Pavan Sukhdev describes how important sustainability in the sector economy is and how sustainability can be achieved. In particular, he explores on the term natural capital.
The term “capital” is an economic metaphor for “a thing of value”. It implies the existence of stocks of assets which have value and will, if used appropriately, generate or secure flows of benefits, such as income. The most popular economic definition of “income” was by Hicks (1946), who equated an individual’s ‘income’ in any given period to the amount of expenditure in that period which still left the individual’s capitalintact. A sense of ‘sustainability’ is captured here, as only sustainablespending (i.e. spending which leaves capital intact) is a measure of income.
Unfortunately, we live in a world in which many forms of capital face risks of depletion. Natural capitalis at risk from numerous directions as ‘Planetary Boundaries’ are rapidly approached and even breached, social capitalis being battered by increasing intolerance and polarization abetted by irresponsible politics, and human health, the mainstay of human capital, is increasingly damaged by pollution and indeed by our diets, which, delivered through an unsustainable food system, have become the main risk factor driving the global burden of disease.
We are also aware that these impacts on all these forms of capital are being driven by the economy’s main agent – the private sector – which accounts for two-thirds of global output and jobs. Despite that, today’s corporation is required by statute to quantify and report onlyits impacts on shareholder financial capital, and not its impacts or dependencies on any other forms of capital (human, natural, etc) belonging to various sections of society including
importantstakeholderssuch as employees, customers, suppliers, regulators, governments, citizens, the youth, etc. This makes very little sense from any perspective, be it that of transparency, or justice, or sustainability. We cannot manage what we do not measure, and without measuring sustainable corporate performance – i.e. performance that integrates natural, human and social capital externalities – how are we to succeed in achieving private sector sustainability? And if corporations are not sustainable, then how can the economy, of which they are the dominant part, ever become sustainable?
“Integrated Profit and Loss Reporting” or <IP&L> evolved as a corporate initiative in sustainability leadership, in response to the publication of the <IR> or Integrated Reporting Framework of the IIRC and the need to devise and use a wider-lens, ‘stakeholder’ view of corporate performance. This approach has been used (and in some instances, published) by many sustainability leaders around the world, such as Akzonobel (a European chemicals giant, in 2014), Amata (a forestry company in Brazil, in 2015), Yarra Valley Water (Melbourne’s water utility, in 2016), Sveaskog (Sweden’s largest forestry company, in 2018) and others. It is an approach and framework which draws from the Integrated Reporting Framework(“<IR>”, 2013) of the International Integrated Reporting Council (“IIRC”) and incorporates lessons for discovering & measuring natural capitalimpacts and dependencies from the Natural Capital Protocol (2016),a universal process guideline and framework prepared by the “Natural Capital Coalition” (‘Coalition’). The Natural Capital Coalition has grown from its origins as the “TEEB for Business Coalition” (2012) into a wide-ranging community of practice which targets a deeper understanding of corporate impacts and dependencies on natural capital. The consensus built by the Coalition has helped to support, replicate, and scale ‘best-of-breed’ work done by corporate leaders in sustainable business practice.
The four dimensions of the wealth (‘capital’) of third-parties (who could be individuals, or communities, or the public at large) most impacted by businesses are summarized in the table (below), with a few examples given of each asset class and type of ownership.
Table :Capital Classes & Ownership Categories: Examples from a Business Context
The above framework at the micro-economic level uses only four forms of capital. This is consistent with mainstream literature in environmental economics as well as the ‘inclusive wealth’ approach adopted by United Nations University and UN Environment in their Inclusive Wealth Report, which presents such capital analysis at a macro-economic level. In that report’s foreword, Prof. Partha Dasgupta explains the four forms of capital thus;
“Inclusive wealth is the social value of an economy’s capital assets. The assets comprise (i) manufactured capital (roads, buildings, machines, and equipment), (ii)human capital (skills, education, health), and (iii) natural capital(sub-soil resources, ecosystems, the atmosphere).
