Chapter Six: Efficient Investing in Inefficient Markets
How Securities Over Regulation Damages Returns
Limited liability laws created the modern public markets by ensuring investors in public companies risk was limited to the amount invested and they were not exposed to risks taken by the company beyond the risk of a total loss of their investment. Efficient markets require regulation to instil confidence among investors that they will not be victims of fraud or corporate abuse by the companies in which they invest. Provincial Securities Acts in Canada, and the U.S. counterparts the Securities and Exchange Act of 1933 and the Securities Exchange Act of 1934 comprise the primary legislative framework designed to protect investors and the Securities and Exchange Commission (SEC) in United States and Provincial Securities Commissions and Federal Canadian Securities Administrators (CSA) in Canada are the front line of administering and enforcing those laws, in both cases backed by tribunals and courts.
The costs of that regulation are imposed on those being regulated and Canadian securities commissions do not rely on taxpayer funding. The SEC is funded by taxpayers but offsets much of the costs through fees levied on all securities transactions and benefits from fines imposed on issuers or intermediaries who are found to have breached securities laws. Over half of Canada’s securities trading takes place in Ontario. The OSC has annual expenses of about $138 million all of which is covered by fees received from market participants and a small amount from recoveries in enforcement actions. On balance, the costs of North American securities regulation have little impact on investor returns.
The regulations themselves, however, are a significant factor in causing lower investor returns when those regulations go beyond what is necessary to sustain safe and efficient markets. Climate change disclosure mandates is a recent example. The Sustainability Accounting Standards Board (SASB) found the cost of a single climate change disclosure document aligned with SASB guidelines averaged $750,000. The Principles for Responsible Investing (PRI) issued a report saying the cost for an asset manager to analyze climate change disclosure of companies in their portfolios often exceeded $1 million.
The SEC did is own survey and found the disclosure cost per issuer amounted to $640,000 in the first year of disclosure and ongoing costs of $530,000 per year. The SEC survey also found the cost to intermediaries to analyze the disclosure amounted to over $1 million per institutional investor. All of these costs come out of returns otherwise enjoyed by the owners of the corporations. United States has over 58,000 listed companies. The annual cost of climate change disclosure for issuers is ~$30 billion to ~60 billion. Canada has about 3,900 listed issuers (1,500 of them listed on TSX) and the cost of climate disclosure is over $2 billion. Statista reports there are over 2,000 Institutional investors in the U.S. and hundreds more in Canada. Their costs of analyzing climate disclosure totals over $2 billion.
In total, mandated climate disclosure costs over $62 billion and reduces the marekt value of the issuers by close to $1 trillion (using a 16 times multiple). There are zero benefits, since the climate change rhetoric is aphysical nonsense.
An entire cottage industry has grown up to provide ESG reporting, claiming a plethora of benefits like “building trust with investors, customers, employees, partners and regulators” none of which result in higher returns to investors. As mentioned in a previous chapter quoting Aswath Damodaran, ESG is a “feel good scam” that penalizes investors and tries to supplant the role of government as the source of social policy by imposing that responsibility on corporate boards of directors with no direct oversight by the electorate. It is little more than an effort to promote socialist ideology without first getting voter support.
Where regulators over reach their role, investors suffer. Regulators are also subject to a phenomenon called “regulatory capture” where the regulator gets too close to those regulated and begins to act in the in the interests of those being regulated rather than the interests of those they exist to protect. In 2022, I wrote a paper on regulatory capture during my courses for a Masters’ Degree in Securities Law at Osgoode Hall Law School in York University. For those interested in that phenomenon, the paper is at this link. In that paper, I presented an argument and evidence that ESG and climate activists have “captured” not only Canadian securities regulators but also our judiciary, our Liberal government and its cabinet, and many members of Provincial legislative bodies. Institutions created to protect investors and citizens have become proponents of left wing ideology at the expense of those they were sworn to protect.
Securities regulation is a necessary part of efficient capital markets, but damages that efficiency when it reflects the political ideology of a party in power and imposes regulations not enacted by an act of any legislature but within the delegated discretion given the regulatory body. Climate change and ESG rhetoric are elements of left wing ideology, unsupported by empirical evidence of their value to society and well out of the realm of why corporations exist and their vital function in building wealth in society.
OSC proposed NI 51-107 sets out the draft climate change disclosure the Ontario regulator seeks to impose and in its narrative claims as a benefit a lower cost of capital for issuers who provide such disclosure. A lower cost of capital to the issuer is identical to a lower return to investors, what issuers pay is what investors get. We now have a regulator whose obsession with its ideological view of the “public interest” expressly proposes regulations that overtly damage the interests of the investors they are sworn to protect.