Controlling externalities: ownership structure and cross-firm externalities

The increasingly influential 'universal owner' theory posits that index funds have incentives to reduce cross-firm externalities to maximise portfolio value. We develop a more general conceptual framework for understanding how firms' ownership structures and company law affect the internalisation of cross-firm externalities. This approach takes account of the fact that across the world most firms have controlling shareholders. We introduce the concept of 'controller wealth concentration' as a determinant of controllers' pecuniary incentives to internalise externalities. Our framework suggests that, in principle, dual class (and other controlling minority) structures have the hitherto ignored advantage of allowing controllers to diversify their personal wealth (thereby potentially mitigating cross-firm externalities). We provide some evidence that controllers' personal wealth is nonetheless typically undiversified and discuss possible reasons why controllers fail to diversify. We conclude that controlling shareholders typically have weak pecuniary incentives to internalise externalities, underscoring the importance of government regulation of externalities.