Mandates by the Securities and Exchange Commission (SEC) requiring disclosures on environmental, social, and governance (ESG) compliance should be limited to matters that directly affect the cash flows of firms, according to a statement released last week by the Financial Economists Roundtable (FER), a worldwide group of 50 senior financial economists including Wharton professors.
According to the group, the SEC should refrain from measuring the broader societal impacts of ESG compliance by listed firms because those matters are outside the regulator’s areas of expertise. “While several members of FER expressed concerns over lack of progress on environmental and social issues, the group agreed the costs of the SEC mandating these kinds of disclosures could be substantial and the potential gains would likely be slight,” said Richard Herring, Wharton professor of international banking and professor of finance, who is one of the 30 signatories to the FER statement.
“Our recommendations balance the benefits of disclosure under the SEC mandate against the costs that arise from measurement, regulatory overreach, and forestalling private efforts ongoing in this area,” the statement explained.
The statement is timely: The SEC is now in the process of gathering comments from the public on “climate change disclosures” it may require from its registrants, or firms that issue securities. It had aired the proposal in March with a list of 15 questions for consideration. In recent times, the SEC has been more vocal than earlier in ESG-related disclosure debates, including comments from its commissioners. “Today, investors increasingly want to understand the climate risks of the companies whose stock they own or might buy,” SEC chair Gary Gensler had stated in July.
The FER specified how it expected the regulator to mandate environmental and social (E&S) disclosures. “The SEC should require a registrant to disclose its E&S-related cash-flow impacts in its 10-K or 10-KSB,” it stated. (While 10-Ks are annual filings by listed firms on their financial performance, 10-KSBs are filed by small businesses that are sometimes referred to as penny stocks.) “This mandate would include E&S-related risk factors and current cash outflows (e.g., investments made) that affect the firm’s E&S outcomes,” it specified.
The FER called for SEC action on two other fronts: It wanted the regulator to require firms that disclose their ESG ratings to concurrently disclose the process and the weights assigned to various metrics to arrive at those ratings. It also called upon the SEC to draw up a glossary of ESG criteria with clear definitions. That is not an unusual suggestion, said Wharton accounting professor Catherine M. Schrand, another signatory to the FER statement. She pointed out that the Equal Opportunity Employment Commission has such a glossary for small businesses and the Environmental Protection Agency has its glossary of environmental terms.
“We do not think that the SEC should certify environmental or ESG rating agencies like they did with the credit rating agencies.” –Catherine M. Schrand
“We want firms to be explicit about the costs and benefits [of ESG compliance], and we want the SEC to establish more exacting criteria by which agencies can judge whether firms are complying or enacting and adopting ESG criteria,” said Wharton finance professor Jeremy Siegel, who is also a signatory to the FER statement. “Those criteria are very vague at the present time. There are no centralized or standardized definitions of what constitutes an ESG firm, and that can be very confusing for investors. One rating agency may give a firm a very high rating and another may give a low rating.”
FER members wanted to set boundaries for the SEC in the ratings industry. “We do not think that the SEC should certify environmental or ESG rating agencies like they did with the credit rating agencies,” Schrand said. Many FER members believed that “the certification and only allowing certain credit rating agencies to operate created an oligopoly that led in part to the 2008 financial crisis,” she added. “There wasn’t market competition for the best ratings.”
Those recommendations are important “because there are hundreds of billions of dollars of funds that are tied to ESG funds and rating services,” Siegel said. Total assets incorporating ESG principles managed by U.S. institutional investors have grown appreciably over the past 15 years, to $6.2 trillion as of 2020, and public pension funds account for more than half of that (54%), according to data from the US SIF, also called the Forum for Sustainable and Responsible Investment.
“If the SEC adopts our proposals, we believe that ESG investing would become more popular because investors will know that firms are using more uniform criteria by which to judge them as ESG-compliant or not,” said Siegel. “If you could have more trust in the ESG rankings of the rating agencies, then that should encourage more investors.”
Similarly, if firms disclose their costs of ESG compliance, some investors who find those uncomfortably high may decide against investing in those firms, Siegel continued. Yet some others may be undeterred by those costs. “For some investors, it’s not just about dollars and cents,” he added. “There are people that will invest in firms that they like and may even accept lower returns because they believe that it is part of doing good for society, which they value.”
