Written by: Jake Kuyer, Associate Director and Sarah Nelson, Senior Economist, at Oxford Economics
Imagine buying a house without a viewing, assessors’ opinion, or any market information. Yes, in hot real estate markets this sometimes occurs, but would you feel confident making that purchase? Or would you rather have detailed information on the house’s age, structural integrity, and any issues that would require a substantial investment to fix or place your home equity at risk? Maybe you’d like to have an assessor check for water damage, or the state of the plumbing or electricals. At a minimum you would want some sort of reassurance that the risk it would fall apart shortly after you move in is negligible. In fact there is a whole industry based around providing information to potential home buyers.
Now imagine that the current owner refused to tell you any details on its condition and won’t let you or your assessors into the house to take a look. Would you buy it? Probably not. This perhaps exaggerated example, based on George Akerlof’s classic “market for lemons” theory, represents a form of information asymmetry, a market failure that arises from a mismatch between what the seller knows and what the buyer knows, making a mutually beneficial transaction less likely to occur.
Informational market failures occur in all corners of modern economies, from real estate to used car dealerships, and from online commerce to equity markets. Government regulators have the important but unenviable job of correcting these failures. This is a fundamental characteristic of a market economy, as anyone who has taken an introductory economics class could tell you.
The Securities and Exchange Commission (SEC) has the job of correcting informational asymmetries in financial markets by helping investors understand the risks of their investments. If the SEC could assist in our ill-fated house sale, it would require the owner to hand over the relevant information. It would also set out how that information should be presented, so that you can easily compare it to information on other properties. This would help you make the best decision on your home purchase and help the market run efficiently.
Most of the time, the SEC’s regulations are met with a collective yawn by the public and politicians alike. Its latest proposal to support efficient markets, however, has been making waves.
Facilitating Healthy Markets
In March last year, the Commission published a proposal that will require listed companies to disclose climate-related impacts and risks to their business. The rules follow the recommendations of the Taskforce for Climate-Related Financial Disclosures (TCFD), recently brought under the umbrella of the International Sustainability Standards Board, itself aligned to the International Financial Reporting Standards to which most companies in the world align their financial reporting. The TCFD recommendations have already been adopted in some form by the European Union, the UK, Canada and other major US trading partners.
While investors have been mostly supportive of the proposal, the reception from some politicians has been frosty, to say the least. Opponents have claimed everything from agency overreach to violations of free speech and partisan activism. To the contrary, the SEC’s proposal would facilitate healthy, efficient market operation. As a general principle, markets are most efficient when all market participants have access to complete and accurate information about potential trades. In finance, this principle means that markets will be efficient – meaning stock prices will reflect the true value of a company – when investors can access all relevant information. It is the SEC’s job to regulate disclosures of that relevant information.
That’s not to say that all information about a company should be public. Information that is relevant to the long-term value of a company should, however, be disclosed, so that investors can accurately and reliably assess whether a company is worth investing in. Indeed, investors have been asking for this information for years, for example BlackRock CEO Larry Fink’s annual letter to CEOs called for better risk data in 2020.
Importantly, the proposed regulation does not interfere with capital market valuation. The SEC is not in the business of directing investment or making value judgements – that’s for investors to do. Arguably, that is literally investors’ jobs: to put a price on a company by buying or selling stocks. The SEC’s proposal is about ensuring relevant information is available, not what is done with it. If an investor decides they aren't concerned about climate-related risks, then they don’t have to act.
Deciding the value of a company in the face of a changing climate and economy is somewhat more complex than purchasing a home. But the same principles apply. Knowing the risk that you are taking on is essential to your willingness to complete a trade. Climate disclosures do not tell you whether you should buy a share or not – just like a report on the condition of a house isn’t the only factor in making the final decision on your purchase. But the information they both provide will give you an indication of the risks involved, allowing you to make a more informed decision.
What house buyer wouldn’t want to make their purchase with the best information available? American investors, operating in one of the most mature, innovative, and successful capital markets in the world, deserve the same benefit.
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