It is worth stating up front that, for us, the value creation boundary is an abstract concept. However, we believe it is a powerful concept, with the potential to re-wire our thinking and re-shape our behaviours.
We value order in our lives. We will pay to have our homes cleaned, but not to have them messed up. It is similar for goods. We will pay up for the highly-ordered final product, but not for the raw materials it is made of. Next, we note that economics has long recognised the concept of externalities – costs or benefits that fall on people not directly involved in the economic activity. From here two things follow. First, that there is a value creation boundary which lies between these innocent bystanders, and the parties involved in the economic activity. Second, that value is created inside the boundary and destroyed outside it. In other words, the externalities are, in aggregate, negative. Several questions spring to mind: who are the insiders, and who are the outsiders? Where should we draw the boundary, and are there consequences to that decision?
The planetary reality
The tightest boundary we can draw is around a single individual. So I derive value from my home being cleaned but tend not to think about the impact outside my boundary. These impacts include, first, the production of chemicals used to clean my home, and their escape from my home as waste; second, my share of CO2 emissions from the electricity powering the vacuum cleaner; and, third, the fact that most of the vacuum cleaner will end up in land fill at the end of its life. Having considered my impact outside the boundary I have a choice to ignore it, or to adjust my cleaning mandate (only lemon juice and vinegar? More sweeping and less vacuuming?).
Switching to the widest possibility, we could draw the boundary around the earth’s atmosphere. In this framing, we recognise the earth as a largely-closed system (so a good idea to maintain the life-support systems) with the free input of solar energy, and the ability to costlessly dump excess heat into the universe. If I adopt this mindset then I probably do need to limit my cleaning chemicals to lemon juice and vinegar, and in aggregate we will only be able to extract lemon juice at the rate the earth is able to replenish the crop. In addition, I ought to ensure my electricity comes from renewable sources, and that my vacuum cleaner was designed with a circular economy mindset (rather than a linear use-then-throw mindset).
Where to draw the boundary?
The logic of the value creation boundary is that the more tightly we draw it, the larger the domain over which we are having a negative impact (this doesn’t mean the negative impact gets bigger). Further, this engenders an adversarial, negative-sum environment. To create value for our small group, we need to be able to dump harm on some other group. However the other groups know this, and have the same incentives. In case this is too abstract, think about the choice between divestment and engagement. Divestment is nothing other than my group dumping unattractive securities on another group. Not wrong, but not positive sum either. Engagement runs the risk of still holding securities with a collapsing value before business models can be adapted. But it can be a positive sum activity, and it signals a ‘wider boundary’ mindset.
The more we expand the boundary the more of humanity we include. This carries the advantage of reducing the antagonism between groups, but the substantial disadvantage of removing cheap dumping grounds for the waste of the economic activity we invest in.
If we choose not to draw the value creation boundary that widely, we are identifying that we hold one or more of the following beliefs or values:
- My investment time horizon is sufficiently short that I do not have to worry about potential negative consequences over the longer-term
- I am subject to fiduciary duty, which I interpret to mean my responsibility is solely to maximise the next period’s risk-adjusted return
- I am powerless to influence externalities so there is no point expending any such effort
- I recognise the importance of addressing externalities but prefer to be a free-rider on the efforts of others
- My ideology does not support this action. I believe unconstrained free markets produce the best outcomes, so if the externalities matter that much someone will create a profitable business to address them
- My values do not support this action. I care passionately about my group [ie clients / members] but have no regard for anyone outside this group.
The above list does not reflect my values and beliefs, but they are valid – at least somewhat. The point is that the value creation boundary is a thinking device. Each investment organisation, whether asset owner, asset manager or other service provider, will need to work out where to draw their own.
Back to the planet
There is a growing recognition of the validity of ecological boundary conditions (eg Rockström et al (2009), Future-Fit Foundation, Doughnut Economics (2017) etc). Due to the scientific foundation of these boundary conditions we do not need a values-based discussion to support them. We accept that beliefs may differ but, by definition, valid beliefs must be consistent with the available data, and so the range of disagreement is constrained.
If we return to people, then drawing the value creation boundary around the atmosphere includes all of humanity. We are saying that value must be created for all humans, not just subsets. This is the UN’s sustainable development goal. Accepting some degree of responsibility for these social goals is necessarily (but not exclusively) values-based. And values can legitimately vary widely. For our part (ie mine and TAI’s value creation working group members), we believe that all investment organisations should develop the beliefs and values to support this social floor, as well as the ecological ceiling.
So what?
Where we choose to draw the value creation boundary will impact our subsequent actions. It will determine which business models are appropriate to be in the portfolio, and which should be excluded. It will influence decisions over the provision of new capital. And how seriously to take voting and engagement. It may influence new thinking over the structure of incentive arrangements. Where and how organisations choose to draw this boundary is carried forward in new research, published by the Thinking Ahead Institute, entitled Mission critical: understanding value creation in the investment industry.
We believe the zeitgeist is shifting such that society will increasingly expect corporations to take greater responsibility for a wider set of issues affecting a bigger group of stakeholders. The value creation boundary is a powerful concept to help guide the thinking regarding which issues, and which stakeholders.
Tim Hodgson is head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute (TAI).
