Green finance, sustainability disclosure and economic implications (2024)

4.1.1 Sustainability reporting

Sustainability reporting started as voluntary disclosures. As this trend increases, some countries established regulations that require mandatory disclosure. Corporate disclosure of sustainability benefits the reporting entities and leads to “improved reputation, better risk management, and increased customer and employee loyalty” (). As green finance gains popularity, the capital market demands high-quality information reported by participating companies to guide the allocation of resources toward sustainable business projects and models.

The literature documents an increase in environmental disclosure over the past few decades around the globe and the environmentally sensitive industries tend to be the ones that see the most reports (; Deegan, 2002; ). The growing demand and supply of sustainability reports call for a set of standards that govern the reporting practice. Multiple standards co-exist at the current stage. One example is the Global Reporting Initiative (GRI), which came into being in 1997 with the goal of developing global standards for sustainability reporting. Another example is the Sustainability Accounting Standards Board (SASB) in the US, established in 2011 to develop a framework to guide publicly listed companies in terms of sustainability accounting and reporting.

Quantifying the impact of environmental initiatives is an important task in sustainability reporting. Jeffers (2007, 2008) discusses what should be considered when developing a framework to measure green initiatives and notes the importance to identify and estimate relevant variables in translating environmental initiatives into quantifiable financial data. Gray (2006) offers critiques about sustainability reporting by demonstrating the tension that such reports, especially the high-quality ones, would simply show how incompatible prevailing economic goals are with environmental and social goals. Adams (2020) revisits Gray's (2006) study incorporating recent developments in sustainability reporting standard setting and suggests that the development of GRI standards has brought positive changes.

4.1.2 Carbon accounting

One aspect of quantifying the environmental impact of decision-making is measuring greenhouse gas (GHG) emissions. Carbon accounting as the name suggests specifically focuses on the recognition and measurement of GHG emissions. Through a systematic review of existing literature, Stechemesser and Guenther (2012) derive a definition of carbon accounting as follows: “carbon accounting comprises the recognition, the non-monetary and monetary evaluation and the monitoring of greenhouse gas emissions on all levels of the value chain and the recognition, evaluation, and monitoring of the effects of these emissions on the carbon cycle of ecosystems.”

Based on Stechemesser and Guenther (2012)’s definition, Marlowe and Clarke (2022) review the carbon accounting literature focusing on the business organization level as well as city-level quantification of GHG emissions. They identify a global trend of increasing emissions and conclude that quantifying carbon emissions involves significant measurement uncertainty and lack of comparability. They thus call for policies, procedures and academic work to improve the reporting of carbon accounting.

4.1.3 The assurance of sustainability reporting

Like financial reporting and disclosure, sustainability reporting provides information for decision-making. The efficiency of resource allocation hinges on the quality of information reported by business entities. As sustainability reporting and the use of information in sustainability reports grow, there is a call for independent assurance of such reporting by third parties. Junior, Best, and Cotter (2014) review the literature and analyze the Fortune Global 500 companies to provide comparative and trend analyses of sustainability reporting and assurance of these reports. They find that while an increasing percentage of organizations issue sustainability reports over time, there is no such trend in the practice of having the sustainability reports assured.

A recent study by Alsahali and Malagueño (2021) provides an updated overview of sustainability assurance practices based on a sample of 13,000 companies around the world. The period that they focus on is the recent decade to match the emergence of countries mandating sustainability reports. The study addresses the following aspects of sustainability assurance. First, they examine the trend of sustainability assurance and find that even though significant growth in assurance is observed from 2012 onward, it lagged behind the growth of the sustainability reports. Second, they examine three types of assurance providers, i.e. accounting, engineering and consulting firms, and find that while accounting firms have the largest market share, the most growth is seen in engineering firms. Considering the existence of multiple assurance standards, e.g. the International Standard for Assurance Engagements (ISAE 3000) and the AA1000 AccountAbility Standard (AA1000 AS), the study investigates the choices of standards and finds that different types of assurance providers have different preferences, which raises the concern of inconsistency in the assurance practice. Third, they examine the incidence of companies changing assurance providers from one type to another and find more switches toward engineering and consulting firms than toward accounting firms.

