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2 Externalities—internalization

Overview
The social and environmental factors identified in Chapter 1 are externalities,
which affect other parties without these effects being reflected in market
prices. As neoclassical models use market prices as relevant signals for
decision-making (e.g. investment, production, or consumption decisions),
these social and environmental externalities are not incorporated. This chap-
ter discusses how to address this market failure, which hampers sustainable
development.
There are several mechanisms to internalize social and environmental
externalities. A major method is government intervention through regulation
or taxation. Social legislation in the developed world is a successful example of
internalizing social externalities. While a very few countries have implemented
effective carbon taxes to curb carbon emissions, most countries have no, or
very low, carbon taxes. Even worse, fossil fuel subsidies are still widespread
and hinder the adoption of renewable energy.
The corporate sector is increasingly working on the internalization of
externalities. This chapter explains the integrated value approach, which
measures the financial, social, and environmental dimensions, and subse-
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

quently calculates the ‘true’ or integrated price of a product or the integrated

value of a company. While companies can do much to internalize non-priced
externalities, there is insufficient collective effort. A system perspective towards
governance is required to address this shortfall (see Chapter 4). Moreover,
government intervention, or the threat thereof, may be needed to address social
and environmental externalities.
Although the United Nations (UN) Sustainable Developments Goals
Agenda has set a clear timeline to address the main social and environmental
externalities by 2030, there are significant political and technological uncer-
tainties about how these externalities will unfold over time. Scenario analysis is
a process of analysing possible future events by considering alternative pos-
sible outcomes under uncertainty. This chapter outlines the process of select-
ing scenarios (e.g. low, medium, high carbon tax), calculating the discounted
cash flows (DCFs) for each scenario and synthesizing the scenario results by
weighting the probabilities attached to each. We apply scenario analysis to the
valuation of fossil fuel companies, which may become stranded assets under a
scenario with a high carbon tax and/or a major technological breakthrough in
renewable energy production.

Schoenmaker, Dirk, and Willem Schramade. Principles of Sustainable Finance, Oxford University Press USA - OSO, 2019.
ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/bibliojaveriana-ebooks/detail.action?docID=5611187.
Created from bibliojaveriana-ebooks on 2022-01-26 20:49:03.
40 PRINCIPLES OF SUSTAINABLE FINANCE

Central banks and supervisors can also conduct stress tests of the financial
sector using extreme scenarios. A case in point is a carbon stress test, which
measures the exposure of financials to carbon emissions in their investment
and lending portfolio. The outcome of these stress tests can raise awareness of
exposure to major externalities and prompt financial firms to mitigate these
exposures.

Learning objectives
After you have studied this chapter, you should be able to:
• explain the concepts of externality and internalization;
• understand the role of government regulation and taxation;
• understand the integrated value approach for measuring externalities;
• explain policy and technology uncertainty;
• use scenario analysis.

2.1 Why externalities matter

Our economic system of production and consumption serves to create welfare
for society. The production function shows how factor inputs are converted
into product outputs. In the neoclassical tradition, the Cobb–Douglas produc-
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

tion function (Cobb and Douglas, 1928) is written as:

Q ¼ FðK; LÞ ð2:1Þ
where Q represents the output of (consumption) goods and services, K is
physical capital input (the value of machinery, equipment, and buildings), and
L is labour input (the total number of person-hours worked). However, the
neoclassical production function neglects the use of natural resources, includ-
ing waste and energy resources, and the impact of the production process on
social and human capital.
To address this shortcoming, a first step is to distinguish between funds and
flows (Daly and Farley, 2011). Labour and physical capital are funds that
transform a flow of resources into a flow of products, but are not themselves
physically embodied in the product. Labour and physical capital thus provide
fund services, while the flow of resources is that which is being transformed
(or used up). A second step is to incorporate natural resources (both non-
renewable or abiotic resources, such as mineral resources and fossil fuels,
and renewable or biological resources, such as timber, fresh water, solar

energy, and biomass) into the production function. The ecological economics
production function (Daly and Farley, 2011) embodies the fund–ﬂow distinc-
tion (funds uppercase; ﬂows lowercase) and accounts for energy use and waste
emissions:

q þ w ¼ FðK; L; N; r; eÞ ð2:2Þ

where q represents ﬂows of (consumption) goods and services, w ﬂows of

waste, r flows of natural resources, and e flows of energy. N stands for the fund
function of natural capital, like a forest yielding the service of watershed
protection or wildlife habitat. The flow function of natural capital yielding a
flow of resources is already captured in r (e.g. the timber of a forest). Another
example of a natural resource is land, whereby land restoration projects make
a clear distinction between flow and fund functions (Ferwerda, 2016). In its
fund function, land is the soil, whose supply is inherently fixed and can be
primarily financed with green bonds or bank loans (see Chapters 9 and 10).
The flow of (ecosystem) services comprises, for example, the annual crops
cultivated and harvested by farmers. The entrepreneurial activity of farming is
riskier and typically financed by a mix of equity and debt. A final step is to
include the social impact of production. The enlarged production function is
written as:
q þ w ¼ FðK; L; N; S; H; r; eÞ ð2:3Þ

where S represents the social and relationship capital and H the human capital
used in the production process (see Chapter 6 for the six capitals). Whereas
the social and relationship capital covers social activities, nuisances, or contribu-
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

tions to local communities and relationships within and between communities,

the human capital dimension refers to people’s competencies, capabilities, and
experience and includes issues such as health and safety, gender equality, training,
and job satisfaction.
The original Cobb–Douglas production function stresses the substitutability
between the production factors. A classical example is investment in advanced
machinery, which reduces the need for labour. However, natural resources are
complementary and cannot be substituted with labour or physical capital.
When producing steel, for example, you cannot reduce the amount of iron ore
used as input. The non-substitutability of capitals is a principle of sustainabil-
ity. Nevertheless, natural resources can be substituted with other natural
resources. An example is the light-weighting technique, which uses aluminium
instead of steel. This in turn can reduce energy use: aluminium vehicles, for
example, are lighter and thus need less energy to be driven. Another example
of substitutability is renewable energy, which can replace the use of fossil fuels.
Technological development, which is often exponential, plays an important
role in the transformation of production processes.

As discussed in Chapter 1, we are in a transition from a linear economy

(take, make, use, and waste) to a low-carbon and more circular economy to
reduce the reliance on natural resources. A key goal of the sustainable devel-
opment agenda is to ensure sustainable consumption and production patterns
(see goal 12 in Box 2.1). Sustainable production and consumption means that
the use of natural resources (N, r), including the flows of energy (e) and waste
(w), stay within the regenerative and carrying capacity of the Earth system.
However, abiotic natural resources ðN a Þ, such as mineral resources, are
finite. The speed of depletion (T in years) of abiotic resources is given by the
following equation:
Na

T¼ ð2:4Þ
Da
where Da represents the annual global demand or consumption of abiotic
resources. Impending exhaustion ðTÞ cannot be easily calculated from current
reserves for two reasons. First, the reserve base (Na) consists of discovered and
undiscovered resources. In the case of copper, for example, identified resources
as of 2014 are twice as large as the amount projected to be needed through to
2050, indicating that about 70 years ðT ¼ 70Þ are left. But estimates of yet-to-be
discovered copper resources are up to 40 times more than currently identified
resources (Meinert, Robinson, and Nassar, 2016). Next, annual global consump-
tion ðDa Þ is dependent on several factors. While recycling and substitution
reduce world demand for mineral resources, population growth and rising
standards of living require new primary supplies of mineral resources.
Figure 2.1 shows the end-of-life recycling rates for metals. The recycling
rate for much-used metals such as the ferrous metal iron (Fe—atomic number
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

26) and the non-ferrous metal aluminium (Al—atomic number 13) is over
50 per cent. In contrast, where materials are used in small quantities in
complex products, for example the precious metal tantalum (Ta—atomic
number 73) in electronics, recycling is technically much more challenging
and amounts to less than 1 per cent in Figure 2.1.
Next, the goal of inclusive economic growth and decent work (goal 8 in
Box 2.1) means that social and human capitals ðS; HÞ should be preserved in
the production process. The framework of the UN Sustainable Development
Goals (SDGs) provides a common language to discuss the capitals (see Box
2.1). How can we incorporate these capitals or factors of the enlarged produc-
tion function in our decision-making?
The remainder of this chapter deals largely with negative externalities due
to ignoring these capitals. For completeness, we stress that there are also
positive externalities, such as companies investing in renewable energy, mater-
ial savings, training their employees, sustainable food production, and/or
improvement of health care. At the country level, international cooperation
(through trade and other mechanisms) reduces, for example, war.

