By: Jake Kuyer, Associate Director, and Sarah Nelson, Senior Economist at Oxford Economics
Imagine buying a second-hand car. What information would you like to know? Perhaps its model year, odometer mileage, and fuel efficiency would help you assess how much it will cost to run and how polluting it might be. Maybe you’d like to have a mechanic check under the hood, to assess the risk that your new purchase will sputter out as you drive it off the lot.
Now imagine that the car dealer refused to tell you the mileage and won’t let a mechanic take a look at the car. Would you buy it? Probably not. This example, based on George Akerlof’s classic “market for lemons” theory, shows how market failures arise from a mismatch between what the seller knows and what the buyer knows or — as economists would put it — from an information asymmetry.
Information asymmetries abound in financial markets. Investors can’t know all the ins-and-outs of a company, but they must make their investment decisions anyway. Financial regulators like the US Security and Exchange Commission (SEC) can help, by requiring companies to disclose any risks and dependencies that are financially material.
If the SEC could assist in our ill-fated car sale, it would require the dealer 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 provided by other dealers. They would help you make the best decision on your car purchase and help the market run efficiently.
Compulsory impact disclosure
The SEC has recently announced two major proposals to help investors understand their impacts and risks. Most of the time, the SEC’s announcements are met with a collective yawn by the public and politicians alike. Its latest proposals, however, have been making waves.
In March last year, the Commission published a proposal that would 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 with 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.
The SEC followed this announcement in May 2022 with proposed amendments to how funds and advisors incorporate environmental, social, and governance (ESG) factors in their investments. Funds would have to provide more information for ESG-labelled assets, including disclosing the impacts of any assets with specific goals and reporting progress with reliable metrics.
While investors have been mostly supportive of the proposals, 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 proposed regulations do 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 proposals are about ensuring relevant information is available, not what is done with it. If an investor decides they aren’t concerned about climate-related risks and other factors, then they don’t have to act on them.
Trust in the claims
Climate change is only one factor that could materially affect investments’ value and returns. Regulation in Europe has taken a broad approach to risk disclosures that highlights other considerations. Nature-related dependencies include the threat that biodiversity loss will cause disruptions to its upstream supply chain, often in countries far beyond the company’s direct sphere of influence. Social and geopolitical factors come into play as well.
The SEC’s proposed disclosures take a relatively limited stance to risk disclosures by focusing only on climate risks, but it is a key first step in providing investors with material information to support their decision-making process. Meanwhile the proposed amendments to ESG claims will help avoid mislabelling and thereby mis-selling financial products. It makes sense that consumers of financial products should be able to trust the claims being made about what they are considering investing in.
Deciding the value of a company in the face of a changing climate and economy is significantly more complex than purchasing a used car. But the same principles apply. Being able to compare products and understand the risks is essential to your willingness to complete a trade. Climate disclosures and ESG claims do not tell you whether you should buy a share or not — just as a car mechanic doesn’t make the final decision on your purchase. But the information they both provide will give you an indication of the risks and rewards involved, allowing you to make a more informed decision.
What car buyer wouldn’t want to make their purchase based on 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.