4.2.1 Firm-level determinants of sustainability reporting

Hahn and Kühnen (2013) review existing literature from 1999 to 2011 on determinants of sustainability reporting and disentangle factors that have received consistent evidence regarding their impact on sustainability reporting from other factors around which evidence is inconsistent and ambiguous. Company size is the only internal factor found to have a positive influence on sustainability reporting, whereas evidence is mixed regarding the impact of financial performance and social and environmental performance. Among the external factors, the literature generates consistent results on how media exposure as a proxy for visibility is positively associated with sustainability reporting and that companies from industries with more significant environmental impacts tend to engage more in sustainability reporting. At the time of this review, very limited research has examined the impact of regulation even though countries such as Denmark, Norway and Sweden already started to impose policies and legislation to require companies to make sustainability disclosure.

4.2.2 Regulation, governance, and sustainability reporting

The European Union (EU) Emission Trading Scheme introduced in 2005 represents a significant movement toward governing and incentivizing low-carbon initiatives. Based on a “cap and trade” principle, companies must keep their carbon emission under the cap and at the same time can buy or receive emission allowances to trade with one another.

In terms of regulation of sustainability disclosure, the EU adopted Directive 2014/95/EU, also called the Non-Financial Reporting Directive (NFRD), which was then incorporated by member states into their legislation requiring large European companies to publish regular reports on the social and environmental impacts of their activities. Jackson, Bartosch, Avetisyan, Kinderman, and Knudsen (2020) investigate the effectiveness of mandatory non-financial disclosure requirements and found that firms in countries with such mandates adopt more socially responsible activities without reducing socially irresponsible activities.

Evidence from outside of the EU suggests a positive impact of mandatory disclosure requirements. Ioannou and Serafeim (2017) study the effect of mandatory sustainability reporting by looking at companies in mandating countries including China, Denmark, Malaysia and South Africa surrounding the passage of related regulations. They find that firms not only increasingly provide sustainability disclosure in response to the regulation but also increasingly have their reports assured on a voluntary basis to signal the quality of their reports. The regulation-driven disclosure of sustainability is also found to have a positive association with firm value as proxied by Tobin’s Q. Ren, Huang, Liu, and Yan (2023) test whether the mandatory corporate social responsibility (CSR) reporting requirement in China leads to improved environmental practices and find that firms bound by this mandate show increased green innovation and that such effects are positively moderated by local enforcement intensity, state ownership, and media coverage.

Internal and external governance mechanisms have also been found to promote information disclosure. Using a global sample of 1,047 companies, Fernandez-Feijoo etal. (2013) find evidence that the pressure of stakeholders leads to improved transparency of sustainability reports. Recent literature has provided consistent results on the influence of corporate governance on sustainability reporting around the globe. For instance, Masud, Kaium, Nurunnabi, and Bae (2018) document that in their sample of South Asian countries companies with foreign and institutional ownership, more independent and larger boards tend to have better sustainability reporting performance. Based on a sample of Australian resources companies, Ong and Djajadikerta (2020) show that more independent boards, multiple directorships and representation of female directors are positively associated with the extent of sustainability disclosure, proxied by Ong etal.’s (2016) index. Gallego-Álvarez and Ortas (2017) find evidence consistent with the stakeholder theory in the governance literature in that corporate sustainability reporting practices are responsive to stakeholders’ demands, which in turn are influenced by the cultural environment.

4.3.1 Sustainability disclosure and firm performance

Early evidence on how sustainability translates into company value has been mixed (). While research has found a positive association between sustainability initiatives and corporate value (e.g. ; ), other studies find no significant stock market impact imposed by sustainability reports () or even negative association between corporate social performance and financial performance ().

More recent research provides evidence on the positive side. Alshehhi, Nobanee, and Khare (2018) analyze the literature on the relationship between corporate sustainability practices and financial performance. Reviewing 132 research papers shows the majority of evidence of the positive relationship between the two. International evidence suggests largely consistent results. Lo and Sheu (2007) examine US companies and find a positive relationship between corporate sustainability and firm value as proxied by Tobin’s q. Similar results are found among listed companies in Singapore (). Kuzey and Uyar (2017) examine a sample of Turkish public companies and document a growth of sustainability reporting in the country and find evidence that sustainability is value relevant. Bachoo Tan and Wilson (2013) add Australian evidence to the literature and find that high-quality sustainability reporting reduces the cost of capital and enhances the market’s expectation of future firm performance.