1 2
H He
3 4 5 6 7 8 9 10
Li Be B C N O F Ne
11 12 13 14 15 16 17 18
Na Mg Al Si P S Cl Ar
19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
K Ca Sc Ti V Cr Mn Fe Co Ni Cu Zn Ga Ge As Se Br Kr
37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54
Rb Sr Y Zr Nb Mo Tc Ru Rh Pd Ag Cd In Sn Sb Te I Xe
55 56 * 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86
Cs Ba Hf Ta W Re Os Ir Pt Au Hg Tl Pb Bi Po At Rn
87 88 ** 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118
Fr Ra Rf Db Sg Bh Hs Mt Ds Rg Cn Nh Fl Mc Lv Ts Og

* Lanthanides 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71
La Ce Pr Nd Pm Sm Eu Gd Tb Dy Ho Er Tm Yb Lu
** Actinides 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103
Ac Th Pa U Np Pu Am Cm Bk Cf Es Fm Md No Lr

> 50% > 2550% 125% < 1%

Figure 2.1 Recycling rates for 60 metals

Note: The periodic table of global end-of-life functional recycling rates for 60 metals, with the individual
metals categorized into one of four ranges of recycling.
Source: Adapted from Graedel et al. (2011).

BOX 2.1 SOCIAL, HUMAN, AND NATURAL CAPITALS IN THE SDG FRAMEWORK

The UN has developed 17 SDGs, as discussed in Chapter 1. Table 2.1 splits them in ‘people’
SDGs, which cover basic needs and are linked to social and human capitals ðS; HÞ, and ‘planet’
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

SDGs, which require urgent action and are linked to natural capital ðN; r; e; wÞ.

Table 2.1 Linking SDGs and capitals

SDG Brief description Social & human capitals Natural capital

1 No poverty X
2 Zero hunger X
3 Good health and well-being X
4 Quality education X
5 Gender equality X
6 Clean water and sanitation X
7 Affordable and clean energy X
8 Decent work and economic growth X
9 Infrastructure, industry, and innovation X
10 Reduced inequalities X
11 Sustainable cities and communities X
12 Responsible consumption and production X X

(continued)

BOX 2.1 CONTINUED

13 Climate action X
14 Life below water X
15 Life on land X
16 Peace, justice, and strong institutions X
17 Partnerships for the goals X

2.1.1 INTERNALIZING EXTERNALITIES

While an enlarged production function is easily written down, the problem is
that many of the social and environmental factors are externalities or external
effects, which affect other parties without these effects being reflected in
market prices. Neoclassical models use market prices as relevant signals for
decision-making (e.g. investment, production, or consumption decisions) and
thus do not incorporate social and environmental externalities. The share-
holder value model in finance as usual and sustainable finance (SF) 1.0
(see Chapter 1) uses these market prices when maximizing profits. There is
thus a market failure to account for social and environmental externalities.
It should be added that there is also a government failure in the form of lack of
policies, and uncertainty about future policies, to deal with these externalities.
What are the consequences of ignoring these externalities? As natural
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

resources are underpriced (only the costs of extraction and, where applicable,
mining concessions are counted), the overuse of scarce natural resources,
including fossil fuels and waste, in production continues. Moreover, there is
an underinvestment in new technologies and infrastructure that rely less on
natural resources and more on renewable energy. In his aptly titled book Why
Are We Waiting?, Stern (2015) argues we need to stop investing in old-type
energy and production infrastructures, as such investments add to the
installed base for years to come and slow down the transition. On the social
side, current labour practices, such as underpayment, discrimination, lack of
health and safety procedures, and child labour, may continue.
This chapter reviews the methods for internalizing social and environmental
externalities. Chapter 3 provides an overview of the sustainability players,
including the instruments at their disposal, forums in which they might work
together, and the opportunities and threats they face (see Table 3.1). We
identify ﬁve main players, which can apply various internalization mechanisms:
1. Government: A ﬁrst best solution to internalize externalities is taxation or
regulation by the government. Section 2.2 analyses how this can be done.

2. Civil society: Non-governmental organizations can raise awareness of

social and environmental externalities through a public voice in the
media. The aim of public debate is to stimulate other players (government,
financials, business, and consumers) to behave responsibly and address
externalities. Societal connections, such as families, social clubs, sport clubs,
churches, and charitable organizations, also develop civic values. Chapter 3
briefly discusses the role of civil society.
3. Investors: Financial institutions can incorporate environmental, social, and
governance factors in their investment and lending strategy and engage
with corporates in which they invest. Chapters 3, 4, and 7 analyse how
investors can engage effectively with corporates. Chapters 8 to 10 discuss
the role of various financial institutions in detail.
4. Corporates: Corporates can incorporate the costs of externalities into
business practices across the value chain of production. Section 2.3
describes how externalities can be measured and priced. Chapter 5 exam-
ines how corporates can embrace sustainability in their strategy and change
their business models.
5. Consumers: Consumers can buy sustainable products and services.
Responsible advertising can influence consumer behaviour. Chapter 3
briefly discusses the role of consumers.

To address the problem of ignoring negative externalities and to preserve the

common good for present and future generations, governments can use taxation
or regulation to price or internalize externalities. A case in point is the imposition
of carbon taxes to cut carbon emissions (Stern, 2008). But this ﬁrst best solution
is difﬁcult to achieve due to international coordination failure in addressing
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

global challenges, such as climate change. Nevertheless, there are societal forces
at work that put pressure on investors and business to internalize social and
environmental externalities. To function long term, business is dependent on a
vibrant and healthy society. This is the social licence to operate (see Chapter 1).
The challenge of sustainable development is to what degree business is able to
internalize social and environmental impacts, as illustrated in Figure 2.2.
Chapter 3 discusses barriers to change as well as possible governance
solutions to achieve sustainable development. An integrated approach is
needed, whereby sustainability is incorporated in business models and ﬁnan-
cing decisions from a system perspective (i.e. the ecosystem of the Earth).
Sections 2.2 and 2.3 describe methods for governments and business to
measure and price externalities. Daly and Farley (2011) warn against economic
imperialism, which seeks to expand the boundary of the economic system until
it encompasses the entire ecosystem of the Earth. The challenge is to draw a
boundary for applying market-based principles. In some cases, the market is
the most effective means of allocating resources. In other cases, the market
approach does not work because of the inherent characteristics of some

Impacts

Business Internalization Society

rate

Dependencies

Figure 2.2 Internalization of social and environmental impacts

Source: Adapted from True Price.

environmental goods and services. Examples are in the ﬁeld of biodiversity

loss (treatment of endangered spices, like whales) and land use (preserving
land for nature or biological farming).
Starting from the current situation, whereby most environmental external-
ities are not priced, there is scope for expanding the use of the price mechan-
ism for the allocation of natural resources. But the regenerative and carrying
capacity of planet Earth needs to be respected to stay within planetary
boundaries, as discussed in Chapter 1.
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

2.2 Government intervention

Why Are We Waiting? The Logic, Urgency, and Promise of Tackling
Climate Change
Nicolas Stern
To reduce negative externalities, governments can apply two basic approaches:
raising prices through taxation to reduce demand and limiting quantity
directly through regulatory quotas and letting prices adjust. Theoretically, we
could get the same result given a demand curve (Daly and Farley, 2011). As
demand curves are uncertain and tend to shift, direct quotas provide more
certainty of staying within ecological limits of using natural resources and
sinks. Where planetary boundaries are becoming very critical, regulation
through quota or complete bans (i.e. zero quota) is more appropriate.

2.2.1 ENVIRONMENTAL EXTERNALITIES

An example of an international regulatory approach is the 1987 Montreal
Protocol on Substances that Deplete the Ozone Layer. The ozone layer in the
Earth’s stratosphere filters ultraviolet solar rays that are harmful to humans. In
1987, 24 governments agreed to phase out chlorofluorocarbons (CFCs) by 2000,
leading to a long-term recovery of the ozone layer. The Montreal Protocol is a
landmark agreement that has successfully reduced the global production, con-
sumption, and emissions of CFCs and included trade sanctions to achieve the
stated goals of the treaty (Velders et al. 2007). The treaty negotiators justified the
sanctions because depletion of the ozone layer is an environmental problem
most effectively addressed at the global level. Without the trade sanctions, there
would be economic incentives for non-signatories to increase production,
damaging the competitiveness of the industries in the signatory nations as
well as decreasing the search for less damaging CFC alternatives.

