If the financing of the energy transition is becoming ever more urgent, given the growing impact of global warming, it is however necessary to direct more international capital towards investments that contribute to collective well-being. In this regard, it is especially important to take into account the environmental impacts of private investments. These crucial issues for the future of the planet and future generations are addressed at length in the research work of Christian Gollier, director of Toulouse School of Economics (TSE). In his latest book, Ethical Asset Valuation and the Good Society (Columbia University Press, published in October 2017), he has developed an atypical scientific approach to evaluate savings and investment decisions, so that they can serve the public interest. In this interview, he discusses the main recommendations arising from his work.
ILB: In your essay published in 2017, you develop a method that runs counter to classical economic theory. Your aim is to orient investment toward long-term assets that will bring social benefits to future generations. What is the starting point for your work?
Christian Gollier: In recent years, finance has been heavily criticized for being the source of many dysfunctions, the most dramatic example of which was the financial crisis of 2008-2012.
I wanted to reflect on this topic, especially with socially responsible investors in mind, with a view both to putting these criticisms in perspective and to providing an ethical framework for thinking about the allocation of capital in the economy. To start from the basics, it’s important to remember that companies do not only produce returns and employ labour, they also generate both positive and negative externalities, commonly referred to as extra-financial performance. However, these externalities should be taken into account, from the standpoint of the general interest, in issues of asset valuation, portfolio allocations and real investment in the economy. One of the major problems of our economies, for the last two hundred years, has been the efficient allocation of capital. Until now, the best solution to the problem has been the financial markets, but this is not perfect in terms of efficiency and compatibility with the general interest.
What are the current sources of market inefficiency?
CG: The issue of climate change is crucial.Companies have no incentive to reduce their carbon emissions, although there have been some attempts around the world. I’m thinking in particular of the European emissions trading scheme for carbon allowances, which is the most successful system. Unfortunately, for several reasons, both political and economic, the price of carbon allowances is currently too low for companies to really take into account, in their investment decisions and technological choices, the damage to the climate caused by the use of fossil fuels.
What solutions might there be for solving the problem of negative externalities caused by companies?
CG: Like most academic economists around the world, I believe that governments should strengthen their policy of combatting climate change by imposing a higher carbon price than the one prevailing today in the emission allowances markets. Another alternative would be for companies themselves, through incentives from the financial markets, to incorporate a carbon price and their environmental performance into their investment choices, so that they make the most intelligent decisions. This is what the socially responsible investment funds (SRI) market is aiming to do. In my book, I try to combine the basic principles leading to a transparent methodology for evaluating investment choices with a socially responsible approach,since the financial markets can play a part in the fight against climate change.
What principles and methodology should be advocated for corporate investors to adopt a more socially responsible approach?
CG: I propose identifying the different sources of non-financial performance, such as safety at work or the reduction of inequalities, as well as the various emissions of pollutants. In addressing SRI funds, my aim is to make them aware of the importance of including carbon prices and negative externalities into their investment valuations and portfolio allocations, as well as simply maximizing returns. For example, companies are currently obliged to publish their carbon emissions in their annual reports. SRI funds should therefore look at corporate emissions and multiply them by the price of carbon, and then re-incorporate this cost in their valuations. They should also adopt the same method general, SRI funds adopt a “best-in-class” view, but without really quantifying emissions. Instead they make relative comparisons between companies according to their degree of social responsibility.
What do you propose for assessments of companies by SRI funds?
CG: My approach goes much further than the simple “best-in-class” view. I propose using quantitative finance techniques, particularly the Markowitz model, on dividend-per-share profitability data, which includes non-financial performance
ethically evaluated under an SRI filter. It doesn’t matter that SRI funds post different values for positive and negative externalities. What is important is that investors can choose in accordance with their own ethical preferences.
This would also make SRI funds moreb transparent, and therefore more attractive.
With your approach, each SRI fundb would decide on the values to be given to externalities.
CG: It’s not a matter of assigned values arbitrarily.For example, if we take the price of carbon, an SRI fund might decide to estimate it at 100 euros per tonne. Is that sufficiently ethical or not? Many economists are working on this topic, including within the IPCC (Intergovernmental Panel on Climate Change), and have much to contribute. For economists, the ideal solution would be to price a tonne of carbon at the marginal cost or damage it generates, even if its actual price level has not been
settled. I think that the damage caused by a tonne of carbon should be put around 50 euros, even if there is no consensus among scientists on this subject. At the end of the day, SRI funds should be looking to environmental economists to calculate the cost of carbon for society.
In the absence of an international consensus on the price of carbon, is it not difficult to apply your approach?
CG: It’s true that there’s residual scientific uncertainty about the intensity of climate damage caused by carbon emissions and it will take a few more decades to assess it conclusively. But the lack of absolute certainty does not mean that we should refrain from acting or taking decisions, especially since we all live under uncertainty of one kind or another, yet we make decisions. Uncertainty should not be a reason for inaction. Instead, we should incorporate risk into our decisions. Financiers have been doing this for ages. So why not do so with regard to climate change? for other negative externalities, and even for positive externalities such as well-being within the company and wage increases for the lowest paid employees (possibly because of relocation), which helps reduce global inequality.