Consistently, carbon accounting research suggests that GHG emission has a negative impact on firm valuation. Griffin, Lont, and Sun (2017) document a negative pricing impact of GHG emission and quantify such impact to be a $79 price discount per ton of GHG emission. Matsumura, Prakash, and Vera-Munoz (2014) examine the effect of carbon emissions on firm valuation and document a negative impact in the magnitude of a $212,000 decrease in firm value for every thousand incremental metric tons of carbon emissions. Further, they find that companies that voluntarily disclose carbon emissions receive a valuation benefit compared to the companies that do not disclose such information.

Most existing research excludes financial institutions from their sample due to the unique feature of the financial industry. Buallay (2019) however specifically study 342 financial institutions from 20 different countries and associate their ESG score with firm performance. The findings show a positive impact of sustainability on market valuation whereas a negative impact on financial and operational performance. The evidence offers insights from the financial industry and suggests that the long-term and short-term effects of sustainability efforts can be different.

4.3.2 Sustainability disclosure and value relevance

A set of research specifically investigates the impact of sustainability reporting on how the market evaluates financial statement metrics, that is, value relevance. Lourenço, Callen, Branco, and Curto (2014) refer to the inclusion of the company in the Dow Jones Sustainability United States Index as a proxy for sustainability reputation. They find that the index companies’ financial data have higher value relevance, suggesting that sustainability reputation is valued by the market. Comparing a set of Indonesian companies that received the Sustainability Report Award with their counterparts, Sutopo, Kot, Adiati, and Ardila (2018) find that the value relevance of award-winning companies is higher, suggesting that high-quality sustainability reporting increases the perceived value of financial statement data. Berthelot, Coulmont, and Serret (2012) provide Canadian evidence that the capital market positively values the reporting of corporate sustainability even when it is voluntary.

Evidence on value relevance points to the capital market benefits of sustainability reporting, which by enhancing transparency and firm reputation improves the market perception of financial reporting. Sustainability as non-financial disclosure has a spillover effect on the efficiency of the capital market while incorporating information contained in financial disclosure into the market valuation.

6.2.1 Firm financial performance

In this subsection, we review literature that examines the relationship between a firm’s financial performance and its green finance practices.

In general, the literature tends to find a positive relationship between green practices and financial performance, although there is disagreement in existing studies. In Alshehhi etal. (2018)’s review paper, 78% of the 132 articles reviewed report a positive relationship between green practice and financial performance, 6% report a negative relationship, and 7% report a no-impact relationship.

We examine the literature and argue that three factors could have contributed to the differing results. First, the variation in the results is attributed to the measurement of financial performance as well as that of green practice. Overall, firm financial performance is measured by (1) the stock market returns, (2) market-based measures such as Tobin’s Q, Price to Earnings (P/E) ratio and market valuation or (3) accounting-based measures such as the return on assets (ROA), return on equity (ROE) and earnings per share (EPS). Different choices of measures could have led to different results. In terms of measuring green practice, there is significant disagreement (; ) as to which factors and green practices are relevant, how to assess them, and the relative weight to put on each. The measurement issue we discussed earlier in relation to sustainability reporting also confounds the research of green finance. As researchers utilize data collected from corporate reports, the lack of consistent standards and framework that govern such disclosure leads to concerns about the credibility of research findings. For example, Cornell and Damodaran (2020) build a framework to examine how being socially responsible can manifest in the tangible ingredients of value and look at the evidence for whether being socially responsible is creating value for companies and investors. The authors argue that findings of a positive relationship between ESG and financial performance are sensitive to both how ESG and profitability are measured.

