October and November are big months for Year 12 students across Australia. The next generation is completing its final school exams and the rite of passage into the outside world of work and further studies.
In an investment context, it is timely to consider the differing elements of the subject of economics being studied by our future leaders, and how it is changing.
The lessons from economics are expanding
Economics is about the allocation of scarce resources for production, distribution and consumption. For decades, the Year 12 curriculum has covered economic growth, unemployment, inflation, external trade and exchange rates, and then assessed available tools including fiscal, monetary, microeconomics and labour policy.
Progressively more evident in the school curriculum is that the natural environment is materially edging its way into the mix. Topics like sustainable development, externalities, market failures, public and private goods and environmental issues (including climate change and depletion of non-renewable resources) are now key areas studied.
And with good reason. Recent research by the Australian Conservation Foundation, supported by Australian Ethical, shows that roughly half Australia’s GDP (49.3% or $892.8 billion*) has a moderate to very high direct dependence on nature, and indirectly every single dollar that flows through the economy depends on the health and survival of natural systems.
So, at the core of the lessons for students and for investors alike is how might we protect nature’s fine balance and maintain its integrity to support a long-term healthy society and the linked economy and investment environment.
A new set of goals for nature is coming
This will be the subject of COP-15 to be held in December 2022. The UN Biodiversity Conference will convene governments from around the world to agree to a new set of goals for nature over the next decade with this objective in mind.
At Australian Ethical, we are aligned with the interest of the final year students in wanting to understand the economic paradigms around the environment – its strengths, weaknesses and challenges - and how we might position for long-term success.
1. Economics history and private goods
Economics has a multi-century history, with many high-profile contributors, including Adam Smith, Milton Friedman and John Maynard Keynes. It also has had a fair history of success, which in part is built on some bruising experiences of the past. Year 12 students can marvel on how effective application of monetary and fiscal policy might support more stable economic cycles, or how microeconomics can lead to improved productivity.
If we delve into this success, however, much of it has been around private goods, which are goods where the utility or benefit derives to its owner.
Private goods and linked markets by their very nature tend to be more efficient allocators of assets. Dating all the way back to Adam Smith in the 1700s and the 'invisible hand', free markets support effective production and pricing of products and services. While over the years a range of flaws have emerged (such as labour market exploitation and market concentration) that need regulations to address them, in general, competitive markets have supported strong global outcomes with innovation and international trade uplifting many communities around the world.
As investors, we too have tended to focus on the private markets and their success. There have been a breadth of companies available for investment selling private goods and services that have delivered strong investment returns over an extended period.
2. Challenges with public goods and especially the environment
The challenge for economics has been public goods. These are goods, like the environment, where one can’t exclude a consumer from enjoying the benefit, even if they are not willing to pay.
The core of the problem is market failure, as the price mechanism only takes into account the private benefits and costs of production to consumers and producers and does not consider the wider cost (or externality) to the public good (in this case the environment).
To address this market failure, it has been up to the government to set up the system so that the environment is not overlooked in private transactions. And our year 12 students have seen plenty of evidence of success, such as:
- banning CFCs to protect the ozone layer
- making single use plastics and certain chemicals illegal
- using water rights to improve river water usage.
Unfortunately, the big global issues like climate change and biodiversity, where individual company and country action can seem minor relative to the issue, have been challenging. The preferred economic solution here is placing a tax or fee on production or consumption that approximates the environmental cost of this economic activity, and in effect internalising the externality.
But carbon taxes and levies have been politically problematic, with countries concerned around their relative positioning versus other countries not taking similar action. The rapid changes of political leadership (linked to proposed carbon taxes) and extended international negotiations, demonstrate the political complexity.
3. Identifying the need for a sustainable solution
With this economic division between private and public goods over the past several decades we have seen a dichotomy: strong businesses and market outcomes, but materially weaker environmental conditions.
While Australia prior to the pandemic had not had a recession for almost 30 years, Australia’s recent State of the Environment report now rates our country as on a poor rating across a host of ecological metrics. And while over 1 billion people have lifted themselves out of extreme poverty in the last 25 years around the world~, over that same period our global temperature has increased by over half-a-degree to be 1.2 degrees higher than pre-industrial times^.
A sustainable approach towards economics is needed because we can’t live with this dichotomy forever. Sustainable development requires a healthy environment to underpin long term multi-generational economic success. We need both strong economic and environmental outcomes.
4. Sustainable pathways for economics and investors
The core of the challenge has been addressing private transactions that are generating negative externalities, or what are sometimes called ‘free riders’.
Fortunately, economics has many tools beyond taxes or levies which which can influence supply and demand and perhaps generate positive externalities.
We have seen governments put in place programmes to support supply and lower costs of products that are avoiding emissions in energy generation. Government initiatives including clean energy subsidies, financing incentives and renewable energy zones. Plus, there is also emission reduction funding and linked carbon credits.
Investors play a role as well. In Australia, where our superannuation assets are now larger than GDP, the role of investors can tilt the economic scales materially. And presently a shift to a more flexible renewable energy grid, is part of the superannuation sector conversation.
Back to our year 12 students and their teachers
We should be grateful for their broader focus and considering the environment more meaningfully in the syllabus. Our future leaders will think more creatively about our challenges and build solutions ranging from economic policy settings to new technology. But this is an urgent and complex challenge, and in the meantime, investors should also be aware of externalities and free riders and look for investments that drive long term strong sustainable outcomes with our scarce global resources in mind.
References
*Australian Conservation Foundation; The nature-based economy: How Australia’s prosperity depends on nature; September 2022.
~World Bank: https://www.worldbank.org/en/news/press-release/2018/09/19/decline-of-global-extreme-poverty-continues-but-has-slowed-world-bank
^World Meteorological Organization (2021). WMO Statement on the State of the Global Climate in 2020. WMO-No. 1264. Geneva. ISBN 978-92-63-11264-4.
Angus Dennis is Investment Director at Australian Ethical, a sponsor of Firstlinks. This information is of a general nature and is not intended to provide you with financial advice or take into account your personal objectives, financial situation or needs.
For over 35 years, Australian Ethical has used its Ethical Charter to evaluate companies and the broader impact they play on the environment and society. We invest in portfolios that have a net benefit to this broader set of stakeholders, so we see an overweight in our listed equity portfolios to sectors like renewables and healthcare, and we avoid a range of companies with net negative contribution including fossil fuels, that can fit within the ‘free rider’ category. We also specifically target unlisted renewables via a range of strategies including catalytic private equity and infrastructure like equity and debt.
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