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Smog Gives Traders and Regulators Foggy Heads


How transitory air pollution lets unfit IPOs sneak through the cracks

Smog and traffic jam in Beijing.
  • A study of China’s initial public offering (IPO) approval process shows that the passing rate for IPOs on days with a high level of air pollution in Beijing is five percentage points higher than on clear days, and 12 percentage points higher on very hazy days.
  • Compared to IPOs approved on clear days, IPOs approved on polluted days have lower profitability and return on equity and worse stock returns within one year of listing. This represented a loss to investors of roughly US$4 billion between 2014 and 2020.

It’s one thing to look at pictures of Beijing shrouded in smog and imagine having to work under such conditions. It’s quite another to spend your days in one of the capital’s buildings that feels like a hotbox run by chain-smokers.

Wei Wang knows that feeling. A Smith School of Business finance professor, Wang has been teaching in the school’s Master of Finance-Beijing program for seven years and is director of the program. His most challenging times are on windless winter days, when a dense mass of fine particulate matter from nearby coal plants seeps into buildings, causing eyes to water and chests to tighten.

“Once, I remember teaching a class from nine until four p.m.,” says Wang. “By 11:30, I couldn’t even breathe and was in such a bad state, and that classroom was equipped with an air purifier.”

Hanging out with his colleagues from Renmin University, Meng Miao and Zhengyu Zuo, conversation turned to the deleterious effects of air pollution, from high crime rates to low worker productivity. It’s well known that fine particulate matter reduces human physical and cognitive capacity. It can also trigger bad moods and related psychological pressures.

Given such effects, the three researchers speculated about potential links between bad air pollution and financial decision-making. This may sound like a farfetched connection but plenty of recent evidence has laid the groundwork. One recent study linked short-term variations in fine particulate matter in Manhattan to substantial movements in the S&P 500. Another uncovered a negative relation between air pollution during corporate site visits by investment analysts and subsequent earnings forecasts. A study in China showed that investors make worse trades on hazy days and that air pollution makes investors more susceptible to “attention-driven” buying behaviour rather than fundamentals-based trading.

Hazy days and IPOs

Wang and his colleagues took a different angle: the initial public offering (IPO) approval process led by the China Securities Regulatory Commission (CSRC). The critical IPO review meetings involve a seven-member committee of the CSRC and company officials and occur in standard Chinese government offices in Beijing, where an air purifier is considered a luxury and therefore not allowed.

The researchers speculated that on meeting days with a high PM2.5 level (particulate matter 2.5 microns in diameter), environmental conditions could affect committee members—and their judgment—in one of two ways. First, their cognitive capacity could be overly taxed. And if they’re not thinking clearly, lax regulatory oversight on polluted days would lead to more low-quality firms successfully listing their stocks. Alternatively, hazy days could put members in a foul mood and prompt them to more readily reject IPO applications, leading to more high-quality firms getting rejected.

The researchers decided to test whether either of these theories held up. They built a sample of 1,488 IPO applications filed with the CSRC between 2014 and 2020. Then they identified which were approved or not and cross-referenced them to the names of the committee members who reviewed the applications. Next, they obtained the transcripts of the review sessions, paying particular attention to the questions raised by the committee members. And finally, for environmental conditions, they gathered location- and time-specific air quality data from the monitoring station closest to the CSRC offices. 

When they crunched and analyzed all that data, the results pointed in a fairly clear direction: on hazy days in Beijing, CSRC committee members showed uncharacteristically poor judgment when reviewing IPO applications.

The researchers discovered that the IPO passing rate on polluted days in Beijing (days with high PM2.5 levels) was five percentage points higher than on clear days, and 12 percentage points higher on very hazy days. As one would expect, IPOs from firms in green-related industries were more likely to be approved on polluted days. But the significant implication is that plenty of firms were approved that clearly were not ready for prime time on the stock market.

Real-world evidence proved as much. The researchers found that, compared to IPOs approved on clear days, IPOs approved on polluted days had lower profitability and return on equity and worse stock returns within one year of listing.

“Our back-of-the-envelope calculation,” says Wang, “suggests that the total investor loss as a result of lax oversight by the review committee amounts to close to 28 billion renminbi (US$4 billion) between 2014 and 2020.”

The dumbing down effect

Still unconvinced there’s a connection between transitory air pollution and unfit IPOs being approved by regulators? Wang offers further evidence for how the challenging conditions taxed the cognitive reserves of CSRC committee members. 

The researchers used natural language processing to analyze the transcripts of the discussions between regulators and representatives of firms seeking IPO approval. They categorized questions posed by the regulators into two groups: complex questions that required reviewers to think deeply about the quality of the application; and intuitive questions that didn’t require much analysis.

They found that, on hazy days, the reviewers asked fewer, shorter and less complex questions, and they were less likely to ask followup questions. The effect was more pronounced when the review committee was made up of older members and non-residents of Beijing (those presumably less tolerant of air pollution). The only ones who seemed less likely to give prospective IPOs a pass were those members up for re-election to the committee.

“The evidence reflects the deterioration of reviewers both physically and mentally,” says Wang, “as followup questions rely more on improvisation than on preparation.”

Given the findings of this study, there appear to be simple workarounds if regulators care to implement them. In financial centres with recurring air pollution—Beijing being Exhibit A—government offices can be outfitted with air purifiers. Failing that, meetings scheduled on hazy, smoggy days can be postponed or moved to safer locations. 

The larger and more intriguing issue to consider—particularly in this age of finance-by-algorithm—is what we still don’t know about the finance decision-making process. There are many more subtle factors shaping that process than we may think.

Humility in this industry is in short supply. Perhaps that should change.