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Jim Hawley: my response to investor reporting on both portfolio and systems-level performance

“The paper’s definition of externalities as that which “cannot be adequately priced by the market place” is far too limited”

Have your say: comment on this response and the original article: ‘It’s time for investors to start reporting on both portfolio and systems-level performance at RI’s Linked-in site

The Investment Integration Project’s (TIIP) paper raises what have been for too long critical yet minimally addressed questions about the systemic implications of “normal” asset management and investment strategies. The paper frames the systemic issues robustly, while focusing on the challenges of what it might mean for portfolios to take account of various systemic issues. In particular it brings the financial back in (think Hyman Minsky), not just to the ESG paradigm, but into dominant economic paradigms as well. I’d like to comment one major point—externalities—and then briefly on some smaller issues
Universal Owners and Externalities
It is useful to put the paper in the context of my past work on universal owners (UO). The core idea behind the UO hypothesis is that normally firms produce positive and negative externalities, some proportion of which are internalized within a diversified (“universal”) portfolio. Externalities in traditional economic analysis are either pecuniary or non-pecuniary, the former having a direct, market-based value (e.g. mitigating costs of polluted river water), while the latter have a demonstrable economic impact, but no clear current market value. The UO hypothesis implies that a specific portfolio will operate sub-optimally to the degree it internalizes both types of negative externalities, and because the investment universe is dominated by this type of portfolio, the economy as a whole will also be sub-optimal. This tends to align the economy as a whole and UO portfolios. In this regard, the paper’s definition of externalities as that which “cannot be adequately priced by the market place” is far too limited as it does not distinguish between pecuniary and non-pecuniary externalities. It misses core elements in current public policy—for example, carbon markets’ cap and trade—as well as a key point that Coase makes about the role of liability law as an incentive to private bargaining. While the “market” may or may not price externalities depending on specific conditions, there are “social” (read: third party) costs, both pecuniary and non pecuniary. The paper argues that some externalities “cannot be accurately priced…at the current time,” but some can and are.From an investment portfolio perspective, many externalities may well be non-pecuniary. But that means there are economic costs (or benefits), with or without a current exact monetary value. This matters for two reasons. First, non-pecuniary externalities depend on the ability of analysts (or courts or private negotiations or cap and trade type markets or tax policy) to develop a proxy price, at which point they become pecuniary. Markets can be incentivized or constructed to transform a proxy price into a real one. Second, to the degree that externalities are internalized within UO portfolios, they will have pecuniary and non-pecuniary impacts, both of which can be measured through standard input-output models. Such measurements can help minimize collective action problems inherent in effective systemic action by portfolio managers. Once realized, costs or benefits make for under- or out-performance, and become a material wake-up call. The challenge for portfolio managers is to focus on those externalities that have the most impact. In sum, the paper can benefit from developing its thinking about externalities.
In general, I find the discussion of Modern Portfolio Theory nicely framed, but wonder if it might benefit from a more detailed discussion about how financial deregulation from the 1990s stacks up against the re-regulation of the 2000s. Helpful also would be a more detailed account of what in fact constitutes a “systemic framework” on which portfolio managers might focus and how interests have become hard baked into investment and corporate management that conflict with these frameworks.
Also benefitting from further elaboration would be discussions of the huge problems relating to collective action, long-termism as a strategy in investment, and systemic impact reporting, as well as the development of actual case studies of this approach in action, perhaps with climate change a test case.

Jim Hawley is Head ESG Research, TruValue Labs, San Francisco and Professor, Department of Management, Saint Mary’s College of California, Moraga, CA

Have your say: comment on this response and the original article: ‘It’s time for investors to start reporting on both portfolio and systems-level performance at RI’s Linked-in site