The story of OxyContin is not a heartwarming one. It involves kickbacks to medical professionals, suppression of research findings, overprescription, misleading advertising, and a long list of other illegal and/or unethical actions. It involves massive financial success for the drug’s producer, Purdue Pharma, over the twenty-plus years from the painkiller’s 1996 launch until the firm’s misdeeds eventually caught up with it. More recently, it involves a 2020 bankruptcy, guilty pleas to three felonies and a legal settlement transferring all of the firm’s assets to a public benefit company – an outcome described by the firm’s Chairman as effectively being seized by the government.
And it also involves, of course, an opioid epidemic. An epidemic touching millions of American lives, and leading to tens of thousands of deaths each year.
Or, as an economist would put it: it involves an externality. An externality is any spillover cost imposed by economic activity on third parties. The epidemic and the associated cost borne by the broader community were largely indirect – or external – consequences of Purdue Pharma’s actions.
A nationwide health crisis is an extreme example, but externalities – spillover effects – are in fact all around us. They can be beneficial: herd immunity or the boost to a neighborhood from a great local school or restaurant, for example. More often, they are harmful: the disruption we suffer when a pig farm opens next door or the local airport builds a new runway; the tragedy of the commons; the real (but unknown) price we are all starting to pay as atmospheric CO2 builds up and the climate changes.
Externalities are a huge and unavoidable part of how the economy operates, so much so that the shareholder activist Bob Monks has described the corporation as “an externalizing machine in the same way that a shark is a killing machine.” Indeed, the investment firm Schroders have estimated that the externalities generated by listed companies worldwide are equivalent to more than half of their profits, and that one third of companies would be loss-making if their negative social and environmental impacts were to be taken into account. In today’s highly-connected world, very little economic activity is externality-free, neither touched by nor touching the rest of society.
Externalities and ESG investing
The rise of ESG investing, to a large extent, boils down to an increase in the attention being paid to externalities.
At first sight, it might seem that an investor does not need to be concerned about externalities. After all, if we are focused only on the return on our investments, then it might seem like we should be glad if costs are borne by society in general rather than by our portfolio holdings. There are two reasons we should be concerned, however: the first is that externalities might not remain external forever; the second is that even if the costs remain external, they are still real costs, real impacts.
Let’s consider first the direct financial angle. Classical economics says that externalities should be internalized. In other words, if your economic activity imposes a cost on third parties, then you should compensate them. That’s why Milton Friedman, who vehemently opposed most forms of government intervention, nonetheless argued in favor of a carbon tax in order to align incentives (“make it in the interests of the car manufacturers and the consumers to keep down the amount of pollution.”) This makes the externality go away, and keeps economic theory intact: you can still count on the invisible hand and the magic of markets.
The lawsuits brought by various States (and others) against Purdue Pharma were, in effect, efforts to redirect costs incurred back to their source, to internalize the externality. When that happened, the economics of OxyContin looked very different.
As Schroders’ numbers demonstrate, most externalities are not currently internalized. And it would be impractical to try to do so: there are too many of them; they can be difficult to put a value on; there’s usually no simple way to transfer compensation from the right source to the right recipient. Corporate lobbying doesn’t make it any easier, either.
Nonetheless, every externality has the potential to be internalized, and the biggest ones generally are eventually. Think of it as the inevitable policy response. So if we’re investing in companies that are generating lots of externalities, they have the potential to bite us. This is why carbon taxes are now becoming more common, for example. Even if externalities are not considered a cost, they are a risk factor.
Universal ownership
The universal ownership perspective adds another layer to the financial impact of externalities. This perspective begins with a recognition that, for large pools of capital, the biggest investment exposure is to the whole economy, not to individual companies or sectors. And this means that costs can never truly be made external, they can only be shuffled to a different part of the portfolio. In the words of Hiro Mizuno, former CIO of Japan’s $1.5 trillion Government Pension Investment Fund: ”when a company makes a profit at the expense of the environment, for example, that cost still has to be incurred somehow, somewhere, some time.”
One is responsible for one’s impacts
So that’s one reason for investors to be concerned about externalities: the potential financial impact they have on the companies that create them and on the broader portfolio. The second reason is this: that even if it is others – not us – who bear the costs, we still have some responsibility for our impacts. Peter Drucker expressed it best: “Any institution exists for the sake of society and within a community. It, therefore, has to have impacts; and one is responsible for one’s impacts.”
So there’s both a financial and a non-financial element to the investor’s interest in externalities. Logically, a line must exist between these, a line between the costs that will directly impact our portfolio performance and those that will remain external, always to be borne by others. But there’s no way to know where that line is in practice. There’s no way to be sure which externalities will be internalized, to what extent they will be internalized, by what means, or when.
So it’s not just investors who include non-financial considerations in their investment choices who need to pay close attention to externalities. For every investor, externalities matter because every externality is a potential cost – a risk factor, in other words. Either way, externalities are a big deal.
Endnote: Really?
As of January 2021, it still only takes one click from Purdue Pharma’s homepage to run into the statement that “we have always been guided by our core values – collaboration, integrity, courage and innovation.” *Sigh*