Disclosure of Climate Risk Helps Stocks Trade More Smoothly

Dropping facts into a polarized investor pool reduces the impact of ideology and leads to broader ownership

Given the politicization of climate change policy in the U.S., it wouldn’t be a shocker if publicly traded companies wanted to avoid the topic altogether.

A working paper by Nanyang Technological University’s Jiang Luo, University of Manchester’s Konstantinos Stathopoulos, UCLA Anderson’s Avanidhar Subrahmanyam, University of Nottingham’s Xiaoxia Ye and San Diego State University’s Ran Zhao suggests, however, that investors are realizing notable value from such disclosures. This climate-related transparency creates broader ownership in companies, enhances stocks’ liquidity and helps stock prices to more accurately reflect fundamental value, rather than sentiment or investor guesses.

Notably, the authors observe that America’s deep political divisions over climate change may be precisely why climate disclosure works so well. The more polarized investors are, the more valuable factual information (disclosure) becomes.

The analysis makes a case that providing more climate disclosure appeals to both climate optimists and pessimists. It seems to deliver facts that push both camps to rethink their investment thesis, scaling back their reliance on their beliefs about climate change. When companies provide detailed climate data, it gives both climate optimists (who may have underestimated risks) and pessimists (who may have overestimated them) concrete information to recalibrate their positions based on a more fact-based analysis of how the disclosed information may impact future cash flows.

Enabling Short Selling

The net impact from having more information to go on is that more climate disclosure attracts more (and different) investors, which is preferable to the potential for greater price volatility that can come from more concentrated ownership.

And as ownership broadens, that effectively increases the pool of investors who may be willing to lend out those shares. That lending mechanism is what enables short selling, the market strategy premised on the bet that a stock’s value will fall. While short selling is often perceived as negative, it boosts trading volume and improves liquidity, which in turn makes stock prices more reflective of fundamental value. The researchers observe that broader ownership increases the supply of lendable shares, helping to lower the cost of shorting and improve market quality.

This analysis is agnostic on whether the information disclosed is good or bad news for the firm but focuses on whether a public company increased its disclosure, and if that had any knock-on effects in the ownership and trade-ability of the stock.

Searching for Climate Words

To first identify firms that significantly increased their disclosure the researchers started with 10-K filings — annual reports made to the Securities and Exchange Commission broadly discussing a company’s operations and financial condition — in 2009. As early as 2009, the SEC was signalling it would soon require disclosure of climate risk to business operations. While the formal rule didn’t go into effect until 2010, the researchers used 2009 as their starting point as that is when the market began to focus on disclosure around the issue. 

The research team applied a three-pronged test to identify firms with a big increase in climate disclosure: comparing their rank in disclosure before 2009 and after; their usage of climate-related words in their 10-Ks; and whether removing a firm from a given sample impacted the level of disclosure for the entire sample. 

Then the authors analyzed firms whose disclosure significantly changed starting in 2009/2010 to see how they functioned in the marketplace through 2014.

The researchers found that ownership increased 8% relative to a calculation (general standard deviation) of investment in other companies. The spread between bid and ask prices narrowed 14% on that same basis, a signal of better liquidity. And the supply of stock to short (another liquidity metric) rose 8% while the cost to short dropped more than 20%.

Given the deeply polarized views of climate change in the United States, the researchers dug into modeling work to study the intersection of political beliefs and climate disclosure on investor behavior.

The blue line in the graph below is an analysis when there is a more intense level of polarization, the red line is when polarization exists, but not as fiercely. Ownership (the Y axis) increases with more disclosure (the X axis) in both scenarios, but to a higher level when there is a more polarized universe of potential investors.

A similar analysis for short selling produced the same general trend. The authors also observed that the impact on higher liquidity and reduced price volatility was stronger when they assumed the marketplace was more divided in its climate change beliefs.

ESG Funds Play a Role

The throughline in the modeling is that once given hard facts, people at the extremes moderate their investing behavior, with the net impact being an improvement in ownership, which then sets off a cascade of other changes in a stock’s market “quality.” 

In the real world, one group that has helped drive this ownership broadening is the segment of investment funds with an environmental, social and governance mandate. According to the US SIF foundation, $6.5 trillion of the U.S. stock market is now managed with an ESG focus. 

The researchers observe that socially responsible investment funds in particular increase their ownership of companies that provide more climate-related transparency.