New Metrics

Environmental Profit & Loss Accounting:
Can We Make It Work?

In November 2013 the first World Forum on Natural Capital took place in Scotland, signaling that the concept of natural capital accounting (NCA) as pioneered through emerging tools such as the Environmental Profit & Loss (EP&L) account is starting to pick up pace. Even more recent is the establishment of the Natural Capital Business Hub in February, showcasing a broad range of promising natural capital case studies that have yielded a positive return on investment.

By Renilde Becque | Published 10 years ago | About a 7 minute read

NCA draws strongly on well-established ideas around calculating the economic value of ecosystems services as a tool in decision-making — but it takes this a step further by not using it merely as a decision tool when comparing between development or product alternatives, quantifying the (replacement) costs of the provisioning and regulatory services that ecosystems provide. It puts the natural environment on the balance sheet by integrating it into government and business accounting frameworks. This makes a compelling argument as an instrument for economic storytelling.

Even so, in the current absence of global NCA standards similar to the traditional accountancy field, and with complex and multi-tiered supply chains, developing NCA balance sheets can seem like a mammoth task for a multinational company. Apparel company PUMA and in its footsteps other early pioneers of the EP&L account have gone about this by using ‘Environmentally extended Input Output’ (EIO) modeling, a technique developed in the ‘70s, which identifies the interdependencies of different branches of an economy and allows for pinpointing hotspots across the supply chain, in order to quickly zoom in where it matters most (‘materiality’).

Natural capital accounting can therewith bring insight in the true costs of (product) development, as well as the associated risks and vulnerabilities plus the level of direct company control, the so-called tiers in a supply chain, in order to decouple growth from unsustainable dependency on vulnerable natural resources.

The Basics

So how does EP&L actually work? At the heart of EP&L are the use of EIO models, which calculate environmental impacts throughout supply chains by combining economic flows and environmental data. An IO table represents all economic transactions between all sectors in a specific country during a year. For each sector, the EIO table integrates this with environmental impact data, which are expressed as monetary values — instead of physical units — per each currency unit (say one dollar) of consumption for a sector in the table.

The economic magnitude of one sector’s input from another defines its aggregated environmental impact, until all economic flows to produce one unit of output at the top of the supply chain have been accounted for. Current EP&Ls, with only a handful published to date, generally cover between one and four of these key environmental impacts or ‘eKPIs’; most notably greenhouse gases, other air pollutants, land use change and water.

Then how to calculate the environmental impact cost of an eKPI? For air pollution, for example, the associated damage costs can be calculated through the use of Impact Pathway Analysis — identification of burdens (e.g. pollutant emissions) through to impact assessment, translating exposure into physical effects with the use of dose–response functions, and finally applying monetary valuations.

Land use change on the other hand, which is used as a rough proxy indicator for biodiversity and ecosystem services, compares the value generated by the current ecosystem to the value generated by the (most probable) natural ecosystem. By integrating the monetary value of environmental impacts with economic flows throughout a supply chain we can generate an estimate of environmental profit & loss against absolute financial costs and revenues.

Next with the results in hand, it’s time to look at the useful application of EP&L in a corporate setting. Its practical value has so far been claimed to lie in its use as a:

strategic tool — creating insight and transparency to direct sustainability initiatives where they are most effective;
risk-management tool — allowing for an early view on emerging risks from a view of future optimization of resources;
transparency/communication tool — acknowledging the extent of a company’s impact and the cost to nature of doing business;
supply chain tool — providing new insight into activities and actors throughout the supply chain.

Not every actor wholeheartedly agrees with this list though, reflecting the view that further elaboration is required as to how EP&L results can be effectively applied to inform e.g. the content of risk registers and influence investment or project appraisal decisions.

The Challenges

Generating credible EP&L results is not without its share of challenges. For a start, there is a high level of complexity in the methodologies applied. Combined with the present lack of standardization, current estimates run at 12-18 months for the generation of an EP&L covering multiple eKPIs. This can deter widespread adoption of EP&L as a tool to make externalities a firm part of a company’s balance sheets.

Another disadvantage lies with the use of EIO tables, fundamental to the current EP&L approach. Such tables are vulnerable to certain flaws and uncertainties, which can reduce the reliability and appropriateness of the results. Take for example the granularity of analysis, which is limited by the number of sectors in the economic matrix of the EIO tables applied — neither allows well for incorporating in-country heterogeneity.

The use of single-country EOI tables may also not sufficiently represent those sections of the supply chain that operate in a different part of the world and can fail to take into account international trade. A table representing, say, the US’ economic structure will generally be a poor match for components of the supply chain operating in Asian economies. Furthermore, the statistical data used to represent countrywide economic flows can be relatively old, with a risk of not accounting for the rapid rate of change in technology and production efficiencies as well as changes in cost & pricing structure in sectors since.

A key way forward to offset such flaws is the use of ‘hybridization,’ where for certain high-impact spend categories the results are improved with data collected directly from suppliers or from specific secondary sources such as Life Cycle Assessment (LCA) databases. Herewith we can combine the strengths of both practices: the completeness of EIO tables and the precision of real-time data tracking or LCA modeling.

Another approach to improve reliability of outcomes is the European-led CREEA project, which is in the process of producing harmonized data sets in order to create multi-regional EIO tables covering an extensive range of sectors, emissions, natural resources and countries worldwide.

Nonetheless, for the time being EP&L results may only provide an indication of lower bound of a corporate’s impact as not every aspect of human interactions with the environment has yet been valued. It is also important to be aware that EP&L at present is more a backward-looking indicator reflecting current perceptions of welfare impact, and not necessarily of sustainability over the longer term.

The Way Forward

EP&L is generally considered to have great potential as a decision-making tool, although to date we still have to see the game plan for how this potential will be harnessed. The development of a manual will therefore be essential to guide businesses through the process, address uncertainties and allow for comparability between companies. Furthermore, EP&L will have to be able to talk to other standards such as the GRI sustainability reporting guidelines.

We will also require unified pathways which business can use to balance their books, or at least balance liabilities with positive environmental assets, where such liabilities can or have not yet been eliminated. It will therefore be essential to craft an expanded offsetting approach, including carbon, biodiversity and other offsets that seek out environmental ‘revenues’ to offset residual losses.

Finally, while natural capital accounting tools such as EP&L may be seen as the next generation of CSR, we have to realize that the current approach is still rooted in a belief structure of continuous growth, albeit with more environmentally friendly outcomes through shifting resources or locations.

Even so, natural capital stocks cannot necessarily be readily substituted for other forms of capital or restored, as in the case of manufactured and financial capital. An EP&L-induced switch to, for example, more bio-based resources could find us running into the limits of annual biomass production or competing with food production for scarce arable land, effectively putting the accounting value of such resources well beyond the consumer’s reach.