Why investors may need mandatory certification of firms' ESG claims

Research finds that independent audits can enhance the reliability of ESG information

Published: Sep 7, 2022 02:09:24 PM IST

Updated: Sep 7, 2022 02:54:25 PM IST

The SEC has recently proposed rules that would require extensive climate-related disclosures (ESG) by publicly traded companies Image: Shutterstock

As many publicly-traded companies have made commitments regarding Environmental, Social and Governance (ESG) issues, such as climate change, investors are taking note.

But just how companies measure and report progress remains up for debate. Recently, the U.S. Securities and Exchange Commission (SEC) proposed rules to standardize climate-related disclosures for investors.

Xu Jiang, an associate professor of accounting at Duke University’s Fuqua School of Business, studies the economic consequences of accounting and auditing standards, and says reporting may not be enough to ensure investors have adequate information about ESG issues. He argues instead that requiring independent certification of ESG claims might be a better approach.

Jiang recently co-authored a paper, “The Value of Mandatory Certification: A Real Effects Perspective,” forthcoming in the Journal of Accounting Research, that examines the impact of mandatory disclosure versus mandatory certification of information that’s available to investors.

Mandatory disclosures refer to public information that can affect the future value of the firm, such as direct information about cash flow and earnings, or indirect information about cash flow, such as climate risk disclosures that would eventually affect cash flow. Mandatory certifications by independent auditors ensure that disclosures being made to investors are indeed accurate.

In the following interview, Jiang describes their findings and the significance of their research.

Can you briefly describe the main findings of your paper?

We show that in the presence of myopic managers—those who only care about short-term prices and whose choices and private information signals are not observable by investors—merely requiring disclosure of the firm’s performance is not sufficient. That is why mandatory certification is also crucial. In fact, mandating disclosure without certification may result in even worse outcomes, in terms of investment efficiency, than not requiring either.

Why is that significant for investors?

Because investors in general face myopic managers who have an information advantage. When managers only care about short-term outcomes, investors need proper disclosure regulations that control how managers should disclose information to make sure the investors’ long-term interests are protected. How such regulation should be designed is therefore significant for investors.

The SEC has recently proposed rules that would require extensive climate-related disclosures (ESG) by publicly traded companies. What are the implications of your findings on the SEC's proposal?

Our findings suggest that merely mandating disclosure is not enough, which is particularly relevant given that, in practice, very few firms certify such ESG disclosure.

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While mandatory certification would be beneficial to investors, what financial impact would the cost of this certification have on businesses? Might it force some business to close?

The cost of certification may be extremely burdensome for some businesses, in particular small businesses. However, if the regulator’s objective is the welfare of the whole economy and all investors, then such a mandate is necessary. Perhaps the regulator can consider providing some assistance for small firms to comply in the form of subsidies that lower their certification costs.

As we continue to see more and more climate-related catastrophes, what more should the SEC. consider going forward?

Mandate not only disclosures related to climate risk, but that such disclosures be certified through either an auditor or consulting firms specialized in estimating climate risk, including, for example, the amount of carbon dioxide emissions.

[This article has been reproduced with permission from Duke University's Fuqua School of Business. This piece originally appeared on Duke Fuqua Insights]