Externality is a relatively new economic concept. Economist Arthur Pigou came up with the framework in the 1920s to describe situations when hapless observers get caught up in the consequences of economic activities. Pigou postulated that externalities occur when the production or consumption of a good causes an impact on third parties not directly related to the transaction.
It is possible
for externalities to be positive. For
example, walking or riding a bicycle to work creates the positive externality
of reduced congestion for parties are driving their cars to work or who do not
even have jobs. Another example can be
found on an apple farm. Bees have access
to the apple tree blossoms and produce more honey that can be harvested by
other animals or even humans thus expanding food chain productivity.
Mostly we focus on negative externalities. Perhaps this is because there are so many and the nature of negative externalities encourages perpetuation. Take the case of a coal-fired power plant that emits particulates and toxic gases from its chimneys. First, humans and animals within range of the emissions experience health issues and must pay higher doctor and veterinarian bills. Insurance companies are also impacted by higher health insurance claims. Second, the entire world is negatively impacted by greenhouse gas emissions lead to rising ocean levels and warming climates. These exported costs of power production are at the heart of Pigou’s externality thesis.
It is important
to note that gas flares are only one element of the negative externalities
created by the oil and gas industry. Nonetheless, the gas flare situation provides
a very good illustration of why externalities must be a part of every investors
decision making framework.
Pigou developed
the idea of ‘deadweight welfare loss’ to illustrative the economic consequences
of negative externalities. This is a
different concept than welfare payments to low income or disadvantage
persons. However, it certainly does have
to do with the welfare of the community which is left with the bag full of
nasty stuff.
Economics get
excited about graphs like the one shown here in part because it simplifies and
makes orderly what is an unruly social phenomenon. Pigou himself made note of the communications problem. In his book The Economics of Welfare published in 1920, Pigou wrote that the
industrialists of his time were not concerned about external costs borne by
society. They had no incentive to
internalize the full social costs of their production processes.
What is more
there have been few who have been interested in challenging them, least
of all stockholders and customers. The
ability to export significant costs associated with production builds profits
and supports shareholder dividends. Who wants to cut off the grandma's dividend check?
Producers have
also been quite successful in frightening consumers with the prospect of higher
prices. Those who actually consume
petroleum products may not be among those third parties who are paying the
externalized costs, so consumers have little incentive to upset the apple cart. They can keep their gas costs low, for
example, and other people can worry about the healthcare and insurance bills.
As the years have gone by the ‘externality’ chicken has come home to roost. The costs of environmental degradation in particular have begun to impinge on everyone. In his book The Economics of Ecosystems and Biodiversity, Dr. Pavan Sukhdev claims that environmental externalities alone are costing society more than $2 trillion. The shockingly large aggregate number notwithstanding, efforts to correct the problem are more important. Investors need a clearer picture of the true costs of production.
The Environmental Profit and Loss (EPL) statement is a start. The sports footwear and clothing maker Puma SE (PUMSY: OTC) was the first
public company to attempt incorporating environmental costs into operating
costs. The Puma EPL statement summarizes the
costs to society caused by the environmental impact of Puma’s operations - an
internalization of externalities. Puma
first EPL was reported in 2011. In the
nine years since, the company has been successful in increasing revenue while
bringing the environmental costs per revenue dollar down by 13.6%. Of course, those successes may simply have been the result of better shoes or fancier t-shirts. Certainly, Puma's EPL has not taken away from its success.
The EPL does not
replace the financial profit and loss statement that investors have used for
decades to make investment decisions.
Valuation exercises are likely to be driven by the same financial
measures for some time to come. However,
the argument can be made that for management the EPL exercise could be an
excellent driver of improved performance that will ultimately be captured in
conventional financial statements.
Indeed, Puma has achieved successively higher net income in the last
five years on both higher sales and improved profit margins.
Unfortunately, progress
has been slow toward adoption of environmental accounting disclosures. Royal Philips N.V. (PHG: NYSE)
published its first EPL for the year 2018, winning endorsement from public
accounting firm Ernst & Young. Using
different methodology than Puma, the Philips report expresses climate change
and human toxicity in monetary terms using environmental prices. Likewise Novo Nordisk A/S (NVO:
NYSE) has also put its biotechnology operations up
for closer scrutiny with its first EPL published in 2014.
As a health technology companies, Royal Philips and
Novo Nordisk have much less to hide than and oil and gas companies. It may require some encouragement for large
polluters to pull back the curtain on the amount of their true costs that is pushed
off onto the public. In the next post we
look at incentives and mechanisms for corporate responsibility.
Neither the author of the Small Cap Strategist web
log, Crystal Equity Research nor its affiliates have a beneficial interest in
the companies mentioned herein.
No comments:
Post a Comment