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Responsible Investing and Environmental Economics

Green Finance and the Transition to a Green Economy
  • Carol PomareEmail author
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Abstract

This chapter aims at discussing responsible investing and environmental economics within the context of climate change. It was observed that publicly traded firms are applying sustainability strategies in their operations and capital spending, because investors are increasingly interested in responsible investing. For publicly traded firms and responsible investors, such changes towards more sustainability mitigate the risk for future unburnable carbon and/or bursting of the carbon bubble on capital markets because of climate change-related regulations. However, because of greenwashing, some concerns arise that material amounts of publicly traded firms’ unsustainable performances may be hidden from financial statements and annual reports. As a consequence, the challenge for responsible investors is not only to: (i) evaluate the scale of environmental operational and capital investments (e.g., attempts to decrease toxic emissions) but also to (ii) evaluate publicly traded firms’ environmental performance associated with the assets locked into their reserves (e.g., oil reserves for oil publicly traded firms). This chapter follows a specific structure to explore the challenge for responsible investors. Section “Introduction and Literature Review” is focused on an introduction and literature review. Section “Featured Case in Point” is focused on a featured case related to responsible investing and environmental economics. Section “Reflection Questions” refers to reflection questions with theoretical developments on: (i) investing and economics, (ii) responsible investing and environmental economics, and (iii) responsible investing with passive versus active investing strategies. Section “Exercises in Practice” presents applied exercises to be used in class. Section “Engaged Sustainability Lessons” summarizes engaged sustainability lessons. Section “Chapter-End Reflection Questions” expands on the chapter with reflection questions. The discussion in terms of the impact of responsible investing on environmental economics is of interest, since it is believed that substantial adjustments of regulating practices are required for publicly traded firms to realistically alter their financial statements and annual reports, for responsible investors to be fully informed, and for engaged sustainability to thrive.

Keywords

Socially Responsible Investing (SRI) Divestment Green finance Environmental economics Green house gas emissions Stranded assets Carbon bubble Capital markets Efficient market hypothesis 

Introduction and Literature Review

This chapter aims at discussing responsible investing and environmental economics within the context of climate change. Indeed, it was observed that publicly traded firms were applying sustainability strategies in their operations and capital spending, because investors were interested in responsible investing. For publicly traded firms and responsible investors, such changes towards more sustainability mitigated the risk for stranded assets (i.e., unburnable carbon) and bursting of the carbon bubble (i.e., sudden decrease of stock prices) on capital markets .

In the next sections, responsible investing strategies will be reviewed, as well as, their link with environmental economics . The featured case in point will be related to Canadian crude oil extraction firms.

As an introduction to investing , here are some broad definitions of typical investing options (i.e., for details see Investopedia at: http://www.investopedia.com/terms/s/security.asp). First, bonds are debt securities under which the issuer owes a debt and typically is obliged to pay interest (i.e., a coupon) and to repay the debt (i.e., the principal) to the lender, at a later date (i.e., the maturity date). Second, stocks of a corporation are related to a publicly traded firm’s ownership with a single share of stock representing fractional ownership of the firm. Third, Mutual Funds (MFs) and Exchanged Traded Funds (ETFs) typically are baskets of bonds and/or stocks . Fourth, a stock index or stock market index is a measurement of the value of a section of the stock market that is used to compare the return on any specific investment (i.e., it is computed from the prices of selected stocks to describe the market).

For responsible investors , being responsible means using green investment strategies to assess environmental operations and capital investments, as a way to mitigate any adverse impact of publicly traded firms’ unsustainable practices. For example, responsible investors may decrease investment in industries with high levels of Green House Gas (GHG) emissions. Responsible investors may change their investment strategies for ethical reasons, but also because they expect a bursting of the carbon bubble related to traditional investors investing in fossil fuels and the sudden decrease in stock prices because of climate change-related regulations (e.g., regulations against Green House Gas, GHG, emissions) leading to fossil fuels becoming stranded or unburnable.

In a related vein, Socially Responsible Investing (SRI) is an ethical positioning that has recently been endorsed by capital markets. This endorsement by capital markets led to the development of green finance options for responsible investors, including bonds (e.g., debts of publicly traded firms investing in environmental operations and capital expenditure) and funds (e.g., basket of stocks from publicly traded firms investing in environmental operations and capital expenditure). More specifically, in the context of green finance, the focus is typically on green bonds, green Mutual Funds (MFs) and/or green Exchanged Traded Funds (ETFs).

In this section, we explore Socially Responsible Investing (SRI) and capital markets with the following questions : (i) What are you getting when you put your money into a Socially Responsible Investments (SRIs)? and (ii) How do you know which investments with a “sustainable” label actually fulfills its promise?

What Are you Getting with Socially Responsible Investments (SRIs)?

Socially Responsible Investing (SRI) is more than not buying the shares of publicly traded firms in controversial industries like tobacco, firearms, alcohol, gambling, or oil (i.e., divestment). Socially Responsible Investing (SRI) is considering a wide range of corporate behaviors as related or not to Environmental, Social and Governance (ESG) factors (Davidson 2016).

Responsible Investing Through Divestment

Divestment is the opposite of investment, as it is the process of avoiding an asset for either financial, or social, or political reasons. Assets that can be divested may include a subsidiary, business department, real estate, equipment and/or investment in stocks (i.e., for details see Investopedia at: http://www.investopedia.com/terms/d/divestment.asp). In the context of climate change, divestment happens when responsible investors withdraw from a particular industry or a specific geographic region due to political, social or environmental pressures (i.e., for details see Investopedia at: http://www.investopedia.com/terms/d/divestment.asp).

A fossil fuel equity exposure ratio is a ratio used to assess the exposure of any investment option (e.g., Mutual Fund (MF), Exchange Traded Fund (ETF), or publicly traded firm) to fossil fuel as compared to the broader capital market (Ansar et al. 2013). As a reference, the fossil fuel exposure ratio of a university endowment or a public pension fund is generally very small (Ansar et al. 2013). On average, university endowments in the United States have 2–3% of their assets invested in fossil fuel equities (Ansar et al. 2013). The proportion in the United Kingdom (UK) is higher with an average of 5%, because the Financial Times Stock Exchange (FTSE) 100 Index has been described as having greater proportion of fossil fuel companies (Ansar et al. 2013).

