The difference between existential and non-existential societal issues and reinterpreting vs. expanding the concept of financial materiality
I noticed that in everyday life, we tend to mix together two categorically different types of societal issues which call for different types of responses and priorities. One category represents existential risks to humanity — in particular the climate crisis — whereas the other category represents non-existential risks (“non-existential societal issues”). By “non-existential societal issues” I refer to all those ethical challenges that organized human societies had to struggle with since their early origins, such as poverty, human rights abuses, wealth inequality, violence, discrimination, the destruction of (local) ecosystems, toxic waste etc. While we still have a long way to go as a species, we can look back at considerable successes in terms of universal human rights, (local) environmental rights, improved average living standards and life expectations, achievements in terms of education and culture etc, which characterize us as an advanced, complex civilization. This is what is what constitutes human progress; it’s akin to a marathon — an enduring struggle for a more compassionate, wiser and more united human society.
The climate crisis, in contrast, is akin to a 3 km (i.e. 3 decades) race against the clock that we are involuntarily forced to deal with right now. Winning this “race to zero” requires us to muster all our strength and determination as if our life depended on it, because, in a way, it does. Stabilizing the earth’s climate system is not just another impact theme (or SDG) among others: the rapid — and socially just — decarbonization of the global economy over a limited timeframe has emerged as the defining mission of this century. It has become a new categorical imperative in the 21st century that is both, time critical (as well as temporary) and of existential importance, determining our capability to make continued progress on other societal challenges in the future. It wasn’t like this at the beginning of this century. It is only after 30 years of insufficient climate action that we have now gotten to the edge of a cliff, where our ability to realize systemic change determines our planet’s habitability for the duration of geological timescales — hundreds of millennia. It is difficult to overstate the importance of getting the next 30 years right — there is so much at stake, so much to regret — especially for our descendants — should we collectively fail. In this context I highly recommend Toby Ord’s book “The Precipice”(the first chapter is provided for free). Ord makes a compelling philosophical argument for why we should care about the (very) long-term future. Here is an excerpt that I hope can raise our urgency awareness:
“…During the twentieth century, my best guess is that we faced around a one in a hundred risk of human extinction or the unrecoverable collapse of civilisation. Given everything I know, I put the existential risk this century at around one in six: Russian roulette. (See table 6.1 on p. 167 for a breakdown of the risks.) If we do not get our act together, if we continue to let our growth in power outstrip that of wisdom, we should expect this risk to be even higher next century, and each successive century. These are the greatest risks we have faced. If I’m even roughly right about their scale, then we cannot survive many centuries with risk like this. It is an unsustainable level of risk. Thus, one way or another, this period is unlikely to last more than a small number of centuries. Either humanity takes control of its destiny and reduces the risk to a sustainable level, or we destroy ourselves.
Consider human history as a grand journey through the wilderness. There are wrong turns and times of hardship, but also times of sudden progress and heady views. In the middle of the twentieth century we came through a high mountain pass and found that the only route onward was a narrow path along the cliff-side: a crumbling ledge on the brink of a precipice. Looking down brings a deep sense of vertigo. If we fall, everything is lost. We do not know just how likely we are to fall, but it is the greatest risk to which we have ever been exposed.
This comparatively brief period is a unique challenge in the history of our species. Our response to it will define our story. Historians of the future will name this time, and schoolchildren will study it. But I think we need a name now. I call it the Precipice. The Precipice gives our time immense meaning. In the grand course of history — if we make it that far — this is what our time will be remembered for: for the highest levels of risk, and for humanity opening its eyes, coming into its maturity and guaranteeing its long and flourishing future. This is the meaning of our time.
I am not glorifying our generation, nor am I vilifying us. The point is that our actions have uniquely high stakes. Whether we are great or terrible will depend upon what we do with this opportunity. I hope we live to tell our children and grandchildren that we did not stand by, but used this chance to play the part that history gave us.
Safeguarding humanity through these dangers should be a central priority of our time. I am not saying that this is the only issue in the world, that people should drop everything else they hold dear to do this. But if you can see a way that you could play a role — if you have the skills, or if you are young and can shape your own path — then I think safeguarding humanity through these times is among the most noble purposes you could pursue…”
In order to help clarify the differences (as well as similarities) between the “climate crisis” and “non-existential societal issues” I have a created a few slides (linked and attached) that summarize the root causes and key interventions as well as the different types of financial materiality, suggesting either its reinterpretation/expansion, as well as other important systemic interventions needed to reshape capitalism as we currently know it.