2.2.1.1 Taxing externalities

Where possible, economists prefer pricing externalities through a Pigouvian
tax, which reflects the social costs of the damage. The Pigouvian tax is set at
the marginal external cost and is a cost-effective method to achieve the
targeted reduction. When adjustment costs are higher than the tax, firms
pay the tax. By contrast, firms with low adjustment costs find it cheaper to
adjust than to pay the tax. The final outcome in an economy with profit-
maximizing firms is that the marginal adjustment cost will equalize the tax.
Accordingly, Stern (2008) suggests that a carbon tax is an efficient way to
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

achieve the public good of a low-carbon economy. The price signal will then
guard the transition towards a low-carbon economy. In a similar way, appro-
priate pricing of natural resources (virgin materials) helps to avoid depletion
and provides an incentive for material savings and recycling efforts.
Some countries have started to implement carbon pricing through carbon
taxes or carbon emissions trading systems (ETS). The objective of the latter
approach (also known as cap-and-trade system) is to cap the total level of
carbon emissions. Firms that perform better than expected in reducing their
emissions can sell their surplus allowances to larger emitters. In this way, the
ﬁrms that are more effective in reducing the emissions get rewarded, while the
least-effective ones get penalized. This market mechanism, with an interplay
between demand and supply of emission allowances, produces a market price
for carbon emissions (Bianchini and Gianfrate, 2018). The caps ensure that
the required emissions reductions will progressively take place by keeping all
the emitters within the boundaries of the pre-allocated carbon budget.
Early adopters of carbon taxes were the Scandinavian countries in the 1990s,
which currently have carbon taxes ranging from $50 to 130 per tCO2e

(ton carbon dioxide equivalent). The Scandinavian experience shows that

carbon pricing can be effective in changing behaviour and reducing carbon
emissions. Åkerfeldt and Hammar (2015), for example, report that the gradual
increase from €27 per tCO2e in 1991 to €123 per tCO2e in 2013 led to a shift in
the energy mix from fossil fuels towards biofuels, as well as apartments in
Sweden being heated by district heating (fuelled by household waste and
various wood residues). The result was a reduction in carbon emissions of 23
per cent, without a negative impact on economic growth. Taxing the resource
base of our predominantly brown economy (i.e. coal, oil, gas, and many other
minerals) can steer the economy away from resource-intensive growth towards
smart-technology industries in renewable energy, clean water, new and better
materials, and waste management.
More broadly, 40 national jurisdictions and over 20 cities, states, and regions
have put a price on carbon in 2016, covering almost a quarter of global carbon
emissions (World Bank, 2016). However, about three quarters of the emissions
covered are priced at less than €10 per tCO2e. A case in point is the European
ETS system with a carbon price of €10 per tCO2e at the time of writing, because
of the oversupply of emission allowances. These low prices have limited effect
on carbon emissions. The most recent estimates for an effective carbon price
are $40–80 per tCO2e by 2020, rising to $50–100 per tCO2e by 2030 (Stiglitz
and Stern, 2017).
Most governments have thus not (yet) implemented effective carbon prices.
There are several reasons for insufﬁcient action. First, there is a coordination
failure between national governments, as global warming is a global public
good (Barrett, 2008; Tirole, 2017). The free-rider effect prevents action.
Secondly, governments have a short horizon of up to four years, the length
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

of the election cycle. Faced with such a short horizon, politicians follow public
opinion rather than impose the (currently) unpopular idea of a carbon tax,
which only brings beneﬁts in the longer term. Thirdly, there are intergenera-
tional trade-offs between present and future generations. While these gener-
ations should be treated equally from an equity perspective, the present
generation may care less about future generations. Section 2.3 discusses the
appropriate discount factor for dealing with the future. Fourthly, there is
uncertainty about the fundamental causes of global warming. Climate sceptics
consider the possibility that global warming is not caused by human activity.
Box 2.2 discusses optimal carbon tax policy in the case of climate scepticism.
Instead of solely reaching the carbon emission threshold with carbon taxes,
Acemoglu and colleagues (2012) propose to reach the R&D threshold above
which clean technology becomes more efﬁcient than dirty technology. Their
solution to redirect technical change towards cleaner technology is a mix of
carbon taxes (to make dirty technology more expensive) and research subsid-
ies for clean technology (to redirect research).
The size of environmental externalities is staggering. And instead of these
externalities being priced, fossil fuels are actually subsidized. The International

BOX 2.2 OPTIMAL POLICY AND CLIMATE SCEPTICISM

What is the optimal policy given uncertainty about the fundamental causes of global
warming? While the majority scientific view is that human emissions contribute to climate
change—reflected in the UN IPCC—climate deniers argue that it is very challenging to
measure with precision the impact of human activity on the climate and there is tremendous
disagreement about the degree of impact. So, climate deniers would not agree that human
activity is a primary contributor to global warming.
But even climate change deniers have some doubt about whether man-made emissions
contribute to global warming or not. Prudent science should therefore deal with the error that
a model is falsely assumed to be correct. To reflect the two opposing views of the climate–
economy interaction—one in which human emissions contribute endogenously to climate
change and another in which the climate follows exogenous projections of committed
warming—Van der Ploeg and Rezai (2017) propose an agnostic approach to policy which
accounts for the scientific uncertainty that climate change deniers could be right after all.
Climate change sceptics or agnostics attach a (small) positive probability to climate change
deniers being right or, at least, acknowledge the possibility that global warming is not caused
by anthropogenic carbon emissions at all.
Using the dynamic integrated model of climate and the economy, Van der Ploeg and Rezai
(2017) find that the cost of avoiding the most harmful aspects of climate change is small
compared with the cost of inaction. So robust policies, such as doing one’s best or minimizing
regret under the worst possible outcomes, call for pricing carbon.
Not pricing carbon may benefit current generations by avoiding the economic burden of
climate regulation, giving politicians the (dishonest) excuse to avoid painful restructuring of
carbon-based industries. Van der Ploeg and Rezai’s results, however, discredit this wait-and-
see approach. Using modern decision theory, they show that agnostics should decarbonize
the economy rapidly as the consequences of erring on the ‘wrong’ side are too grave. The
agnostic policymaker’s response to climate change deniers is thus price carbon.
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

Monetary Fund reports that pre-tax energy subsidies for fossil fuels amount to
$333 billion, which is 0.4 per cent of world GDP in 2015 (Coady et al. 2017).
These subsidies are counterproductive and a highly inefficient way to provide
support to low-income households. With externalities covering environmental
damage estimated at $4,150 billion (5.6 per cent of GDP), the post-tax
subsidies amount to 6 per cent GDP. Fossil fuel subsidies discourage needed
investments in energy efficiency, renewables, and energy infrastructure. So,
there is no need to subsidize renewables; it is sufficient to tax fossil fuels
appropriately.

2.2.2 SOCIAL EXTERNALITIES

Turning to social externalities, differences among countries are even more
pronounced. Developed countries largely internalized these externalities after
World War II through regulations on issues such as maximum working hours,

health and safety conditions, gender equality, and minimum wage. By contrast,
many developing countries do not have social legislation and still experience, for
example, underpayment and child labour, as discussed in Chapter 1. The SDGs
cover many of these social externalities (see Box 2.1).
Also on the social side, taxes are used to change behaviour. The classical
example is taxes on alcohol and tobacco, which have long been an important
means of raising revenues for public spending in many countries. There is
increasing interest in using taxes on these, and other unhealthy products like
sugar-sweetened beverages, to achieve public health goals. If the primary
policy goal of a health tax is to reduce consumption of unhealthy products,
then evidence supports the implementation of taxes that increase the price of
products by 20 per cent or more (Wright, Smith, and Hellowell, 2017).
Summing up, some progress is being made, but substantial environmental
as well as social externalities are still not effectively addressed through govern-
ment regulation or taxation.

2.3 Measuring and pricing externalities

A first step for business towards addressing or mitigating the remaining
externalities is to measure and price these externalities, where possible.
Attaching a financial value to social and environmental externalities facilitates
the optimizing process among the financial (or economic), social, and envir-
onmental dimensions (F, S, E), as discussed in Chapter 1. Innovations in
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

technology (measurement, information technology, data management) and

science (life-cycle analyses, social life-cycle analyses, environmentally extended
input–output analysis, environmental economics) make the monetization of
social and environmental externalities possible (True Price, 2014). In this way,
the integrated value I can be established by summing the financial, social, and
environmental values in an integrated way. In the earlier literature, this meth-
odology is labelled total or true value methodology.
The methodology for calculating the integrated value involves measuring,
monetizing, and balancing financial and non-financial values (KPMG, 2014;
True Price, 2014). Figure 2.3 illustrates the four steps to calculate the
integrated value:
1. We start by calculating the financial value and quantifying and monetizing
the social and environmental impacts (bar 1).
2. We then internalize the social and environmental externalities and calcu-
late the integrated value as the sum of the values (bar 2).
3. Next, we adjust to account for the combination of the three factors. As
explained in Chapter 1, there are several non-linear trade-offs between the

20
18
16
14
F 15 I* 12
12 F 14
10 I9
8
6
4
2
0
S3 S1
2
E1
4
E3
6
8
10

Figure 2.3 From ﬁnancial value to integrated value

Note: F = financial value; S = social value; E = environmental value; I = integrated value; I* = optimized
integrated value. The first two bars illustrate the values based on the original production process; the
final two bars show the values based on the optimized production process.

economic, social, and environmental aspects of corporate investment.