On the one hand, the direct impact of fossil fuel divestment on equity or debt is limited (Ansar et al. 2013). The maximum possible capital that might be divested from fossil fuel companies by university endowments and/or public pension funds represents a small pool of funds as per the fossil fuel equity exposure ratios described above (Ansar et al. 2013). As such, even if the maximum possible capital was divested from fossil fuel companies, these companies’ share prices would be unlikely to suffer massive declines (Ansar et al. 2013). Some investors would probably even welcome the opportunity created by the divestment to increase their holdings of these fossil fuel companies, particularly if these stocks presented a short-term discount (i.e., bargain) because of other investors’ divestment (Ansar et al. 2013).

On the other hand, even when divestment outflows are small and do not directly affect future cash flows of publicly traded firms, divestment triggers an indirect change in social norms that tends to close channels of previously available money, with a downward pressure on the stock price of the targeted publicly traded firms (Ansar et al. 2013). One indirect impact is the stigmatization resulting from a divestment campaign which may pose a real threat to firms and their value chain (Ansar et al. 2013). As with individuals, a stigma may produce negative consequences. For example, firms heavily criticized in the media may suffer from a bad image that scares suppliers, subcontractors, employees, and customers away. Governments and politicians may prefer to engage with “clean” firms to prevent adverse effects on their own reputation or potential for reelection. Another indirect impact is the restrictive legislation resulting from divestment campaigns. Indeed, in most divestment campaigns, there is intensive lobbying in favor of restrictive legislations against the targeted firms (Ansar et al. 2013).

Historically, research credits divestment by prominent American universities, as well as, by important public pension funds, as leading to a tipping point, and as paving the way for other universities or public institutions in the United States (USA) and abroad (Ansar et al. 2013). For example, a first wave of divestment started in the United States (USA) about social issues related to tobacco or Apartheid in South Africa, with divested amounts that were very small but created public awareness (Ansar et al. 2013). Both in the case of tobacco and the Apartheid, the divestment campaigns took a few years to take off, until very high profile American universities announced their divestment from these industries or geographic area, during what was known as a second wave of divestment (Ansar et al. 2013). This involvement of very high profile American universities was the tipping point paving the way to a generalized global impact.

Similarly, a withdrawal of debt finance from fossil fuel companies by some institutions or any increase in cost of capital as a consequence of a divestment campaign may not pose any serious debt financing problem in terms of short-term liquidity or capital expenditure for fossil fuel firms in highly functioning markets (i.e., high information efficiency) (Ansar et al. 2013). Changes in social norms are relevant, however, in relatively poorly functioning markets (i.e., low information efficiency). In particular, borrowers in countries with low financial depth (i.e., low informational efficiency) may experience a restricted pool of debt financing if financial institutions in the local financial network withdraw their support because of a divestment campaign (Ansar et al. 2013). While an increase in cost of capital is unlikely to have an effect on overall corporate finance of major fossil fuel firms, their ability to undertake large capital expenditure projects in difficult environments may be diminished due to divestment campaigns and lower availability of debt financing within poorly functioning markets (Ansar et al. 2013).

As a consequence, a divestment campaign may entail small outflows in the early phases of a campaign, but drastic outflows once a certain tipping point has been reached in terms of market norms (Ansar et al. 2013). As such, even if the direct impact of divestment outflows is small in the short term, a campaign may have massive long-term indirect impacts on the value of a target firm (Ansar et al. 2013).

Responsible Investing and Business with a Purpose

Sadler (2017a) uses a quote from Sir Richard Branson, the well-known CEO of Virgin, in one of his book “Screw Business as Usual,” which is as follows: “Never has there been a more exciting time for all of us (…) where doing good really is good for business.”

Richard Branson’s quote highlights a phenomenon where purpose (i.e., doing good) becomes a critical part of business success, as: (i) customers demand it; (ii) employees are attracted to it; and (iii) investors embrace it through responsible investing (Sadler 2017a).

Richard Branson’s quote also highlights a generational shift as, 25 years ago, entrepreneurs wanted to be successful and seldom alluded to a greater purpose (Sadler 2017b). Apparently, generational change is a big factor in this phenomenon, as Deloitte’s Millennial Survey 2014 found that millennials demand that companies from which they buy endorse social and environmental responsibility (Sadler 2017b). About 51% of millennials say they would pay extra for sustainable products which are four times the number of baby boomers ready to pay extra for sustainable products (Sadler 2017b). The new generation of entrepreneurs, especially millennial entrepreneurs, also has a support network of nonprofit organizations (e.g., Green Chamber of the South’s Greenhouse Accelerator, etc.) whose specific purpose is to enhance a millennial entrepreneur’s chance of success when embracing a social or environmental purpose (Sadler 2017b).

Richard Branson’s quote finally highlights a transition with more than 10% of professionally managed investments now focusing on Environmental, Social and Governance (ESG) factors (Sadler 2017b). The democratization of investments for social and environmental impact projects could be one of the most important trends nowadays (Sadler 2017b). First, responsible investors have now access to potentially lucrative partnerships with a focus on: (i) renewable energy; (ii) organic farmland conversion; or (iii) brownfield remediation (Sadler 2017b). Second, more than 2,000 companies in 35 countries have passed a series of “triple-bottom-line” tests to become what is known as “Certified B Corporations” (Sadler 2017b). The success of “Certified B Corporations” with investors shows that responsible investors are looking for real and measurable environmental impacts (Sadler 2017b). Third, among celebrities who made a strong case for responsible investing, Bill Gates, the well-known billionaire and philanthropist, recently launched a $1 billion fund called Breakthrough Energy Ventures (Dolan 2016). With Breakthrough Energy Ventures, Bill Gates, Mike Bloomberg, the founder of Bloomberg LP and the former mayor of New York City (i.e., for details see Bloomberg at: https://www.boomberg.com), and 20 other well-known investors, including Silicon Valley Venture capitalists, focused on investing in new and “clean” forms of energy (Dolan 2016). Fourth, the well-publicized Breakthrough Energy Venture was not an exception, since: (i) thanks to a tracking method based on energy supply and other industries estimates, it is now known that, in 2013, responsible investing and green finance amounted to an approximate US$331 billion (Campiglio 2016); and (ii) 69% of Fortune 500 companies presented higher demand for “low carbon” ventures in 2016 (Velasquez-Manoff 2016). Finally, the development of green finance was fueled by very high demands in developing regions, like China (Campiglio 2016). Indeed, China is now seemingly the main investor in renewable energy with US$56 billion invested in such type of energy (Campiglio 2016).

