial decisions. In the long run, this should promote market discipline and nudge companies towards adopting cleaner, more sustainable practices, reducing overall pollution levels.
However, while the potential benefits of mandatory disclosure seem clear, the landscape has complexities. For instance, what are the net gains of imposing mandatory disclosure requirements when many companies voluntarily provide such information in their financial statements? This raises questions about redundancy and the added value of additional regulations. Moreover, there’s a concern that the inherent difficulties in accurately measuring climate-related risks could hinder market discipline rather than enhance it. Another potential unintended consequence of mandatory disclosures is the promotion of carbon leakage. This occurs when companies, in response to stringent measurement and disclosure policies, decide to relocate their production to countries with less rigorous environmental standards. Paradoxically, such a move could increase global carbon emissions as production shifts to regions with fewer controls.
In a recent working paper, we analyze these intricate issues, developing an economic framework that simulates the decision-making processes of domestic firms. These firms have choices; they can produce locally or outsource their production to foreign suppliers. Both options have environmental consequences, with domestic production leading to direct carbon emissions and outsourcing to foreign suppliers incurring indirect carbon emissions. These complex calculations also involve allocating indirect emissions from upstream and downstream activities. To simplify this, we assume that domestic firms share a common supplier. It’s important to note that each firm’s production plan generates short-term financial gains but carries long-term environmental costs, which are at the heart of our analysis.
We model two primary types of climate risks affecting a firm’s long-term environmental costs. First, there’s the transition risk, which relates to how well an organization manages and adapts to changes to reduce greenhouse gas emissions and transition towards renewable energy sources. For instance transition risk also involves how exposed a firm is to change in government policies to fight climate change. This risk is typically idiosyncratic, varying based on individual firm characteristics and operating conditions. The second type is physical risk, stemming from the actual impacts of climate change, encompassing harm to businesses and assets caused by acute climate-related disasters like wildfires, hurricanes, and floods, as well as chronic risks stemming from long-term temperature changes, droughts, and rising sea levels. Physical risk, in contrast, is influenced by broader climate change patterns and is more linked to the cumulative environmental impacts of all firms rather than just individual ones.
A central focus of our research is to examine the tangible consequences of climate-related disclosures. These disclosures are a critical tool for market participants, enabling them to assess firms’ climate risks arising from their operational impacts on the environment. Improved pricing efficiency, resulting from better-informed market participants, can alter firms’ production choices, affecting both production efficiency and environmental impact. In practice, domestic regulators often impose requirements on measuring the environmental impact of firms’ operations within their jurisdiction. For example, the European Union (EU) mandates firms to measure greenhouse gas emissions from their European productions. However, these regulators face limitations when it comes to regulating measurements of firms’ productions beyond their jurisdiction. The EU, lacks the authority to directly regulate climate-related aspects of productions outside Europe. This limitation is a central driver of carbon leakage, which is a key focus of our study.
To address this issue, we compare two distinct approaches: first, a direct emissions regime where a domestic regulator mandates domestic firms to report only the environmental impact of their own production, excluding indirect emissions from foreign suppliers, and second, an indirect emissions regime, where domestic firms are required to report not only their own production’s environmental impact but also the total environmental impact of their foreign suppliers’ production.
Our research yields several crucial findings. Even when we account for measurement challenges, it becomes evident that when prices accurately reflect climate-related risks, mandatory climate disclosures lead to enhanced efficiency compared to relying solely on voluntary reporting. This result aligns with intuition since firms often do not fully account for the environmental impact of their production, leading to overproduction and excessive pollution levels compared to socially optimal standards.
In the presence of measurement issues, where accuracy and reliability are paramount, the disciplining role of prices depends on the precision of firms’ direct and indirect emissions measurements. More precise disclosure of direct emissions influences domestic production choices, effectively reducing direct emissions. Similarly, when foreign suppliers provide precise disclosure regarding total indirect emissions, it helps curb domestic firms’ indirect emissions. However, a potential drawback arises: more precise direct emissions disclosure can lead to carbon leakage. Firms may shift their production to foreign suppliers in regions where indirect emissions are less accurately assessed and priced.
One potential solution to mitigate the risks associated with carbon leakage is to mandate the disclosure of information related to indirect emissions. While this approach can effectively reduce carbon leakage, it may inadvertently lead to reverse leakage, where firms move their production to jurisdictions with more relaxed disclosure requirements. Therefore, requiring stricter indirect emissions disclosures becomes beneficial only when the precision of direct emissions disclosure is sufficiently high. In other words, the improved precision of indirect emissions disclosures should be matched by similar improvements in the accuracy of direct emissions disclosures to ensure an overall welfare gain.
A key policy implication stemming from our research is that domestic regulators should strive to align the precision of direct emission disclosure with that of indirect emissions disclosures. Regulators should not establish disclosure requirements in isolation. Instead, regulators should coordinate their policies on a global scale. This coordination is vital to ensure that regulatory efforts are effective and harmonized across different regions, thereby avoiding regulatory arbitrage.
Our analysis also highlights the need for caution when considering unilateral increases in emission disclosure requirements, especially in developed countries. This is particularly relevant when considering the limited availability of high-quality emission data in developing countries integral to the global supply chain. Thus, in designing climate-related disclosure policies, regulators should carefully assess whether to mandate indirect emissions disclosure on a case-by-case basis, given the potential ambiguous effects it may have on different industries. In this regard, our research helps bridge the gap and provide a nuanced perspective on varying policy decisions made by regulators, such as those in Europe and the United States, concerning mandating indirect emissions disclosure.
Overall, our research paper acknowledges the benefits of mandatory climate-related disclosures for informed decision-making and market discipline but raises potential concerns about carbon leakage. We present an economic framework, highlighting regulators’ dilemma in implementing climate-related disclosures while emphasizing their importance in addressing climate risks. We also emphasize the need for precision in both direct and indirect emissions disclosure and global regulatory coordination.
Lucas Mahieux is an Assistant Professor of Accounting at the Tilburg School of Economics and Management, Tilburg University.
Haresh Sapra is the Charles T. Horngren Professor of Accounting at the University of Chicago Booth School of Business.
Gaoqing Zhang is an Associate Professor of Accounting at the Carlson School of Management, University of Minnesota, and a Visiting Professor of Accounting at the Tepper School of Business, Carnegie Mellon University Pittsburgh.
This post was adapted from their paper, “Climate-Related Disclosures: What Are the Economic Trade-Offs?” available on SSRN.