Experts agree that climate change and global warming pose systemic risks to the world economy, with major impacts on the availability of resources, the price and structure of the energy market, the vulnerability of infrastructure and the valuation of companies. But from a macroeconomic level, little has been done.

One of the first lessons students are taught when studying economics is the basic problem of limited resources and unlimited wants. Given that resources are scarce, there are trade-offs to consider when determining what to produce and what to consume. Solving this problem should allow the efficient allocation of resources, but what if we’re not measuring outcomes or indeed resources correctly? What if wants are not unlimited or can’t be fully measured in dollar terms?

Generally we were taught that some resources are free – such as air - and others are subject to a cost – such as labour.  While there has been some focus on the “externalities” of economic actions, such as air or water pollution, these concerns have largely been absent from the headline discussions and the scale of them inadequate based on what science tells us we are doing to the planet.

Climate change is a cost on all of us and will likely have significant macroeconomic consequences. But are resources such as air, water, green space being valued correctly when we determine what should and shouldn’t be produced in an economy? The science around climate change would argue no. Experts agree that climate change and global warming pose systemic risks to the world economy, with major impacts on the availability of resources, the price and structure of the energy market, the vulnerability of infrastructure and the valuation of companies. But from a macroeconomic level while some great work has been undertaken over the past ten years by some organisations, overall little to date has been done.

Over the past 10 years there has been increased attention and focus on the importance of considering environment, social and governance (ESG) factors when investing. Responsible investing is now well recognised and sought after by many investors when seeking to allocate capital. The results from integrating ESG factors into the investment process clearly show a benefit to investment performance, as shown in CFSGAM’s latest Responsible Investing report.  This in turn should lead to a more efficient and sustainable allocation of capital, underpinning long-term returns for investors and society while creating a more sustainable economy.

But should it be left purely up to investors to allocate resources to create a more sustainable economy? Should the economic framework evolve to help? There has been some evolution on this by analysis such as the World Economic Forum’s global risk report. Overtime, environmental and social issues have become increasingly prevalent in the report rather than economic factors. Between 2007 and 2010 there were no environmental and only one social risk in each year, while in 2016, eight of the top ten were environmental and social risks and included extreme weather events, natural disasters, water crises, large-scale involuntary migration and unemployment. One important point the paper makes is that recent political outcomes, including Brexit and the rise of populism, bring into focus policy questions such as how to make economic growth more inclusive and how to reconcile growing identity nationalism with diverse societies .

Currently the success or otherwise of an economy is largely represented by growth in Gross Domestic Product (GDP), as well as secondary indicators such as the unemployment rate and even the inflation rate, which is the main goal of monetary policy. But in the same way that investors are broadening the set of indicators to reflect that the allocation of capital and use of ownership rights have both real world and real investment impacts, perhaps placing economic growth and prosperity in a broader context,  could help to better allocate scare resources across the economy.

In some sense central bankers have started to evolve their framework beyond an inflation target. We can see this in Australia. The Reserve Bank of Australia, under Governor Dr. Phil Lowe, has raised the importance of financial stability in setting monetary policy, noting it has been conscious that “a balance needs to be struck between the benefits of monetary stimulus and the medium-term risks associated with rising levels of debt relative to our incomes”. The RBA has also more recently specifically called out a focus on “public interest” and “the human cost of financial instability” when setting policy.

While this is a start and could help improve the resilience to future financial crisis, alternative measures of GDP should also be discussed. One example, is the “Doughnut of social and planetary boundaries”  that notes that humanity’s 21st century challenge is to meet the needs of all within the means of the planet, ensuring no one falls short on life’s essentials, while ensuring we do not overshoot our pressure on the Earth’s life supporting systems on which we all fundamentally depend. Importantly, it brings together social and environment concerns, which should be supplemented with economic goals. Maybe just like incorporating ESG principles into investing, this could see benefits to economic outcomes going forward.  

The Doughnut of social and planetary boundaries (2017)

Source: www.kateraworth.com/doughnut

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