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Economic Analysis of Widespread Adoption of CSR and Sustainability Reporting Standards

Posted by Christian Leuz

In a recent report, coauthored with Hans Christensen and Luzi Hail, we provide an economic analysis for a widespread adoption of corporate social responsibility (CSR) reporting standards in the United States. Using an extensive review of the academic literature in accounting, finance, management, and economics we discuss possible economic consequences, including real effects and implementation issues, related to the adoption of such disclosure and reporting standards by U.S. companies. The seven key questions I address below reflect the structure of our report.

Among various definitions of CSR, we consider “CSR” to denote corporate activities and policies that assess, manage and govern a firm’s responsibilities for and its impacts on society and the environment. In line with this definition, we refer to CSR reporting as the measurement, disclosure, and communication of information about CSR-related topics, including CSR activities, risks and policies. Overall, our economic analysis yields to several key insights, which I briefly summarize here. However, I encourage readers to evaluate our report in its entirety.

 

1. What does the academic literature in accounting, finance, and economics tell us about the potential costs and benefits of CSR disclosures to firms?

Generally speaking, we suggest that much of the voluntary financial disclosure literature findings (on capital market effects, real effects, disclosure costs) would apply also to CSR reporting. However, the wide-ranging and multifaceted nature of CSR topics and the large set of potential users of CSR information imply that research findings for financial reporting do not necessarily carry over one-for-one to CSR reporting. We need to carefully apply and adjust the insights from financial reporting when discussing potential economic consequences of mandatory CSR standards.

 

2. What does academic literature in accounting, finance, and economics tell us about the effects of CSR standards on CSR reporting practices?

The key features of CSR reporting predict considerable heterogeneity in firms’ reporting practices as well as significant challenges for measurement and standardization. At the same time, standardization of CSR reporting could have large payoffs (e.g., harmonizing disparate reporting practices on CSR activities that are similar in substance). Importantly, however, adopting CSR standards is not sufficient for harmonized CSR reporting practices. The reporting incentives literature suggests that the role of accounting standards in shaping reporting practices has its limits. Standards provide substantial discretion, which firms exercise in line with managers’ reporting incentives. This argument applies equally to disclosures (e.g., firms can use boilerplate language if they prefer disclosures to be uninformative). Analogously, it is important to think about managers’ incentives to provide CSR information. The international accounting literature shows that adopting the same set of reporting standards is not sufficient to achieve harmonized reporting practices, and this outcome is not just a matter of enforcement. The literature shows that as long as firms’ reporting incentives differ, harmonization of reporting practices is limited, even when the standards are well enforced. These insights are important if expected comparability benefits and harmonization of CSR reporting are a key motive for the adoption of CSR standards.

Furthermore, the interaction of CSR reporting standards with other institutional arrangements deserves attention. In particular, assurance and proper enforcement of CSR standards are critical and require a substantial (public or private) infrastructure. We highlight that, in many cases, CSR reporting standards are likely harder to enforce than financial accounting standards (particularly when it comes to the materiality issues).

 

3. What are the key determinants and the current state of CSR reporting?

Our review of the CSR literature on the determinants of (voluntary) CSR disclosures as well as an independent analysis of SEC-registered firms’ reporting practices in regulatory filings based on SASB data confirms that there is substantial heterogeneity in CSR disclosures, both across industries as well as within industries. We also note that the economic forces that drive voluntary CSR disclosures share some commonality with voluntary disclosures in general. This commonality, in turn, makes it difficult for researchers to separately estimate the effects of CSR disclosures on capital-market and other outcomes (e.g., because the outcomes also reflect firms’ other disclosure strategies and choices).

Furthermore, we find that there is substantial variation in the level of reporting harmonization across industries. While this evidence could be viewed as suggesting a need for harmonization and CSR standards, we have to interpret it cautiously. The observed variation likely also reflects heterogeneity in firms’ business activities, the materiality of these activities as well as heterogeneity in costs and benefits of providing disclosures.

