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Natural Capital – Internalising the externalities

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While 2012 was in many ways a frustrating year for followers of United Nations climate negotiations, the Rio+20 Earth Summit in June did see a significant commitment on the part of financial institutions that may contribute to the development of a new way of looking at how businesses and the environment are inextricably linked.

 The “Natural Capital Declaration” was launched in Rio de Janeiro by a group of banks, investment funds and insurance companies, under the auspices of the United Nations Environment Programme. Through the Declaration, chief executives from financial sector agreed to work towards integrating natural capital considerations into financial products and services.

“Natural capital” is defined by the International Institute for Sustainable Development as “the land, air, water, living organisms and all formations of the Earth’s biosphere that provide us with ecosystem goods and services imperative for survival and well-being”. In other words, natural capital is the global stock of environmental assets that contribute essential inputs to the way we live our lives. Examples cited include pollination of crops by bees, recycling of nutrients in healthy soils and valuable ecosystems such as forests, peat beds and mangrove swamps, which provide natural protection against flooding and soil erosion.

In the traditional capitalist model, economic performance is judged without any regard to the utilisation of natural capital. Hitherto, these assets have usually been considered “externalities”, suggesting that no value can be ascribed to them and meaning that there is no onus on companies or governments to try to use them wisely.

In a world where natural resources are increasingly under pressure, investors are beginning to recognise that this may not be a viable modus operandi for business operations over the long term. As the global population rises to 8 billion over the next 20 years - creating exponential growth in the demand for food, water, energy and materials - the threat to environmental assets and ecosystems may become severe.  

The most recent “One Planet” report from the World Wildlife Fund (WWF) suggested there has been a 30% decline in biodiversity over the last forty years, and argues that weaker ecosystems and scarcity of resources threaten not only food and water supplies, but also the way businesses and industry operate, including the planet’s ability to deal with carbon emissions. WWF warns we are currently using 50% more resources than the Earth can provide and that by 2030 even the combined capacity of two planets would not be sufficient to support global demand, unless consumption patterns can be radically changed.

Research commissioned by the UNEP Finance Initiative (UNEPFI) presents the problem in a different way.  Companies typically do not pay the full costs of environmental damage caused by their business activities, so these costs are indeed largely “external” to financial accounts. As a result, markets are not accurately accounting for the dependence of businesses on ecosystem services such as clean water and a stable climate. At the same time, environmental costs are becoming increasingly financially material. The UNEPFI report suggests that, under a “business as usual” scenario, global environmental costs could reach $28.6trn, or 18% of GDP in 2050.

These externalities may directly affect shareholder value.  Inefficient allocation of capital to highly polluting activities may cause a decline in asset values over time, while environmental costs can impact the portfolio as insurance premiums, taxes or penalties, inflated input prices and the physical cost associated with disasters. Such costs could also reduce future cash flows and dividends.

Given the magnitude of the potential impact on financial performance, accurate measurement of natural assets, as well as environmental costs, becomes essential. In Rio, signatories to the Natural Capital Declaration, together with governments and business leaders, called for a financial system that recognises the way natural capital contributes to the economy, business and the community, and agreed to make efforts to develop methodologies to value and account for nature’s contributions.  Speaking at an event during the conference, Paul Polman, Chief Executive Officer of Unilever, said: “The world urgently needs a shift to a more sustainable, equitable form of capitalism, but we cannot do this without the financial sector, whose lending and investment decisions determine whether our natural capital is further depleted or enhanced.”

Some companies are already experimenting with initiatives to achieve a better understanding of the relationship between business and natural capital. In 2011, Puma, the German sports goods company, created an environmental profit and loss account, which monetises the impacts that Puma makes on a number of different factors, including greenhouse gas emissions, water consumption, acid rain and smog precursors, waste and impacts on land use. By publishing this analysis (developed in cooperation with PwC and Trucost, an environmental data specialist), Puma is making a bold statement that if these environmental externalities were to be valued properly, they would clearly reduce corporate profitability.  Investors should take note.

Alexandra Boakes Tracy is Chairman of Association for Sustainable & Responsible Investment in Asia.

 

 

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