The monetization helps corporations to ﬁnd the optimal combination of
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

the three factors. In our example, the corporation is able to reduce both the
social and environmental impact from 3 to 1 at an extra cost of 1 (bar 3) by
adapting its production process.
4. Finally, we calculate the integrated value I* (bar 4).
Reducing the social and environmental impact in step 3 is not always costly.
With the rapidly declining cost of solar energy for example, we are getting
close to the point where the use of renewable energy can reduce carbon
emissions without extra costs. It should be recognized that the integrated
value methodology has to make assumptions (e.g. about the size of the
externalities) and is surrounded by uncertainty (e.g. about the development
and/or exact price of externalities).
Our example in Figure 2.3 shows that the internalization of the externalities
leads to an increase in the integrated value from 9 (bar 2) to 12 (bar 4). In the
traditional ﬁnance approach, which maximizes F only, the original production
process would be continued (bar 1 at 15 is higher than bar 3 at 14) and the
additional value would not be realized. When pricing of the externalities

and/or reputation damage materialize in the medium term, the old production
process becomes obsolete and the new production process becomes more
favourable. In the case of medium to long-term investments, the assets used
in the original production process might become stranded assets (see later in
this section) resulting in a loss of ﬁnancial value. To avoid this risk, companies
(and their ﬁnanciers) might start to internalize the externalities before the
government (taxation, regulation), the employees (strike action, talent drain),
or the public (reputation, customer strike) do so.
Box 2.3 provides an example of how a sector can apply the integrated value
methodology, also labelled true value or true price methodology, to products
and make changes over the full value chain. More broadly, the transition to a
low-carbon and more circular economy, stimulated by the internalization of
social and environmental externalities, involves changes in behaviour and new
consumption and production patterns based on sharing (e.g. car sharing) and

BOX 2.3 THE TRUE PRICE OF ROSES FROM KENYA

A true price analysis was conducted to identify a business case for sustainable rose farming.
The study covered cut blooms from T-hybrid roses from Lake Naivasha in Kenya and compared
roses produced at a conventional farm to those produced at a sustainable farm. Mapping the
supply chain showed that the retail prices of roses per stem produced on both types of farms
were on average the same (€0.70). The true price, on the other hand, was much lower for the
sustainable rose (€0.74) than the conventional rose (€0.92). This difference in true price comes
mainly from the environmental impact associated with transporting the roses via airfreight and
the social impact in terms of workers’ incomes.
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The true price analysis identified various projects to reduce environmental and social costs:
• Transport by ship to reduce carbon emissions.
• Solar-powered greenhouse to reduce non-renewable energy use.
• Closed-loop hydroponics to reduce water and fertilizer usage.
• Training in health and safety to improve workers’ skills.
• Gender committees to reduce harassment and gender discrimination.
• Payment of a basic living wage to improve the well-being of workers.
The true price analysis maps the costs of each project and its effect on the profit and loss of
an average farm. For example, health and safety training would generate about €4,500 profit
per hectare, while switching to transport by sea would increase profit by €5,000 per hectare.
Better social standards for rose-farm workers and more environmentally friendly growing and
transportation techniques are financially feasible, without negatively affecting farm owners’
bottom lines.
Some improvements in social standards, such as paying a living wage to workers, were less
feasible if farm owners have to bear all the costs. Based on an economic value chain analysis, it
was shown that providing a living wage could be possible when a fraction of the costs are
borne by wholesale traders, retail traders, and consumers. This strengthened the promotion of
better social and environmental standards.
Source: True Price (2014).

minimal use of natural resources (e.g. energy and material savings). These new
patterns include both reusing or recycling and using products up to their
technical, instead of fashionable, lifetime cycle. Chapter 3 on responsible
consumption and Chapter 5 on circular business models discuss this in
more detail.

Stranded assets Stranded assets refer to assets that lose their value. Caldecott,
Tilbury, and Carey (2014) introduced this term for fossil fuel assets, which
may become stranded due to government regulation (e.g. carbon pricing) or
technological change (e.g. reduced cost of solar photovoltaic (PV) or wind). It
is more widely applicable to carbon-intensive assets, such as real estate or
traditional cars. Real estate with a low energy-efficiency label may lose its
(collateral) value if measures to improve its energy efficiency are not cost-
efficient (see Chapter 10). Diesel cars are, for example, losing their value, as
there is a move to ban them from entering city centres in order to reduce
pollution levels.
Stranded assets can also happen in other areas. A case in point is land use.
Intensive agriculture (with frequent use of fertilizer and irrigation) may cause
soil erosion, leading to less or no food production from the degraded land in
the future and species loss (e.g. in the Midwest region of the United States or in
north-east China). Land can thus become a stranded asset. Several planetary
boundaries are then worsened (see Figure 1.2 in Chapter 1): not only land-
system change, but also biodiversity, biochemical flows (phosphorus and
nitrogen in fertilizer), climate change, and freshwater use. The estimated
economic cost of ecosystem services and biodiversity lost because of land
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degradation is over 10 per cent of annual global GDP (IPBES, 2018). On the
social side, land degradation is also a major contributor to mass human
migration and increased conﬂict (IPBES, 2018).

2.3.1 THE MONETIZATION OF EXTERNALITIES: PITFALLS

While the monetization of externalities helps to bring social and environmen-
tal externalities into corporate decision-making, there are several caveats to
the market-driven calculation of integrated value. First, the calculation is
traditionally done on efﬁciency grounds: the minimal input of resources
needed for the maximum output of goods. As discussed in Chapter 1, ecosys-
tem management requires building and maintaining resilience or quality in
the system or process so it has the capacity to absorb shocks and to avoid
tipping points. So, we propose optimization with scope for adaptive capacity.
Some industrial companies use, for example, safety, not only for the protection
of the people and the environment but also for the control of the production
process (reducing production losses); they thus ‘overinvest’ in the quality of

production facilities and safety procedures. Incorporating adaptive capacity is

primarily an issue of taking a sufficiently long horizon extending over the full
cycle of the production system or process. In that way, the benefits in terms of
shock-absorbing capacity and the costs of extra resources are included. The
integrated value approach is based on a medium to long horizon. For pricing
of carbon emissions, for example, this long-term approach implies using
an effective future carbon price of $50 to 100 per tCO2e in the calculations
(see Section 2.2).
Next, monetization cannot fully express the ethical aspects of externalities,
such as human rights or health and safety (KPMG, 2014). The three capitals
(financial, social, and environmental) are also not substitutable. More gener-
ally, Porritt (2007) distinguishes five types of sustainable capital: natural or
environmental capital (stock or flow of energy and materials—both renewable
and non-renewable), human capital (people’s capabilities, experience, and
motivation), social capital (institutions that help to maintain and develop
human capital in partnerships with others), manufactured capital (fixed assets
and material goods), and financial capital (financing of an organization).
Chapter 6 discusses these capitals in more detail.
Finally, working out integrated value can lead to perverse outcomes: the
negative environmental impact of deforestation, for example, can be offset by
large economic gains; in other words, legitimizing destruction. To avoid these
outcomes, we incorporate the constraint that the social-environmental value
cannot be reduced compared to its initial value (see equation 1.2 in Box 1.4).
Another caveat is the inherent uncertainty (e.g. underlying climate scenarios)
that makes pricing difficult.
On the positive side, participation can improve quality and support for the
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integrated value concept. Coulson (2016) suggests that producers could

involve stakeholders in the application of the integrated value methodology
to form a more inclusive and pluralist conception of risk and values for social
and environmental impacts. Next, the reliability of the input factors (i.e. the
size and price of externalities), the underlying calculations, and the reported
outcomes are important for the credibility of the integrated value concept.
Integrated reporting and certiﬁcation (Chapter 6) play a key role in the
monetization of externalities.

2.3.2 INSUFFICIENT PRIVATE EFFORT

The adoption of sustainable business and ﬁnance practices is a major advance
towards sustainable development, but it might not be sufﬁcient for two reasons.
First, the fallacy of composition arises when one concludes that something is true
of the whole, at the macro level, from the fact that it is true of every part, at the
micro level. Even if individual companies internalize social and environmental

externalities, it is not certain that planetary boundaries are not crossed. One
example is the current drive of companies to reduce their carbon footprints.
This eco-efficiency push is a welcome trend in itself, but the available evidence
suggests that the projected trajectories for carbon emissions exceed the
allowable carbon budget for staying below 2° Celsius of global warming
(eco-effectiveness). Dyllick and Muff (2016) call this discrepancy the ‘big
disconnect’. Busch, Bauer, and Orlitzky (2016) also make the paradoxical
observation that increasing sustainable investment does not necessarily
induce sustainable development and call for a system perspective, which we
explore in Chapter 4.
There are several reasons for the divergence between the micro and macro
outcomes. First, companies and financial institutions use a private discount
factor to discount future CFs. Stern (2008) argues that the public discount
factor should be very small or zero because the government should value
current and future generations equally. Because social and environmental
impacts are particularly felt in the long term, private discounting leads
to insufficient effort from a social welfare perspective. Next, only about
20 per cent of companies are actively managing their carbon footprints
to some extent (see Table 4.3 in Chapter 4). These micro efforts are not
enough to keep the carbon emissions within the allowable carbon budget at
the macro level.
Secondly, the boundary problem compounds the challenge of internalizing
externalities. When regulation for one sector is tightened, business will shift to
other sectors and countries with fewer or no requirements (Goodhart, 2008).
Exemptions in the EU ETS, such as airlines operating between EU and non-
EU countries, highlight the boundary problem—as well as the international
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coordination problem—in environmental regulation. This is an example of

