Externalities: The world's measure of success is changing

The fast view

• The persistence of smog across London baffled economists in the late nineteenth century. The theory at the time held that market forces would address the negative impacts on health, laundry and lighting. In the end, the government had to intervene to address these externalities.
• Roll forward to COP26, a conference aimed at tackling a giant externality: climate change. A notable difference was the engagement of the private sector. Where once governments were relied upon to incentivise better behaviour, companies now appear to be taking up the baton. We think that’s because they increasingly recognise that orientating towards sustainable business models – including ones that contribute to the world’s net-zero ambition – is critical to their future growth and license to operate.
• Externalities linked to emissions are already being priced, via carbon credits and related mechanisms. We expect a wider range of externalities to be priced in future, with potentially significant implications for investors. Our externality framework sets out to map the range and materiality of the externalities relevant to each company and country. At present, we see a broad dispersion in the extent to which material externalities are reflected in asset values – suggesting opportunities for active investors.
• Traditional investment analysis focuses on matters relating to financial capital, such as generating profits, paying salaries and contributing tax revenues. By also assessing how companies and countries use and manage natural capital, social capital and human capital, we believe we can make a better assessment of companies’ long-term potential.
• Externalities need careful analysis and a contextual approach. The semi-conductor industry highlights the potential complications: in this industry, commonly used metrics like carbon-footprint per unit of revenue can be misleading; footprint per wafer is far more informative. And in comparing semi-conductor companies, the extent to which manufacturing is outsourced needs to be factored in. In this session, we also examined approaches to analysing externalities in medical technology and insurance.
• Analysis of corporate culture provides a useful lens into how companies understand and manage the externalities they face. We believe that our research in this area, and the resulting analytical framework we have developed, help us to understand whether a company can execute on its business goals, including its sustainability agenda.