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choosing instead to state in its 2011 through 2014 10-K filings that “it was not possible to reasonably predict the impact that any such laws or regulations may have on [Peabody’s] results
of operations, financial condition or cash flows” New York Attorney General 2015. Although Peabody eventually agreed to fully disclose in its 10-K filings the potential impact of climate
change regulation on the value of its coal reserves, investors suffered millions of dollars in losses as the company’s shares dropped from 1,000 in 2011 to around 4 four years later, and it filed
for bankruptcy in April 2016.
III. THEORY AND HYPOTHESES DEVELOPMENT
According to federal securities laws, materiality is “the cornerstone” of the corporate disclosure system and serves as a “standard for determining whether a communication filed or
otherwise omits or misstates a fact of sufficient significance that legal consequences should result” Sommer Report 1977, 320. In Basic, Inc. v. Levinson 485 U.S. 224 1988, the
Supreme Court upheld the definition of materiality as laid out in TSC Industries, Inc. v. Northway, Inc. 426 U.S. 438, 439 1976, further clarifying that to fulfill the materiality
requirement there must be “a substantial likelihood that disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of
information made available.” Heitzman et al. 2010, 111 state that “materiality defines the threshold between the
important and the trivial.” Drawing on both federal securities regulation and case law, Heitzman et al. 2010 assert that if a given item meets a materiality threshold, then managers have an
affirmative duty to disclose it in the firm’s SEC filings. Regulation S-K articulates the non- financial statement disclosure requirements under both the Securities Act and the Exchange Act
SEC 2016. Both of these Acts require registrants to disclose information deemed necessary by
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the Commission, in the public interest, or for the protection of investors SEC 2016, 23928.
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The 2010 SEC interpretive guidance requires registrants to apply existing materiality rules, consistent with the Supreme Court’s definition of materiality and case law, to guide their CCR
disclosure decisions.
Cost of Equity Effect: Materiality and Enforcement of CCR Disclosures
Notwithstanding the existing regulation, managers’ decisions whether to disclose CCR are complicated due to two key institutional factors. First, there is little consensus, even across
firms within the same industry, on whether climate change is a material risk to firms Hulac 2016; Coburn and Cook 2014.
9, 10
For instance, Wells Fargo has not been disclosing CCR in its 10-K filings, even though the company includes detailed GHG emissions data in its corporate
social responsibility report. Second, the SEC has not consistently enforced regulations on CCR disclosure. Therefore, managers’ perceptions of SEC enforcement of these disclosures likely
vary along a continuum from weak to strong. As Figure 1 shows, managers’ ultimate CCR disclosure decisions are the observable outcome of their unobservable assessments of the
materiality and SEC enforcement of CCR disclosures, as well as their evaluations of the costs and benefits of disclosing versus not disclosing CCR. We use Figure 1 to guide our discussion
and motivate our hypotheses. |
Insert Figure 1 about here |
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Although the initial materiality determination is management’s, this judgment is subject to challenge or question by the Commission or in the courts Sommer Report 1977, 332. To determine whether information is material,
courts evaluate whether the “likelihood exists that the event is reasonably likely to occur” Schwartz and Mussio 2007. If a firm determines that a trend, demand, commitments, event, or uncertainty is unlikely to occur, then the
firm has no duty to disclose Wallace 2008, 307.
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In fact, disagreements regarding CCR materiality surfaced in the SEC commissioners’ 3-2 vote on the 2010 interpretive guidance. One dissenting commissioner did not believe that the guidance “will result in greater
availability of material, decision-useful information geared toward the needs of the broad majority of investors” Casey 2010.
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We discuss this further and provide empirical evidence in Section V.
10
Disclosing Material CCR is Mandatory
Due to disclosure requirements laid out by federal securities laws, disclosing information in regulatory filings may signal that managers assess the information as material. A recent study
finds that mining-related citations and injuries of firms that disclose mine safety records in SEC filings are significantly lower than those of non-disclosing firms Christensen, Floyd, Liu, and
Maffett 2016. The authors reason that investors and other stakeholders might perceive managers’ decisions to disclose mine safety records as an implicit signal that managers assess
this information as material. Importantly, these records are already publicly available through the Mine Safety and Health Administration’s MSHA website. Further, SEC filings broadcast mine
safety records to a wide range of interested parties at a low incremental acquisition cost—even if investors are not explicitly looking for them.
