Posted inAnalysis

Can ESG disclosures reduce stock market shocks?

A recent paper, produced by the Global Research Alliance for Sustainable Finance and Investment (a collaboration of academics at universities across the world researching sustainable finance and investment), concludes that mandating ESG disclosures has clear benefits.  

The analysis was based on an international dataset of mandatory ESG disclosure regulations between 2000 and 2017 that were introduced in 25 countries; including Australia, China, and the UK.

According to the study, mandatory disclosure tends to have a bigger impact on smaller firms, as they are less likely than their larger peers to have previously voluntarily disclosed such information. The authors also found that smaller firms – as well as those with lower ESG quality – were more likely to file ESG reports after mandatory disclosure was introduced.

Conversely, larger firms – as well as those smaller companies with better ESG policies – may have already voluntarily disclosed ESG information before the introduction of rules. This was also the case for international firms. This may be because they have stronger motives to disclose on ESG to a wider audience and are more exposed to stakeholder scrutiny.

Quality of information

But, even if mandatory disclosure increases the availability of ESG reports, does it improve the information used by financial market participants to value firms?

The study suggests that mandatory ESG disclosure does have positive informational effects on market participants because it increases “the availability and quality of firm-specific non-financial information”, thereby improving the information used to forecast earnings. Also, the mandatory nature of the disclosures “could reduce ambiguity about the fundamentals of a firm”.

The authors said the accuracy of earnings per share forecasts by financial analysts improved significantly after disclosure became mandatory, and forecasts became less dispersed.

Meanwhile, negative ESG incidents, such as the 2010 spill in the Gulf of Mexico, become less likely if ESG disclosure is introduced. The researchers measured such incidents using a proxy constructed by RepRisk based on media reporting about negative ESG events.

Stock price crashes

A reduction in negative ESG events lowered the risk of stock price crashes, according to the report. Indeed, after the introduction of mandatory ESG disclosure, the likelihood of stock price crashes decreased by about 26%

The research paper said: “When accumulated bad ESG news reaches a tipping point and [is] released to the market all at once, such batch-releases can result in sharp stock price declines.”

Since mandatory disclosure regulations accelerates ESG information disclosure through ESG reports, this could help reduce crash risk. 

The paper’s authors also stressed that the gap between supply of and demand for ESG information would typically be bigger for firms headquartered in common law countries, suggesting a greater need for mandatory ESG disclosure regulation in those countries.

Commenting on the paper, Alex Bernhardt, global head of sustainability research at BNP Paribas Asset Management, said: “This important research confirms that enhanced disclosure of ESG information can inform idiosyncratic or company-specific price discovery for investors”.

He added: “But it also importantly demonstrates that information access can reduce systemic risk by reducing the likelihood of market crashes. While some regulatory jurisdictions are already moving to enhance ESG disclosure requirements, hopefully this new research will help bring those on the fence onto the other side, particularly regulators with systemic risk management in their mandates.” 

David Burrows

For more than 25 years, Dave has written for a wide range of newspapers and broadcasters including The Times, The Financial Times, The Independent, The Wall Street Journal, The Mail on Sunday, Reuters...

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