Green Disclosure Requirements and the Green Transition
Green disclosure requirements, which mandate companies to publicly report their environmental impact and sustainability efforts, have emerged as a prominent policy tool. Advocates of green disclosure regulation emphasize their importance in promoting transparency to support the economy’s green transition. For instance, the European Union describes the Sustainable Finance Disclosure Regulation (SFDR) as a “transparency framework” that will help sustainable investors make informed choices. The main objective of the regulation is to help “the shift to a net-zero economy.”
Designing Effective Green Disclosure Requirements
While green disclosure requirements offer a potentially powerful policy, regulators face numerous questions when designing these requirements. For example, should they be as strict as possible or could there be benefits to limiting transparency? Should the requirements evolve and become stricter over time, like the EU’s SFDR and the SEC’s climate disclosure rules? How should factors such as the cost of investments in green technology affect the design?
Our paper, “Dynamic Green Disclosure Requirements,” considers how regulators should optimally design green disclosure requirements. A key takeaway from our work is that if regulators employ very strict requirements from day one, it can backfire and prevent firms from becoming greener.
The Benefits of Limiting Transparency
We model the green transition as a dynamic and multi-step process. This allows us to capture the idea that the early stages of the green transition process may be particularly costly for firms, reflecting factors such as the need to write down stranded assets, undertake substantial capital expenditures, or engage in green research and development. Importantly, high initial costs of adopting green technologies can create potential “roadblocks” in the green transition process.
We show that strict green disclosure requirements early on may not be effective if such roadblocks exist. In such cases, regulators can benefit from implementing laxer disclosure requirements that effectively obscure firms’ precise level of greenness from investors. We refer to this deliberate obfuscation as “government-mandated greenwashing.” Such an approach rewards firms with a “mis-valuation subsidy” because sustainable investors assign disproportionately high prices to firms for undertaking initial steps in the green transition, providing them with the incentives they need to overcome early roadblocks. This notion of government-mandated greenwashing differs from the common concept, which typically refers to firms intentionally misrepresenting their level of greenness.
Consider the example of a car manufacturer deciding whether to transition to producing electric vehicles (EVs). This green transition involves multiple steps. For example, developing an EV model is one significant step, but ensuring that the batteries are sustainably sourced is another critical aspect. If strict green disclosure standards required both the production of EVs and fully sustainably sourced batteries for the manufacturer to be considered “green,” the costs might be prohibitively high, deterring the company from taking any action. However, if the company is rewarded for taking the first step of developing an EV by getting a label of “green,” even if its battery sourcing is not fully sustainable, the manufacturer is more likely to begin the transition.
Increasing Transparency Over Time
How do we incentivize the car manufacturer to source its batteries sustainably eventually while still maintaining its incentive to develop an EV model? We show that a dynamic approach, in which green disclosure requirements become stricter over time, can incentivize the company to enact ‘clean’ sourcing of its EV batteries after it has already overcome the roadblock of switching production to EVs. Implementing stricter green disclosure requirements in the future not only incentivizes companies to pursue later stages of the green transition but can also boost early steps in the green transition as firms anticipate these future investments.
While such a dynamic approach may best help firms complete the green transition and overcome early roadblocks, we highlight an important trade-off between the speed and the breadth of the green transition. Dynamic green disclosure requirements may slow down the pace of the green transition for some firms while increasing the total number of firms that eventually reform.
Practical Implications and Future Directions
Our analysis offers insights to regulators for assessing green disclosure initiatives. In practice, many green disclosure requirements that have been implemented to date become more stringent over time. For example, the SEC’s climate disclosure rules mandate less detailed, more qualitative disclosures in fiscal year 2025 and require more detailed disclosures relating to financial expenditures and greenhouse gas emissions starting in fiscal year 2026. Our model suggests that such dynamic features may be optimal by encouraging firms to undertake significant early investments necessary for the economy’s green transition.
Looking ahead, the design of green disclosure requirements will be a crucial building block in facilitating the planet’s green transition. Given the urgency of the climate crisis, more research is needed to understand how to best use disclosure regulation to incentivize firms to transition toward greener technology.