There are at least two mechanisms to compel firms’ disclosure of material information. First, the SEC ensures that firms are providing mandatory disclosures by periodically reviewing
firms’ SEC filings and issuing comment letters if the filings are deficient. Research shows that the SEC’s comment letter review pressures companies to disclose material firm-specific risks in
their SEC filings Johnson 2010; Bozanic, Dietrich, and Johnson 2015. Recent research also documents lower bid-ask spreads and higher earnings response coefficients following SEC
comment letter resolution Johnston and Pettachi 2015. Second, stakeholders continue to pressure firms—via a flurry of shareholder resolutions—and to demand the SEC to enforce
disclosures of material CCR EY 2015; Coburn and Cook 2014; Gelles 2016; Hulac 2016; Ceres 2007. As discussed earlier, ExxonMobil’s shareholders recently filed a class-action lawsuit
against the firm due to its refusal to disclose its oil reserves as stranded assets Hasemyer 2016.
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Based on the above discussion, if managers assess CCR as material to the firm and view the regulation regarding these disclosures as strongly enforced e.g., through the SEC’s periodic
review of registrants’ filings, then they will comply with mandatory disclosure under Regulation S-K see Figure 1, box 5. Disclosing not disclosing signals that managers assess climate
change as a material not material risk to the firm. Therefore, we expect that firms disclosing CCR will have higher COE than non-disclosing firms to compensate investors for material CCR.
Managers View Disclosing Material CCR as Essentially Voluntary
Despite mounting pressure from regulators and investors, managers may perceive SEC regulation as weakly enforced. Although the SEC issued interpretive guidance on reporting CCR,
related legislation on cap-and-trade that registrants had anticipated was ultimately not enacted. This led some public companies to view enforcement of CCR disclosures in general as a lower
priority for the Commission GAO 2016, 21.
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Indeed, the SEC has issued only a small number of CCR-related comment letters Coburn and Cook 2014, 5. In 2010 and 2011 combined, the
SEC issued only 49 comment letters specifically addressing these disclosures, while they issued only three such comment letters in 2012 and none in 2013 Coburn and Cook 2014, 5. Some
parties have interpreted the lack of CCR-related SEC comment letters as indicative of the SEC not enforcing CCR disclosure regulation Gelles 2016.
If managers assess CCR as material to the firm but perceive the regulation regarding these disclosures as weakly enforced, then they will view disclosing material CCR as essentially
voluntary. This will likely trigger an analysis of the benefits versus the costs of disclosing
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According to the SEC staff, the priorities of the Commission changed after the 2010 Guidance was issued. As a result, the Commission’s Investor Advisory Committee, which was charged with making recommendations
regarding climate-related disclosures as part of its overall regulatory mandate, was disbanded shortly after the Guidance became effective. Instead, the SEC’s priorities and limited resources moved to the Dodd-Frank Act and
the JOBS Act GAO 2016, 21; Cheney 2012.
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material CCR see Figure 1, boxes 3 and 4. The costs of disclosing CCR include the deleterious effects of revealing proprietary information Verrecchia 1983 and CCR-related supply chain
risk. The benefits of disclosing CCR include avoiding potential climate change-related lawsuits McCann 2016; Olson and Viswanatha 2016; Hasemyer 2016.
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Thus, if managers conclude that the perceived benefits of disclosing material CCR outweigh the perceived costs, then they will
choose to disclose see box 4. Otherwise, managers will choose to not disclose, even if they assess CCR as material Figure 1, box 3.
If managers view disclosing material CCR as essentially voluntary, consistent with the voluntary disclosure literature Healy and Palepu 2001; Botosan 2000, 1997; Verrecchia 1983, a
perceived benefit of disclosure is a potential decrease in the firm’s COE. Research on voluntary disclosures of corporate social responsibility CSR reports documents that firms that issue CSR
reports experience a decrease in their COE if the firms show superior CSR performance Dhaliwal et al. 2011. Voluntary disclosures are also used to reduce potential regulatory
intervention Blacconiere and Patten 1994. If managers view disclosing material CCR as essentially voluntary, then disclosing not disclosing signals that managers view the benefits of
disclosing as greater lower than the costs of disclosing boxes 4 and 3, respectively. Based on these arguments, we expect that firms that disclose material CCR will have a lower COE than
non-disclosing firms.
Disclosing Nonmaterial CCR is Voluntary
Much like boxes 3 and 4 in Figure 1, boxes 1 and 2 reflect the results of managers evaluating the perceived benefits of disclosing relative to the perceived costs of disclosing if they
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Managers’ decisions whether or not to disclose CCR may be unrelated to their assessments of the materiality of CCR. For example, a decision to not disclose may be due to the fact that the firm has neither the resources nor the
systems in place to measure and report on CCR and its effects on a firm’s operations and cash flows. As discussed in Section IV, we control for these other factors to rule them out as alternative explanations for our findings.
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assess CCR as not material to the firm. Disclosing not disclosing implicitly signals that managers view the benefits of disclosing as greater lower than the costs of disclosing boxes 2
and 1, respectively. Again, consistent with the voluntary disclosure literature Healy and Palepu 2001; Botosan 2000, 1997; Verrecchia 1983, a perceived benefit of disclosure is a potential
decrease in the firm’s COE. Based on these arguments, we expect that firms that disclose CCR will have a lower COE than firms that do not disclose CCR.