Responsible Investing Through Green Bonds

As described previously, green bonds are fixed income instruments which finance debt for environmentally sustainable positive net present value projects while supposedly offering competitive returns to the responsible investor (i.e., for details see Investopedia at: http://www.investopedia.com/terms/g/green-bond.asp). Green bonds are issued to generate money that supports environmentally friendly business ventures, and when one invests in green bonds, one is buying into this responsible investing philosophy (Sadler 2017b).

Fixed-Income Instruments for Socially Responsible Investing (SRI) is a relatively new concept compared to other types of financial instruments (Sadler 2017b). Green bonds are increasingly being issued to fund environmentally-oriented projects delivering similar credit quality and income characteristics as any other mainstream fixed-income issue (Sadler 2017b). Even the municipal bond market can be segmented to deliver social impact (Sadler 2017b). By focusing on green segments (e.g., green education, green health, clean water, green space, etc.), responsible investors can build a portfolio aligned with their social and environmental values (Sadler 2017b). While the idea is still in its infancy in Europe or the United States (USA), it is likely to grow rapidly as green investing becomes more and more mainstream (Sadler 2017b).

In Europe , in May 2007, the European Investment Bank issued more than one billion Euros worth of “Climate Awareness Bonds” (Sadler 2017b). It was the first bond issue made available through a public offering process in the European Union (E.U.). The funds were set to be used in funding renewable energy projects as part of Europe’s commitment to produce 20% of its energy from renewable sources by 2020 (Sadler 2017b). Rather than pay a coupon, the bond was held for 5 years before being redeemed at face value plus an amount linked to the performance of an index, the Financial Times Stock Exchange (FTSE) “Good Environmental Leaders Europe 40” (i.e., an index of large-cap companies that are involved in renewable energy or energy efficiency-related businesses) (Sadler 2017b). A 5% minimum return was guaranteed (Sadler 2017b). Similarly, the Deutsche Bank was apparently one of the founding members of the green bond principles in Europe (Deutsche Bank 2017). Alexander von zur Muhlen, the Group Treasurer of Deutsche Bank, reportedly said that the green bond market had matured in 2014 and that the size and number of green bonds offerings had substantially increased since then, making green securities a viable investment option (Deutsche Bank 2017). For that reason, Deutsche Bank had already made 200 million Euros in eligible green bond investments (Deutsche Bank 2017). A Deutsche Bank report released in 2017 even announced the Bank’s intention to invest one billion Euros into a portfolio of high-quality liquid assets in the form of green bonds (Deutsche Bank 2017). These high-quality liquid assets were to be held as part of the Bank’s Liquidity Reserve investments. By establishing this portfolio, the Deutsche Bank, among other European financial & investing institutions, aimed at supporting the expansion of the green bond segment in Europe (Deutsche Bank 2017).

In the United States (USA), green bonds got a boost from an amendment to the America Jobs Creation Act in 2004 (i.e., officially titled the Brownfields Demonstration Program for Qualified Green Building and Sustainable Design Projects and shortened to green bonds) (Sadler 2017b). This program was designed to provide funding, in the form of AAA-rated bonds issued by the United States (USA) Treasury to finance environmentally friendly developments. The objective was to reclaim contaminated industrial and commercial land (e.g., brown fields) (Sadler 2017b). The use of bonds to fund environmentally friendly projects, in some cases, even gave tax-exempt income (i.e., green bonds are usually taxable, but recently some green bonds issued by states in the United States (USA) were made nontaxable to investors) while generating a feel-good factor from supporting environmentally friendly projects (Sadler 2017b).

As such, Europe and the United States (USA) are building on their successful green bond origination franchises and highlighting this opportunity to fund sustainable initiatives while achieving relatively attractive returns for investors.

Responsible Investing Through Green Funds

As described previously, green funds are investments with a focus on supporting positive net present value environmental projects committed to: (i) the conservation of natural resources; (ii) the production and discovery of alternative energy sources; (iii) the implementation of “clean” air and water projects; and/or (iv) Socially Responsible Investing (SRI) practices (i.e., for details see Investopedia at: http://www.investopedia.com/terms/g/green-investing.asp).

First, Wall Street now has sustainable investing divisions that create products for key demographics, like for millennials who are eager to align their investments with their values (Davidson 2015). Indeed, capital markets relate to publicly traded firms that are listed on various stock exchanges and there has been a huge increase in Environmental, Social, and Governance (ESG) indexes in 2015 to more than 150 up from 25 in 2010 (Davidson 2015).

Second, a Mutual Fund (MF) is an investment made up of a pool of assets such as stocks of publicly traded firms and similar assets (i.e., for details see Investopedia at: http://www.investopedia.com/terms/m/mutualfund.asp). In terms of green Mutual Funds (MFs), major investment firms, like Morgan Stanley (i.e., for details see Morgan Stanley at: https://www.morganstanley.com) welcome the major responsible investing business opportunity: “Clients are really starting to think differently about their portfolios” says Audrey Choi, Chief Executive of Morgan Stanley’s Institute for Sustainable Investing (Davidson 2015). Jean Rogers, the Chief Executive and Founder of the nonprofit Sustainability Accounting Standards Board (SASB) (i.e., for details see the Sustainability Accounting Standards Board at: https://www.sasb.org) says that several popular funds are available for investors who want to leave all decisions to the experts (Davidson 2015).

Third, an Exchange Traded Fund (ETF) is also an investment made up of a pool of assets such as stocks of publicly traded firms and similar assets, but generally has lower fees than Mutual Fund (MF) (i.e., for details see Investopedia at: http://www.investopedia.com/university/exchange-traded-fund/). The fees are generally lesser, as Exchange Traded Funds (ETFs) are available on self-directed platforms (i.e., platforms where investors make all investing decisions without the help of a financial advisor) or robo-adviser platforms (i.e., platforms with a logarithm picking investments based on users’ answers about investment preferences and assembling a “sustainable” portfolio if required to). In terms of Exchange Traded Funds (ETFs), since December 2013, assets in the sustainable category have more than doubled, with 22 new Environmental, Social and Governance (ESG) Exchange Traded Funds (ETFs) tracking Environmental, Social and Governance (ESG) indexes (Davidson 2015). As of July 2015, assets invested in Exchange Traded Funds (ETFs) tracking Environmental, Social and Governance (ESG) indexes have grown nearly 30% to $1.8 billion (Davidson 2015).

