Why Climate Disclosure is Key in Driving Efficient Green Investments

The debate continues on whether corporations have a social responsibility that goes beyond maximizing profits. Should companies only focus on generating the highest return for their shareholders? Or, as the world faces a climate crisis, should they also invest in technologies that improve their environmental performance?

Perhaps the two goals are not separable, according to new research from Hao Xue, an associate professor of accounting at Duke University’s Fuqua School of Business.

“If a company's financial and social performances can be separated, then we already know—from Milton Friedman—that it’s most efficient to just maximize the profit and then let the shareholder choose what they want,” Xue said. “But for other scenarios, for instance with pollution, those outcomes may not be separable.”

In his paper, “ESG Disclosure, Market Forces, and Investment Efficiency,” published in The Accounting Review, Professor Xue shows that sharing reliable emission information enables sustainability-conscious investors to influence how companies operate.

But Xue also cautions that more precise emission disclosures aren’t always better, as they can pressure companies to focus too much on environmental issues. The key, he says, is finding the right balance in how much information companies share.

Why companies need to report their climate performance

Xue’s model assumes that some investors are sensitive to the social performance of the company. When they trade stocks, such investors value environmentally conscious firms. But there is a problem: investors can’t always see what’s really going on inside a company.

“Even if they care more about the environment and want to punish the polluting firms by lowering their stock price, they don’t have the information they need to see firms’ actual emissions,” Xue said. “If that is the case, they can only guess.”

Xue’s research shows that “Environmental, Social, and Governance” (ESG) disclosures would give companies a way to share this missing information. When firms report on their environmental performance, it helps investors better assess the firms, and stock prices begin to reflect both financial results and responsible practices.

That, in turn, pushes companies to align their investments with what shareholders value—not just short-term profits.

However, Xue cautions that overly precise ESG disclosures may bear the risk of pressuring firms to place too much emphasis on ESG factors, undervaluing the financial performance of the company.

The key, according to Xue, is balance. The purpose of ESG disclosure is to align firms’ profit-ESG trade-off with that of the stakeholders, he said. This is a delicate task, which cannot be achieved without a proper level of disclosure.

“The disclosures are a tool to iron out market inefficiencies,” he said. “Market forces should still drive how firms make decisions.”

Why climate disclosures should be mandated

Governments around the world are taking different approaches to corporate climate disclosures. In 2022, the European Union adopted the “Corporate Sustainability Reporting Directive,” requiring companies to disclose the environmental and social impacts of their activities. On the other hand, the U.S. Securities & Exchange Commission (S.E.C.) has been recently retreating from the pro-disclosure stance of the previous administration.

Xue’s research shows that such mandates might be necessary. When firms operate in an economy where pollution reduces productivity for everyone—for example, through the effects of climate change—each company has an incentive to let others take on the costs of reducing emissions. Economists call this the “tragedy of the commons”: when everyone benefits from a clean environment, but no one firm wants to bear the cost of protecting it.

His model shows that if climate disclosure is voluntary, “everybody would disclose too little, and pollute too much.”

“In this case, mandating a more precise or detailed climate disclosure than would be voluntarily provided motivates self-interested firms to act on common interests in reducing emissions,” Xue said. “

Less intrusive than a carbon tax

In economic terms, mandating climate disclosures acts like a Pigouvian tax—a common example of which is a carbon tax, a mechanism that makes companies internalize the social costs of their actions. 

“Interestingly, a regulator can leverage market forces and a disclosure mandate to achieve a similar result as a Pigouvian tax,” Xue said, “motivating firms to internalize the externalities created by their climate-related investments.”

But unlike a direct carbon tax, disclosure rules work through transparency rather than taxation, Xue explained.

“A disclosure mandate effectively brings the social cost of emissions to individual firms’ decision-making,” he said. “It’s less intrusive and much easier to pass at the legislative level.”