Principal-Agent Theory and the Rise of ESG Reporting: Incentives, Institutions, and Regulation

The principal-agent concept is one of the most important theories in economics. This concept describes a relationship between two parties, principals and agents, in which principals delegate decision-making authority to agents. In a corporation, investors or shareholders are the principals and the managers are the agents. One of the issues that result from the principal-agent relationship is that the managers typically possess more information regarding the company's activities than the investors. Furthermore, they might have different goals or objectives than the investors, and therefore the agency problem is fundamental to the economic relationship between these two parties. ESG reporting is one of the responses to the agency problem.

The primary purpose of ESG reporting is to reduce information asymmetry. Investors are increasingly looking to better understand both the financial performance of the company, but also the risks associated with their investment, such as exposure to climate risks, potential labor disputes, supply-chain vulnerabilities, and regulatory penalties. Managers possess far more information about these various risks than the outside investors. ESG disclosure provides investors with a way to receive the information needed to make informed decisions.

The reasons driving ESG reporting can be closely linked with capital allocation. As sustainable investment continues to grow, it has evolved from being a strategy that is somewhat niche, to a segment of the global capital markets. By the end of the year 2024, sustainable investment funds managed approximately $3.56 trillion in assets, while ESG-focused exchange-traded funds held more than $645 billion in global assets. Investors continue to allocate significant resources to companies that they perceive to have better opportunities for managing environmental and social risks.

The prospect of a lower cost of capital can provide a strong incentive for companies. If investors perceive strong ESG performance as indicating reduced long-term risk, companies may be able to obtain lower costs of capital. In addition, providing better ESG disclosures can help companies attract institutional investors, enhance access to capital, and strengthen lender relationships. Therefore, ESG reporting operates as a signal that allows companies to identify themselves as being uniquely positioned in a competitive capital market.

The expansion of ESG reporting at the regulatory level provides another support for the economic view of ESG reporting: that, for many risk factors, the market is not able to accurately assign a value to them due to information deficits. Climate change is an example of an economic factor that will impact the value of assets based on potential physical damage, transition costs, or future regulation. In the absence of standardised ESG disclosures, therefore, investors have significant uncertainty regarding their investment in such assets. For this reason, regulators and government officials have established reporting standards that enhance market efficiency and transparency.

A prominent example of this trend is the Corporate Sustainability Reporting Directive (CSRD) in the European Union. Early projections indicate that nearly 50,000 companies will need to provide standardised ESG disclosures, substantially increasing the level of ESG information available to investors and stakeholders. The CSRD was designed to create a set of ESG data that will allow the capital marketplace to create a more level playing field, so that the marketplace can make more accurate comparisons of companies' disclosures about their ESG performance.

The political economy associated with ESG reporting becomes intriguing, particularly in terms of competing incentives. Investors typically prefer to receive additional transparency into the performance of a business, while many businesses prefer not to disclose extensive amounts of information, due to the costs associated with complying with the regulations. Regulators want to create an environment that improves capital market outcomes; however, they also need to be conscious of the needs of businesses as it relates to administrative burdens and competitiveness. The interest of these three groups — investors, businesses, and regulators — creates a politically contested atmosphere around ESG reporting regulations.