As such, it is more and more common to use green Mutual Funds (MFs) or green Exchange Traded Funds (ETFs). The idea is to invest in a basket of “sustainable” firms with a selection based on a series of established rubrics identifying “sustainable” firms that have a focus on Environmental, Social and Governance (ESC) practices.

Do Investments with a Sustainable Label Actually Fulfill their Ethical and Financial Promises?

Investors not only expect their investments to be related to Socially Responsible Investing (SRI); they also expect a competitive return for their Socially Responsible Investing (SRI). In February 2015, the Wall Street Journal (i.e., for details see Wall Street Journal at: https://www.wsj.com) interviewed two professors, Alex Edmans (i.e., Professor of Finance at London Business School) and David J. Vogel (i.e., Professor of Ethics at the Haas School of Business) and reported their answers to the following question: Does Socially Responsible Investing (SRI) make sense?

No, Socially Responsible Investing (SRI) Does Not Make Sense

Davidson (2015) states that the main issue for Socially Responsible Investing (SRI) may be the lack of uniform information for both individual and institutional investors (e.g., low information efficiency), with “sustainable” meaning different things depending on who is using the terminology. According to David J. Vogel, Professor of Ethics, interviewed by the Wall Street Journal, Socially Responsible Investing (SRI) does not always make sense, because there is no consensus on: (i) How to define sustainability, and (ii) how to construct a portfolio based on this concept.

On the one hand, the challenge for Socially Responsible Investing (SRI) is not only to evaluate the scale of operational environmental performance (e.g., energy efficiency of operations) but also the realistic assessment of environmental performance associated with the product locked into a firm’s reserves (e.g., oil for crude oil extraction firms). According to James Leaton from the Carbon Tracker Initiative (i.e., for details see Carbon Tracker at: http://www.carbontracker.org), “the imperative to tackle climate change will require an energy transition. It will require changes to our energy evaluation system and infrastructure” (Davidson 2015). Josh Ryan-Collins, from the New Economics Foundation, adds that climate change is important, because “Environmental, Social and Governance (ESG) are not always properly incorporated into the price setting mechanism” (Davidson 2015).

On the other hand, Socially Responsible Investing (SRI) and socially screened portfolios use diverse and inconsistent criteria to assess Corporate Social Responsibility (CSR) . The data used to assess a company’s Corporate Social Responsibility (CSR) or sustainability is limited. For example, the Global Reporting Initiative (GRI), the largest reporting guideline, contains voluntary data from only 1,295 firms (i.e., less than 2% of the world’s publicly traded firms) (Davidson 2016). In the area of carbon emissions, analysts rely on a firm self-reporting, which may or may not be accurate, and which rarely includes the carbon footprint of a firm’s products in the supply chain (Davidson 2016). As discussed previously, Jean Rogers, the Chief Executive and Founder of the nonprofit Sustainability Accounting Standards Board (SASB) is trying to develop uniform standards for about 80 industries across 10 sectors (Davidson 2015), in order to mitigate this lack of consistency, even if this may take a long time (i.e., for details see Investopedia at: http://www.investopedia.com/terms/s/sec.asp).

As such, there may be a role for Governments and regulatory bodies to enforce rules to establish detailed policy and regulatory frameworks domestically and correct this failure in using uniform sources of information (i.e., low information efficiency) (Davidson 2015).

Yes, Socially Responsible Investing (SRI) Does Make Sense

According to Alex Edmans, Professor of Finance, interviewed by the Wall Street Journal in 2016, Socially Responsible Investing (SRI) makes sense, because many traditional investors think that it does not, and as a consequence many investors undervalue Socially Responsible Investing (SRI) .

Traditional investors ignore companies’ Corporate Social Responsibility (CSR) or sustainability, because traditional investing focuses on: (i) tangible measures of a company’s value (e.g., profits and sales growth), and (ii) Socially Responsible Investing (SRI) is intangible or hard to value right now (i.e., low information efficiency). Traditional investors only catch on when Socially Responsible Investing (SRI) effects show up on the bottom line, and as such when it is too late to get a bargain (i.e., since the stock price has already risen) (Davidson 2016). If climate change is here to stay in the long run, this means that Socially Responsible Investing (SRI) investors get the bargain, as long as there is such information inefficiency.

Over the past two decades, numerous studies have attempted to establish a link between a publicly traded firm’s tendency to embrace sustainable business practices and their financial performance within a weaker market environment (i.e., low information efficiency) (Shank and Shockey 2016). First, returns for companies with high scores on the American Customer Satisfaction Index (ACSI) were double those of the Dow Jones Industrial Average (DJIA) from 1997 to 2003 (Davidson 2016). Second, companies with high eco-efficiency (i.e., that generate the least waste relative to the value of their products and services) outperformed companies with low eco-efficiency (Davidson 2016). Third, a look at specific market sectors provided further evidence of the financial value of Socially Responsible Investing (SRI). Ethical investors typically over-weighted health care (i.e., based on the social benefits of treating disease) and technology (i.e., e-commerce uses far fewer resources than physical stores). Both sectors have apparently far outperformed the Standard & Poor’s (S&P) 500 over the past 10 years, while the energy sector (i.e., dominated by production from nonrenewable sources) has been flat overall or fallen substantially. Please note that the Standard & Poor’s (S&P) 500 is an index of 500 stocks seen as a leading indicator of American equities and as a reflection of the performance of the large cap universe (i.e., for details see Investopedia at: http://www.investopedia.com/terms/s/sharperatio.asp).

As such, these findings may have some relevance for investors, fund managers, financial analysts, policymakers, and regulators (Shank and Shockey 2016). Indeed, these findings suggest that global warming has increased awareness of environmental concerns and begun to impact publicly traded firms’ practices, because it is having an impact on investment profits (Sadler 2017b).

Summary

As a summary, this section aimed at discussing responsible investing within a context of climate change (e.g., green finance). Indeed, for responsible investors, being responsible means changing their investment strategies to focus on environmental operations and capital investments in order to mitigate any adverse impact of publicly traded firms’ assets (e.g., unburnable carbon) on capital markets (e.g., bursting of the carbon bubble related to investors over-investing in fossil fuels publicly traded firms until their stock price falls).

