Externalities are a choice: why society should expect company directors to take impact responsibility

Externalities occur when producing or consuming a good causes an impact on third parties not directly related to the transaction.

At least this is the way most economists, or at least economic textbooks, think about them and has become part of our generally accepted thinking about the world.

As we all know, externalities are a bad thing. They are a bad thing because where there are externalities there is a difference between private returns and societal returns. Which means that markets are not operating efficiently. As the International Monetary Fund (IMF) points out:

To promote the well-being of all members of society, social returns should be maximized and social costs minimized. This implies that all costs and benefits need to be internalized by households and firms making buying and production decisions. Otherwise, market outcomes involve underproduction of goods or services that entail positive externalities or overproduction in the case of negative externalities. Overproduction or underproduction reflects less-than-optimal market outcomes in terms of a society’s overall condition (what economists call the “welfare perspective”).

Overproduction of goods with negative externalities pretty much sums up the climate crisis. In fact, you can pretty much look at sustainability from the perspective of externalities. Whilst there are positive and negative externalities and positive and negative impacts, many of the global challenges we face from climate change, nature loss and inequality result from businesses’ negative impacts or their dependency on using resources which are not costed or under-costed. In other words, externalities. 

Many of the global challenges we face from climate change, nature loss and inequality result from businesses’ negative impacts or their dependency on using resources which are not costed or under-costed. In other words, externalities

There are externalities whenever there are costs (or benefits) being experienced that have not been factored into decisions to allocate resources to activities. Although these could be public or private managed activities the basic micro-economics model starts with businesses. This model tells us at what price demand and supply will meet. And supply depends on the costs of producing whatever is being demanded. The costs that are included, which we could call ‘internalities’, are mainly based on contracts – for example, with employees and suppliers – but would also include other legally required costs like taxes or licenses to operate. These are then what economists refer to as the costs of production. Those other costs, the ‘externalities’, are an unfortunate side effect of a market economy and are best addressed, perhaps only addressed, by government action.  

The same IMF paper gives a clue as to why.

Consumption, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions. Sometimes these indirect effects are tiny. But when they are large they can become problematic – what economists call externalities. Externalities are among the main reasons governments intervene in the economic sphere.

Sometimes they are tiny, sometimes that are large. But how large is large? What about all the externalities in between tiny and large? Perhaps large is implicit in a government’s decision to intervene? And what about direct? If it’s indirect it is no longer an externality even though it is still a cost being experienced by someone that has not been factored into the cost of production.

Government interventions are often slow off the mark, may not intervene where necessary... and may have unintended side effects

If I pay someone below the living wage, they will be experiencing a cost, by definition, as someone is now earning a non-living wage. But if they have little or no choice, if the alternatives are worse, they may accept that wage. And I have externalised some of my costs by paying less. Surely an externality. Except they are directly related to the transaction and so not. But either way we still have an inefficient market where there is a difference between private and societal returns. The other problems are that lots of small externalities add up to very big problems. And government interventions are often slow off the mark, may not intervene where necessary, may choose interventions that do not work and may have unintended side effects.

Finding a better way

If only there were a better way. A way where the decision to address an externality was closer to the cause, faster and designed to shift resources away from activities that generated externalities. If only.

There is. Perhaps surprisingly, the solution lies in accounting standards.

International Accounting Standards (IAS) and specifically in (IAS) 37 deal with the issue of recognising costs. As might be expected they deal with costs arising from contracts and from other enforceable requirements, but IAS 37 goes further. Not only does IAS 37 recognise some costs where the cost is contingent on an uncertain future event, described as contingent liabilities, it also recognises that directors might choose to structure their commitments in a way that creates costs.

This is nothing short of amazing because it blows apart the idea that externalities are some sort of inevitable and unavoidable consequence of a market economy that can be best addressed by government interventions.

True, there is a big problem with the foundations on which accounting standards rest, but the building itself is incredible. The standards are designed to serve the information needs of the maximum number of users, but they rest on the premise that these users have an interest in expected financial returns – and only in financial returns. And this just doesn’t stack up. Most of us – as current or potential investors, one of the primary user groups – are interested in the other social and environmental consequences as well as those financial returns, both for ourselves and for others as well. But putting the foundations to one side for a moment, the resulting architecture for what constitutes useful information, when there is always uncertainty in our decisions, is a thing of great beauty.