With regard to many non-existential societal issues, at a global scale, the “materiality gap”, i.e. the delta between financial materiality and societal materiality, may be considered relatively narrow. In this situation it might be sufficient to “reinterpret” materiality. More stringent and reliable disclosure of negative real-world outcomes can enable engaged shareholders to work with companies to successfully address ethical (and financially material) issues that may not have been taken into account properly. Whenever a company appears to get away with negative societal outcomes legally and profitably, better disclosure can help put publicly listed or investor-owned companies under pressure to address these issues. (This should apply to regulators and policy makers as well, since we need to keep in mind that no such corrective mechanism exists for privately held or state-owned companies, including the many SMEs that make up a large share of the economy). Corresponding with the relative narrowness of the materiality gap in this case, the magnitude of the market failure at hand can be considered to be fairly limited and company-specific (and/or specific to developing countries). However, we can’t generally assume that more ethical behavior always improves financial performance — I would argue that more often than not quite the opposite is the case. Using improved financial performance as a primary argument for better stewardship is a double-edged sword. Whenever the solution to a societal issue requires accepting additional costs and/or uncertainties which are deemed to hurt near– to mid-term profitability more than the financial damage of a tarnished brand reputation, liability claims or penalty fees, for example, the translation of disclosure into action is going to be difficult. Financial materiality can point into the wrong direction. For instance, financial materiality considerations certainly resulted in the Tabacco industry successfully lobbying and misinforming for decades against the “transition risk” of stronger public health regulation. Creating uncertainty about societal materiality has been a preferred strategy to protect economic value in the past.
With regard to the climate crisis, the materiality gap is immense, reflecting a massive and ongoing market failure in plain sight (the economist Nicholas Stern called it “the greatest market failure in human history”). This is a situation where the reach of financial materiality urgently has to be expanded — I’m afraid there is no way around it. I hope that an awareness campaign might help bring this particular point across. An indication for the scale of the materiality gap is provided by the social cost of carbon for which estimates (e.g. by the Biden Administration or Stern & Stigliz, for example) range between 50–100 USD/ton CO2 emission. The German equivalent to the EPA even estimates 200 EUR/ton, while theoretical estimates for the “ultimate cost” of carbon go as high as a mindblowing 100.000 USD/ton. Considering annual CO2e emissions are currently at about 50 billion tons, a 100 USD/ton social cost estimate would indicate a yearly amount of 5 trillion USD of intergenerational economic damages that are unaccounted for by current the financial materiality definition. In 2019, the IMF estimated subsidies for fossil fuels at 4.7 trn USD in 2015 (most of which refer to indirect, non-cash transfer subsidies that reflect socialized costs and damages due to air pollution and climate change). Another compelling study from 2018 estimated the “unpaid social cost of carbon” in the fossil fuel industry at USD 12.7 trn between 1995–2013, possibly up to as high as USD 115.5 trn. The authors refer to this amount as “legal looting”, defined as “society’s failure to charge fossil fuel firms for the damage that their activities cause represents an implied subsidy”. In the context of the climate crisis, the materiality gap could as well be named the “carbon pricing gap”.
Eventually, the systemic risk of a collapsing global economy and/or global security (which are both mutually reinforcing and increasingly likely to occur at some point within this century under the current “business as usual” pathway) would become financially material for every market participant, especially “universal owners”. But until it does, this kind of financial materiality is more abstract, long-term, time-uncertain, economy-wide and not company-specific. Whereas the economic damages of unmitigated climate change can be relatively well measured and estimated, such estimates are much more difficult with regard to the systemic risks of escalating societal issues such as racism, inequality and ideological radicalization, which can lead to a (more localized) societal breakdown and potential economic losses — there are hardly any estimates available for the “social cost of human rights violations”, for example. (Note that in this case there is additional risk of an authoritarian, radically nationalist, and militaristic response in an effort to protect the social order). In any case, I’m afraid that existential as well as non-existential systemic risks, quantified or not, will be deemed to be of relatively little financial materiality for specific companies and non-universal asset owners/investors.
For this reason, and due to the scale of the materiality gap with regard to systemic climate risk, it is unlikely that merely more aggressive shareholder engagement (even when based on improved climate risk disclosure) can make a substantial and timely difference, especially in comparison with various other systemic interventions that are urgently needed (see slides). For financial system change to become an effective instrument against the climate crisis, the real economy needs to change accordingly. The fossil fuel industry, in particular, confronts investors with its own special conflict of interest and perverse incentives. This industry is firmly committed to protecting its destructive business model and actively working through lobbyism and misinformation to mitigate the regulatory transition risk that a strong climate policy response would imply for their enterprise valuations. When I recently took a closer look into Shell’s accelerated decarbonization plans I noticed that their upstream capex projects yield on average more than 20% IRR. Natural gas investments yield on average IRRs of 14–18%. Both IRRs are significantly higher than for their renewable energy projects and provide perverse incentives. It is hard to push for a transformation when market failure (as well as regulatory failure) continues to allow for so much money to be left on the table.
On a positive note, at least we can anticipate that solving the climate crisis would provide the co-benefit of reversing the goal priorities of the current economic and financial system: Taken together, the multiple systemic interventions suggested would establish long-term stewardship as a higher priority than near- to mid-term economic “value” creation at all cost. “Stewardship primacy” would effectively replace the “primacy of economic profit”. Under the condition of stewardship, economic profit would still play its part as a mechanism to efficiently allocate scarce resources, but more to the benefit of humanity than to its demise. This way, the current extractive, exploitative and unsustainable form of capitalism could be transformed into a more sustainable, more stakeholder- and impact-oriented version of itself, which would then provide a solid foundation for continued human progress on non-existential societal issues for many centuries to come.
