Accounting for Natural Capital

Introduction

The argument in this chapter is that the concept of mutuality has important implications for corporate accounting for natural capital. Such an accounting must respect the preservation of natural resources as an end in itself, and not as something that is secondary to shareholder interests. Mutual accounting should seek to reflect the full impact of a company on natural capital, and in so doing it should recognize how the distinctive properties of ecosystems and other natural resources raise distinctive challenges for accounting. Finally, a mutual accounting system must be deployed alongside a corporate purpose that incorporates the intrinsic benefits of natural capital, because there is otherwise an unavoidable conflict between the objective of natural capital maintenance and other objectives of the business; in this regard, accounting can be understood as a measurement system, a window on corporate performance, but it can only be truly mutual if the business being measured is itself pursuing an objective of mutuality.

Natural Capital and Accounting

The resources of nature (‘natural capital’) feature prominently in the 2018 World Economic Forum’s annual Global Risks Report (WEF, 2018). With global risk defined as ‘an uncertain event or condition that, if it occurs, can cause significant negative impact for several countries or industries within the next ten years’, the report compiled survey evidence from World Economic Forum (WEF) multi-stakeholder communities, members of the Institute of Risk Management and the professional networks of the World Economic Forum Advisory Board Members. Nine global risk factors, from a list of thirty, were assigned higher-than-average perceptions of both likelihood and impact. Of those, six were specifically concerned with natural capital. In descending order of overall rating, these were: extreme weather events (e.g. floods, storms, etc.), leading to major property, infrastructure, and/or environmental damage, as well as loss of human life; natural disasters; the failure of governments and businesses to enforce or enact effective measures to mitigate climate change, protect populations, and help businesses impacted by climate change to adapt; water crises, whereby a significant decline in the available quality and quantity of fresh water harms human health and/or economic activity; human-caused environmental damage and disasters (e.g. oil spills, radioactive contamination, etc.); and major biodiversity loss and ecosystem collapse (terrestrial or marine), with irreversible consequences for the environment, resulting in severely depleted resources for humankind as well as industries.1 In addition, the report notes that ‘truly systemic challenge here rests in the depth of the interconnectedness that exists both among these environmental risks and between them and risks in other categories—such as water crises and involuntary migration. And as the impact of Hurricane Maria on Puerto Rico has starkly illustrated, environmental risks can also lead to serious disruption of critical infrastructure.’

In contrast, and as recently as 2010, not a single issue concerned with natural capital was ranked in WEF’s top five global risks, for either impact or likelihood.

The point here is stark and simple: human impact on natural capital has become an overwhelmingly pressing concern for business and society (Wilson, 2016). The point is made here with data from WEF (2018). It could equally well be made with, for example, authoritative evaluations of the existential threats posed by climate change (IPCC, 2018) and of the current, unprecedented and unsustainable rate of loss of biodiversity (WWF, 2018).

This is not a time for the corporate sector to offer an uncritical assertion that it is somehow the solution to the challenges faced by the natural world. On the contrary, the very effectiveness of corporate growth has ‘enabled’ our unprecedented rate of natural capital consumption and depletion, such that the corporation has historically been the problem rather than the solution (Mayer, 2013). The need for fundamental change is, to say the least, pressing.

Enter mutuality. If nature is regarded as a stakeholder in corporate activity, and if that activity can be regarded as benign only if all stakeholders are reasonably respected and rewarded, then there is the hope of avoiding the current, unsustainable trade-off between economic growth and adverse impact on the natural world. Moreover, there is an important sense in which this is not an option. If there is not mutuality between the natural world and other stakeholders in the corporation, then we are headed for disaster.

Of course, a mutual business is more easily imagined than realized. An important practical challenge in the realization of mutuality lies in the design of an appropriate system of accounting, because measures of corporate performance provide a means of directing and evaluating corporate activity, while also enabling a system of reporting and so of external accountability. Accordingly, this chapter concerns the role of accounting in the context of corporate responsibility with respect to the natural world.

Importantly, the preservation of natural capital must be regarded as an end in itself. It cannot—in the context of mutuality—be regarded as something to be traded off against growth in financial capital. This is because a mutual business is not one in which the benefits to one category of stakeholder are achieved at the expense of another. It would not, for example, be ‘acceptable’ to regard shareholders’ financial capital as available for depletion for the benefit of other stakeholders. A more subtle and negotiable question is how much financial capital should be allowed to grow in relation to growth in other stakeholder investments, but the basic principle of financial capital maintenance is ‘non-negotiable’.

Challenges for Accounting

Enacting mutuality in the context of natural capital raises four distinct challenges for the measurement of corporate performance, and thereby for accounting.

