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Investment thesis: Negative externalities (or saving the world)

What are negative externalities?

Economics coined the term ‘negative externality’. In business, it refers to situations where harm is done, that is not included in the cost of production or consumption. Basically, its where creating, using or throwing away a product costs more than what you actually paid for it. And the cost isn’t paid in money – it’s paid for by the environment or by other peoples’ wellbeing.

For instance, the factory that puts its waste products into the river causing fish to die and cancer in the village downstream. The coal power plant that produces carbon dioxide that is not priced into the cost of the energy consumers are buying. The nightclub that is so noisy its neighbours can’t get to sleep until the early hours of the morning. The fast food chain that doesn’t help pay for the health impacts their food causes. The manufacturers of alcohol – which is attributed as a major contributor to violence – who don’t contribute to solving this problem.

Personally, I believe the most critical negative externalities to solve are those that affect the climate. We are running out of time to solve for these.

The economics of negative externalities

The first thing you learn in an economics class is the traditional demand and supply diagram.

The orange line represents demand – as the price falls, more people want to buy the product.

The purple line represents supply. At a low price very few companies can profitably produce the product. As the price increases, more and more companies want to sell that product.

Equilibrium is where demand and supply naturally meet, and the price remains stable. This is fine if all we care about is money, but the model fails to capture negative externalities – the real cost of producing things.

The dotted line in the second picture represents the true cost of production – the environmental and social costs included. If we included this in the price of products then the price would go up, and the quantity sold would go down.

Unfortunately, we don’t count this cost, hence we have the problem of negative externalities.

Why now?

There are three reasons negative externalities have become a critical issue to solve at this point in time.

First, the world’s population is now so large that it’s impossible to just go elsewhere if a negative externality is affecting you. Even in the remote arctic native people are being advised not to eat the local fish due to pollution. Thus, everyone, everywhere, is now affected by negative externalities.

Second, we are nearing irreversible tipping points when it comes to the climate. If we don’t solve for negative externalities soon, it’s likely that the earth will experience severe and unavoidable environmental changes.

Third, the growth in demand for sustainably and ethically produced goods. Individuals are demanding that the companies they buy from, the politicians they vote for, and the organisations they support address negative externalities.

Types of innovation

There are 4 categories of innovation when it comes to negative externalities:

  1. Track – Measuring the amount, and the impact, of negative externalities
  2. Trade – Offsetting the impact of negative externalities
  3. Replace – Developing new products and means of production that reduce or eliminate the negative externality
  4. Reverse – Creating products and systems that reverse the damage done in the past by negative externalities

More detail on each, and some example start-ups operating in each space are below.

1. Track – Measuring the amount, and the impact, of negative externalities

Tracking involves understanding where in the production process the negative externality is created, how much there is, and the downstream impact of it. For instance, Mark Bittman estimated the true cost of a hamburger as being at least double what we pay for them (you can find the brilliant article here. In the diagram above, tracking only tells us where the dotted purple line is.

If tracking seems useless in terms of solving the problem, think of all the people trying to lose weight who track their every morsel of food. The act of tracking doesn’t actually change the calories going in and out of their body, but it does help highlight where the problem areas are in their diet that caused them to put on weight. Tracking also helps the individual become motivated to change their habits, and it provides a sense of accountability – especially if that tracking is public.

Start-ups in this space typically rely on the goodwill of companies to buy their product and service. Unless government mandated, there is no requirement for organisations to track their negative externalities. However, there is incentive for them to avoid tracking as it may lead to them having to pay to remedy those societal costs, or cause reputational damage if consumers become aware of the harm they are doing.

Given this, it’s unlikely that start-ups devoted to tracking can be successful at scale unless:

  • Government regulations require tracking creating a captive market
  • The start-up becomes the nationally / globally recognised rating agency that all companies seek endorsement from
  • They use the data they’ve collected and expand into trading

 

Australian start-ups to watch:

  • Emmi – tracking the legal, regulatory, market and reputational risks related to carbon for traders

2. Trade – Offsetting the impact of negative externalities

Since negative externalities are not included in the price of a product or service, trading is a way to incorporate those costs. Companies spend money equivalent to the estimated impact of their negative externality, with the aim of offsetting their impact. The classic example is buying ‘carbon credits’ where trees are planted to offset a company’s carbon emissions. In the diagram above, trading is a way to for companies to pay the ‘gap’ between the solid purple, and the dotted purple lines.

Similarly to tracking, trading often requires the goodwill of either companies, or consumers (companies often pass on the cost of offsetting to their customers as an optional add-on).

However, legislative changes and consumer demands point to trading becoming a mandatory part of business in future. Many countries already have an emissions trading scheme in place for carbon.