Second, extant studies use different research methodologies and study designs, which further exacerbates the problem of inconclusive literature when it comes to the relationship between green practice and financial performance. Commonly used methodologies include regression analysis, survey, content analysis, wavelet analysis, and event study. The positive relationship documented by most studies can be contributed to the mechanisms discussed in subsection 6.1. In addition, Chang, Fu, Jin, and Liem (2022) find that green practice increases firm value by motivating employees, strengthening relationships with suppliers, boosting long-term growth, increasing dividends and reducing financing costs. Nevertheless, this could also be an endogeneity issue, with firms doing well financially being more likely to initiate green efforts.

Third, differences in firm size, industry, market examined and time period also contribute to the differing results. For instance, the negative relationship between green practice and financial performance, in particular stock return, is usually documented in earlier studies. This calls for research to examine the role of moderating variables such as firm size, economy and institutional background, and industry type, in order to identify potential groupings along the lines of those variables. This also calls for granularity in research that looks at various institutional settings and situations, as we may not have a “one-size-fits-all” result.

6.2.2 The cost of capital

Another way to study the impact on firm performance, in line with the valuation category, is to examine the cost of capital associated with green financial instruments and firms’ green practices. Studies have in general agreed that investors and lenders require a higher return from firms with environmental concerns and that companies with green practices tend to have a lower cost of capital.

In particular, Chava (2014) shows that firms with significant environmental concerns pay a higher interest rate on loans (20% higher loan interest rate, approximately 25bps) and has a higher cost of equity (approximately 7% higher) and that these firms have fewer banks participate in their loan syndicate and have lower institutional ownership. Similarly, Jung, Herbohn, and Clarkson (2018) find a higher cost of debt associated with firms failing to disclose carbon emissions in the carbon disclosure project survey, with a one standard deviation increase in carbon risk associated with a 38-62bps increase in the cost of debt. Bolton and Kacperczyk (2021) document that high carbon emission firms face a higher cost of capital for both the US and international stocks. Kim, Wan, Wang, and Yang (2019) find a negative relationship between institutional ownership and toxic release from facilities to which institutions are geographically proximate.

Overall, the price impact of investors’ preferences for green assets has been broadly documented in the literature with the findings that companies with a high environmental performance benefit from a lower cost of capital. Hasan, Hoi, Wu, and Zhang (2017) find that firms with environmental commitment face lower bank loan and bond spreads and less restrictive non-pricing loan terms. Hachenberg and Schiereck (2018) and Zerbib (2019) both document a small negative premium (−1bps to −2bps) between green bonds and conventional bonds, and Chen etal. (2019) find less-demanding collateral associated with green loans. Authors mainly attribute this negative yield differential to a financial reality: intangible asset creation (e.g. Flammer, 2015) as well as better risk management and mitigation (). These findings are consistent with previous studies that highlight the long-term view of socially responsible firms and an associated reduced level of risk of violation and damaged reputation (). Also, green loans strengthen the capital structure of small businesses to sustain them from financial distress by extending loans to small businesses at lower interest rates and extended repayment periods (Cullen, 2018).

Other studies examine stock response upon green bond announcement. For instance, Zhou and Cui (2019) find that green bond issuance has a positive impact on firms’ stock prices, profitability, operational performance, and innovation capacity. Tang and Zhang (2020) show that the positive stock returns around green bond announcements are associated with an increase in institutional ownership and stock liquidity. Similarly, Wang etal. (2020) find positive abnormal stock returns after the issuance of green bonds consistent with the stakeholder value maximization theory. Specifically, the authors document a significant pricing premium of corporate green bonds relative to matched conventional bonds and that the economic magnitude of this premium is more pronounced for issuers with better performance in corporate social responsibility.

These studies emphasize the relationship between green bonds and equity performance and value creation. However, as discussed in Section 5, we do not suggest a causal relationship between green bond issuance and firm performance, as green bond issuance can be perceived as a signal of green practice without delivering direct green results.

6.2.3 Implications for investors

With findings on the reduced cost of capital and hence enhanced firm value associated with firms with green practices, a strand of literature examines the green investing practice (also called “sustainable investing”).

Overall, the popularity of green investing is attributed to two motives. The first motive is to change firm behavior in improving their green practice, thus creating more positive externalities. This second motive can be achieved through two channels of exit by divesting from nongreen companies (Edmans, 2023) and voice that involves engaging with a company through voting, private meetings, and public activism to cut its carbon footprint (Edmans, 2023; ).

