Capital Market Expectations of Risk Materiality and the Credibility of Managers’ Risk Disclosure Decisions

Abstract

Research shows the capital market can refine firm risk inferences using Form 10-K risk disclosures, raising the question: do managers’ disclosure decisions credibly reflect their private risk materiality assessments? We use experts’ judgments about industry-level risk materiality to impute market expectations of climate-change risk (CCR) materiality to test whether the association between disclosing CCR in 10-K’s and firm risk (proxied by cost of equity (COE)) varies with market expectations. Using S&P 500 firms’ CCR disclosures over nine years, we find that disclosing firms’ COE is 26 bps lower than nondisclosers overall. In industries where the market expects CCR to be material, disclosing firms’ COE is 51 bps lower than nondisclosers, while in industries where the market expects CCR not to be material, disclosing firms’ COE is 20 bps lower than nondisclosers. Our results indicate that market CCR materiality expectations allow inferences about the credibility of managers’ risk disclosure decisions.

Keywords: Regulation S-K; climate change risk; risk assessment; voluntary disclosure; mandatory disclosure; enforcement; Sustainability Accounting Standards Board’s (SASB) Materiality Map™; cost of equity capital; self-selection

JEL Classification: G18, G32, M14, M41