Environmental accounting changes economic reality

published: talkinbusiness.net | May 13, 2013

What are the risks and costs posed by environmental degradation on the economy and society? In this new blog post, Tobias Stöcker calls for a general adjustment of economic theories for external costs of natural and social capital.

The Economics of Ecosystems and Biodiversity” report, also known as TEEB, was the first large scale research that attempted to monetize the environmental and social costs of economic activities that are unaccounted for.

These costs are known as external costs (or externalities) and are imposed on parties that are not involved in the economic transaction that caused the costs. Well known examples of externalities include the effects of acid rain or nuclear waste storage, but also lesser known costs such as the displacement of people due to ecological degradation of their habitat.

The first set of results that were presented in 2008 already showed that business as usual would lead to annual external costs at least as big as the total cost of the 2008 financial crash. They also showed that ecological conservation measures such as the declaration of non-fishing zones are (maybe the most) cost effective ways to increase economic output. The first TEEB report marked the beginning of the understanding of the true risks and costs posed by environmental degradation on the economy and society.

The impact of external costs

In April 2013 the TEEB for Business Coalition published a new report listing the top 100 external costs and their magnitudes. It also identified the sectors with the highest externalities per region.

The report limited itself to primary production and processing sectors, leaving out downstream and product-use impacts. This means that the actual figures are  even higher than the investigation shows. It should come as a shock to realize that many sectors cause higher external costs than that they make profits.

In other words, if those costs were internalized, the companies would be bancrupt within years. This should shed new light on coal power generation in Asia and North America or cattle farming in South America, two of the top five sectors with the highest impact on natural capital.

The TEEB study showed that the costs of natural capital losses need to be estimated at USD 7.3 trillion annually, roughly 13 per cent of the global economic output in 2009. One could say that this would be the first ever estimation of the price to resolve the tragedy of the commons.

A conclusion that can be drawn from this new TEEB study is the need to incorporate its findings into existing economic models and theories in order to provide decision makers with the total picture.

The Smart Zone revisited

As an example, let us consider the 2004 model of Ulrich Steger (IMD) defining a ‘Smart Zone’ that tries to define the business case for sustainability investments by companies. (see figure “The Smart Zone 1.0″)

The Smart Zone 1.0

This model still forms the basis of influential reports such as the “SAI Guide to sustainable sourcing of agricultural raw materials” (2013) or a FAO report on cotton production in West Africa (2006), but it needs revision in the light of the TEEB findings.

As a result of new insights into external costs, the main shortfall of the Smart Zone as designed in 2004 lies in the fact that it only considers the individual economic performance of a single company. In order to be more realistic, the model also needs to include the collective economic performance, being either positive or negative. Important to note is that economic performance in this context also includes externalities, i.e. the economic valuation of degradation or creation of natural and social capital.

This adjustment would do justice to the fact that perfectly compliant companies nowadays still have negative impacts on environmental and social systems. They are still decreasing global natural capital, and with it the capacity for future value creation, including their own capacity to create economic value in the long run.

Therefore, the model should put a new threshold at the point where externalities are neutral. That marks the point where individual economic value creation is at least as big as the collective economic equivalent of environmental and social value degradation. Preferably, this point would mean that the economic activities of an individual company have zero negative impact on environmental and social systems.

The vertical axis of the ‘Smart Zone 2.0′ is enlarged with the negative dimension of this axis, defining the collective perspective on economic performance as opposed to the limited, individual perspective.

The Smart Zone 2.0

The second change is to accompany the conventional compliance level with a level where externalities are neutral. (This would in fact be the compliance level in a sustainable society.)

Changing the model in this way results in two negative zones at either end of the horizontal axis (Individual Economic and Social Performance = ESP), meaning that the performance of the individual company results in a net negative (collective) economic impact.

The Smart Zone keeps its meaning, but it is probably smaller. Furthermore, companies that believe to be in the Smart Zone under the 1.0 regime, might find themselves still in the Negative Zone under this new version. This is due to the fact that current levels of compliance still allow companies to have negative impacts on natural capital that are larger than their economic profits.

Lastly, what I call the “Beneficial Zone” represents investments in ESP by individual companies that decrease their own economic performance, but still yield a positive collective performance. This is beneficial to society, but does not improve the economic performance of the individual company.

This might be a typical zone in which companies invest in ESP because they think it is “the right thing to do” but does not directly show on the bottom line. Nonetheless, these activities can add non-economic value.

This first revision could serve as an example to a general revision of economic theories, which need to be adjusted for external costs of natural and social capital.

This might bring an end to the side effect of many current models and theories, that now appear to sanction activities of individual companies that result in net-losses for humanity and are in essence self-destructive.

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