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What’s the Context for Extolling the Virtue of Markets?

April 2, 2010

I am continuing to reflect on Geoffrey Heal’s When Principles Pay. Heal clarifies “popular” belief in the efficiency of markets.  As Arthur Pigou, an early 20th Century economist, notes that when a firm’s private and social costs are the same, markets work well for society, and align corporate and social interests.  When these costs are not aligned, markets are not effective nor efficient.  Heal goes on to explain the First Theorem of Welfare Economics is that under certain conditions, among them no external costs, competitive markets do well in leading to economic efficiencies.  He notes that a precondition for the alignment of corporate and social interests is that no costs are externalized (all are paid for by the corporations).  We all know that’s not happening.

Normally government would address the issue of externalized costs would be to tax them.  In our current political environment, that is unattractive.  The public winds up shouldering the environmental external costs through expenditures such as Superfund to clean up sites of severe pollution, health impacts via particulates in the air, pollutants in the water, mercury in the soils, and so forth.  In addition to environmental costs, there can be significant related social costs as well.

Heal then argues that corporations gain by realigning corporate interests with social interests, as it reduces conflicts with society and government.  Certainly society gains.

For corporations to move in this direction takes vision, courage… and a push from the markets, regulatory agencies or influential NGOs and consumer groups generally helps.  Sometimes, it involves the courage and vision to collaborate, as happened when major global banks established The Equator Principles, a investment framework for all industry sectors that also built on existing environmental standards.

To a significant extent, the roles of market rating agencies act to increase the transparency of corporate risks and liabilities, especially such groups as Innovest and KLD.  Even UBS has noted that corporate balance sheets should carry warnings about environmental and biodiversity damage liabilities that valuation by analysts should take into account.  These risks become more important as more governments adopt the principle that the “polluter pays.”

Heal advocates the use of the stock market value to asset book value ratio, within individual industries, as a good indicator.  He also compliments the ratings from Innovest and KLD, and has completed a study that appears to correlate superior social and environmental performance improving a company’s stock market valuation.

Clearest are Heal’s conclusions:

– A company’s performance on social and environmental issues can affect its financial performance.

– Social and environmental policies are NOT philanthropy, public relations or marketing; they are focused responses to social and environmental issues that are directly related to a company’s operations.

–good policies encourage identification of the problems associated with operations

–they encourage devising ways to reduce the problems

– Doing well by NOT doing good is generally not sustainable.

– There are two “classes” of corporate social responsibility:

–internalizing the external costs associated with a company’s operations

–modifying the way in which a company’s activities would, if left to market forces, impact on its poorest employees or customers

– As a corporate strategy, aligning corporate and social interests reduces risk, reducing the possibility of lawsuits, brand damage, regulatory exposure and often improving operations and market valuation.

Heal is a good read.

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