Featured Case in Point

This section aims at discussing responsible investing as an incremental strategy that mitigates the adverse impact and likelihood for stranded assets (e.g.,unburnable carbon) and stock market collapse (e.g., bursting of the carbon bubble) related to the move to environmental economics .

In this section, incremental changes are explored through a case study, the case of crude oil extraction firms in Canada . In fact, it is believed that incremental changes towards a more sustainability oriented financial system mitigate the possible adverse impact of transition risks related to stranded assets and nonsustainable financial system for emission-intensive firms, like crude oil extraction firms in Canada.

Environmental Economics and the Case of Crude Oil Extraction Firms

Hawley (2015) describes fossil fuels, in general, as being on their way to becoming stranded (i.e., unburnable), but Hawley (2015) also adds that there seems to be a lag in response to the stranded asset analysis for some fossil fuels, in particular for oil extraction firms , and this despite the fact that the decreasing price of oil has had a negative impact on the price of stocks for oil extraction firms in general.

With the long-term inflation-adjusted price of oil decreasing around $40 a barrel in 2014–2016: (i) stock prices for oil extraction firms have fallen about 17% since mid-2014; and (ii) the S&P Energy Index has fallen about 32% during the same period (Olson 2016a, b, c). Decreasing oil prices led to significant capital expenditure reductions for oil extraction firms, with some companies moving to “cleaner” natural gas projects (Olson 2016a, b, c). However, according to Olson (2016a, b, c), from the Wall Street Journal, some oil extraction firms were recently under investigation, because of how they valued their oil wells (i.e., oil reserves). New York Attorney General and the Security Exchange Commission (SEC) reportedly questioned the price assumptions some oil extraction firms used to book their oil reserves (Olson 2016a, b, c). Such a scrutiny led to an additional fall in share prices for these oil extraction firms (Olson 2016a, b, c).

This example demonstrated a lag in response to the stranded asset analysis of fossil fuel, in particular for oil extraction firms (Hawley 2015). Therefore, it is believed that the case of Canadian crude oil extraction firms may shed an interesting light on the complexity of the drivers involved in environmental economics.

Environmental Economics and the Case of the Canadian Crude Oil Extraction Firms

Canada is the sixth largest crude oil producer in the world, with the third largest petroleum reserve (Canadian Geographic 2014). The production of crude oil in Canada contributed CA$18 billion in royalty and tax revenue in 2012 (Canadian Geographic 2014). Interestingly, 97% of Canada’s share of crude oil production is situated in Alberta, one Province of Canada (Canadian Geographic 2014).

Canadian crude oil extraction firms have received a lot of attention in the media lately. Peritz (2014) reports that the Hollywood star, Leonardo DiCaprio, travelled to Alberta. The purpose of Leonardo DiCaprio’s trip was to research for a documentary, called “Before the Flood.” The Canadian Press recounted that Leonardo DiCaprio’s new climate change documentary was against crude oil extraction firms in Alberta, since the actor held a high-profile environmentalist position (Peritz 2014). This event followed other celebrities’ apparent attacks against crude oil extraction firms in Alberta (e.g., musician Neil Young and film director James Cameron). In January 2017, Jane Fonda (2017) also talked about the “hard truths that brought her to Alberta” in an open letter to the Globe and Mail (i.e., for details see The Globe and Mail at: https://www.theglobeandmail.com). Jane Fonda made the following statement: “Even if we do everything needed to make a managed and compassionate transition to a low carbon economy, climate change that we have already caused will have a dramatic effect”.

In light of the media attention, the question of the complexity of the drivers of environmental economics may be explored through the case of crude oil extraction firms in Canada at two different levels: (i) the concept of stranded assets (i.e., unburnable carbon related to crude oil), and (ii) the concept of non sustainable financial systems (i.e., stock market collapse and bursting of the carbon bubble related to the Canadian crude oil extraction firms).

Stranded Assets and Bursting of the Carbon Bubble

The dominant crude oil asset held by some crude petroleum extraction companies in Canada is unconventional crude oil , which may be more emission-intensive to produce than other oil related assets (Charpentier et al. 2009; Heidari and Pearce 2016). On average, crude oil extraction companies in Canada (i.e., unconventional crude oil industry) are believed to be three times more Green House Gas (GHG) emission-intensive than the conventional oil industry (Charpentier et al. 2009). Indeed, the production of unconventional crude oil apparently results in emissions ranging from 99–176 compared to 27–58 kgCO2eq/bbl for conventional oil production (Charpentier et al. 2009). The difference in Green House Gas (GHG) emission intensity between unconventional and conventional oil production is apparently due to higher energy requirements for extracting bitumen and upgrading bitumen from the tar sands (Charpentier et al. 2009).

The emission-intensive nature of crude oil extraction companies in Canada may challenge the industry’s ability to export unconventional crude oil in the future. While the Keystone XL and additional pipeline capacity may represent the simplest path to get Canadian unconventional oil to market in the United States (USA), Canada is keen to move more of its resources to Asia (Johnson and Boersma 2015). If regulatory risks increase worldwide, the Green House Gas (GHG) regulatory framework may evolve to limit Green House Gas (GHG) to sustainable levels only. As a consequence, the reserve resources and energy security of Canada controlled by crude oil extraction companies may become stranded (i.e., unburnable), in which case these assets may no longer sustain the market price of the publicly traded firms that control them (i.e., stock prices of crude oil extraction companies may fall leading to the bursting of the carbon bubble ).

Lenient Versus Constrained Regulatory Framework

Under a lenient regulatory framework , crude oil extraction companies may have continued their planned production without being restricted by any national emissions target in Canada (Mc Diamid 2015). Indeed, G20 countries were spending $452 billion a year to financially subsidize their fossil fuel industries (Mc Diamid 2015). Crude oil extraction companies in Canada have long benefited from Government financial support to reduce political and financial risks (Mc Diamid 2015).