Start-ups betting on tracking becoming more widespread might be successful by:

  • Developing more efficient ways to offset externalities (and therefore selling credits to companies at a lower price)
  • Becoming the go-to trading marketplace for a particular externality type (like any marketplace, it’s often a winner-take-all scenario)

 

Australian start-ups to watch:

  • Path Zero – Carbon offsetting for businesses
  • Trace – Carbon offsetting for retail consumers and small businesses
  • Nori – Buy carbon removal directly from farmers

3. Replace – Developing new products and means of production that reduce or eliminate the negative externality

Inventing products that fulfil the same customer need, but don’t create the same amount of negative externalities, is the third area of innovation. Think of Tesla replacing petrol cars with electric cars. Or CarbonCare in Canada that created a new way to produce cement that not only captures all the emissions within the material, but in doing so also makes the cement stronger (cement accounts for 6% of global carbon emissions). Or traditional manufacturers like General Motors innovating in their production processes to eliminate waste (and save $1b while they are at it).

Replacement has the effect of shifting the dotted purple line and the solid purple line closer together, or ideally overlapping them, because replacement removes the negative externalities not captured in the cost of the product.

There is a ton happening in this space, although it typically falls into one of these areas:

  • New products (eg. Solar power replaces coal power)
  • New raw materials (eg. Replacements for plastics)
  • New means of production (eg. Made to order products reduce the waste of unsold stock)
  • New means of distribution (eg. Local production such as vertical gardens in cities reduce the pollution and energy needed to transport food)

From an investor standpoint, a start-up must not only create a product that solves for the negative externality. They also most make that product either higher quality than the product they aim to replace, or lower cost. If they can do both that’s even better.

 

Australian start-ups to watch:

  • Replated – Replacing disposable food takeaway containers
  • GreatWrap – Compostable cling wrap and industrial plastic wrapping made from food waste
  • Vow – Growing meat in the lab, replacing the need for environmentally intense farming
  • V2 Food – Plant based meat alternatives, replacing the need for animal farming
  • Clara Foods – Creating animal proteins from plant based inputs, reducing environmental impact of animal farming
  • Nourish Ingredients – Creating fats and oils that replicate those of animal products but are plant based
  • Uluu – A new biomaterial made from seaweed that can replace plastic
  • Stacked Farm – Vertical farming that consumes 95% less water than traditional farming, and removes most of the transport costs
  • Regrow – Uses agricultural data to monitor and recommend more sustainable agricultural practices that improve carbon sequestration

4. Reverse – Creating products and systems that reverse the damage done in the past by negative externalities

Most successful companies in this space are able to create valuable products using negative externalities from other companies as the raw materials. For instance, food waste, carbon dioxide, plastics in the ocean, glass that is thrown out, broken electronics, old building materials when houses are knocked down etc. In some cases other companies are paying to dispose of these negative externalities so a start-up can profit on both sides of the equation – by getting paid to collect the negative externality, and by turning it into something valuable that they can sell to customers.

Some companies tackle a negative externality head-on, creating a product that directly address a negative externality problem. For instance, Dr. David Vaughn developed a way to regrow 100 years worth of coral growth in just two years (coral reefs are home to 25% of the world’s biodiversity). And Dendra Systems in the UK has developed a system that could replant a billion trees a year using AI and drones that disperse seed pods with nutrients to help plants grow.

For investors, the problem with this type of innovation is who pays? We don’t currently put a value on environmental damage so it’s hard to put a price on reversing that damage. Thus these innovations typically come out of research facilities without a profit imperative attached, or are developed in response to a prize (eg. The XPrize just released a $100m prize for carbon removal) or government grant. If the technology can be commercialised then investing in something that helps the world can also be profitable.

Australian startups to watch:

  • BeyondAg and GoTerra – Both companies turn food waste into pet food and fertiliser using insects

The long term view

As a long term investor, I’m looking at companies addressing 3 and 4 (‘replace’ and ‘reverse’). Ideally, with enough entrepreneurs working in this space, we could hope to make 1 and 2 largely obsolete. There is no need to track or trade externalities if you are not creating any in the first place. (Although in reality, there may be a place for ‘tracking’ and ‘trading’ for many decades to come as different countries will have different levels of technology, geographic locations and ability to implement solutions without negative externalities.)

As consumers we also have an obligation to demand more of our governments and organisations. Price is not the only thing you should look at when you buy something. And at a national level, GDP is not the only measure we should be using to track our progress (for some alternatives to GDP read this: https://ethical.net/politics/gdp-alternatives-7-ways-to-measure-countries-wealth/)

Ultimately, we might see economic models other than capitalism that bring the full costs of production and consumption into the price – everything from the impact on the earth of harvesting the raw materials, all the way through to the impact on the earth of throwing something away once we are done. As ecological economist Robert Costanza argued ‘we’ve been cooking the books for a long time by leaving out the worth of nature’.

In the meantime, there is plenty of opportunity for start-ups addressing negative externalities, and investors in this space can both make money, and make the world better.

May 29, 2021