Flipside: Not all externalities are negative in ESG investing

ESG factors have long been viewed as risk factors to manage. Aviva’s 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’ – 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.

Negative externalities

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

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