Under a constrained regulatory framework , however, financial subsidies to emission-intensive companies have been phased out, including financial subsidies that ended in January 2015 (Mc Diamid 2015). At the Federal level, the Government of Canada want to set-up a carbon tax of $50 a ton by 2022 (Bakx 2016b). At the Provincial level, the Provinces of British Columbia, Manitoba, Ontario, and Quebec have implemented policies intended to reduce Green House Gas (GHG) emissions (Bakx 2016b). Several Provinces have joined the Western Climate Initiative (WCI), a regional cap-and-trade system (Bakx 2016b). British Columbia has introduced a carbon tax. Manitoba and Ontario have implemented subsidies, grants, and loans for the adoption of management practices that reduce Green House Gas (GHG) emissions (Bakx 2016b). Quebec has adopted Green House Gas (GHG) emission standards for transportation (Bakx 2016b). The government of Alberta has also expressed its willingness to cap emissions for big crude oil extraction firms and to implement an economy-wide “price for carbon” policy in an effort to curb their emissions. According to Bakx (2016a), since 2007, Alberta had a type of carbon tax for its large emitters which charged $15 a ton of Green House Gas (GHG) emissions. In January 2016, the rate has increased to $20 a ton. Alberta is expected to charge $30 a ton by 2018. On November 2, 2016, a new legislation was announced to make Alberta the first major oil-production jurisdiction to implement a Green House Gas (GHG) emission limit (Giovannetti 2016). For large industrial players, Alberta designed its policy to: (i) reward the most efficient when it comes to Green House Gas (GHG) emission per barrel of crude oil; and (ii) penalize those who produce more pollution to produce the same amount of crude oil (Bakx 2016a). These financial incentives/penalties were the biggest change under the new royalty system to support emission-intensive companies that were more efficient in terms of their Green House Gas (GHG) emissions.

Incremental Mitigation of Stranded Assets and Bursting of the Carbon Bubble

On the one hand, in a Green House Gas (GHG) emission constrained regulatory environment, other countries may become increasingly cognizant of the Green House Gas (GHG) emission related to their energy imports, which may place crude oil extraction companies in Canada at a significant competitive disadvantage. Drinkwater (2016) reports that the Canadian Association of Oilwell Drilling Contractors was concerned that a carbon tax was going to move international capital away from Alberta (Bakx 2016a). First, restrictive legislations on Green House Gas (GHG) emissions may prevent crude oil extraction firms from converting their reserve into marketable products. Crude oil extraction firms in Canada may then hold “stranded assets”, which may have a negative impact on the valuation of crude oil extraction firms’ stocks. Second, restrictive legislations on Green House Gas (GHG) emissions may lead to the bursting of a carbon bubble, since high allocation rates of emission-intensive investments by Canadian institutional investors, such as the Canada Pension Plan (CPP), may massively expose Canadians to stranded fossil fuel assets, if restrictions in the Green House Gas (GHG) emission regulatory framework are to be imposed further.

On the other hand, in a Green House Gas (GHG) emission constrained regulatory environment, the Canadian oil patch may benefit from a competitive advantage (Bakx 2016c). Some industry associations reportedly endorsed the regulatory changes in Alberta (Bakx 2016b). Some companies even seemed so enthusiastic about the new policy that they applied for early access. For instance, one companie apparently spent $25 million to drill new wells in the Duvernay-Montney basin in Northeast Alberta (Bakx 2016b) and reportedly stated that this spending would not have happened without the royalty changes (Bakx 2016b). Another example was another companie Quest project, a joint venture with the Government of Alberta (Bakx 2016b). The companie apparently did not make money from Quest, but the project reportedly reduced how much the company had to pay in carbon pricing and reportedly allowed for investments in Alberta to compete with those in the United States (USA) according to the COO at the time (Bakx 2016b).

As such, each driver or combination of drivers may or may not have a material impact on business operations for crude oil extraction firms in Canada depending on the way financial support is being used (i.e., financial subsidy to reduce emissions as opposed to financial subsidy to increase production). As well, more restrictive legislations on Green House Gas (GHG) emissions may or may not lead to the bursting of a carbon bubble.

In fact, it is believed that incremental changes towards a more sustainability oriented financial system mitigate the possible adverse impact of transition risks related to stranded assets and nonsustainable financial systems for emission-intensive firms in Canada.

Summary

As a summary, the case of the Canadian crude oil extraction firms demonstrated the complexity of the drivers for stranded assets and bursting of the carbon bubble within an environmentally oriented economy. These drivers seem to interact in highly complex ways with a long list of policy, legal, political, technological, reputational, and economic drivers that help the mitigation of transition risks, in terms of stranded assets and bursting of the carbon bubble.

Reflection Questions

This chapter aims at discussing responsible investing and environmental economics within the context of climate change at a more theoretical level. Indeed, in the previous sections, it was observed that publicly traded firms were applying sustainability oriented strategies in their operations and capital spending, because investors were interested in responsible investing to move towards environmental economics.

Theory on Investing and Economics

Broadly speaking, investing is related to economics through the “increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2005, p. 3). For example, since the 2008 subprime mortgage financial crisis, academics have been increasingly interested in the link existing between investing and economics (Davis 2009; Lounsbury and Hirsch 2010; Marti and Scherer 2016), since questionable investing practices (i.e., derivatives of subprime mortgages) have been shown to damage the economy (i.e., 2008 financial crisis).

The Efficient Market Hypothesis (EMH) is a finance theory developed in the 1960s by Eugene Fama (i.e., for details see Investopedia at: http://www.investopedia.com/university/concepts/concepts6.asp). The Efficient Market Hypothesis (EMH) states that it is impossible to beat capital markets (e.g., S&P500, NSDAQ, TSX200, etc.) in terms of investment returns, because stocks of publicly traded firms already reflect all relevant information within capital markets (e.g., financial statements, quarterly financial reports, etc.).

On the one hand, supporters of this model believe that it is useless to search for undervalued stocks of publicly traded firms (i.e., for details see Investopedia at: http://www.investopedia.com/university/concepts/concepts6.asp). Indeed, if markets are efficient , prices already reflect all available information, and an investor cannot buy a stock at a bargain price (i.e., high information efficiency and passive investing as the best option).

On the other hand, fundamental and technical analysts believe that it is not useless to search for undervalued stocks of publicly traded firms, as markets are not always perfectly efficient , and prices do not always perfectly reflect all available information (i.e., for details see Investopedia at: http://www.investopedia.com/university/concepts/concepts6.asp). As such, an investor can buy a stock at a bargain price under certain conditions (e.g., low information efficiency and active investing as the best option).

Theory on Responsible Investing and Environmental Economics

In relation to responsible investing , the Efficient Market Hypothesis (EMH) supports the theoretical argument that a publicly traded firm’s value increases when it incorporates environmental business strategies into its operations and capital expenditure (Shank and Shockey 2016). This is based on the connection existing between the implementation of such sustainable business strategies, and the stabilization of future cash flows (e.g., no bursting of the carbon bubble) as well as the reduction of corporate risk exposure (e.g., no assets stranded because of climate change-related regulations) (Shank and Shockey 2016) as seen in the case of Canadian crude oil extraction firms.

