Externalities: When the long term meets the short term

In late November, KLP, Norway’s largest pension fund ($70 billion), announced it would blacklist companies which generate more than 50% of their revenues from coal-based activities.  This follows similar moves by asset managers in Sweden, Australia and the USA and hundreds of others worldwide.

Recently coal-related stocks came under selling pressure as a result of executive actions undertaken by President Obama.  This was among a list of factors which has seen coal share prices fall by 50% over the past three years, thereby underperforming the rising market by roughly 80%, a disaster for which pensioners ought to hold their highly paid fund managers to account.

Steps such as those undertaken by KLP are laudable, but they do feel like shutting the barn doors well after all the horses (well, at least 80%) have bolted.  They would have done their beneficiaries a far greater service if they have been more farsighted in their thinking and taken externalities into account.

Externalities are a term used in economics to describe real costs or benefits passed on to society, which 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 depleting the planet’s ozone layer.  The pollution is external to their core activities (mining and energy production); an unfortunate by-product.  This engenders real costs and is thus a negative externality, but some firms generate positive externalities.  ClearlySo, which works only with firms generating high social impact, works with many of these.  London Early Years Foundation, which provides nursery education, is one example.

The key point regarding externalities is that they do generate real costs or benefits.  One might consider them as taxes or subsidies which are passed on to society without political involvement or democratic accountability.  In the case of positive externalities we tend not to mind as things we want are provided for free, but when costs are transferred to society by firms profiting at the public’s expense, we are not pleased.  In today’s fiscally challenging times we are outraged.  Political leaders are responding by making firms pick up these costs—the externalities are thereby “internalised”.

We will see much more of this, and investment managers who fail to appreciate the externalities generated by their investees will suffer as a result.  Until recently, firms seemed able to get away freely with the harm they caused; obesity, lung cancer, water pollution—fund managers behaved as if the long term costs generated would never have any consequences.  But as governments step in to internalise these costs, such factors gain short term significance—and penalise lazy fund managers.  On the other hand, some progressive investors, such as AXA Investment Managers, use the analysis of such factors to gain a performance edge over rivals who ignore these factors.

Governments are also just beginning to reward enterprises generating positive externalities, or beneficial social impacts.  This is at a very early stage, but momentum is gathering, as rewarding such firms 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 underperformance for some fund managers, as the beneficiaries of KLP have learned to their misfortune.

First published in Third Sector in November 2014.