The above competing arguments lead to our first hypothesis:
H1: The COE of firms that disclose CCR in Form 10-K is different from the COE of firms
that do not disclose CCR in Form 10-K. Our hypothesis may not obtain if the market considers that firms’ voluntary CCR
disclosures through non-SEC mechanisms are sufficiently informative to investors. Alternatively, the market may view CCR disclosures as mandatory but boilerplate in nature
Merkl-Davies and Brennan 2007. In both cases, managers’ decision to disclose CCR may provide no incremental information to investors about firm risk. In addition, if CCR is a
diversifiable risk Sharpe 1964; Lintner 1965, then there will be no association between disclosing CCR and COE.
The above discussion highlights the importance, both theoretically and empirically, of recognizing that disclosing firms may be systematically different from non-disclosing firms.
Both economic theory Akerlof 1970 and voluntary disclosure theory Beyer et al. 2010 posit that, if disclosure is voluntary, then managers choose to disclose when the benefits of disclosing
outweigh the costs of disclosing. This underscores the importance of correcting for self-selection when estimating disclosure models. Therefore, using data from disclosing firms to draw
inferences about non-disclosing firms without adjusting for the systematic differences between them can give rise to biased coefficients, and thus, erroneous conclusions.
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Inter-Industry Materiality Differences
Our first hypothesis examines the association between investors’ inferences regarding managers’ CCR materiality assessments which are unobservable, their CCR disclosure
decisions which are observable, and firms’ COE. Both the SEC and the FASB recognize that materiality is context specific, varying greatly with the nature of business. The Sommer Report
1977, 340 specifically discusses differences in materiality of information across industries and states that “… disclosures material to one industry should not be required for other industries as
to which they are not applicable.” We draw on prior research examining the differences in materiality of information across different types of firms to probe deeper into the association
between managers’ decisions whether to disclose CCR and firm risk. Cheng, Liao, and Zhang 2013 find that smaller reporting companies that chose to
continue disclosing certain non-financial information in SEC filings after a mandatory-to- voluntary regime shift by an SEC rule experienced an increase in market illiquidity. However,
the increase in illiquidity was even larger for firms that discontinued disclosing this information. The authors argue that the association between the choice to disclose and market illiquidity
depends on the materiality of the potentially reduced information. They further reason that material information provided in firms’ SEC filings may be especially useful to smaller reporting
companies’ investors because, relative to larger firms, these companies have a poor information environment, including lower analyst following and media coverage. The findings from Cheng et
al. 2013 point to the important role of the materiality of nonfinancial disclosures for smaller companies’ investors, but do not address the materiality of such disclosures for investors of
larger companies.
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Christensen et al. 2016 examine reporting requirements in mining companies. The Dodd-Frank Act of 2010 requires mining companies to disclose in Form 10-K their mine health
and safety records, information which is uniquely material to this industry. The authors find a lower incidence of mining-related citations and injuries for disclosing firms relative to non-
disclosing firms, even though these records are already publicly available elsewhere. The authors reason that investors may perceive managers’ decisions to disclose mine safety records in SEC
filings as an implicit signal of that information’s materiality. In addition, disclosing reduces investors’ cost of gathering this information.
To our knowledge, the Khan et al. 2016 study is the first to examine inter-industry differences in the materiality of ESG issues for investors. Using the newly-available SASB
Materiality Map
™
, they hand-map sustainability investments to independent ratings of firms’ ESG performance specifically, KLD ratings to measure investments on material and immaterial
ESG issues for each of their sample firms across 45 industries.
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Importantly, SASB’s Materiality Map
™
relies on the Supreme Court’s definition of materiality. Khan et al. 2016 report that firms with strong ratings on material ESG issues have better future accounting
performance than firms with inferior ratings on the same issues. In contrast, firms with strong ratings on immaterial ESG issues do not outperform firms with poor ratings on these same
issues. Further, firms with strong ratings on material ESG issues and concurrently poor ratings on immaterial ESG issues have the best future accounting performance. The authors conclude
that materiality guidance enhances the informativeness of ESG data for investors.
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KLD statistics currently available in the MSCI database in WRDS provide firm-level ratings on an array of over 50 sustainability issues and rank firms’ performance on those issues. This database and SASB’s Materiality Map
™
are discussed further in the next section.
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The above studies indicate that the relationship between firms’ decisions whether to disclose CCR and COE will likely vary depending on report users’ judgments regarding the
materiality of CCR across industries. Based on these arguments, our next hypothesis examines the role of materiality on the association between disclosing CCR and COE:
H2: The association between disclosing CCR in Form 10-K and COE is stronger for firms
where users judge such disclosures as material than for firms where users judge such disclosures as not material.
IV. RESEARCH DESIGN