The theoretical question that responsible investors may consider, however, is whether or not environmental information is already reflected in capital markets and in publicly traded firms’ stock prices (Shank and Shockey 2016). If not, responsible investors should identify those publicly traded firms whose equity values and stock prices do not fully reflect their sustainable efforts yet in order to get the bargain (Shank and Shockey 2016).

Green House Gas (GHG) Emissions and Environmental Reporting

Responsible investing is related to environmental economics with the question of Green House Gas (GHG) emission reporting and its impact on capital markets. Indeed, research shows that the stock price and equity value of companies reflect Green House Gas (GHG) emission information.

First, academic research shows that capital markets are taking the cost of Green House Gas (GHG) emission into consideration when valuing companies. Whether using accounting-based measures (Ameer and Othman 2012; Lopez et al. 2007) or market-based measures (Hill et al. 2007; Shank et al. 2005), some studies found that financial value was created when publicly traded firms were recognized as being more sustainability focused than their peers (Shank and Shockey 2016). Academic research also showed the impact of Green House Gas (GHG) emission on equity value, with the cost of Green House Gas (GHG) emission on equity value going from AU$17 to AU$26 in Australia (Chapple et al. 2013), and being €75 in Europe (Clarkson et al. 2008). The cost of Green House Gas (GHG) emission on equity value went from US$204 to US$348 for American companies from 2006 to 2008 (Matsumura et al. 2014). Using a model of prediction of GHG emission when not disclosed by emission-intensive firms, Griffin et al. (2012) even found that nondiscloser and discloser firms were affected to the same extent by their levels of Green House Gas (GHG) emission. This phenomenon was explained by the fact that Green House Gas (GHG) emission is value relevant independently of the level of disclosure by emission intensive firms, since investors and capital markets use multiple channels of information to be efficient (Griffin et al. 2012).

Second, academic research shows that capital markets are taking the impact of present and/or future regulations in terms of Green House Gas (GHG) emission (e.g., carbon taxes and cap-and-trade programs) into consideration when valuing companies. Indeed, Europe has pioneered the development of carbon dioxide emissions trading programs, known as Emissions Trading Schemes (ETS) (Considine and Larson 2009). Research shows that Emissions Trading Schemes (ETS) are value relevant for companies in Europe (Clarkson et al. 2008). Research also shows that the “future carbon permit price” can be estimated with the cost of Green House Gas (GHG) emission on equity value going from AU$17 per ton to AU$26 per ton of carbon dioxide emitted in Australia (Chapple et al. 2013). Griffin (2013) shows that the average S&P500 company’s balance sheet and net income are to be adversely affected under several different accounting treatments for emission allowances, with the greatest impact being for emission intensive companies.

Corporate Social Responsibility (CSR) and Environmental Reporting

Responsible investing is related to environmental economics with the question of how the “good organization” may be recognizable through Corporate Social Responsibility (CSR) . Some suggests that a distinct contribution to our understanding of this link can be made by: (i) analyzing the rise of corporate governance for “good organizations,” and (ii) exploring how different types of shareholders/stakeholders influence corporations to be “good organizations” (Jackson 2000).

First, corporate governance follows an agency model , where “principals” (i.e., shareholders/stakeholders) are opposed to “agents” (i.e., executive managers) in the sense that agents may not communicate all information to the principals (i.e., which results in information asymmetry and moral hazard from executive managers inside the corporation who may be hiding information from shareholders/stakeholders outside the organization) (Jackson 2000). In the context of environmental economics, information asymmetry and moral hazard may be referred to as “greenwashing” (i.e., when a “green organization” spends more time and money claiming to be “green” through advertising and marketing than actually implementing business practices that minimize its environmental impact).

Second, over the past decades, a theory and practice of corporate governance came to prominence in which shareholders played a key role against information asymmetry and moral hazard (Davis 2009). The belief was that shareholders were the legitimate beneficiaries of corporations as their focus was on ensuring the flow of reliable information (i.e., no information asymmetry) and accountability of executive managers (i.e., no moral hazard) (Veldman and Willmott 2016). In this context, corporate governance through Corporate Boards (i.e., that represent shareholders) was believed to promote the flow of reliable information and accountability in different ways: (i) from direct engagement for information exchange with Board Members (McNulty and Nordberg 2015) to (ii) arms’ length evaluations and responses to executive managers’ strategies (Aglietta and Rebérioux 2005). In the context of environmental economics, however, corporate governance may not be as useful if Corporate Social Responsibility (CSR) is hard to contrast from “greenwashing” , because Corporate Social Responsibility (CSR) is not well-defined to begin with.

Theory on Responsible Investing and Passive Versus Active Investing Strategies

In relation to responsible investing, the Efficient Market Hypothesis (EMH) supports the theoretical argument that a publicly traded firm’s value increases when it incorporates environmental business strategies into its operations and capital expenditure (Shank and Shockey 2016). As a consequence, in an efficient market, a passive investment approach of responsible investing and environmental economics seems to be the best option (Shank and Shockey 2016). As a consequence, in a nonefficient market, an active investment approach of responsible investing and environmental economics seems to be the best option (Shank and Shockey 2016).

Passive Strategy and Efficient Environmental Reporting

In an efficient market, a passive investment approach of responsible investing and environmental economics seems to be the best option, as no bargains can be available (North and Stevens 2015). As such, publicly traded firms identified as leaders by the Dow Jones Sustainability Indices (DJSI) may not outperform a portfolio of firms as a whole (e.g., all firms comprised in the Dow Jones Sustainability Indices), because environmental information for sustainable publicly traded firms is efficiently priced by capital markets (Shank and Shockey 2016).

Passive investment strategies are thus appropriate for capital markets where there is high level of information efficiency (Shank and Shockey 2016). Newer measures of sustainability, such as the Dow Jones Sustainability Indices (DJSI) (i.e., which utilize a number of nonfinancial performance data simultaneously) increase the information efficiency for sustainable publicly traded firms. Supporting this argument, academic research has compared the financial performance of firms in one of the major sustainability indices to benchmarks of broader markets (Shank and Shockey 2016). Consolandi et al. (2009) found that the Dow Jones Sustainability Indices (DJSI), for sustainable European firms, slightly underperformed market benchmarks from 2001 to 2006. Xiao et al. (2013) investigated the role of corporate sustainability (i.e., using the Dow Jones Sustainability Indices) in asset pricing from 2001 to 2007 and found no significant impact of sustainability on equity returns.