The first challenge arises if there is a conflict in corporate objectives with respect to financial capital and natural capital, and a conflict therefore in the notion of what constitutes performance. Specifically, it is widely understood and accepted that (in the typical case) financial returns for shareholders provide the primary basis for understanding how well a company has performed. All other metrics are secondary, they are instrumental to the ultimate purpose of financial return. If, therefore, performance with respect to the preservation of natural capital stands in conflict with performance with respect to financial returns, then the conventional resolution is that the latter ‘wins’. Clearly, if the preservation of natural capital is an end in itself, then the conventional solution is problematic. The challenge here is that the accountant is not currently called upon to measure a bottom line other than financial profit for shareholders. Providing an alternative bottom line would not solve the problem of preserving natural capital, but what it would do is give the problem appropriate salience.

The second challenge—which relates closely to the first—is one of framing. The issue here is the context within which natural capital is said to be preserved. Is the focus of concern the natural capital on which the corporation depends in order to sustain its activities? Or is the focus instead the natural capital which is affected by the activities of the corporation? In other words, is the concern with dependency or impact? In both cases, there is also a secondary question, namely whether and how natural capital can be specified and measured in order that its preservation (or otherwise) can be understood. It will be argued that impact is ‘what matters’ and that—to the extent possible—impact measurement should not be partial. The link to the first challenge above is that the primacy of financial returns for shareholders leads instead to the opposite conclusion, that dependency should be the focus. This second challenge is in effect an extension of the first; it is a call for the accountant to understand and measure the bottom line in terms of corporate impact on natural capital.

The third challenge is to recognize a critical difference between accounting for financial capital and accounting for natural capital. There is something dangerously beguiling in the shared language of ‘capital’, along with the appropriation of an economic logic in conceptualizing the natural world. This approach invites us to view as analogous performance measurement with respect to financial capital and to natural capital. In particular, it appears that depreciation in financial accounting is analogous to depreciation in natural capital accounting. Yet it is not. The challenge here is to ‘see through’ the accounting and to guard against the misrepresentation of underlying phenomena.

While the first three challenges can be understood as conceptual (alternatively as normative, or ethical)—what should a corporation focus on in order to preserve natural capital?—the fourth and final challenge raises a more practical question, grounded in the law and in conventional business practice, which is what can a corporation do in order to preserve natural capital? Historically, economic growth has been achieved at the expense of natural capital (IPCC, 2018; WWF, 2018). In part, this is because laws and conventions have allowed this to be the case (Barker, 2019). An implication is that—historically at least—the ‘obligation’ to make good consumption of natural capital is not actually an obligation at all. The challenge here is the practicality of ‘doing the right thing’. The challenge is to identify the mechanism by which accounting can have practical consequences. As will be argued, this can ultimately be achieved only if the purpose of the corporation does not entertain the consumption of natural capital in the service of the growth of financial capital (Mayer, 2018).

Overall, the argument here is that the meaningful application of ‘mutuality’ to the preservation of natural capital calls for all four of the above challenges to be addressed.

The Dominance of Financial Returns

The problem of a conflict in corporate objectives can be illustrated with an example. In selecting such an example, it is worth keeping in mind that, within any given industry, there are leaders and laggards with respect to corporate responsibility towards the natural world. The example is provided here of a leader, within the context of the chemicals industry. The reason for choosing a leader is to illustrate a core problem that plagues even best practice. The example (‘ChemCo’) is anonymized because the purpose is not to vilify the company in question; after all, it is leading the way and should be encouraged for so doing. But the data are real because this makes the message more powerful.

ChemCo defines sustainability according to the Vision 2050 of the World Business Council for Sustainable Development (WBCSD), that ‘people live well and within the resource limits of the planet’. This is very much the language of mutuality. ChemCo asserts its commitment to a leadership role with respect to sustainability, which it notes is deeply embedded in its corporate values. Very much in line with the language of mutuality, ChemCo seeks to maintain a balance between economic success, protection of the environment, and social responsibility, which it argues has been fundamental to its way of doing business for decades.

ChemCo backs up its broad statement of commitment with a very specific, and very impressive, target. By the year 2030, its commitment is that all of its products and processes should be three times as efficient as they are today. Moreover, its performance with respect to enhancing efficiency is starting to head towards satisfying this ambition. Over the time period 2013–17, energy consumption per unit of output has reduced by 9 per cent and carbon dioxide emissions per unit have likewise reduced by 8 per cent.

Meanwhile, ChemCo’s business has been growing, and so lower environmental impact has not obviously been at the expense of financial performance. Sales were just over €16bn in 2013, growing to €20bn in 2017. Operating profit has likewise grown over this period, from €2.5bn to €3.5bn.

So far, so good. Consider, however, the ecological indicators presented in Table 13.1, noting that these are reported as absolute amounts rather than on a per unit basis. The simple observation to make here is that environmental performance has deteriorated. This decline would be greater in the absence of the efficiency gains that ChemCo has realized, yet those gains are insufficient to offset the effects of growth. Moreover, the ‘headline’ in ChemCo’s reporting of corporate performance is the growth in sales and in profit; it is not the growth in ecological impact.

