Rodney Schwartz: It's time for investors to appreciate 'externalities'

Social impacts of firms are emerging as an important third dimension - after perceived risk and return - for investors to consider, says our columnist

Rodney Schwartz
Rodney Schwartz

At the end of November KLP, Norway's largest pension fund, announced that it would blacklist companies that generated more than 50 per cent of their revenues from coal-based activities.

This comes after similar moves by hundreds of asset managers in countries including Sweden, Australia and the US.

Coal-related stocks came under pressure in the US recently as a result of action by President Obama. This was among factors that contributed to a fall of 50 per cent in coal share prices over the past three years. They have under-performed a rising market by about 80 per cent - a disaster for which pensioners ought to hold their highly paid fund managers to account.

Steps such as KLP's are laudable, but they do feel like shutting the stable doors after all the horses (well, about 80 per cent of them) have bolted. KLP would have done its beneficiaries a far greater service if it had been more far-sighted in its thinking and taken externalities into account. This is a term to describe real costs or benefits passed on to society that are external to the core actions of economic agents. Those in the coal industry mine coal to generate energy, which harms society by polluting the atmosphere and increasing the greenhouse effect. This pollution is external to the industry's core activities (mining and energy production). It is an unfortunate by-product. This engenders real costs and hence is a negative externality, but some firms generate positive externalities.

The key point about externalities is that they generate real costs or benefits. One might consider them as taxes or subsidies, passed on to society without political involvement or democratic accountability. In the case of positive externalities, we tend not to mind, because they provide things that we want for free; but when costs are transferred to society by firms profiting at the public's expense, we are less pleased. Political leaders are responding by making firms pick up these costs – the externalities are thereby internalised.

We will see more of this in the future, and investment managers who fail to appreciate the externalities generated by their investees will suffer. Until recently, firms seemed able to get away with harm – such as obesity, lung cancer, water pollution. Fund managers behaved as if the long-term costs would never have consequences. But as governments require these costs to be internalised, such factors gain short-term significance – and penalise lazy fund managers. On the other hand, some progressive investors use the analysis of such factors to gain an edge over rivals who ignore them.

Governments are also beginning to reward enterprises that generate positive externalities or beneficial social impacts. This is at an early stage, but momentum is gathering because it reduces demands on the public purse. All this means that the social impacts of firms are emerging as an important third dimension - alongside perceived risk and return – for investors to consider. Failure to do so will mean under-performance by some fund managers – as the beneficiaries of KLP have learned to their misfortune.

Rodney Schwartz is chief executive of ClearlySo, which helps social entrepreneurs raise capital

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