Active Strategy and Inefficient Environmental Reporting

In a nonefficient market, however, an active investment approach of responsible investing and environmental economics seems to be the best option, as bargains can be available (North and Stevens 2015). As such, in limited situations (e.g., capital markets with low information efficiency for sustainability), firms identified as leaders by the Dow Jones Sustainability Indices (DJSI) may outperform a portfolio of sustainable firms as a whole (i.e., all firms comprising the Dow Jones Sustainability Indices), because information for sustainable firms stocks is not efficiently priced by capital markets (Shank and Shockey 2016).

Active investment strategies are thus appropriate for capital markets where there is low information efficiency (Shank and Shockey 2016). Orlitzky (2003) conducted a meta-analysis that examined 52 prior studies dating back to 1975 (i.e., lower level of information efficiency in the past) and found that accounting-based measures of financial performance better reflected Corporate Social Responsibility (CSR) efforts compared to market-based measures (Shank and Shockey 2016). Rodgers et al. (2013) found that a firm’s Corporate Social Responsibility (CSR) commitment led to better financial performance on both accounting-based and market-based financial metrics in capital markets with low information efficiency (Shank and Shockey 2016). Support of the link between more sustainable firms and lower corporate risk was found in Lee (2009) and Ghoula (2011) in capital markets with low information efficiency (Shank and Shockey 2016).

As such, depending on the information efficiency level, responsible investing and environmental economics may or may not be aligned with the Efficient Market Hypothesis (EMH). This is based on the connection existing between the implementation of such sustainable business strategies, and the stabilization of future cash flows (e.g., no bursting of the carbon bubble) as well as the reduction of corporate risk exposure (e.g., no assets stranded because of climate change-related regulations).

Exercises in Practice

The World’s Most Sustainable Companies

Pre-Class Preparation

The professor goes to the lists of all the best performing companies according to “Sustainalytics” (http://www.sustainalytics.com/sustainability-research-rankings/) for three categories of corporations:

In-Class Games

Game 1: Hang Man (or Growing Flower)

Hangman (i.e., the hangman may be replaced by a drawing of a growing flower if considered more appropriate) involves the students having to guess a particular corporation’s name with a high “Know the Chain” ranking according to “Sustainalytics”.
  • The professor or a student thinks of one company with a high ranking according to “Sustainalytics,”, and draws a line of blank boxes on the board which indicates how many letters the name has.

  • Students then ask for clues to the company and then add letters. For every letter students get wrong, a body part of the hangman (i.e., or a part of the flower) is drawn on the board. Once the picture is complete, the man is “hanged” (i.e., or the flower is “grown”) and students lose. If they win, however, the entire word is spelled out on the board. In both cases, the details of the company are explored in class via the company website and/or in-class discussions about the company.

This is a fun way of promoting a better knowledge of companies with high “Know the Chain” rankings and getting the class involved.

Game 2: Five Questions

This game may get a few laughs from the students while increasing their understanding of “Know the Chain” rankings according to “Sustainalytics”.
  • Have a student sit in front of the board, facing the class, and write the name of a corporation with a high “Know the Chain” ranking above his/her head (i.e., without him/her being able to read the name; but with the class being able to read the name).

  • The student then has to ask the class up to five questions about the corporation until he/she finds out which corporation it is.

Game 3: Class Survey

A nice way of helping students break the ice in their first class may be using the below ice-breaker.
  • Get students to survey each other on a wide range of topics related to “Responsible Investing and Environmental Economics”.

  • You may use the “Chapter End Questions” as a guide and divide the class into groups of two or three students discussing each question separately.

  • Then, each group may disclose their answers to the “Chapter End Questions” in front of the whole class.

  • Students may get bonus marks related to their performance on this task.

Engaged Sustainability Lessons

This chapter aimed at discussing responsible investing and environmental economics within the context of climate change.

In November 2015, in Paris, Governments have shown their interest in stimulating change and the transition to a low-carbon economy through global regulations (i.e., for details see the United Nations Framework on Climate Change at: http://unfccc.int/paris_agreement/items/9485.php). In the context of such a transition, nonresponsible investors may face financial risks for their investments in terms of stranded assets and bursting of the carbon bubble. As such, there may be a strong relationship between responsible investing and environmental economics .

Regarding responsible investing , it was observed that economic performance of publicly traded firms which are applying the concept of sustainability in their operations and capital spending is improved, because investors are more and more interested in responsible investing.

Regarding environmental economics , such changes towards more sustainability mitigate the risk for unburnable carbon and the bursting of the carbon bubble on capital markets as demonstrated with the example of some Canadian crude oil extraction firms.

Through information asymmetry and/or moral hazard , however, some concerns arise that material amounts of publicly traded firms’ actual environmental performance may be hidden from financial statements and annual reports (e.g., greenwashing).

As a consequence, the challenge for responsible investors is not only: (i) to evaluate the scale of actual environmental operational and capital investments (e.g., information efficiency) but also (ii) to evaluate publicly traded firms’ environmental performance associated with the asset that may be locked into their reserves.

Chapter-End Reflection Questions

This chapter aims at discussing responsible investing and environmental economics within the context of climate change.

Questions to use with students may cover (i.e., but are not limited to) the following items:

Responsible Investing
  • What is the impact of current responsible investing practices on climate change mitigation?

  • What is the impact of responsible investing on fostering energy transition?

  • What is the ethical versus financial relevance of responsible investing?

  • What are emerging practices in green finance?

  • Which socially responsible investment strategy has the greatest potential to bring out the “good organization”?

Environmental Economics
  • Which are the key stakeholders for fostering environmental economics?

  • What are the main drivers for environmental economics? e.g., regulatory pressure, stranded asset and carbon bubble risks, new social movements…

  • What are the barriers for environmental economics?

  • How can corporate governance be developed to enable the “good organization”?

  • What are the societal implications of different discourses on corporate governance?

Cross-References

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Copyright information

© Springer International Publishing AG 2018

Authors and Affiliations

  1. 1.Ron Joyce Center for Business StudiesMount Allison UniversitySackvilleCanada

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