What are the real effects of climate-related disclosures?

Climate change is recognized as a significant threat to both the real economy and the financial industry, creating an urgent requirement to assess and manage this risk. In recent times, regulatory bodies and standard-setting organizations have taken substantial steps to combat climate change by creating guidelines and standards for reporting on climate-related matters.

Mandatory disclosures

The prevailing belief is that mandatory disclosures related to climate risks would enable market participants to factor in these risks. This would instill discipline and encourage firms to adopt cleaner practices, reducing pollution. However, the costs and benefits are not entirely clear. For instance, what are the net gains of mandatory disclosures when firms already voluntarily provide such information in their financial statements? Given the inherent unreliability in measuring climate-related risks, could mandatory disclosures hinder market discipline instead of enhancing it? Moreover, could these disclosures inadvertently promote carbon leakage by pushing firms to relocate their production to countries with less stringent policies, potentially resulting in increased carbon emissions?

In a recent working paper, we delve into these issues using an economic framework where domestic firms produce either locally or by outsourcing to foreign suppliers. Each of these firms generates direct carbon emissions when they produce domestically and indirect carbon emissions when they outsource production to foreign suppliers. To account for measurement errors when allocating indirect emissions from upstream and downstream activities, we assume that domestic firms share a common supplier. Each firm’s production plan generates short-term financial gains but also carries long-term environmental costs.

We model two types of climate risks that impact a firm’s long-term environmental costs. The first type is transition risk, linked to how well an organization manages and adapts to changes to reduce greenhouse gas emissions and shift to renewable energy. This risk is typically idiosyncratic and depends on individual firm characteristics and operating conditions. The second type is physical risk, stemming from climate change, encompassing harm to businesses and assets caused by acute climate-related disasters (such as wildfires, hurricanes, floods) and chronic risks from long-term temperature changes, droughts, and rising sea levels. Since physical risk is influenced by broader climate change patterns, it is likely influenced by the cumulative environmental impacts of all firms rather than individual ones.

Tangible consequences

A central focus of our research is to examine the tangible consequences of climate-related disclosures. These disclosures assist market participants in assessing firms’ climate risks arising from their operational impact on the environment. Improved pricing efficiency, as a result, alters firms’ production choices, affecting both production efficiency and environmental impact. In practice, domestic regulators impose requirements on measuring the environmental impact of firms’ operations within their jurisdiction. For instance, the European Union (EU) mandates firms to measure greenhouse gas emissions from their European productions but faces limitations in regulating measurements beyond its jurisdiction. In other words, the EU is unable to directly regulate climate-related aspects of productions outside Europe. This limitation in climate-related regulation is a key driver of carbon leakage, a central focus of our study. We compare two approaches: (1) a direct emissions regime, where a domestic regulator mandates domestic firms to report only the environmental impact of their own productions, excluding indirect emissions from foreign suppliers, and (2) a commingled indirect emissions regime, where domestic firms must report not only their own production’s environmental impact but also the total environmental impact of their foreign suppliers’ production.

Our research yields several important findings. Even in the absence of measurement challenges, when prices fully reflect climate-related risks, mandatory climate disclosures enhance efficiency compared to voluntary reporting. This result is intuitive, as firms often do not fully consider the environmental impact of their production, leading to overproduction and excessive pollution compared to socially optimal levels. In the presence of measurement issues, while prices continue to deter pollution incentives, their disciplining role depends on the precision of firms’ direct and indirect emissions measurements. More accurate disclosure of direct emissions influences domestic production choices, reducing direct emissions. Similarly, precise disclosure by foreign suppliers regarding total indirect emissions curbs firms’ indirect emissions.

Globally coordinated policies

However, more precise direct emissions disclosure can prompt firms to shift production to foreign suppliers where indirect emissions are less accurately assessed and priced, leading to carbon leakage. To mitigate the problem, one potential solution is to mandate the disclosure of information related to indirect emissions. While this reduces carbon leakage, it may also lead to reverse leakage, as firms move their production to jurisdictions with still laxer disclosure requirements. As the precision of indirect emissions disclosure improves, if we want to make this information welfare-enhancing, the precision of direct emissions disclosure must be enhanced as well.

A crucial policy implication of our research is that the precision requirements of direct and indirect emission disclosure must be aligned. In other words, regulators should not set disclosure requirements in isolation but coordinate their policies globally. Our analysis cautions developed countries not to create unilateral increases in disclosure requirements, particularly considering the limited availability of high-quality emission data in developing countries integrated into the global supply chain. Regulators should assess whether to mandate indirect emissions disclosure on a case-by-case basis, given the potential ambiguous effects. Our findings help reconcile EU and US policy decisions on mandatory indirect emissions disclosure.

One contentious issue is the measurement of Scope 3 emissions of individual firms, particularly when allocating indirect emissions in cases of shared upstream and downstream activities. We shed light on this debate by comparing a commingled indirect emissions regime with a separated regime in which domestic firms must disaggregate and report the portion of total environmental impacts attributable to them from the foreign supplier’s production. We demonstrate that the optimality of a separated indirect emissions regime versus a commingled one depends on two firm environment features. The first is intuitive: if measuring and allocating indirect emissions to individual firms is sufficiently reliable, then separation is preferable as it provides high-quality information that enhances market discipline relative to a commingled regime. The second feature is more intriguing: whether separation is desirable depends on firms’ relative exposure to different types of climate risk. Separating indirect emissions improves efficiency when firms’ climate risk exposure is more idiosyncratic. Therefore, regulators should mandate separated indirect emissions reporting in industries primarily exposed to transition risk (such as oil and gas companies), while allowing commingled reporting in industries where physical risk dominates climate risk (as in the case of agriculture, aquaculture and fishing).

This blog was originally published by LSE Business Review on 9 October 2023.