Pricing in externalities to illuminate the true cost of investing in unsustainable companies and sectors

Guest Author

Christian Zabbal

ImpactAlpha, May 16 – Every time a new, sustainable infrastructure innovation has come to market – solar energy, electric cars, plant-based proteins, for example – pundits and talking heads gleefully point out that these solutions are more expensive than the alternatives that they are replacing – fossil fuels, combustion engine cars, traditional meat.

This has been called the “sustainability premium.” Much ink has been spilled over just how big, if any, of a sustainability premium consumers will tolerate, and why such a premium means that the innovation will fail.

Put aside for a second the fact that these pundits are always comparing the price of the sustainable, low-carbon option today with the cost of the existing high carbon option that has been around for, sometimes, hundreds of years, and that, over time, as the new solutions gain scale and experience, their costs fall dramatically. Batteries have come down in cost by 90% over the past decade, for example, and solar cells cost about a tenth of what they did in 2010.

Even if we assume that the costs of these sustainable solutions never come down, does the concept of a sustainability premium make any sense?

The main reason that unsustainable solutions tend to be cheaper than sustainable ones is because they simply don’t price in externalities. The price of many old, high-carbon infrastructure solutions today in energy, food, waste, transport and other verticals reflects production costs, but not remedial costs, be those carbon emissions, water use, health impacts, or even social justice.

It’s like ordering a large sofa to your home, and having one workman deliver it in pieces and assemble it inside because it won’t fit through the door, and the other one knock a giant hole through your wall and drive away. Yes, the second delivery was a lot cheaper – but no one would think of arguing that the first workman charged you a ‘no hole through the wall’ premium.

‘Unsustainability discount’

This is the only advantage traditional, unsustainable infrastructure currently enjoys over the new wave of innovations – call it an ‘unsustainability discount’. Because these industries were born at a time when we didn’t realize the magnitude of the externalities involved, we allow them to not charge their customers for it. But as we have started to understand the magnitude of the problems created by this old infrastructure, the sheer scale of that unsustainability discount is becoming clear – and it’s massive.

Let’s look at energy as an example. The Brookings Institute published a study that showed that the price of fossil fuels should be 170% higher than it is, if effects on the health of those around the production sites were priced in.

If you don’t believe them, you can calculate it yourself: If we power an average home in the US for a year, for example, we would need around 10,000 kwh. Producing that via coal would cost around $400, and would generate around 3 tons of CO2. Cheap power, right? Well, yes, as long as you don’t consider the externalities: the proliferation of carbon emission regulations mean that someone is going to need to remove those 3 tons of CO2, and that will cost between $750 and $1,800.

Another example: Beyond greenhouse gasses, a combustion engine car produces particulates and other emissions that create health issues. Air pollution in the US due to transportation is responsible for about $120 billion in damages per year. If we were to charge this back to the 8 million vehicles produced annually in the US, the air pollution alone would add $15,000 to the cost of each vehicle – and that doesn’t count the carbon impact of these vehicles.

That is the dirty secret of the unsustainabilty discount. It is, in many industries, very, very large – far larger than the price differential between sustainable and unsustainable solutions. Most of these legacy industries become immediately marginal if they were forced to absorb even a fraction of the unsustainability discount that they currently enjoy.

Yet investors have largely failed to account for the unsustainability discount and hence the true costs of unsustainable solutions. That is starting to change.

Fleeting advantage

Now, two things are happening. Firstly, more sustainable solutions are emerging across these industries, which create alternatives against which these unsustainability discounts can be measured.  Secondly, the need to reckon with the problems created by these externalities – water shortages, climate change, health issues due to pollution, and so on – is becoming more and more urgent, and also politically feasible.

This means that, over the coming years, more and more of these unsustainability discounts will be coming under scrutiny, measured, complained about, and eventually eroded far faster than in the past. The new infrastructure bill unveiled recently by the Biden administration will only accelerate these trends. 

This is what investors in those industries should be concerned about – not a conceptual sustainability premium that drops quickly with scale anyway, but how quickly these unsustainability discounts will be taken away. If a pension fund or an institutional long-term investor is exposed to these industries, they are benefitting – for now – from a very significant ‘pass.’ That pass will get revoked sooner rather than later as carbon is priced, governments strive for revenues and public sentiment seeks culprits to start paying for the externalities that have been borne by the public purse for many years.

How quickly these discounts disappear – and who will be left holding companies whose true cost makes them more than toxic – is going to be the investment theme of the next decade as the world of transport and food and energy and waste begin a generational transformation.

Christian Zabbal is Managing Partner and co-Founder, Spring Lane Capital, LLC.