Does stock market short-termism make capitalism irresponsible?

The primary stock market characteristic driving climate issues is not a truncated time horizon. It’s the corporation’s capacity to externalize environmental and climate harms.

Stock market short-termism is said to drive ESG and CSR shortfalls, worsening environmental quality and global warming in particular, making the corporation less responsible. A stock market of rapid traders is not a stock market, in the conventional view, that can think about sustainability and climate catastrophe. The recent EU initiative on sustainable capitalism (such as via this study)  strongly asserts this proposition, and it is one that is widely believed on both sides of the Atlantic. “The short-term payback periods of financial markets take precedent over the long-term time horizons of ecological and social systems,” says one analysis. “The finance world’s short-termism will destroy our communities, economies and the planet,” the World Economic Forum was told in Davos. 

The policy implication of this linkage between short-termism and climate change is quite important since in this view, which seems to be conventional in public policy circles, stock-market-driven short-termism perniciously affects public firms, making them pollute and warm the planet. Thus, the commonly-discussed remedies for stock market short-termism are even more important to implement. To (help) save the planet, we should tax stock trading, enact higher capital gains taxes on short-term holdings than on long-term holdings, reduce shareholder activists’ power, and diminish stock markets’ capacity to influence firms.

This thinking can give hope to climate activists that solutions (or at least mitigations) through corporate governance reform are at hand. With governments too passive in the face of relentless global warming, climate activists can imagine that corporate governance changes that lengthen corporate horizons, which are more plausibly attainable than, say, a wide and seriously effective carbon tax, can make a major difference and maybe even save the planet from climate catastrophe.

This thinking is conceptually incorrect for the most part and, if policymakers are persuaded by it and act on it, they will not do much good for the environment or for stakeholders, nor will they do much to arrest climate change. The primary stock market characteristic driving climate issues is not a truncated time horizon. It’s the corporation’s capacity to externalize environmental and climate harms. The two are often conflated but are quite different.

It’s not that the selfish short-term corporation will pollute while a long-term one will not. Both will pollute across time.

Here’s what I mean. Posit a corporation that is exceedingly long-term in its focus, highly valuing the profits it expects to reap decades hence. Will its incentives to pollute and contribute to global warming reverse, as compared to its short-term cousin? In general, no. The pollution problem is that neither the short-term nor the long-term firm internalizes the costs from the corporation’s pollution. A corporation that’s strongly oriented toward shareholder value over social value will look more closely at the bottom line profit and worry less about the costs society bears from its pollution—those costs are externalized and do not hit the corporation’s bottom line. Others suffer from the corporation’s pollution, not the corporation itself—and not its stockholders as investors.

It’s not that the selfish short-term corporation will pollute while a long-term one will not. Both will pollute across time.

True, time horizons are not absolutely and in all ways absent. Executives may worry about profits on their watch more than long-term profits. But even here, the operative mechanism is that the firm that pollutes does not pay for its pollution. The problem is still primarily one of externalities, not primarily one of truncated time horizons. To deal with the short-term executive, the solution is not so much to lengthen his or her time horizons as to make the firm (or the executive) pay for its pollution, whether that pollution is now, or in the future. Fix the externality problem and one fixes the ESG/CSR problem. Fix the perceived time horizon problem and the polluting firm still pollutes.

The difference between corporate time horizons and externalities can be readily illuminated by comparing corporate overproduction and excessive burning of hydrocarbons to our personal burning of hydrocarbons—when driving our cars, for example. Corporate hydrocarbon burning (and hydrocarbon sales, and other petroleum use) risks climate catastrophe for the planet decades from now. And personal hydrocarbon burning, such as when I drive my car and when you drive yours, has us individually contributing to global warming and to the risk of climate catastrophe decades hence as well.

The harms are spread over society generally and not borne primarily by the firm’s stockholders, its executives, or its employees. 

But our personal shortened time horizons when driving our cars to work are not the principal motivations inducing us to risk climate catastrophe. The primary mechanism here is that neither the polluting corporation nor the gasoline-burning car driver, such as myself and maybe you, absorbs the full costs of their own pollution. These costs are spread over society. So my driving harms the environment, but it does so (1) only to a small degree and (2) with almost no impact to me. And when the corporation, even the megacorporation, burns hydrocarbons, or finds them, refines them and sells them, it harms the environment, but with almost no negative impact to the corporation. The harms are spread over society generally and not borne primarily by the firm’s stockholders, its executives, or its employees. 

The costs of the pollution are externalized, but not the profits. The convenience of my driving to work today is nice for me, but the resulting pollution and the car’s contribution to environmental degradation are not good and something we car-drivers often regret. However,  the costs are borne by society overall. My time horizon is not what counts; my capacity to externalize the costs is what counts. 

Why is understanding this incentive—and the difference between time horizon problems and externalization problems—important?  Because, as said above, if we overly weight shortened time horizons as the impetus for pollution—thinking that short-term firms pollute while long-term firms do not—policymakers will favor standard policies to reduce stock market short-termism. But they will not reduce pollution and global warming much, or at all. A considerable portion of the public thinking on the subject goes in this erroneous direction.

Thinking that the climate problem is in large measure a stock market time horizon problem makes it easier for policymakers, because that thinking diminishes the pressure they would otherwise feel to pursue effective but politically stressful action. Fulminating against stock market short-termism as causing climate change—and even taxing the corporation or the stock or the trading of the stock—will not motivate anti-government populism but will satisfy it.  Unpopular government actions—like enacting an effective carbon tax or taxing us more at the gas pump—will, in contrast, damage a governing party’s popularity.

Mark J. Roe is an inaugural ECGI Fellow, and the David Berg Professor at Harvard Law School. The issue considered here—distinguishing externalities from time horizons—is more extensively analyzed in chapter 3 of his book, Missing the Target: Why Stock Market Short-Termism Is Not the Problem (forthcoming, Oxford University Press).

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