Quite how beautiful has recently been highlighted by a new legal opinion from George Bompas KC on directors’ legal responsibility to present accounts that show a true and fair view; an idea that opens a link between the exciting realm of accounting and the legal requirement for truth and fairness in accounts. Social Value International had recently commissioned this opinion in the context of the increasing threats to society, nature and the environment, loosely considered under the umbrella of sustainability.

There is a lot in the 27 pages of the opinion, but one thing stands out – in paragraph 41, where the third sentence states:

On the other hand, a company which actively wants to make concrete sustainability commitments might deliberately choose to structure its commitments in such a way as to create future or even present year obligations which impact upon the accounts…

This is worth repeating.

A company that actively wants to make sustainability commitments…

Might deliberately choose to structure its commitments in such a way as to create future or even present year obligations…

Which impact on the accounts.

An obligation means that the business has no realistic way of avoiding making a payment; they have become ‘liabilities’ in accounting language. Or, in plainer terms, they have become ‘costs’, part of that production cost.

The accounting standard that deals with obligations in general, and the specific scenario of obligations that have been constructed, to which paragraph 41 refers, defines a constructive obligation as:

An obligation that derives from an entity’s actions where:

(a) by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and

(b) as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

Deliberate decisions

Those actions are, of course, deliberate decisions made by the company.

The opinion reminds us that those commitments might relate to sustainability issues; for example, the amount of carbon used during the year, the reliance on underpaid or even unpaid labour in the supply chain during the year, the dependency on a monopolistic or duopolistic market to support excessively high pay during the year.

It turns out that all those externalities are the result of a choice. Directors could choose to structure commitments that include these costs by creating constructive obligations. They could for example make a public statement and say something like:

The directors, recognising the risks to the business arising from systemic risks from climate change, accept responsibility for the consequences of carbon use in order to include an externality and drive business decisions that would be consistent with efficient markets, whilst also addressing their responsibilities under section 172 of the Companies Act.

By making the choice not to do this, they create externalities. Externalities are a choice made by directors.

So, whilst micro-economics separates internalised and externalised costs, where internalised costs arise from contracts or legally enforceable claims, and externalised costs are resolved by market interventions, accounting standards are way ahead. Directors can accept responsibility for those costs and internalise them. The language may be rarified, but that is why it is beautiful.

Even better, for all of us caught up in arguments about double and financial materiality, if directors choose to construct obligations and make payments relating to what is sometimes called impact materiality (the impacts and dependencies of the business on people and planet) then these have suddenly become financially material. And just like magic, there is only one materiality.

And if that weren’t enough these costs are not legally enforceable, the normal starting point for recognising a liability. Groups of people suffering the consequence of an ‘externality’ would need to organise and win a class action to make that happen.

Society just needs to expect directors to take responsibility for these costs and then use existing accounting standards to account for them... But this is a choice. And a choice being made in preparing annual accounts

Society just needs to expect directors to take responsibility for these costs and then use existing accounting standards to account for them. And this would clearly be a good thing for efficient markets because resources would now be allocated more, well, efficiently.

But this is a choice. And a choice being made in preparing annual accounts. In many jurisdictions including the European Community and the UK, directors have a duty to approve accounts that show a true and fair view. You might now see where I am going with this.

Can directors really present accounts that are true and fair unless they include constructive obligations for those impacts and dependencies, for the cost of using carbon, for underpaid labour in their supply chain – in order that markets are operating efficiently?

Can auditors sign off those accounts as being true and fair without, at the very least, getting directors’ representations that the obligations were not required?

Perhaps, perhaps not. But if we want a market economy aligned with sustainable development, this is a question that should be addressed by directors and auditors, and which those investors that are concerned about systemic risk in their portfolios may want to start asking.

• Jeremy Nicholls is the assurance framework lead for the UNDP SDG Impact Standards and an ambassador to the Capitals Coalition.

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