Such other durable assets as knowledge, institutions, culture, religion – more broadly, social capital – were taken to be enabling assets; that is, assets that enable the production and allocation of assets in categories (i)-(iii). The effectiveness of enabling assets in a country gets reflected in the shadow prices of assets in categories (i)-(iii)”
Is “Intellectual Capital” a Separate Class of Capital?
Some literature (incuding the <IR> guidelines of IIRC) also recognizes a fifth class of capital, viz, “Intellectual Capital”. However, we live in an age dominated by technology and information, therefore intellectual capitalis ubiquitous, and in fact is usually found embeddedin other forms of capital. It could either be embedded in privately owned produced capital (eg:in the form of Intellectual Property (“IP”) such as patents, copyrights, trademarks, brands, etc, and incorporated into numerous consumer goods) or community owned human capital(eg: traditional knowledge of tribal communities about their local herbal remedies) or human capital in the public domain (eg: wikipedia, non-copyrighted knowledge and technology). In all these cases, it is found that ‘intellectual capital’ is in fact embedded into assets which are part of one of the four classes of capital (usually producedor human capital) held in some category of ownership (private, community, public) and thus it is not necessary to create a separate “capital class” to capture “intellectual capital”.
The usual rationale presented for separating out “intellectual capital” as a separate class is that companies market values far exceed their book values, and that the difference is because of “intangible assets”. This logic is erroneous, for a couple of reasons. Firstly, with the advent of technology companies, several large ‘tech stocks’ trade at very high multiples of earnings (eg: Google, Facebook, etc), but this represents the expected present value of market estimates of their growth in earnings thanks to their intellectual property, business strategies, etc. Secondly, some of the book value of patents and licences that are considered “intangible assets” is lower than their market value simply because of conservative or missing IP valuations in the books of accounts.
What do Ownership Categories tell us about the Ethics of Offsets?
In the table above, community-owned wealth is referred to as “club goods“, and it should be noted that the “communities” we refer to may be as varied as tribal villages, city precincts, or country golf clubs: the key point here is that they exercise sharedownership rights and the ability to exclude others from accessing or benefiting from their club goods. This is not the case for public goods, which by definition are non-excludable and non-rival, in other words, no one can be prevented from using them and use by one party does not prevent use by another. Whilst capital classes are widely considered by corporate managers when evaluating externalities and designing mitigation strategies, more attention needs to be paid to ownership categories.
When evaluating impacts and considering offset strategies, companies would be well advised to ask “whose capital is it anyway?”. Merely attempting to create (for example) natural capital value for one group of stakeholders (eg: general public in the prosperous north) when the actual corporate externality affects quite a different group of stakeholders (eg: access to unpolluted natural resources for a poor rural community in the south) could be at best contentious as an ‘offset’ strategy, and at worst morally offensive. Thus, a Canadian mining company afforesting empty land near its head office in Toronto would not have an ethical case for calling that a “natural capital offset” for its pollution damage to river waters and soils caused by its mining operations in distant Ecuador, because the costsare being inflicted on the health and incomes of poor village communities in Ecuador, whereas the benefitsare accruing to the prosperous citizens of Toronto in terms of a better quality of urban life.
To avoid ethical pitfalls and reputational risks from formulating offset strategies that are either ethically or scientifically questionable, careful consideration needs to be paid to boththe capital class andthe ownership category of affected third-parties
- Proposed Capital-Based Valuation Framework for Business Externalities
Business externalities can result in positive or negative impacts on third-parties. These impacts can be observed as third-party changes in one of four categories ofcapital(natural, physical, human, social) belonging to one of three classes ofownership(i.e. private ownership– such as job skills and health; community ownership– such as village schools, community groves, neighborhood security systems, etc; or public ownership– such as climate stability, national parks, law & order, etc.). Materiality (i.e. economic or social size and significance) is the main reason for including a particular impact, but materiality of particular drivers and impacts differs significantly from sector to sector.