 

4. What are the potential stakeholder effects of mandatory CSR reporting standards?

Empirical evidence on the effects of CSR reporting is limited and still developing. Much of the literature focuses on the valuation and performance effects of CSR activities, not on the effects of CSR reporting. For CSR reporting studies, a key challenge is to disentangle the reporting effects from the effects of the underlying CSR activities, especially when relying on voluntary disclosures (and voluntary CSR activities). Studies on CSR reporting mandates are rare and tend to have less favorable findings than studies on voluntary CSR reporting. Thus, selection problems in studies on voluntary CSR reporting have to be taken seriously when interpreting the results. We need more research on whether mandated CSR disclosures mitigate information asymmetries, give rise to externalities, and the extent to which CSR standards provide market-wide cost savings and/or comparability benefits.

CSR reporting standards have the potential to improve information to investors. By how much likely depends on the specificity of the standards, firms’ ability to “comply” with the standards by providing boilerplate language as well as the enforcement of CSR standards. A mandatory CSR reporting regime could provide commitment and credibility for firms’ CSR disclosures, especially if the standards are specific and well enforced. The magnitude of the capital-market effects from a CSR reporting mandate depends on the extent to which firms currently withhold material CSR-related information and, hence, on firms’ compliance with existing disclosure requirements and securities laws that stipulate the disclosure of material information. If firms already disclose all material CSR-related information, then the primary benefits of CSR standards have to come from a harmonization of reporting practices, including cost savings to investors (e.g., when processing CSR information), better comparability, and/or increases in CSR disclosures due to better across- firm comparisons and peer pressures.

CSR reporting standards could also make it easier for other stakeholders, not just investors, to compare and benchmark CSR topics and activities across firms. While these other stakeholders often are at the core of CSR, their interests are not necessarily defined in monetary terms. Thus, it is less clear what information they need and how one can assess whether their needs are met. Moreover, the interests of these stakeholders can change quickly, for instance, as the public debate of certain CSR issues changes. This shifting nature of the demand for CSR information makes the standardization of CSR reporting challenging. There are fewer studies on the effects of CSR reporting on stakeholders other than investors and capital markets and it is hard to assess the potential effects of mandatory CSR standards on other stakeholders. But if other stakeholders use CSR disclosures for their purposes (for instance, to pressure firms on certain CSR issues, then firms may adjust their behavior, leading to real effects. These potential real effects from a CSR reporting mandate need to be carefully considered.

 

5. What are the potential firm responses and real effects from mandatory CSR reporting standards?

Assuming CSR standards succeed in increasing or harmonizing firms’ CSR disclosures, we expect that firms respond to a CSR reporting mandate by making changes to their business and CSR activities, that is, there are real effects. The literature suggests that firms generally respond to CSR reporting requirements by expanding and adjusting their CSR activities. Benchmarking appears to drive, at least partly, how firms respond (e.g., firms aim to avoid negative publicity associated with performing worse than their peers in sensitive CSR areas). The increase in CSR activities will likely be stronger for poorly performing firms. A CSR reporting mandate could also reveal CSR activities that managers pursue for personal reasons. With a mandate, we expect managers to scale back such activities, so real effects can result in a better alignment of firms’ CSR activities and shareholder preferences.

There is evidence indicating that increases in CSR activities associated with CSR reporting mandates are costly to firms. While it is unlikely that a reporting mandate induces firms to exit core operations, it is possible that some firms scale back or disinvest activities that are more peripheral. This effect is likely stronger for firms at the lower end of the CSR performance spectrum or those bearing high reputational costs from reporting poor CSR performance.

It is difficult to predict whether the potential effects of a mandate on firm responses are net positive or negative from the perspective of investors, other stakeholders, or society. Real effects can induce firm responses that reduce firm value and, hence, are negative to investors. Yet, CSR issues often pertain to negative externalities and, in turn, improvements in CSR could be desirable from a societal standpoint. A CSR reporting mandate could move firms in this direction, but it could also result in unintended real effects, especially if the mandate is broad in scope. We need more research to understand these tradeoffs better.

 

6. What are important implementation issues for an effective CSR reporting mandate?

Several features make the CSR standard setting process different from the process for financial reporting standards. The broader set of potential users of CSR information changes the nature of the arguments brought forward in the process as well as the tradeoffs in setting standards. The CSR standard setting process not only focuses on key economic tradeoffs related to reporting, but is likely also shaped by societal, political and moral debates about the CSR topics themselves.