The second motive for green investing is better risk-adjusted returns associated with green stocks. In particular, the asset pricing literature has now included sustainability as a risk factor with Zerbib (2022) developing a sustainable capital asset pricing model (S-CAPM) and Dimson, Karakaş, and Li (2015) demonstrating the value-enhancing effects of shareholder engagement in environmental issues.

A common green investing strategy is to overweight (underweight) assets with low (high) environmental footprints (; Coqueret, 2022). These practices are supported by studies that find “green” firms outperform “brown” firms (not environmentally friendly). Examples include Aswani, Raghunandan, and Rajgopal (2022), Bolton and Kacperczyk (2021, 2022), Garvey, Iyer, and Nash (2018), Görgen etal. (2020), In, Park, and Monk (2017), and Hsu, Li, and Tsou (2022). In addition, Hartzmark and Sussman (2019) suggest that sustainability is viewed as positively predicting future performance, and Pástor, Stambaugh, and Taylor (2022) find that green assets outperform brown assets in particular as climate concerns strengthened.

Investors have recognized the environmental risks and priced them into their investment decisions (; ). According to Engle, Giglio, Kelly, Lee, and Stroebel (2020), stock investors can hedge against climate risk by forming dynamic portfolios that are long on the winners of climate change and short on the losers. Additionally, Choi, Gao, and Jiang (2020) offer more direct evidence of investor attention to global warming by showing that the Google search volume index, an indicator of retail investor attention, increases with abnormal local temperature jumps while stocks of carbon-intensive firms underperform firms with low carbon emissions in abnormally warm weather.

As the economy recovers from COVID-19, researchers have uncovered the diversification potential of green investing in the face of crises. The literature on spillover, flight-to-quality cross-market interdependence, and hedging opportunities across assets and financial markets has attracted a lot of attention since the subprime crisis of 2007 and now during COVID-19 and its recovery period. Specifically, studies find that investors started shifting toward sustainable avenues of investment during the COVID-19 period, which is in line with the common parlance that investors shift their preferences toward a broader and holistic perspective during times of crises, using green instruments to hedge against downside risks, especially in the backdrop of a crisis (; , 2022; ; Umar Gubareva, Tran, and Teplova, 2021).

In summary, our study of the literature shows that green financial instruments provide an option that improves investors’ returns and supports the financial markets during and post the COVID-19 period.

6.2.4 Implications for companies

While equity investors hedge the environmental risks by creating portfolios, corporate managers make strategic firm-level decisions in consideration of the climate and related risks. For instance, Flammer (2013) documents a cushioned stock market reaction to negative corporate environmental news for firms with high ex ante environmental performance, suggesting environmental practice as a way to reduce firm risks. Lemoine and Rudik (2017) suggest firms should respond to the carbon tax by delaying reducing emissions and cumulating greater emissions to take advantage of the climate systems’ inertia. Liu (2018) finds board gender diversity reduces environmental infringement. Bai etal. (2021) show that firms tend to manage climate change risk induced by sea-level rise (SLR) by acquiring firms that are unlikely to be directly affected by SLR. Similarly, Xiong, Lam, Hu, Yee, and Blome (2021) find that firms mitigate the negative impacts of environmental violations with improved environmental transparency and supply chain diversity. Also, Li, Lin, and Lin (2021) find that firms manage the country-level climate vulnerability risk they face through corporate innovation in climate change mitigation technologies, exploitative patents and global collaborative patents in innovations and promote international strategic alliances. In addition, as discussed in Section 4.2 of the paper, extant literature also documented that firms strategically choose corporate board composition and provide disclosure of green innovation and sustainability practices.

7.2.1 Green finance and sustainability disclosure in the traditional framework of finance, accounting, and economics

As the first research direction, we suggest applying traditional finance, accounting and economics theories and techniques to examining green finance and sustainability disclosure.

