The value creation boundary

It is worth stating up front that, for us, the value creation boundary is an abstract concept rather than an actual, discoverable thing. It is more of a thought experiment and so its value lies in how it might change our thinking and worldview.

We start by asserting that we value order in our lives. We will pay to have our homes cleaned, but not to have them messed up. It is similar for goods. We will pay up for the highly-ordered final product, but not for the raw materials it is made of. Next, we note that economics has long recognised the concept of externalities – costs or benefits that fall on people not directly involved in the economic activity. From here two things follow. First, that there is a value creation boundary which lies between these innocent bystanders, and the parties involved in the economic activity. Second, that value is created inside the boundary and destroyed outside it[1]. In other words, the externalities are, in aggregate, negative. Several questions spring to mind: who are the insiders, and who are the outsiders, and do they tend to be the same people? Where should we draw the boundary, and are there consequences to that decision?

The planetary reality

The tightest local boundary we can draw is around a single individual, for a single good or single service. So I derive value from my home being cleaned but tend not to think about the impact outside my boundary. These impacts include, first, the production of chemicals used to clean my home, and their escape from my home as waste; second, my share of CO2 emissions from the electricity powering the vacuum cleaner; and, third, the fact that most of the vacuum cleaner will end up in land fill at the end of its life. Having considered my impact outside the boundary I have a choice to ignore it, or to adjust my cleaning mandate (only lemon juice and vinegar? More sweeping and less vacuuming?).

Switching to the widest pragmatic possibility, we could draw the boundary around the earth’s atmosphere. Expanding the value creation boundary to this fullest practical extent echoes the logic of ecological boundary conditions. Further, I would argue it is the true heart of sustainability. In this framing, we recognise the earth as a largely-closed system (so a good idea to maintain the life-support systems) with the free input of solar energy, and the ability to costlessly dump excess heat into the universe[2]. If I adopt this mindset then I probably do need to limit my cleaning chemicals to lemon juice and vinegar, and in aggregate we will only be able to extract lemon juice at the rate the earth is able to replenish the crop. In addition, I ought to ensure my electricity comes from renewable sources, and that my vacuum cleaner was designed with a circular economy mindset (rather than a linear use-then-throw mindset).

Where to draw the boundary?

If we were employed in almost any other industry we would have a product or service and we could consider whether to draw our boundary around just our customers, or whether to include their families, their communities, the local ecosystem, or take a whole of planet, whole of humanity stance. As investment entities we start there, and then need to consider our portfolio and the investee companies represented within it.

The logic of the value creation boundary is that the more tightly we draw it, the larger the domain over which we are having a negative impact (this doesn't mean the negative impact gets bigger). Further, this engenders an adversarial, negative-sum environment. To create value for our small group, we need to be able to dump harm on some other group. However the other groups know this, and have the same incentives. In case this is too abstract, think about the choice between divestment and engagement. Divestment is nothing other than the discovery of a value creating opportunity for my group by dumping the unattractive securities on another group. Not wrong, but not positive sum either. Engagement runs the risk of still holding securities with a collapsing value before business models can be adapted. But it can be a positive sum activity, and it signals a ‘wider boundary’ mindset.

The more we expand the boundary the more of humanity we include. This carries the advantage of reducing the antagonism between groups, but the substantial disadvantage of removing cheap dumping grounds for the waste of the economic activity we invest in. We return to this thought below.

If we choose not to draw the value creation boundary that widely, we are identifying that we hold one or more of the following beliefs or values:

  • My investment time horizon is sufficiently short that I do not have to worry about potential negative consequences over the longer-term
  • I am subject to fiduciary duty, which I interpret to mean my responsibility is solely to maximise the next period’s risk-adjusted return
  • I am powerless to influence externalities so there is no point expending any such effort
  • I recognise the importance of addressing externalities but prefer to be a free-rider on the efforts of others
  • My ideology does not support this action. I believe unconstrained free markets produce the best outcomes, so if the externalities matter that much someone will create a profitable business to address them
  • My values do not support this action. I care passionately about my group [ie clients / members] but have no regard for anyone outside this group.

The above list is not our values and beliefs, but they are valid – at least somewhat. The point is that the value creation boundary is a thinking device. Each investment organisation, whether asset owner, asset manager or other service provider, will need to work out where to draw their own. In the next section we disclose our values and beliefs in this matter – and ‘our’ here includes the authors and the members of the value creation working group.

Back to the planet

There is a growing recognition of the validity of ecological boundary conditions. The ecological ceiling representing the outer ring of Kate Raworth’s ‘doughnut’[3] is based on the scientific paper published by Johan Rockström in 2009[4]. Due to the scientific foundation of these boundary conditions we do not need a values-based discussion to support them. We accept that beliefs may differ but, by definition, valid beliefs must be consistent with the available data, and so the range of disagreement is constrained.

If we return to people, then drawing the value creation boundary around the atmosphere includes all of humanity. We are saying that value must be created for all humans, not just subsets. This is the social foundation, and inner ring, of Raworth’s doughnut. It is also the UN’s sustainable development goals. Accepting some degree of responsibility for these social goals is necessarily (but not exclusively) values-based. And values can legitimately vary widely. For our part (authors and working group), we believe that all investment organisations should develop the beliefs and values to support this social floor, as well as the ecological ceiling.

So what?

Where we choose to draw the value creation boundary will clearly have implications for our subsequent actions. It will determine which business models are appropriate to be in the portfolio, and which should be excluded. It will influence decisions over the provision of new capital. And how seriously to take voting and engagement. It may influence new thinking over the structure of incentive arrangements. And quite possibly have other effects we haven’t documented here. But that seems enough to be getting on with for now.


[1] This second statement should be challenged by any enquiring mind. If we have stated that externalities can be costs or benefits why do we jump straight to a net cost? First, we could breach (or amend) our first statement and move any defined subset of bystanders that are net beneficiaries within the boundary. In this case we reinforce value being created witin the boundary and leave all the value destruction outside. Second, we could introduce the passage of time and recognise that short-term, positive externalities can become negative in the long term. Third, we could argue that any economic activity produces waste alongside the intended output. The intended output is priced and sold inside the boundary, the externality is unpriced waste which is dumped outside the boundary. If those arguments fail to satisfy the enquirer, the author would resort to an argument invoking the second law of thermodynamics. In this case, by analogy, the value destruction is the outside-the-boundary increase in entropy which must be at least as big as the value-creating reduction of entropy within the boundary.

[2] Given the size of earth relative to the universe this would appear to be a sustainable strategy for the 5 billion or so years before earth is consumed by the expanding sun. We also obey the second law of thermodynamics as the increase in entropy (our excess heat) is carried by the universe

[3] Doughnut Economics, Seven Ways to Think Like a 21st-Century Economist, Kate Raworth, Penguin Random House, 2017

[4] A safe operating space for humanity, Rockström et al, 23 September 2009 (linked here)