- What to Value: Valuation of externalities is about measuring the economic value of changes in any of the four kinds of capital belonging to anyof the three categories of third-parties as a result of the activities of a business. Valuation must focus on material externalities, determined as material in social and economic terms for the owners of the capital category being impacted. Furthermore, where a business undertakes activity to “offset” its negative externalities, the impacts of such “offsets” must also be valued and set off against the externality.
- Why to Value:Valuation informs and improves business decision-making along the value-chains that generate externalities, by assisting business managers in designing appropriate responses. It enables business responses to their externalities to be prioritized, appropriate, effective and efficient in reducing or offsetting negative externalities and increasing positive externalities. Valuation similarly also informs a range of stakeholders, from investors to civil society, supporting their interests to seek such business responses, to reduce risk to the business in the long term, and reduce negative impacts to society in the short and long term.
It is important for business sectors, by a process of examination and elimination, to determine which third-party impacts deserve their closer attention, measurement, disclosure and management on the basis of materiality.
In evaluating third-party impacts across these classes of capital and categories of ownership, we find that there are eleven major drivers of externalitiesarising from typical business activities, which most commonly generate the most significant third-party impacts.
Of these eleven drivers, six of them are “environmental drivers” (viz, GHG emissions; freshwater extraction; waste generation; land-use change; air pollution; land & sea pollution). These six environmental drivers were first proposed by Trucost plc& PwC in their advisory work, and formed the basis of their “EP&L” (Environmental Profit & Loss) calculation for Puma, in an externality statement published by the company in May 2011. It should be noted that the actual ‘impacts’ referred to in “EP&L” are not only natural capital externalities- there are also human capital externalities (eg: health impacts of pollution and waste).
Two corporate drivers in the space of employee human capital are employee training programsand employee health and safety(EHS) standardswhich, if managed well and to scale, can lead to large positive human capital externalities (seeexample in Chapter 5, “Corporation 2020”, describing the work of GIST Advisory to estimate the human capital externalities of Infosys).
Three corporate drivers that create potentially large social capital externalities – positive and negative – such as impacts on institutional and social architecture, employment opportunity, social inclusion, etc – are primarily due to CSR programs, business models, and company policies. (see Naturaexample in Chapter 5, “Corporation 2020” for an example of a business model that generates positive social capital externalities.) It should be noted that companies do account for (‘internalize’) the costsof CSR programs, but there is no compulsion to measure or report the positive externalities or benefits– positive impacts on third-party social, human, or natural capital – precisely because these are ‘externalities’.Sometimes, CSR program benefits may be targeted as ‘offsets’ to known negative externalities, which is why measuring and reporting the one ought to be accompanied by measuring and reporting the other.
It should also be noted that the eleven drivers are selected based on the area of business activity that generates them and the materiality of impacts they create, rather than their easy fit into the three categories of ownership and four categories of capital.
Classification ambiguities might arise due to confusions between what is a driver, outcome, or impact, and such ambiguities should be addressed consciously, with context and assumptions disclosed. For example, “waste generation” is an environmentaldriver, even though its real impact is on human health, i.e. human capital. Furthermore, within the environmental drivercategory, the waste management process might be such (eg: incinerating plastic waste) that the driver could be classified either as “waste generation” or as “air pollution”, so a decision needs to made – a ‘framework’ choice as it were – on a standard classification so that comparability and consistency across industries and companies is ensured.
A further point to note is that, in general, a company’s societal impacts and externalities can either be classified “by business driver” or “by impacted capital”. The former approach is usually more useful for business management, enabling response strategies to be formulated by the business unit driving the impact. The latter is more useful for impact analysis at the level of the company, industry or sector, providing high-level perspectives for regulators and policy makers as well as industry benchmarks for analysts and investors.
An agreed universal valuation framework such as we have described here would ensure that one approach is followed by everyone, allowing results to be compared across business sectors, and within business sectors across corporations. This is a common ask from analysts, investors, Civil Society Organizations, company regulators and from corporate management themselves.
