Who Pays the True Cost of Environmental Damage?

The TakeAway: Institutional investors need to assert their ownership power to offset environmental costs and push for sustainable companies and public policy.

Despite the worldwide recession, the economic crisis isn’t the only cause of financial losses affecting innocent bystanders.  There’s also the hidden costs of ecological damage from human activity, which amount to a staggering $6.6 trillion per year, according to a groundbreaking study released earlier this month by Trucost, the environmental investment research firm.  That’s 20 percent higher than the $5.4 trillion loss in developed country pension fund values due to the global financial crisis of 2007 and 2008.

Trucost also calculated the environmental impact of the world’s largest 3,000 companies: roughly $2.54 trillion annually.  This places more than half of their profits at risk (after all, environmental liability costs money) and jeopardizes shareholder value.  Add to this the social sustainability costs associated with air and water pollution, catastrophic weather patterns, and so on, and you’ve a recipe for disaster.  The good news: institutional investors have the power to demand honest accounting of these externalities, which can foist companies’ negative impacts onto society.

Commissioned by the UN’s Principles for Responsible Investment (PRI) and UNEP Finance Initiative, the shortened version of Universal Owners: Why environmental externalities matter to institutional investors puts a price tag on natural resources so that investors can measure the true, unaccounted costs of doing business.  (The longer version and methodology are forthcoming.)  The emphasis on “universal owners” differentiates this report from many others, because these investors – pension funds, mutual funds, bank trusts, and the like – have long-term time horizons and collective influence on policymakers and portfolio companies.  The term “universal owners” refers to institutional investors who hold such a wide swath of companies that they represent a proxy for the economies in which they invest—or, indeed, for whole societies.

Trucost bases its argument on this reality:  universal owners cannot escape the current and future environmental (and, indirectly, social) costs associated with their holdings.  There’s a domino effect, too:  “One company’s environmental externalities can damage the profitability of other portfolio companies, adversely affecting other investments, and hence overall market return,” the authors state.  “Ultimately, externalities caused by companies could significantly affect the value of capital markets, or their potential for growth, and with that, the value of diversified portfolios.”

For example, greenhouse gas (GHG) emissions and resulting climate change impacts account for a large and growing share of environmental costs – rising from 69% to a projected 73% of externalities between 2008 and 2050, Trucost says.  (In a footnote, Trucost confesses to making conservative estimates; higher actual values are likely, but the lack of global data requires Trucost to “simplify many economic and environmental complexities”.)  And an ounce of prevention (or “using natural resources in a more sustainable way,” as Trucost says) is worth of pound of cure (or more expensive remediation).

Institutional investors, Trucost argues, need to exercise their ownership rights to address these environmental impacts, and “engage in dialogue with companies together with other investors and seek policy and regulatory solutions to address externalities”—particularly across a sector and within supply chains.  In addition to engagement and proxy voting initiatives, they can draw upon resources such as The Economics of Ecosystems and Biodiversity (TEEB) and engagement forums such as PRI, the Investor Network for Climate Risk (INCR), and the Institutional Investor Group on Climate Change (IIGCC).

Institutional investors also can:

• require fund managers to regularly monitor and report on environmental risk exposure;

• call upon rating agencies, sell-side analysts, and fund managers to incorporate environmental costs into their analysis; and

• encourage “further research to build capacity and improve understanding of the relationship between corporate externalities, ecosystem goods and services, company financial risk, and portfolio returns”.

The shared benefits for companies and investors:  long term environmental and economic well-being.