carbon leakage. Other examples are national-based regulations for products
that companies can circumvent by relocating production to countries with less
strict regulations. A solution to this problem might be the use of product or
activity-based regulation.
There are limits to what the private sector can achieve. While companies and
ﬁnancial ﬁrms are starting to look at social and environmental externalities,
there is clearly a role for government to make production and consumption fully
sustainable through regulation and taxation of these externalities. The starting
point is that much of the transition is driven by private investment, but that
investment is threatened by government-induced risk (Stern, 2015). Policies,
governance, and institutions create a risk–return balance on the basis of which
investors decide whether or not to act. But it is government policy, including
the stability and credibility of policy, that creates the framework for that
investment and sets out a range of pricing and regulatory instruments to
encourage the transition to a low-carbon economy. Stern (2015) adds that
making sound policy is not just about the analysis and implementation of

incentives, but also about social and personal responsibility and values. More-
over, the role of communities is often undervalued. Only with the involvement
of community can we recycle and reuse. Interesting examples of the sharing
economy (e.g. car-sharing schemes) are emerging. Chapter 4 explores the role
of private coalitions for sustainable production and for SF.
We are in the transition to a low-carbon and more circular economy.
The externalities of the current carbon-intensive economy are becoming
increasingly clear to the general public (e.g. more catastrophic weather
events, such as droughts and ﬂooding in countries close to the equator,
and air pollution; see Chapter 11). A case in point is California, where air
pollution from heavy trafﬁc in the 1990s prompted environmental regula-
tions and stimulated innovations, for example in electric cars from Tesla
and in solar technology. China, India, and Mexico face similar or even
worse air pollution, which may at some point prompt stricter environmen-
tal regulations in these countries. Finance is about anticipating such events
and incorporating expectations into today’s valuations, which underpin
investment decisions. Finance can thus contribute to a swift transition to
a low-carbon economy.

2.4 Scenario analysis

The SDG framework in Box 2.1 identiﬁes the main social and environmental
externalities, but there are signiﬁcant political and technological uncertainties
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about how these externalities will develop over time.

2.4.1 UNCERTAINTIES ABOUT EXTERNALITIES

2.4.1.1 Policy uncertainty
On the policy side, at which stage of development will emerging economies
start adopting labour laws addressing working conditions and banning child
labour? When will developed (as well as developing) countries implement an
effective carbon tax? Next, might a possible carbon tax be reversed later, as,
for example, happened in Australia? Uncertainty about policy intervention
increases risk for investors and negatively affects long-term investment
planning. A case in point is uncertainty about the trajectory to phase out
fossil fuel subsidies and introduce a carbon tax, which complicates invest-
ment in energy infrastructure. By contrast, a clear and credible policy path
setting out a step-wise implementation of effective carbon taxes fosters
investment in renewable energy.

2.4.1.2 Technological uncertainty

Technological uncertainty compounds the policy uncertainty. A case in point
is the spectacular rise of solar PV systems, which convert directly solar energy
into electricity. Because solar PV generates power from sunlight, power output
is limited to times when the sun is shining. Nevertheless, there are several
options, such as demand response, ﬂexible generation, grid infrastructure
integration, and storage, to deal cost-effectively with this challenge. The
rapid spread of renewable energy is a bright spot in the global energy transi-
tion towards a low-carbon economy. Despite lower fossil fuel prices, renew-
able power expanded at its fastest-ever rate in 2016, thanks to supportive
government policies and sharp cost reductions.
While being small in absolute terms, electricity from global solar PV
increased from 4 TWh (terawatts per hour; 1 terawatt is 1 million watts) in
2005 to 247 TWh in 2015, achieving a 51 per cent annual growth rate, the
fastest of all renewable electricity technologies. Germany, until recently the
largest producer due to its support for solar PV electricity generation, has
increased production from 0.1 TWh in 2000 to 39 TWh in 2015 (IEA, 2016).
The country provides an interesting example of policy and technological
change reinforcing each other. Currently, China is the largest solar PV elec-
tricity generator, with 45 TWh in 2015, which is largely driven by concerns
about air pollution and capacity targets that were outlined in the country’s
13th ﬁve-year plan to 2020 (IEA, 2017).
Figure 2.4 shows how the adoption of solar PV has repeatedly beaten
forecasts, indicating a virtuous cycle. The 2007 and 2010 forecasts of the
International Energy Agency (IEA) and Greenpeace are consistently lower
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than the actual outcome (measured as global installed capacity in gigawatt

(GW), which is 1 billion watts). But Greenpeace’s forecasts are closer to the
actual outcome and more optimistic than IEA’s forecasts. More generally,
Figure 2.4 highlights that our thinking tends to be linear, while the underlying
technological development may be exponential.
A famous example of exponential technological growth is Moore’s law,
which states that the number of transistors per square inch on integrated
circuits has doubled every year since their invention. A current example of
exponential technical development may be the hydroelectric car, which con-
tains fuel cells that combine hydrogen and oxygen to produce electricity. If the
development and adoption of the hydroelectric car were to continue, this
would be a major driver of renewable energy (reducing the use of fossil fuels).
Solar, wind, geothermal, hydropower, ocean power, and bioenergy are all
sources of renewable energy. The role of renewables continues to increase in
the electricity sector, heating and cooling of real estate, and transport sector.
To show the potential of exponential growth for renewable energy, Rockström
and colleagues (2017) determine ﬁrst that the share of renewables in the

500

450

400
G lobal installed capacity in G W

350

300

250

200

150

100

0
00 02 04 06 08 10 12 14 16 18 20
20 20 20 20 20 20 20 20 20 20 20

Actual G reenpeace 2007 IEA - WEO 2007

G reenpeace 2010 IEA - WEO 2010

Figure 2.4 Solar power capacity: predictions versus actual

Note: Shows global installed capacity in GW. Depicts forecasts by IEA in its World Energy Outlook (WEO)
and Greenpeace in its Energy [R]evolution Report for the use of solar PV and actual use of solar PV. The
actual global installed capacity is consistently higher than the forecasts.
Source: Adapted from Greenpeace (2012 and 2015).
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energy sector has doubled every 5.5 years based on 2005–15 global trends.
Next, they estimate that keeping the doubling time constant in the next three
decades would yield full decarbonization (grey area in Figure 2.5) in the entire
energy sector by around 2040, with coal use ending around 2030–35 and oil
use in 2040–45.
Another way of presenting exponential growth or decline is framing the
decarbonization challenge in terms of a global decadal roadmap based on a
simple rule of thumb or ‘carbon law’ of halving gross carbon emissions every
decade (Rockström et al. 2017). Figure 2.6 illustrates how such a global carbon
law of halving emissions each decade can lead to net-zero emissions around
mid-century, a path necessary to limit global warming to well below 2°C.
There is also a dark side to technological change. Weitzman (2013) warns
against geoengineering, which is a deliberate large-scale intervention in the
Earth’s natural systems to counteract climate change. This is an easy and fast
way to reduce global temperatures. An example of geoengineering is spraying
sulphate aerosols into the atmosphere. This would mimic the reﬂective par-
ticles released from volcanic eruptions, cooling the planet and returning us to

Fossil fuel phase out Period of doubling (years)

100 3 4 5 6 7 8 9 10
H ydro

rs
5.4 yea
N uclear
Share of primary energy (% )

90
80 G as

every

ns
70

ai
lg
ua

:
bling
60 nn
a
of

dou
50 Oil e
as Renew ables
40 re

s of
i nc
r
ate
30 ea
tr Lin
an

20 Coal
st

n
Co nual gains
10 2015: Constant an
2005: 2.8%
0 0.8%

2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100

Figure 2.5 Non-linear renewable energy expansion trajectories

Note: Non-linear renewable energy expansion trajectories are based on 2005–15 global trends. Keeping
the historical doubling times of around 5.5 years constant in the next three decades would yield full
decarbonization (grey area) in the entire energy sector by around 2040.
Source: Rockström et al. (2017).

45
40
35
G lobal carbon
G tCO2 per year

30 emissions
25
Carbon removal
20
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15 Carbon emissions
10 from land use

5
0
2020 2030 2040 2050

Figure 2.6 Global carbon law guiding decadal pathways

Note: The decadal staircase follows a global ‘carbon law’ of halving emissions every decade and a
complementary fall in land-use emissions, plus it ramps up CO2 removal technologies.
Source: Adapted from Rockström et al. (2017).

pre-industrial temperatures. Such a project would be cheap: one ton of sulphur

dioxide would be sufﬁcient to cancel out the climate effects of almost 30,000
tons of carbon dioxide. Due to the affordability of this project, any single
country could unilaterally undertake a geoengineering project. The ease with
which geoengineering could be used is, however, a major drawback at the
same time. Even if the technology were used responsibly, the aerosols would

do nothing to halt ocean acidiﬁcation and a myriad of other problems

associated with carbon emissions. Furthermore, if the aerosol spraying was
halted for some reason, the particles would be washed out of the sky within a
month or so, and global temperatures would skyrocket faster than ever.
Another source of uncertainty is changes in consumer behaviour and
preferences. The determinants of consumers’ willingness to buy sustainable
products and/or to pay a price premium can change over time. There are
several examples of changing behaviour. A well-known example is the decline
in social acceptance with regard to buying clothes produced by child labour.
These changes can happen swiftly. The introduction of Fairtrade chocolate
(minimum wage for small cocoa farmers in West Africa and Latin America) in
the late 1990s/early 2000s has led to a rapid consumer adoption. Moreover,
there is a circular relationship between production and consumption, as
consumers’ adoption of low-carbon or clean products is also based on the
availability of such products (Ottman, Stafford, and Hartman, 2006).