While materiality of CSR information can be defined using the same principles as for traditional financial disclosures, determining “what” is material to “whom” is likely more difficult for CSR information. First, the group of potential users is broader than for financial reports. Second, the link between CSR topics and the financial consequences of these topics to the firm is difficult to assess and often unclear, yet central to the definition of materiality (in particular for investors). Thus, managers likely have substantial discretion in determining which information is material, leading to heterogeneity in CSR reporting practices even in the presence of CSR reporting standards. Currently, there is little research that speaks to materiality issues per se.

Boilerplate language as an avoidance strategy is a concern for CSR reporting, highlighting the difficulty of forcing firms to provide meaningful CSR information. CSR standards can play a role in reducing boilerplate language by prescribing what and how firms have to provide information (e.g., in the form of metrics or numerical disclosures). Much depends on the specificity of the standards. An industry focus of CSR standards could make it harder for firms to avoid disclosures by being explicit about which CSR topics and issues are relevant in a given industry. However, specificity at the industry level can at times run counter to cross-industry comparability, presenting a tradeoff to standard setters.

Enforcement plays a major role, if a mandatory adoption of CSR standards is to have substantive economic effects. Creating an effective enforcement regime presents several challenges and requires substantial infrastructure investments into private assurance and public enforcement mechanisms. Mandatory adoption of CSR standards likely leads to an expansion of the demand for assurance services.

 

7. H​ow would the economic consequences differ if mandatory CSR reporting standards focused on investors and their information needs?

CSR standards could be designed more narrowly and have an explicit scope restriction. In particular, they could be limited to CSR information that is material to investors. If such investor-focused CSR standards are based on existing SEC disclosure requirements for material information, they do not expand the CSR information set that firms have to report. In this case, capital-market or real effects from narrow CSR standards have to come primarily from harmonization of reporting practices, improved comparability, cost savings to firms or investors, or better compliance with existing disclosure regulation. If there is substantial non- compliance with current disclosure requirements, then even investor-focused CSR standard could expand firms’ CSR disclosures if the standards facilitate enforcement and /or improve compliance (e.g., through peer pressure). The resulting increase in material CSR disclosures is expected to have significant capital-market and real effects, which are conceptually similar to those discussed for CSR standards without scope limitation.

A focus on investors more clearly defines the boundaries of CSR reporting, which should make implementation and compliance less costly to firms. Moreover, narrower CSR standards reduce the potential for unintended consequences of CSR reporting because such standards prescribe fewer disclosures that could give rise to costly responses by other stakeholder groups and/or real effects relative to broader standards. However, investor-focused CSR standards do not completely avoid stakeholder responses and real effects induced by these non-investor responses. CSR information that is material to investors is often also relevant to other stakeholders, whose responses can be costly (or beneficial) to firms and in turn trigger changes in firm behavior. It is hard to envision CSR standards that have substantial capital-market effects for investors but at the same time can avoid any potential for other stakeholder responses and/or real effects. Thus, these responses and effects still deserve careful attention even with narrower CSR standards.

If CSR disclosures can be used by all stakeholders, whether or not they are the target audience, the notion of (financial) materiality to investors becomes complex. If the responses of non-investor stakeholders to a CSR issue can lead to significant financial consequences for the firm, then information about this CSR issue becomes material to investors (even when the CSR issue per se seems financially immaterial). Thus, even a standard setter with a narrow investor focus needs to consider what CSR information could be used by other stakeholders and the financial implications resulting from other stakeholder responses. As investors increasingly have non-financial interests and objectives, CSR information related to these interests and objectives can be decision relevant and, hence, needs to be considered even when the standards narrowly focus on investors’ information demand.

Given these considerations, the differences between an investor-focused and a broader stakeholder approach to CSR standards (and the differences between their corresponding materiality notions) may be smaller than they might appear at first.

 

Caveats and scope limitations

Our report is not intended to provide a comprehensive cost-benefit analysis of mandatory CRS reporting standards, nor to quantify the net benefits or costs of adopting CSR reporting standards for individual firms or society as a whole. We also note that predicting potential economic consequences of CSR reporting standards, just as for any other future policy change, is difficult and faces considerable uncertainty.

An extensive and systematic overview of the literature is available for download at: http://ssrn.com/abstract=3313793

 

 

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About Christian Leuz

The University of Chicago Booth School of Business
Joseph Sondheimer Professor of International Economics, Finance & Accounting

Christian Leuz, Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago’s Booth School of Business. He is also a Co-Director of the Initiative on Global Markets, a Research Associate at the ...

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