How ESG Impacts Cash Flows
“Cash flows are directly affected by firms’ ESG activities,” said Schrand. “They might face, for example, a consumer boycott if one of their ships caused an oil spill. Or if people hear about poor diversity practices or poor human resources practices and how a firm treats its employees, consumers might boycott their products. Those are risks to a firm’s cash flows.”
Firms are already generically required to disclose risks to their cash flows, including E&S-related risks, but the risk factor section of the 10-k is notoriously “boilerplate,” Schrand noted. The change the FER suggested is to require firms to disclose their E&S risk factors in a separate section; the accompanying glossary would make those disclosures more informative, she said.
The second type of cash flow disclosures the FER wanted is on cash expenditures or investments by firms to address green outcomes. While the FER statement argues that requiring disclosure of greenhouse gas emissions is not within the SEC’s mandate, the regulator has the right to require firms to separately disclose their investments in facilities meant to reduce GHG emissions, Schrand pointed out.
“Disclosure is always good because more information is better than less information. Investors discount firms where they have less information.” –Jeremy Siegel
Likewise, firms that want to have positive E&S outcomes have to invest in, say, greener technology or move away from certain products because they are not sufficiently green, Schrand noted. Requiring firms to disclose those impacts is “directly within the SEC’s mandate of investor protection,” she added.
Firms could have positive ESG impacts on their cash flows if, for example, they attract more customers that like their environmentally friendly policies, Siegel said. Conversely, they could attract negative impacts on cash flows if they face regulatory fines and penalties for flouting environmental guidelines, he added.
Full and transparent ESG disclosures will also help lower the cost of capital for firms, Siegel pointed out. “Disclosure is always good because more information is better than less information. Investors discount firms where they have less information.”
Backdrop to ESG Disclosure Debates
“Our statement makes an important distinction between two rationales that underlie calls for more ESG disclosure by public corporations,” said Herring. “The first aims to improve public information about the impact of environmental and social factors on the firm’s cash flows to improve the ability of market participants to assess risk and price securities. The second aims to expand information about a firm’s impact on society (including the environment) in the hope that investors and other groups can pressure firms to achieve social and environmental objectives.”
The community pressure for disclosures that help understand how firms’ activities affect society results partly “from many citizens’ frustration with the lack of legislative and regulatory action on environmental and social issues,” the statement pointed out. “For example, although the most equitable and effective tool for controlling greenhouse gas emissions by firms is a greenhouse gas tax or cap-and-trade mechanism, no political consensus has developed to legislate such tools at the federal level in the U.S.,” it explained. “Nor has the U.S. Congress developed legislation requiring firms to disclose workplace-related social issues.”
“Our statement makes an important distinction between two rationales that underlie calls for more ESG disclosure by public corporations.” –Richard Herring
In the absence of legislative action, “proponents of SEC disclosure mandates assume, without widely accepted evidence,” that such disclosures would empower consumers, workers, and investors to pressure firms and lead to positive changes in firms’ E&S-related activities, it added. The FER statement pointed out that “the SEC’s expertise lies in financial disclosures [and that it] does not have the authorization from Congress, nor the expertise, to design disclosures that seek to influence societal outcomes, nor the resources to review such disclosures.”
The FER listed three reasons why “using the SEC as a tool to promote environmental and social change creates significant potential costs, with questionable benefit.” First, disclosure mandates that pressure firms to change their behaviors imposes costs on them; that burden would also likely fall unequally on firms and across the stakeholders of most firms.
Second, by involving itself in setting environmental and social priorities, it could “become a political tool,” the statement continued. Third, “burdensome disclosure requirements will drive some public companies to become private and limit other firms’ willingness to go public.” Regulatory actions that drive firms to be private “could inhibit capital formation and decrease at least some disclosures,” it pointed out. Such outcomes would be contrary to the SEC’s mandates to facilitate capital formation and efficient markets, the FER statement added.
Herring pointed out that the FER is “an independent group with no political or business ties,” made up of senior economists, lawyers, and accountants who have been selected for their contributions to research and public policy. “The group includes four former chief economists of the SEC and so our discussions were well informed by a deep knowledge of the SEC,” he said. “The diversity of the group ensured a vigorous debate on virtually every aspect of the topic.”