2.4.2 THE USE OF SCENARIO ANALYSIS

Scenario analysis is a powerful tool to get insight in the possible development
of externalities when there is a signiﬁcant amount of uncertainty. It is a
process of analysing possible future events by considering alternative possible
outcomes (sometimes called ‘alternative worlds’). Thus, scenario analysis,
which is one of the main forms of projection, does not try to show one exact
picture of the future but alternative scenarios. Another method to deal with
uncertainty is stochastic simulation. However, this method can only be used
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when detailed market data are available and new risks, such as environmental
risks, are not (yet) fully priced in (Lo, 2017).
Bianchini and Gianfrate (2018) show how scenario analysis can be applied
to corporate valuation for investment purposes. Scenario-based valuation
requires at least two scenarios, but very often consist of three (or more): a
best case, a most likely case, and a worse case. The number of scenarios should
be based on how different the scenarios are, how accurately they can be
‘forecasted’, and the available amount of time and resources for preparing
them. De Ruijter (2014) proposes a strategic approach when creating scenarios
for an organization, using the following steps:
1. Determine the most important uncertainties for the future and put them
into a framework. This can be two axes representing two key uncertainties, but
also a decision tree containing the most important questions for the future.
2. Elaborate the scenarios: ﬁll them in with the developments, trends, uncer-
tainties, and possible actions of actors from the transactional environment,
until each scenario forms a plausible and relevant whole leading to new
insights.

3. Re-present the scenarios to make possible future situations and the path
leading there appealing stories.
Analyst reports are the ‘fortune tellers’ of the investment communities.
They form the underlying analytical basis of many investment decisions and
DCF methodology (see Chapter 8 for more details) is used in most analyst
reports. And in turn, DCF requires a forecast of future inward CFs, outward
CFs, and the terminal value of the investment beyond the projection period
(see Figure 2.7). Next, the impact on the risk premium needs to be determined
to calculate the discount rate (which is the sum of the risk-free rate and the
risk premium). For private investors, more risk or uncertainty leads to a higher
discount rate.
This DCF methodology relies on multiyear forecasts. And all forecasting
methods, including the use of expert judgement, statistical extrapolation,
Delphi and prediction markets, contain fundamental weaknesses (De Ruijter,
2017). Forecasting is not meant to highlight the potentially high impact of rare
events. Forecasting often has the explicit assumption of ceteris paribus or ‘all
else is equal’, but what if all else is not equal?
We are coming from a period in which externalities are largely not intern-
alized. Forecasting models based on historical data thus underestimate future
disruptions, if these externalities become internalized (i.e. ceteris non paribus).
What is the probability of a carbon price of $100? On historical frequency,
which is backward looking, the probability is 0 per cent, as it has not happened.
But given the political commitments (see Section 2.4.3), this probability is
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Impactπonπc
ashflows?π(e.g.π
lossπof
πmarketπs
hare)
€

Impactπonπt ?
erm inalπvalue
Terminal value
Cash in

Time
Cash out

Discount rate Impactπonπr

iskπprem ium?

Figure 2.7 Impact of scenarios on DCFs

Note: In each scenario, the impact of the factors on cash ﬂows, terminal value, and risk premium is
calculated.
Source: De Ruijter (2017).

positive. The Bayesian probability can be estimated using all available informa-
tion on, for example, political commitments, changing attitudes towards carbon
pricing in society, and new technologies. This is a forward-looking approach,
highlighting the downward and upward risks.
The ﬁnal step is to synthesize the scenario results by weighting the prob-
abilities attached to each scenario, which add up to 100 per cent. In a three-
scenario setting, a conceivable assumption is that the most likely scenario has
50 per cent probability and the other two scenarios 25 per cent each. In an
example in Section 2.4.3, we show the working of scenario analysis.

2.4.3 CLIMATE MITIGATION SCENARIOS

To illustrating the working of scenario analysis, we apply it to the impact of
climate policy on the valuation of a major oil company. In the recent Paris
Agreement on climate change, countries have reconﬁrmed the target of
limiting the rise in global average temperatures relative to those prevailing
in the pre-industrial world to 2°C and to pursue efforts to limit the tempera-
ture increase to 1.5°C. Meeting such targets requires ensuring that the stock of
CO2 and other greenhouse gases in the atmosphere do not exceed a certain
limit. The Intergovernmental Panel on Climate Change (IPCC, 2014) esti-
mates that the remaining carbon budget amounts to 900 GtCO2 from 2015
onwards. The speed with which the limit is reached depends on the path of
emissions. If current emissions are not drastically cut, the 2°C limit would be
reached by 2035 (see vertical dotted line in Figure 2.8).
There are many uncertainties with regard to climate change. First of all, will
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the world succeed in limiting climate change to 1.5–2 degrees? If so, with what
energy system? What role will energy saving, carbon capture and storage, and
the different forms of renewable energy play in this? The future of techno-
logical innovation is inherently uncertain as is the political will of the global
community to address climate change. Public policy is also a driver of techno-
logical change, for instance through the amount of R&D invested and as a
market maker for clean tech.
Different scenarios are possible, based on the different moment that gov-
ernments start implementing effective environment policies (Advisory Scien-
tiﬁc Committee, 2016). If governments manage an early transition with
substantial cuts in carbon emissions starting in 2020, a ‘soft landing’ is likely
(the ﬁrst dashed curve in Figure 2.8). The ‘orderly transition’ to a low-carbon
economy would be gradual, allowing adequate time for the physical capital
stock to be replenished and for technological progress to endogenously con-
tribute to keeping energy costs at bearable levels. The adverse scenario is one
of late adjustment starting in 2030, resulting in a ‘hard landing’ (the last dotted

70 Physical
risks

50 Physical
G tCO2 per year

and transition
risks
40

20 M ostly
transition risks
10

0
1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050
Projected path
Projected path if emissions are fixed at 2014 level
Transition path for 2°C t arget if starts in 2020
Transition path for 2°C t arget if starts in 2025
Transition path for 2°C t arget if starts in 2030

Figure 2.8 Possible trajectories of carbon emissions

curve in Figure 2.8). In this scenario, the underlying political economy—that

is, the short-term political costs of the transition combined with the need for
global coordination of emission cuts—leads to belated and sudden implemen-
tation of constraints on the use of carbon-intensive energy. This back-loaded
policy intervention will force more severe immediate reductions in emissions.
A portfolio manager or loan officer needs to make an assessment of the
impact on his entire investment portfolio or loan book in each scenario. In a
scenario with government-imposed carbon taxes, for example, the impact is
not confined to the big oil companies or utilities that supply electricity.
Figure 2.9 indicates that the transport sector—cars, lorries, and airplanes—is
responsible for a large part of carbon emissions. Next, real estate, both
residential houses and commercial offices, use fossil fuels for heating and
cooling. Finally, a substantial proportion of the manufacturing industry is
dependent on fossil fuels. All these sectors, which form a large part of the value
added in the economy, are thus affected by potential carbon taxes.

Emissions (100m tonnes of CO2 eq uivalent) 14 Electricity & gas

supply

10 M anufacturing

8 Agriculture,
forestry
and fishing
6 Transportation
Real estate
4
W ater supply
& waste management
2 Wh olesale and
M ining and quar rying retail trade
Finance Construction
0
0 500 1,000 1,500 2,000
G V A (billions of 2015 euros)

Figure 2.9 GHG emissions and GVA by sector, EU

Note: This graph shows greenhouse gas emissions. Real estate emissions include heating and cooling.
GVA is gross value added, taken from Eurostat.
Source: Schoenmaker and Van Tilburg (2016).