Put simply, this is a bit like a bonus/malus system.
CG: Exactly. As in the car insurance market. Some companies emit more than others. In general, SRI funds adopt a “best-in-class” view, but without really quantifying emissions. Instead they make relative comparisons between companies according to their degree of social responsibility.
What do you propose for assessments of companies by SRI funds?
CG: My approach goes much further than the simple “best-in-class” view. I propose using quantitative finance techniques, particularly the Markowitz model, on dividend-per-share profitability data, which includes non-financial performance ethically evaluated under an SRI filter. It doesn’t matter that SRI funds post different values for positive and negative externalities. What is important is that investors can choose in accordance with their own ethical preferences. This would also make SRI funds more transparent, and therefore more attractive.
With your approach, each SRI fund would decide on the values to be given to externalities.
CG: It’s not a matter of assigned values arbitrarily. For example, if we take the price of carbon, an SRI fund might decide to estimate it at 100 euros per tonne. Is that sufficiently ethical or not? Many economists are working on this topic, including within the IPCC (Intergovernmental Panel on Climate Change), and have much to contribute. For economists, the ideal solution would be to price a tonne of carbon at the marginal cost or damage it generates, even if its actual price level has not been settled. I think that the damage caused by a tonne of carbon should be put around 50 euros, even if there is no consensus among scientists on this subject. At the end of the day, SRI funds should be looking to environmental economists to calculate the cost of carbon for society.
In the absence of an international consensus on the price of carbon, is it not difficult to apply your approach?
CG: It’s true that there’s residual scientific uncertainty about the intensity of climate damage caused by carbon emissions and it will take a few more decades to assess it conclusively. But the lack of absolute certainty does not mean that we should refrain from acting or taking decisions, especially since we all live under uncertainty of one kind or another, yet we make decisions. Uncertainty should not be a reason for inaction. Instead, we should incorporate risk into our decisions. Financiers have been doing this for ages. So why not do so with regard to climate change?
Among other inefficiencies of the financial markets, is there not also their short-termism?
CG: This question should be addressed in another way. A company may be prompted to be potentially short-termist because capital is expensive in the financial markets. However, the higher the cost of capital mobilization, the more the company will seek to extricate itself as quickly as possible in order not to penalize its profitability. In such a case, the company is encouraged to be short-termist. The cost of capital thus represents the profitability required by investors, which is a combination of the interest rates at which the company borrows and the rate of return on the shares it has issued. To see whether the financial markets are compelling a company to be short-termist, we need to analyse the interest rates at which it has borrowed in the past. It is these rates that will determine its investment choices and they approximate to a discount rate determined by the financial markets. In the twentieth century, low-risk companies, which were able to finance their capital at an interest rate close to that of government bonds, in fact borrowed at very low real interest rates. Indeed they were much lower than the 4% or so suggested in conventional finance models, with real interest rates in the United States of around 1%, while in France they were even negative due to high inflation. In actual fact the financial markets were long-termist with these low-risk companies. This means that, in order to finance them, households had to save a lot, thereby fuelling the high growth of the last century and our current well-being, despite their having an income level five to ten times lower than our own. On the other hand, for very risky companies, which invested in the new technologies of the time and carried out extensive research and development, the financial markets required much higher rates of return with a high risk premium. This situation tended to inhibit their long-term risk-taking, which is not good for growth and innovation.
If earlier generations were long-termist in terms of saving, what can be said about the present generation and the consequences for future generations?
CG: What the theory of modern finance tells us is that financial markets generate interest rates that are too low and risk premiums that are too high. Put simply, the financial markets make entrepreneurs overly cautious, whereas households are able to control their risks through large, diversified portfolios.
Let us return to the valuation of long-term investments, whose future net social benefits are discounted in order to measure their value creation for society. At level should this discount rate be set?
CG: The huge uncertainties characterising the very long term justify making major sacrifices today for future generations. It is therefore preferable to apply a low or zero discount rate for low-risk, long-term investments (longer than 40 years), in order to encourage governments and companies to implement them. However, for investments over a 20 or 30 year time span, I recommend a real discount rate of around 2%. Indeed, in a high-growth world like ours, future generations will be richer than the present generation. Yet saving today means transferring purchasing power to future generations, thereby increasing intergenerational inequalities. This may seem shocking at first glance, but it should be remembered that even though France has
been in economic crisis for 40 years its real GDP has greatly increased over that period.
In conclusion, what are your priority recommendations for reducing the current impact of climate change on future generations and thus promoting virtuous investment?
CG: The best solution would be for countries to agree on a universal carbon price worldwide. But this will be very difficult if not impossible to implement given national selfishness, the prime example being ‘America First’. As I mentioned earlier, the fallback alternative would be for financial markets to introduce mechanisms for evaluating their investment projects or decisions for governments, companies and entrepreneurs, that include a carbon price at a level compatible with the general interest. In this respect, the growth of SRI funds is a good way of achieving it, though investors need to be sufficiently motivated to move in this direction.
Interview published in the Cahier Louis BACHELIER, October 2018.