For instance, Edmans (2023) posit that insights from mainstream finance and economics can be applied to ESG, as ESG “is economically no different to other intangible assets that create long-term financial and social value.” The same applies to green finance. The rich literature on corporate finance research has examined how to create long-term financial values and how to value investments, and research on asset pricing has explored how the stock market prices risks. Abundant economic research has looked at how to investigate externalities and enhance social welfare. We, therefore, suggest looking at green practices with short-term costs and long-term benefits and examining their relationship with the cost of capital, and firm value impact.

In the area of risk management, in general, green finance is accompanied by potential losses, especially with the long-term nature of investment in green projects (Chen etal., 2019). We suggest that future studies and framing of policies examine the robustness of the risk management models and embrace more responsible financial conduct with environmental viewpoints.

Similarly, sustainability reporting as one type of information disclosure can benefit from situating related research work in the theoretical framework of information asymmetry, disclosure, efficient market, contract theory and agency theory. Future research providing theoretical underpinnings for the demand and supply of sustainability disclosure and thus guidance for the current development of reporting standards and regulations is expected to be valuable.

7.2.2 Data, model and methodology

To the best of our knowledge, there have not been a generally accepted set of green measures that apply to all major countries, both developing and developed countries. It is not easily accessible to get data on green finance as there is still no consensus on the measure of greenness (). Researchers must build practical models on and institutionalize reliable data on green finance. Further research addressing performance indicators and disclosures and their implications is needed.

As a developing concept, green finance is limited in the scope of issues covered and the dimensions of study. The relevant issues on green finance products in the broader green finance spectrum are unclear. Also, there is an overlap of the issues relating to the products and concepts surrounding green finance and scholars, and practitioners are not clear about these issues. Existing studies have shown and discussed a limited number of issues (social, environmental, legal, technological and others) that affect green finance. These issues remain distinctively presented and analyzed with unclear themes. Another area of concern is the ambiguity and unexplored issues surrounding the dimensional approaches of green finance.

In addition, further research can be conducted on identifying the enablers and the challenges to green finance using the quantitative approach. Statistical techniques need to be applied to study the relationship between the variables. The statistical analysis of the enablers will support policymakers in undertaking strategic initiatives based on the comparative advantage of the country or region. The challenges and barriers should be studied for getting more holistic information on the concept of green finance. Lastly, green investment is the main objective of green financing so further studies can be conducted on quantitatively measuring green investment and its progress.

Research on sustainability reporting suffers from endogeneity issues as the practice of sustainability reporting is a result driven by numerous factors, including firm-level characteristics and external economic factors, which are inevitably associated with variables that are the subject matter of research, such as firm performance. Due to endogeneity, it is hard for research studies to rule out spurious relationships and establish causal inferences. There is an imminent call for rigorous empirical design that addresses endogeneity through statistical methods or natural experiment settings for conclusive evidence on the causes and consequences of sustainability reporting.

7.2.3 Long-term and short-term economic implications of green finance and practices

Our review has identified the scarcity of studies that investigate the long-term vs short-term economic implications of green finance and green practices. An example is Diaye, Ho, and Oueghlissi (2021) who examine 29 Organisation for Economic Co-operation and Development countries during the 1996–2014 period and find that while there is a positive relationship between ESG and gross domestic product per capita in the long run, such a relationship does not exist in the short run. It has been a long-lasting concern whether economic and environmental pursuits are compatible (Gray, 2006). The tension likely intensifies in light of the current economic environment where prioritizing the two imminent tasks, economic recovery and moving toward the carbon-neutral goal, becomes ever more challenging. Future research sheds light on the trade-off of long-term and short-term economic effects of sustainable business pursuits and green investment and thus provides insights into balancing economic and environmental goals at different stages of the economic cycle is expected to be highly valuable.

7.2.4 Policy implications

Our literature review has emphasized the importance of further support of public policy and regulation. First, our studies have shown that green finance is associated with reduced environmental impacts through proper regulation. However, the magnitude and the mechanisms differ in various countries, markets and industries. This calls for policy to be specific to different regions and industries, with consideration of differences in economic development status. Second, more studies on green finance issues from developing and developed countries’ perspectives would be useful to regulators and policymakers to align different policy goals and develop well-defined policy objectives.