Green Finance Advisor of Friends of the Earth (HK)
Arguably the greatest driver of innovation and growth in our capitalistic society is the attachment of a financial value to a measurable metric. This has been the underpinning motivation for many bright scientists and entrepreneurs throughout our modern age in its quest for more, and as the system has promised, those who succeed have been rewarded handsomely through financial means.
However, the endless pursuit of growth in the modern era has resulted in significant and perhaps unsustainable alterations in our very own biosphere, be it the rising average annual temperatures, increasing risk of drought, and the ever-present threat of rising sea levels to our coastal habitats. In the face of these risks, our society seems to have delegated the responsibility of solving issues of sustainability to multilateral government organizations and not-for-profit bodies. And since the Kyoto protocol in 1997, it is not surprising that an observer would argue that real progress has yet to be achieved. Perhaps we should take a lesson from the corporate world by financialising negative externalities and thus attaching explicit financial value to metrics of sustainability? Then perhaps a few bright minds of our generation would pursue sustainability as they would grow in the traditional capitalist sense?
Coase Theorem and the Cap and Trade Program
In fact, the financialization of sustainability metrics is not new. Ronald Coase, one of the fathers of modern economics in his Coase theorem states that “if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property…given clearly defined property rights…the result is the economic efficiency of an economic allocation or outcome” (Coase 1960).
Formulated in 1960, this theorem has been the foundation of the cap-and-trade (CAT) market used in the US Acid Rain Programme and the European Emission Trading Scheme (EU ETS). These programs have proven that market mechanisms based on Coasean bargaining is an effective solution in the integrated approach of tackling sustainability issues through the combination of public policy and private initiatives (Chou, Ho 2018). The policymakers define the property rights and set a ceiling for the production of negative externalities, leaving private participants to find an economically efficient bargaining outcome that drives forward measures of sustainability.
Integration into Financial Reporting and Corporate Performance Measurement
While current gradual standardization of Corporate, Social, and Governance reporting in corporate financial reports is a good step forward, it does not do enough to motivate corporate stakeholders in their quest to achieve sustainability targets. Given the effectiveness of previously discussed applications of Coasean bargaining, perhaps we should consider a broader reform of our capital markets.
This could take the form of an inclusion of a range of financialized negative externalities metrics into standard financial reporting which would have direct impact towards a corporation’s share price performance. For example, iPhone’s parent company Apple is estimated to earn around 177% gross margin per iPhone it sells, however, this does not account for the negative externalities it incurs during its production process. For instance, the loss of food production from the conversion of agricultural land into factories, or the industrial waste which pollutes nearby rivers and contaminates land. Introducing financialized metrics of negative externalities into Apple’s financial reporting would certainly cause the relevant stakeholders to strive for sustainability in a measurable way.
This proposal will certainly encounter significant and substantial pushback given the vested interests in our current system, however in the face of imminent threat to the odds of mankind’s survival in this biosphere, isn’t it worth every effort from public policymakers as well as private stakeholders to pursue?
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L.H.T. Choy, W.K.O. Ho (2018). Building a low carbon China through Coasean bargaining. Habitat International 75 (2018) 139–146
Su, J (2018). The $1,250 iPhone XS Max Costs Apple $450 To Make, Nearly A 200% Profit Margin. Forbes Online (https://www.forbes.com/sites/jeanbaptiste/2018/09/27/the-1250-iphone-xs-max-costs-apple-450-to-make-nearly-a-200-profit-margin/#5596414d4966)