Externalities are the unintended and often unanticipated consequences of an economic transaction that affect third parties. Externalities can be positive or negative and they can affect individuals, groups, society, or the environment. 

In this article, I will discuss both positive and negative externalities in general, with a focus on capital markets and investing. I will discuss why they are important and why we should care about them. 

Positive externalities 

Positive externalities are the unintended benefits that accrue to a third party as a result of an economic transaction. For example, if a farmer grows a crop that attracts bees, the bees may pollinate nearby crops, providing a benefit to other farmers. 

Positive externalities in capital markets and investing can occur when the actions of an individual or group of investors have a beneficial impact on others who are not directly involved in the investment. For example, consider an investor who purchases shares in a company that is working to develop a new technology that will significantly reduce greenhouse gas emissions. This investment may have a positive externality on the environment and on society as a whole, even though the investor’s primary motivation for the investment is to generate a financial return. 

Another example of a positive externality in capital markets is the role that investors can play in promoting corporate social responsibility. When investors demand that companies adopt environmentally and socially responsible practices, it can have a positive impact on the broader society and the environment, even though the investors are not directly involved in the operations of the companies. 

Active investing is another great example of an enterprise with positive externalities. William Sharpe famously said that active investing is a zero-sum game. This is often regurgitated by those pushing passive investing, but nothing could be further from the truth. Active investing creates efficient capital markets, with price discovery, liquidity, and the ability to transfer risk from one investor to another. 

Overall, positive externalities in capital markets and investing can help to promote the efficient allocation of resources and contribute to the overall well-being of society. 

Negative externalities 

Negative externalities are the unintended costs imposed on a third party as a result of an economic transaction. For example, if a factory emits pollution, the cost of the pollution may be borne by people living in the surrounding area, even if they are not directly involved in the transaction. 

Negative externalities in capital markets and investing can occur when the actions of an individual or group of investors have a negative impact on others who are not directly involved in the investment. For example, consider an investor who purchases shares in a company that is involved in activities that have a negative impact on the environment, such as mining or oil and gas exploration. This investment may have a negative externality on the environment and on society as a whole, even though the investor’s primary motivation for the investment is to generate a financial return. 

Another example of a negative externality in capital markets is the role that investors can play in promoting irresponsible corporate practices. When investors demand high returns without considering the social and environmental consequences of a company’s operations, it can have a negative impact on the broader society and the environment, even though the investors are not directly involved in the company’s operations. 

Passive investing is another great example of a negative externality. Passive investing removes price discovery and liquidity from markets and can exacerbate market bubbles as passive money chases past winners (momentum stocks). 

Overall, negative externalities in capital markets and investing can lead to market failures and contribute negatively to the overall well-being of society. 

Why should we care? 

It is important to care about externalities because they can have a significant impact on individuals, groups, and the environment, even though the individuals or groups responsible for the externalities may not be directly involved in the economic transactions that cause them. 

Negative externalities, in particular, can lead to market failures. This occurs when the market does not allocate resources efficiently. Market failures can result in inefficient outcomes, such as overproduction of goods or services that impose negative externalities on society or underproduction of goods or services that provide positive externalities to society.

Externalities can also result in distributional issues, where the costs or benefits of an economic transaction are not evenly distributed among all parties involved. For example, a company may benefit financially from a factory that emits pollution, but the costs of the pollution may be borne by people living in the surrounding area.

By taking externalities into account, policymakers and individuals can work to promote more efficient and equitable outcomes. This may involve implementing policies or regulations to internalise externalities, such as taxes for negative externalities, or subsidies for positive externalities to encourage the production or consumption of goods or services.  

It may also involve individual actions, such as choosing to invest in companies that have a positive impact on society or the environment and divesting from those that have a negative impact, raising their cost of capital and therefore, the cost of doing business. 

How does this relate to the free-rider problem? 

The free-rider problem refers to the tendency of individuals or groups to benefit from a public good or service without contributing to the cost of producing or maintaining it. 

In the context of externalities, the free-rider problem can occur when an individual or group benefits from a positive externality but does not contribute to the cost of producing the good or service that generates the externality. For example, consider a farmer who grows a crop that attracts bees, providing a benefit to other farmers through pollination services. If the other farmers do not contribute to the cost of producing the crop that attracts the bees, they may be viewed as “free riders” who benefit from the positive externality without contributing to the cost of producing it. 

The free-rider problem can lead to market failure, as it can result in underproduction of goods or services that provide positive externalities. This is because the full social benefits of the good or service are not reflected in the price, leading to insufficient demand for the good or service. 

To address the free-rider problem, policymakers may implement mechanisms to internalise the externalities, such as taxes or subsidies. For example, a government may implement a tax on the production of a good or service that generates negative externalities, in order to encourage the reduction of those externalities. Alternatively, the government may offer a subsidy to producers of goods or services that provide positive externalities, in order to encourage the production of those goods or services. 

How do externalities relate to carbon tax and tax credits? 

A carbon tax is a tax on the emission of carbon dioxide and other greenhouse gases, which are known to contribute to global warming and climate change. The purpose of a carbon tax is to internalise the negative externality of carbon emissions by making the cost of emitting carbon more closely reflect the social cost of those emissions. 

The goal of a carbon tax is to encourage businesses and individuals to reduce their carbon emissions by making it more expensive to emit carbon. This can be accomplished by setting a price per ton of carbon emissions, which is then applied to the emissions of each business or individual. The higher the carbon tax, the more expensive it becomes to emit carbon and the more incentive businesses and individuals have to reduce their emissions. 

Tax credits, on the other hand, are a form of subsidy that can be used to encourage the production or consumption of goods or services with positive externalities. For example, a government may offer a tax credit to individuals purchasing electric vehicles, in order to encourage the use of cleaner transportation options. 

Tax credits can be used to offset the cost of a good or service, making it more affordable for consumers. In the case of electric vehicles for example, a tax credit may be used to reduce the upfront cost of the vehicle, making it more appealing to consumers and encouraging the adoption of electric vehicles over traditional gasoline-powered vehicles.  

Overall, carbon taxes and tax credits are two policy tools that can be used to internalise externalities and encourage more efficient and equitable outcomes in the market.

Conclusion

Externalities can lead to market failures, which occur when the market does not allocate resources efficiently. In the case of positive externalities, the market may underproduce a good or service because the full social benefits of the good or service are not reflected in the price. In the case of negative externalities, the market may overproduce a good or service because the full social costs of the good or service are not reflected in the price. 

As responsible investors, we need to account for and care about externalities, to ensure that we build a better future for everyone, while delivering great financial returns.