Table 2.2 Assumptions used in scenarios

Scenario O il price Cost EB IT margin

Bu siness as usual $60 + 2% annual 2% annual cost inflation 18%

price inflation

Transition from As business as usual, 2% annual cost inflation; 18% until 2019;
2020 but 4% net drop per no offset of 2020 price 13% from 2020
2020 drop
Transition from As business as usual, 2% annual cost inflation; 18% until 2024;
20 25 but 10% net drop no offset of 2025 price 7% from 2025
per 2025 drop

Transition from As business as usual, 2% annual cost inflation; 18% until 2029;
2030 but 20% net drop no offset of 2030 price –4% from 2030
per 2030 drop

2.4.3.1 Example of impact on an oil company

We can apply these scenarios, as well as a naive ‘business-as-usual scenario’ to
a ﬁctive oil company. We make the following assumptions in Table 2.2. All
scenarios start from a $60 oil price in 2018 with 2 per cent annual inﬂation in
both the oil price and the company’s cost base. The scenarios are exactly the

Table 2.3 Valuations calculated for scenarios

Scenario Fair stock price U pside

Bus iness as usual $163 30%

Transition from 2020 $115 –8%

Transition from 2025 $94 –25%

Transition from 2030 $0 –100%

same in most other respects (volumes sold, capital expenditures (CAPEX)/

sales, number of shares, leverage, etc.). But they differ in terms of the assumed
price shock—driven by the introduction of carbon prices. In the business-as-
usual scenario, no carbon price is introduced at all as it is miraculously
deemed not necessary. In the three transition scenarios, carbon prices are
introduced with varying degrees of speed and shock, that is, early but grad-
ually in the transition from 2020 (allowing the oil company to adapt better)
and late but more radically in the transition from 2030 (giving the oil company
no chance to recover). This explains the differences in earnings before interest
and taxes (EBIT) margins in the four scenarios.
The price shock due to carbon pricing results in the valuations in Table 2.3
(based on a net present value (NPV) analysis, see Chapter 8 for an explanation
and examples of NPV analyses) and price upside given the stock’s current
$126 price.
So, the oil company looks cheap in the business-as-usual scenario, but
overvalued (to differing degrees) in the other scenarios. In the transition from
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

2030 scenario, the company’s margins go negative and its terminal value goes
negative as well. If that scenario were to happen, the company would go
bankrupt and the stock would go to zero. The late transition is the riskiest, as
it leads to the steepest drop in oil price and gives the oil company less time to
transition towards renewable energies, leading to more stranded assets.
But when would that be priced in? First, there would be several years of
good margins and CFs. And more generally: What scenario will happen? And
what is the right price for the stock? That all depends. One could arrive at a fair
value for the stock by attaching probabilities to the four scenarios. As the left
part of Table 2.4 shows, assuming equal probabilities for all four scenarios
results in a fair value of $93. The risk is then 26 per cent undervalued at the
current price of $126.
Alternatively, one could ask what kind of probabilities the current stock
price implies—and the right side of Table 2.4 indicates that the $126 stock price
implies a 60 per cent chance of business as usual versus 13–14 per cent for each
of the other scenarios. If you feel (like we do) that a 60 per cent of business as
usual is an overestimation, then the stock is overpriced.

Table 2.4 Probabilities applied to scenarios

Scenario Fair stock Probab ility W eighted Probabi lity W eighted

price price price

Bus iness as usual $163 25% $41 60% $98

Transition from 2020 $115 25% $29 14% $16

Transition from 2025 $94 25% $23 13% $12

Transition from 2030 $0 25% $0 13% $0

Total 100% $93 100% $126

Focusing on just one of these four scenarios (implicitly attaching a 100 per cent
probability to it) could be a dangerous simplification. Of course, all of this
analysis is highly simplified. Many other scenarios could occur. Also, the
analysis does not take into account the management’s reactions to (antici-
pated) changes in oil prices, such as cuts or raises in investments, which might
ameliorate or worsen the outcomes. The worst outcome for the oil company
would be that it continued to believe in business as usual even after a price
shock happened—rationalizing it with the fact that in the past oil prices always
recovered eventually—albeit after many companies had gone bankrupt.
Reviewing the options, the oil company can, for example, reconsider its
business-as-usual strategy and start replacing its ongoing investment
(CAPEX) in traditional upstream and downstream facilities by investment
in renewables. The analysis in this example of a fictive oil company shows that
scenario analysis can be a very valuable tool with which to consider various
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

scenarios and their probabilities.

2.4.4 STRESS TESTING

Central banks and supervisors conduct stress tests of the financial sector, using
extreme scenarios, to identify tail risks in the financial system. A case in point
is a carbon stress test, which measures the exposure of financials to carbon
emissions in their investment and lending portfolio (ASC, 2016; Schoenmaker
and Van Tilburg, 2016). The outcome of these stress tests can raise awareness
of exposure to major environmental externalities and prompt financial firms
to mitigate such exposures. Thomä and Dupre (2017) argue that traditional
stress tests based on macro-economic scenarios and a three-year horizon
underestimate the transition risk to a carbon-neutral economy. They rightly
argue that the impact of climate factors needs to be analysed at the sector level
and with longer horizons of up to 20 years, as some physical assets have
maturities of 20 years or longer.

Battiston and colleagues (2017) conducted a climate stress test of the

financial system. In line with our argument to include all carbon-intensive
sectors (see Figure 2.9), they carried out a network analysis of the exposures of
financial firms to all climate-relevant sectors. Climate mitigation policies will
adversely affect equity holdings in climate-relevant sectors (as equity absorbs
losses in the first instance) but less so debt holdings (bonds and loans). The
impact of climate policies on assets invested in energy-intensive activities can
in principle be either positive or negative depending on the energy source and
the technologies used in the production process. Further, in other sectors such
as housing, climate policies, and, in particular, energy efficiency, policies can
result in an increase or decrease of property values according to the energy
source used for heating and electricity and the level of compliance with
building requirements on energy-efficiency.
Using empirical data of the Euro area, Battiston and colleagues (2017)
show that while direct equity exposures to the fossil fuel sector are small (3–12
per cent of financial firms’ market capitalization), the combined equity exposures
to climate-policy relevant sectors are large (40–54 per cent) and heterogeneous.
The direct exposures are amplified by second-round effects (i.e. indirect expos-
ures to failing financial counterparties in the first round) of 30–40 per cent.
These results suggest that climate policies could result in potential winners and
losers across financial firms and would not have an adverse systemic impact as
long as they are implemented early on and within a stable framework.
Next, Battiston and colleagues (2017) provided the following aggregate expos-
ures on loans as a fraction of banks’ capital: fossil and utilities = 11 per cent;
energy-intensive = 28 per cent; transport = 16 per cent; and housing (includ-
ing mortgages) = 281 per cent. Climate policies impacting on the energy-
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

intensive, transport, and/or housing sector would imply increased volatility

on large portions of bank loans.
Finally, the question arises of how ﬁnancial supervisors should treat low-
carbon (green) and high-carbon (brown) assets in the capital adequacy frame-
work, which determines how much equity capital a bank has to hold against
risk-weighted assets. Box 2.4 discusses the proposal of a higher risk weight for
brown assets (see also Chapter 10).

2.5 Conclusions
This chapter analyses social and environmental externalities, which are absent
in the traditional production function. We show how social and natural capital
can be incorporated into our decision-making. But what mechanisms can be
used to address these important external effects, which affect other parties,
without these effects being priced in the market?

BOX 2.4 A BROWN CAPITAL CHARGE?

Runaway climate change is the ultimate systemic risk for banks. To discourage lending to
brown assets, a differentiated capital treatment of green and brown assets would be helpful.
The question is whether green assets should get a lower risk weight or brown assets a higher
risk weight.
The European Commissioner Valdis Dombrovskis has announced that he will ‘look posi-
tively’ at a ‘green support factor’ for bank lending (High-Level Expert Group on Sustainable
Finance, 2018). However, Boot and Schoenmaker (2018) argue that it is a bad idea to grant
banks extra-low levels of capital if something is ‘green’; realizing the extra risk of ‘brown’ does
not make ‘green’ extra-safe. Endorsing ‘lowering capital requirements for certain climate-
friendly investments, such as energy-efﬁcient mortgages or electric cars’ is asking banks to
turn a blind eye on proper risk management, as it is not clear which green technologies will
win (i.e. business risk).
Both sides agree that climate risks are material for banks and need to be taken into account
in setting capital requirements. Currently this is not the case—an increasingly important risk
factor is neglected. Instead of the ‘green supporting factor’, Boot and Schoenmaker (2018)
argue that a much stronger case can be made for a ‘brown penalising factor’ for fossil-fuel-
intensive and -dependent assets. Not only does it give lenders the capacity to withstand losses
when the energy transition accelerates, a brown penalizing factor will also discourage further
investments that contribute to climate change. Thus the systemic risk of climate change itself
would be reduced.
Preferably this would be done through the ﬁrst pillar of the capital regulation framework
that sets minimum capital requirements (Boot and Schoenmaker, 2018). Climate exposures—
proxied by the carbon intensity of assets—should be translated into credit risk. This cannot be
done using risk models that are based on historical data, as energy transition is an unprece-
dented development. Rather, scenario studies should be used to quantify the impact of
transition.
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

A major way to internalize externalities is government regulation and tax-

ation. While there are examples of successful regulation, such as social legisla-
tion in the developed world and an international treaty banning CFCs to protect
the ozone layer, major social externalities in developing countries as well as
environmental externalities are not yet effectively regulated or taxed. In par-
ticular, effective policies to curb carbon emissions have been elusive, notwith-
standing the Paris Climate Agreement to limit global warming to 2° Celsius, and
possibly to 1.5° Celsius. Only a very few countries, such as the Scandinavian
countries, have implemented an effective carbon tax of $80 to $100.
Business has started to measure and price externalities, where possible.
The integrated value can be calculated by combining ﬁnancial, social, and
environmental values in an integrated way. The monetization of these factors
helps businesses optimizing the integrated value, for example, by adapting
their production process. As old production processes may become obsolete
(leading to stranded assets), it is in a business’s self-interest to adopt more

sustainable practices. Nevertheless, private effort might be insufﬁcient in the

absence of government intervention.
The future development of externalities is surrounded by policy and
technological uncertainty. Examples of uncertainty are the introduction of
carbon taxes overnight by an incoming government, a ban on child labour, an
imposition of minimum wages, and a rapid decline in the cost of renewables,
such as solar and wind, due to technological innovation (which can grow
exponentially). Scenario analysis helps investors to deal with these uncertainties.
They can calculate the expected enterprise value of the corporates in which they
invest by weighting the discounted CFs under alternative scenarios. Scenario
analysis also helps companies to reconsider their strategy and implement
actions to prepare for certain situations (as discussed in Chapter 5).

