What has happened to the UK? Inflation is at a 40-year high. Energy prices have been essentially nationalised, even as there are talks of winter blackouts and general strikes. Both Gilts and Sterling are busy vomiting up two decades worth of their low-volatility diet, whilst 3,000 new households a dayreceive a mortgage renewal letter that could bankrupt them. And there is no solace from those in charge – Numbers 10 and 11 Downing Street seem to have transformed from the home of government into a short-term holiday let.

We are in the midst of a crisis. Or, In the wonderful world-salad declared by a motion of Milton Keynes City Council, a ‘cost-of-living crisis emergency.’

Everything has certainly become a lot more expensive this year, perhaps ruinously so. My heart goes out to everyone effected, especially those on low incomes (who also bear the least responsibility for this mess). So yes, this is a crisis – but one that shouldn’t have come as a surprise. And more importantly, it’s not one that will just blow over. We need to change our ways to adjust to these new realities – or face a very long emergency indeed.

Understanding a financial heart attack

Picture the UK as someone having a heart attack. They would of course, be rushed to A&E – but their condition is, in truth, no accident at all. A heart attack is rarely an anomalous interruption to a healthy system, but instead a predictable culmination of long-term damage. Years of stress, pollution, poor diet, trauma and inactivity can all be ignored for a time – but not forever. At that point, it might be too late; and for those lucky enough to survive, a radical change in lifestyle beckons.

So it is with the UK today. The risks have long been plain, the warnings ignored. Fifteen years of central bank largesse has left the country addicted to debt and mired in capital misallocation. Decades of wage stagnation mean that the majority of people in poverty are also in work. Worsening energy import dependency – over 60% of gas in 2021 – has left us increasingly reliant on the worst of the world’s autocrats; meanwhile, successive UK governments have cut domestic clean energy programmes (see: any government policy with Green in the name). Even COVID – that great ‘surprise’ – came on the heels of years of warnings, as we loaded the diceof genetic mutation through our destruction of the natural world.

This is the hard truth: these costs – which seem to have appeared from nowhere – have been around for a long time. They just weren’t priced in. This crisis should be seen as a moment of revelation -and an opportunity to change.

Which leads us, neatly enough, to climate.

The impact of accounting for costs

These reflections on the state of the UK today were prompted by my discussion with Ioannis Ioannou for our latest episode of Conversations on Climate. We weren’t talking specifically about inflation, or energy, or contemporary politics at all. Instead, I was interested in where he stood on the old profit vs. purpose debate. Do businesses face a conflict between sustainability and financial returns?

His answer was an unequivocal no. ‘That so-called trade-off is fictious,’ he said, if we take an honest look at the real costs of business activity. ‘If you have profits today that you materialize because you have children [or] modern slavery in your supply chain, if you materialise profits because you were part of deforestation efforts, then you’re not entitled to those profits,’ he insisted. ESG is only bad for the bottom line if we ignore the externalities of modern businesses –climate change being the greatest of all. The strains in the world economy today are, in part, because those externalities are becoming harder to ignore. As Professor Ioannou so succinctly put it, we are facing ‘a global cost correction…[and] it’s time to pay the bill.’

For anyone who thinks this is all a bit wishy-washy, Ioannou pointed to the Impact-Weighted Accounts Initiative, an incredible research project out of Harvard Business School that seeks to quantify these costs on a sector-by-sector basis. It makes for bracing reading. Put simply, full-cost accounting reveals that a huge number of seemingly profitable firms are both socially illegitimate and financially loss-making – profoundly so. Oil and Gas companies have an average impact-scaled EBITDA of -329%, once we begin to price in the cost of their emissions. But they are not alone. The consumer-packaged foods sector has an overall impact-adjusted EBITDA of -103%, largely due to the disease burden of toxic processed foods. One of the two modelled online media firms, with revenues of $3bn, carried $5.6bn in hidden costs once fake news, privacy concerns, addiction, and depression were factored in. Scholars are putting meat onto the bones of something that environmentalists have understood for a long time: if we properly account for externalities, no major global industry is actually profitable.

The power of shadow pricing

In the face of this coming cost correction – and if we accept that it won’t magically disappear just because we keep our eyes shut – what can responsible leaders do? One tool Professor Ioannou pointed to, on the subject of climate change, was internal (or shadow) carbon prices – when firms voluntarily adopt a dollar-value per unit of carbon they emit, across their accounting processes. With this cost embedded in financial models, they are able to future-proof investment and operations decisions to ensure they will remain profitable into a decarbonised (and carbon taxed) future.

Internal carbon prices (ICPs) are already more widespread than you might think. According to a McKinsey review from last year, 23% of their dataset of multinationals already use an ICP – from Microsoft to Mitsubishi – whilst another 22% intend to introduce one in the next two years.

That is great news, and should be celebrated by environmentalists and investors alike. But if we dig into the data, there is still a lot of work to do. Firstly, ICPs are very unevenly distributed – and some sectors really need to play catch-up. Unsurprisingly, energy (40% of the sector) and materials (30%) firms are the most likely to use an ICP, but they are almost unknown in healthcare (1%) and real estate (4%).

Secondly, the average internal price used by these firms is far too low when measured against Paris Agreement targets. It is great news that 29% of financial services firms have an ICP; but at a median price of just $6, we might wonder if this is more talk than walk. With the EU ETS currently pricing carbon at around ten times that amount – likely rising to 140 Euros/tonto meet 2030 targets – these firms are deluding themselves if they believe they are insulated from future carbon taxation. Shadow pricing has to be meaningful, or it means nothing.

That said, there are leaders we can all look to. Danone, for example, has not only an ICP, but also published the world’s first carbon-adjusted earnings per share(CAEPS). This takes the theoretical cost-per-share of Danone’s carbon footprint, and subtracts it from earnings. The value here is tracking change over time – and Danone believe that CAEPS will grow faster than EPS, demonstrating that sustainability, efficiency and future-proofing financial returns can go hand-in-hand.

Sadly, this kind of bold leadership proved too much for Danone’s shareholders, and “One Planet, One Health” CEO Emmanuel Faber was eased out at the end of 2021, reportedly because of anxieties that his sustainability focus threatened financial returns. Which brings us back to my original question to Professor Ioannou – is there a trade-off here? Or, to borrow from the Silicon Valley axiom: is being too early (on carbon pricing) the same as being wrong?

A head start is waiting – so take it

‘The best companies realise that the sooner I invest in eliminating inefficiency and negative impacts, the better it will be when someone knocks on my door to pay the bill – maybe through a carbon tax, for instance,’ Ioannou insisted. ‘Forward-looking companies see that If they are already bringing you the bill, is too late.’

I agree completely. Where would the UK be today if we had put a shadow price on imported energy ten years ago? What if we had internalised the long-run costs of stagnant wages – which the Impact-Weighted Accounts project measure as firms engaging in leveraged borrowing from society? How wise does the Bank of England’s decision to scrap mortgage ‘stress tests’ look now, as rates rocket? Perhaps more importantly, where will be in 2030, or 2040, if we don’t start internalising some of these other off-book costs, today?

The trouble with talking about a crisis is that our ever-accelerating media cycles have trained us to believe that crises have a shelf-life; eventually, they will die of old age or inattention, if nothing else. The reality, from carbon onwards, is that this ‘global cost correction’ is just getting started, and it’s not going away. Only genuine behaviour change – across every layer of society – will bring resolution. So, get busy pricing in these unseen realities now – or face the prospect of the world realising you were running a bankrupt business all along.