ESG factors have long been viewed as risk factors to manage. Giles Parkinson explores the flipside of this proposition, contending that positive externalities are an under-leveraged investment opportunity.
In 1968, Bobby Kennedy gave a presidential campaign speech at the University of Kansas, where he highlighted the flaws in national accounting methods.
“Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage,” he said. “It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armoured cars for the police to fight the riots in our cities…”
Kennedy’s speech was provocative, and still resonates today. He deftly pointed out that while the economic activity of certain commercial endeavours is neatly recorded in national accounts, its overall effects – many of which are often negative – are not.
Identifying and quantifying ‘negative externalities’ is a crucial part of ESG
Identifying and quantifying ‘negative externalities’ – where the production or consumption of a good or service indirectly has a negative impact on third parties – is a crucial part of integrating environmental, social and governance (ESG) considerations into the investment process. However, the flipside practice is usually overlooked – acknowledging the existence of positive externalities and trying to price them appropriately.
Sadly, we don’t have to look too far afield in the corporate world to see examples of negative externalities: the polluting chemical company, the price-gouging drug firm, or the clothing manufacturer exploiting workers in its supply chain. Their financial statements do a poor job of capturing economic reality, and the reporting of revenues, profits and cashflows for such companies comes with heavy caveats. Until litigation or controversies break out, the pollution, extortion or exploitation that enable lower costs can result in higher profits.
The risk of holding such companies materialises when the negative externality hits the headlines, through a shock event like the BP Deepwater Horizon oil spill in 2010, or ‘Dieselgate’, which shattered Volkswagen’s reputation in 2015.1
Looking under the bonnet, it becomes apparent that some stocks rubber-stamped with a AAA independent ESG rating are in fact exposed to significant negative externalities, from tech to chemicals and apparel.2
All sectors are affected, and it is important for investors to conduct thorough due diligence to properly understand the broader implications for companies.
As we discussed in a recent article on controversies3, investors stand to gain from conducting comprehensive due diligence to avoid such exposures, rather than simply relying on backward-looking scores from ESG rating providers.
These verdicts often fail to reflect improvements made by the firm, meaning they will continue to be excluded from funds that filter automatically on such scores. As an example, MSCI’s ESG rating for Volkswagen plummeted to CCC after the scandal broke in 2015 and remains there to this day. This is despite a significant transformation at the company, ranging from a revised strategy that prioritises electric vehicles to company culture and the protection of whistle blowers.4
On the flipside: When positive externalities are investment opportunities
Examples of companies with positive externalities are harder to find and more subjective to quantify. Compensation claims, price regulation, and remediation costs are relatively tangible and straightforward compared to the nebulous societal benefits of cheaper healthcare or a decarbonised economy. Many of these potential positive externalities are linked to structural factors like climate mitigation and adaptation, the digitalisation of certain sectors or the growing importance of artificial intelligence, and some will take a long time to play out. They require thorough thematic and company-specific research, but also patience and conviction. Nevertheless, they matter too.
No firm is wholly good or bad
No firm is wholly good or bad, even those emitting serious and persistent negative externalities. Under a capitalist system, increased production of useful goods and services achieves a common good by alleviating poverty and providing opportunities for work, thereby supporting human dignity.
To a certain extent, all companies have positive externalities – but some go far beyond the norm, such as the multinational discount retailer Costco. The company’s co-founder Jim Sinegal laid out a simple formula for this paragon of stakeholder capitalism: “In order to reward the shareholder in the long term, you have to please your customers and workers. You've got to get the very best people that you can, and you want to be able to keep them and provide some job security. That's not just altruism, it’s good business.”5
The average retail employee in the United States makes $12 an hour. Amid talk in Washington of more than doubling the Federal minimum wage to $15, last February Costco announced it was already moving its starting level from $15 to $16 which, including accrued pay rises and typical bonuses, would bump the average to around $24, not including health insurance (a crucial hallmark of entry into mass affluence in America) and the 401k pension plan.
Paying employees good wages helps us in the long run by minimizing turnover and maximizing employee productivity
During a recent US Senate Budget Committee hearing debating the issue “Should Taxpayers Subsidize Poverty Wages at Large Profitable Corporations?”, current Costco CEO Craig Jelinek remarked: “At Costco, we know that paying employees good wages makes sense for our business and constitutes a significant competitive advantage for us. It helps us in the long run by minimizing turnover and maximizing employee productivity.”6
The evidence of the benefits of this approach are stark: Costco loses just 0.2 per cent of revenues to ‘shrink’ (theft by employees and disgruntled staff), 80 per cent less than Wal-Mart, and has annual employee turnover of just five per cent, compared to the industry average of 59 per cent.
Trane and Valvoline
Sometimes, external events need to occur before the benefits can be reaped in terms of improved company cashflows and profit outlook, such as a green stimulus package or policy development. A positive externality could result where a company is helping to drive a positive societal change, such as delivering more efficient heating and ventilation to lower carbon emissions.
For instance, Trane Technologies is a global market leader in heating, ventilation, and air conditioning, which can deliver efficiency gains in commercial buildings’ energy consumption. Initiatives such as the European Green Deal may incentivise commercial property owners to think much more about energy efficiency, and investors need to assess what it could mean in terms of upside for the company’s cashflows.
Investors can encourage companies to adopt more sustainable practices that could boost revenues and share prices
Indeed, engagement is another potential avenue for transforming positive externalities into increased cashflows. Working with companies, investors can encourage them to adopt more sustainable practices that could boost revenues and share prices. Investors can also collaborate with peers and engage with regulators to lobby for stronger environmental and other regulations, supporting the advent of changes that can crystallise a positive externality.
Sometimes, the benefits of the positive externality do not require the catalyst of an exogenous intervention but are reaped endogenously as part of the normal course of business. A case in point would be Valvoline, the operator and franchisor of quick-lube chain Valvoline Instant Oil Change (VIOC) in the US.
A conventional ESG scoring methodology will typically note Valvoline’s four female executive officers and two board members. But the company’s commitment to gender diversity goes deeper throughout the organisation, with women representing 44 per cent of the senior leadership team, and onto the shop floor, where VIOC workers and managers are twice as likely to be women compared to the industry average.
While women drive fewer miles than men, they are responsible for a similar proportion of journeys. In the otherwise male-dominated world of car maintenance, Valvoline represents a refreshing alternative. Anecdotal feedback from female customers highlights they are more comfortable dealing with other women, and more likely to become a source of repeat business.
It is difficult to quantify precisely how much of VIOC’s best-in-class operating metrics are a result of the company’s commitment to diversity, or the extent to which that commitment was driven by a belief it would be good for business.
Whether consciously or unconsciously, the pursuit of gender equality is a subtle, but important, element of VIOC’s sustainable competitive advantage. In a world where consumer choices are increasingly based on personal values, other companies might do well to follow VIOC’s lead in having employees that are more representative of the customers they are targeting.
Scores versus conviction
A more holistic approach to ESG integration should be applied
Finding companies that benefit from a positive externality can therefore represent an investment opportunity, particularly if fundamental research can help investors uncover and appreciate them before they are widely recognised by the broader market.
Indeed, rating agency ESG scores typically focus their attention wholly on the negative side of the ledger: companies begin the assessment with a perfect record that is progressively marked down as imperfect practices come to light in the analysis.
In this view of the world, those that ‘do no harm’ are equated with ‘doing good’. However, a more holistic approach to ESG integration should be applied, one that acknowledges and attempts to quantify the subtle positive externalities that some companies impose on society and the alternative assessment of their value when seen in this light.