Key concepts used in this chapter

Abiotic resources are non-renewable natural resources, such as mineral
resources and fossil fuels; see natural resources.
Biological or biotic resources are renewable natural resources obtained from
the biosphere, such as timber, animals, fresh water, solar energy, and biomass;
see natural resources.
Boundary problem indicates that when regulation for one sector is tightened,
business will shift to other sectors with less or no requirements.
Capital adequacy requirement is the amount of equity capital a bank has to
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

hold as required by its ﬁnancial regulator. This is usually expressed as a ratio of

equity that a bank must hold as a percentage of risk-weighted assets.
Common good refers to what is shared and beneficial for all or most members
of a given community.
Economic imperialism seeks to expand the boundary of the economic system
until it encompasses the entire ecosystem of the Earth.
Environmental factors or ecological factors are factors, abiotic or biotic, that
influence living organisms; see planetary boundaries for the most critical
environmental factors.
Emissions trading system, also known as cap-and-trade system, introduces an
emission cap (a ceiling on the maximum amount) and permits trading of
emission allowances.
Fallacy of composition arises when one concludes that something is true of the
whole from the fact that it is true of every part individually.
Externalities refer to consequences of activities that affect other (or third)
parties without this being reflected in market prices.

Human capital refers to people’s competencies, capabilities, and experience

and includes issues such as health and safety, gender equality, training, and job
satisfaction.
Integrated value is obtained by combining the ﬁnancial, social, and environ-
mental values in an integrated way (with regard for the interconnections).
Internalization mechanism refers to a method to ‘internalize’ or take into
account externalities.
Natural resources cover non-renewable or abiotic resources, such as mineral
resources and fossil fuels, and renewable or biological resources, such as
timber, fresh water, solar energy, and biomass.
Regulatory quotas are government-imposed limits on quantity.
Pigouvian tax is a tax levied on a market activity that generates negative
externalities. The tax is intended to correct an inefﬁcient market outcome
and does so by being set equal to the social cost of the negative externalities.
Scenario analysis is a process of analysing possible future events by consider-
ing alternative possible outcomes.
Social and relationship capital covers social activities, nuisances, or contribu-
tions to local communities and relationships within and between communities.
Stranded assets refer to assets that lose their value. This term is often used for
fossil fuel assets, which may become stranded due to government regulation or
technological change. It is more widely applicable to carbon-intensive assets or
other assets, such as land, which may become stranded due to soil erosion.
Copyright © 2019. Oxford University Press USA - OSO. All rights reserved.

■ SUGGESTED READING

Daly, H. and J. Farley (2011), Ecological Economics: Principles and Applications, Island
Press, Washington DC.
Dasgupta, P. and P. Ehrlich (2013), ‘Pervasive externalities at the population, con-
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Farnham.
Stern, N. (2008), ‘The economics of climate change’, American Economic Review:
Papers and Proceedings, 98(2): 1–37.
Sukhdev, P. (2008), ‘The economics of ecosystems and biodiversity (TEEB)’, Interim
Report.
Sukhdev, P. (2011), ‘The economics of ecosystems and biodiversity (TEEB)’, Final Report.
True Price (2014), ‘The business case for true pricing: why you will beneﬁt from
measuring, monetizing and improving your impact’, Report drafted by True
Price, Deloitte, EY, and PwC, 2nd edn, Amsterdam, http://trueprice.org/wp-
content/uploads/2015/02/True-Price-Report-The-Business-Case-for-True-Pricing.
pdf, accessed 25 June 2018.

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Principles of Sustainable Finance - (2 Externalities Internalization)

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Principles of Sustainable Finance - (2 Externalities Internalization)

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2 Externalities—internalization

quently calculates the ‘true’ or integrated price of a product or the integrated

2.1 Why externalities matter

tion function (Cobb and Douglas, 1928) is written as:

where q represents ﬂows of (consumption) goods and services, w ﬂows of

tions to local communities and relationships within and between communities,

As discussed in Chapter 1, we are in a transition from a linear economy

> 50% > 2550% 125% < 1%

Figure 2.1 Recycling rates for 60 metals

Table 2.1 Linking SDGs and capitals

BOX 2.1 CONTINUED

2.1.1 INTERNALIZING EXTERNALITIES

2. Civil society: Non-governmental organizations can raise awareness of

To address the problem of ignoring negative externalities and to preserve the

Business Internalization Society

Figure 2.2 Internalization of social and environmental impacts

environmental goods and services. Examples are in the ﬁeld of biodiversity

2.2 Government intervention

2.2.1 ENVIRONMENTAL EXTERNALITIES

2.2.1.1 Taxing externalities

(ton carbon dioxide equivalent). The Scandinavian experience shows that

BOX 2.2 OPTIMAL POLICY AND CLIMATE SCEPTICISM

2.2.2 SOCIAL EXTERNALITIES

2.3 Measuring and pricing externalities

technology (measurement, information technology, data management) and

Figure 2.3 From ﬁnancial value to integrated value

economic, social, and environmental aspects of corporate investment.

BOX 2.3 THE TRUE PRICE OF ROSES FROM KENYA

2.3.1 THE MONETIZATION OF EXTERNALITIES: PITFALLS

production facilities and safety procedures. Incorporating adaptive capacity is

integrated value concept. Coulson (2016) suggests that producers could

2.3.2 INSUFFICIENT PRIVATE EFFORT

coordination problem—in environmental regulation. This is an example of

2.4 Scenario analysis

about how these externalities will develop over time.

2.4.1 UNCERTAINTIES ABOUT EXTERNALITIES

2.4.1.2 Technological uncertainty

than the actual outcome (measured as global installed capacity in gigawatt

Actual G reenpeace 2007 IEA - WEO 2007

Figure 2.4 Solar power capacity: predictions versus actual

Fossil fuel phase out Period of doubling (years)

Figure 2.5 Non-linear renewable energy expansion trajectories

Figure 2.6 Global carbon law guiding decadal pathways

pre-industrial temperatures. Such a project would be cheap: one ton of sulphur

do nothing to halt ocean acidiﬁcation and a myriad of other problems

2.4.2 THE USE OF SCENARIO ANALYSIS

Discount rate Impactπonπr

Figure 2.7 Impact of scenarios on DCFs

2.4.3 CLIMATE MITIGATION SCENARIOS

Figure 2.8 Possible trajectories of carbon emissions

curve in Figure 2.8). In this scenario, the underlying political economy—that

Emissions (100m tonnes of CO2 eq uivalent) 14 Electricity & gas

Figure 2.9 GHG emissions and GVA by sector, EU

Table 2.2 Assumptions used in scenarios

Scenario O il price Cost EB IT margin

Bu siness as usual $60 + 2% annual 2% annual cost inflation 18%

2.4.3.1 Example of impact on an oil company

Table 2.3 Valuations calculated for scenarios

Scenario Fair stock price U pside

Bus iness as usual $163 30%

Transition from 2020 $115 –8%

Transition from 2025 $94 –25%

Transition from 2030 $0 –100%

same in most other respects (volumes sold, capital expenditures (CAPEX)/

Table 2.4 Probabilities applied to scenarios

Scenario Fair stock Probab ility W eighted Probabi lity W eighted

Bus iness as usual $163 25% $41 60% $98

Transition from 2020 $115 25% $29 14% $16

Transition from 2025 $94 25% $23 13% $12

Transition from 2030 $0 25% $0 13% $0

Total 100% $93 100% $126

scenarios and their probabilities.

2.4.4 STRESS TESTING

Battiston and colleagues (2017) conducted a climate stress test of the

intensive, transport, and/or housing sector would imply increased volatility

BOX 2.4 A BROWN CAPITAL CHARGE?

> 50% > 2550% 125% < 1%