Past returns: don’t even guide the past

The argument in this piece is simple, but relatively aggressive: past returns are too high because they were based on false profits.

The Thinking Ahead Institute’s work on value creation led us to propose the concept of a value creation boundary. Value is created inside the boundary and is destroyed outside it. There is discretion as to where to draw the boundary. Drawing a tight boundary concentrates the value created for the fortunate insiders, and means the value destruction for any particular bystander will typically be very dilute. So dilute, perhaps, that they do not even realise they are suffering any value destruction. However, collectively – and over time – the value destruction accumulates and becomes highly visible.

Taking this from the abstract to reality, our lived experience has been within an environment of shareholder primacy, which is nothing other than the drawing of a very tight boundary. Shareholders were the insiders and everyone and everything else fell outside. Now the value destruction has accumulated and is staring us in the face. It is the carbon in the atmosphere, the plastics in the oceans, the phosphorus and nitrogen in our rivers and lakes; it is also visible in the fight for living wages. In fact, if you are willing to allow me some slack I would argue that the UN’s sustainable development goals are a manifestation that the economic machine has caused multiple problems for the masses lying outside the boundary.

So far, so clear. But what has this got to do with past returns?

The value destruction outside the boundary is simply different language for the term economists use – ‘externalities’ (Properly viewed through a wide frame and over a long horizon, there is no such thing as an externality in a closed system). Both versions refer to the dumping of waste into environmental sinks, rather than paying to dispose of it cleanly. In other words, the true cost of production in our economic activity was understated, and hence profits were overstated. It is therefore my contention that past returns were inflated relative to what they should have been, based on these false profits. The only way for past returns not to have been inflated would be if market prices already incorporated the knowledge that profits were overstated, and had done the adjustment for us. In effect we have run down our natural resources and converted them into financial returns, as if that was normal behaviour.

All this would be of no more than academic interest if nothing was likely to change. If we can continue to avoid accounting for the true full cost of production, who gets to declare that the profits are false? So, can we continue to costlessly dump our waste into environmental sinks? It is my belief that the sinks are now full or, with a global population of 8 billion people, will be full in short order. And by ‘full’ I mean in a practical, rather than literal, sense – it will be perfectly possible for greenhouse gases to further accumulate in the atmosphere long after most biological life, including us, has become extinct.

If the sinks are full, then the cost of waste disposal will need to be internalised and profits will fall. And what if society demands that the sinks be cleaned? Hold that thought…

Does the overstatement of past returns matter, and should we care? To answer this question I will simply quote from the FT’s Moral Money email of October 2, 2019: “The influential Wall Street lawyer Marty Lipton argued that business was underestimating the potential litigation risks associated with ESG issues. ‘When significant costs to society from climate change and the depletion of resources are tallied, as they will be, an armada of regulators and plaintiffs’ lawyers will appear,’ he warned… risks were far from abstract, Lipton warned: directors may be held personally accountable if their oversight was deemed in hindsight to have been insufficient.” So, even if we leave aside the moral aspects, and look at this question purely in financial terms, it looks like shareholders should care as returns could be clawed back. And directors should care a lot.

In summary, it is my belief that past returns were over-stated. The implication is that future returns will be lower. More accurately, total value created will need to increase for shareholders to retain the same amount of value as previously. It might be possible, as with the global financial crisis, to get taxpayers to pick up the internalised costs. But taxpayers are also employees and customers, so it is hard to see how corporations dodge the bullet completely. It turns out that drawing the value creation boundary tightly, and acting as if the earth can absorb limitless amounts of waste, is not a game we can keep playing forever.

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).