The message here is that a commitment to improving efficiency with respect to ecological impact is not a commitment to preserving natural capital. Instead, the enactment of mutuality requires—at a minimum— capital maintenance with respect to all stakeholders. A business is not mutual if it records a financial profit while also depleting natural capital. There is, in principle, a very simple challenge here for accounting, which is to keep track not just of financial performance but also of natural capital performance, and to judge both against the benchmark of capital maintenance.

Framing Natural Capital

In order to measure the maintenance of natural capital, it is necessary to consider carefully what is actually being maintained (Barker and Mayer, 2017).

Following a logic of the primacy of the shareholder, natural capital maintenance is relevant only indirectly to corporate activity, to the extent that it is required in order for the economic value creation of the business to be sustainable.2 This is the logic of a dependency upon natural capital. So, for example, a company’s land use might cause both a degradation in soil quality and also a loss of biodiversity. If, for the sake of argument, the loss of soil quality caused a decline in crop yield, and so in revenue for the company, then a reversal of that decline—and, so, the maintenance of natural capital—would be called for. Yet this would not be to treat natural capital maintenance as an end in itself, but instead as instrumental to the primary goal of maintaining shareholder returns (Gray, 1992 and 1994; Bebbington and Gray, 2001; Milne and Gray, 2013; Helm, 2015). This can be seen if, again for the sake of argument, the biodiversity loss had no direct economic consequences for the company, in which case natural capital maintenance would not be desirable from a shareholders’ perspective.

The alternative—implied by the concept of mutuality—is, so to speak, to ask not what natural capital can do for the company, but ask what the company can do for natural capital. This is to be concerned with impact rather than dependency. It is to regard the maintenance of natural capital as an end in itself. It is a perspective that would make no distinction between the loss of soil quality and the loss of biodiversity, because both are depletions of natural capital.3 Critically, it is an approach that defines materiality with respect to impact on natural capital itself, and not selectively with respect to aspects of natural capital that serve shareholder returns. It is important to be clear on this point. To illustrate, the ‘selection of material issues’ in Chapter 13 calls for ‘the organization to select a limited number of material issues that are most relevant and significant to the achievement of its purpose’. If the purpose is mutuality, then those factors must include adverse impacts that remain external to the economics of shareholder returns.

In a practical sense, specifying this concern for impact on natural capital is very far from straightforward. It requires that appropriate natural capital impacts are identified, measured, and reported. In this sense, the selection of material issues in Chapter 13 is simply a practical measure whereby only a limited number of material issues can realistically be identified and tracked. In practice, such efforts are increasingly attempted by some form of adoption of frameworks and other guidelines, such as the Natural Capital Protocol (NCC, 2016), the Global Reporting Initiative (Boiral, 2016; Boiral and Heras-Saizarbitoria, 2017; GRI, 2016), or the Greenhouse Gas Protocol (GHG, 2015).

It is difficult, however, to capture all effects on nature, not least because of the complexity and inter-dependence in ecosystems. The risk here is of being partial, and of excluding from financial calculation impacts that are either difficult to measure or that are ‘convenient’ to ignore because they do not materially affect business operations (RSPB, 2018: 12). Biodiversity is particularly problematic in this regard. The Convention on Biological Diversity defines biological diversity as ‘variability among living organisms from all sources including, inter alia, terrestrial, marine and other aquatic ecosystems and the ecological complexes of which they are part; this includes diversity within species, between species,

and of ecosystems’ (CBD, 2017). The measurement challenges here are complex and considerable (Addison et al., 2019; Adler et al., 2017; Boiral, 2016; Mace, 2019). In addition, it is of course problematic to define the boundaries of the accounting entity, which arise throughout the value chain for impact on natural capital, from original supply to final consumption, whereas for financial capital, the concern for capital maintenance concerns only economic resources controlled directly by the reporting entity (CDSB, 2018; eftec et al., 2015).

As argued in Chapters 10 and 14, mutual profit must be given appropriate salience for the concept of mutuality to be enacted. Salience is not, of course, a sufficient condition for the practice of mutuality. After all, a company could report negative impact on natural capital. Salience is, however, a necessary condition. In addition, and as will now be discussed, it is important that the financial measurement bears a meaningful relationship to the physical reality, with respect to which ‘capital’ has an important difference in meaning in its financial and its natural form.

Different Meanings of ‘Capital’

Financial capital and natural capital are less alike than their common nomenclature might suggest.

Manufactured assets wear out and can be replaced. If the revenue from usage of an asset exceeds the depreciation charge, then value has been created, and replacement is itself likely to be value-creating. In contrast, a distinctive property of many natural assets is that they do not ‘wear out’ but instead are an inherently sustainable source of goods and services. If the natural capital stock declines, then this is not simply a depreciation charge, in the sense of being a measure of the consumption of an asset that is used up and then replaced. It is instead a warning signal. This is unlike manufactured assets, which are inherently transient, with a construction cost that for accounting purposes is allocated, or consumed, over the asset’s useful life. Instead, natural capital assets are ‘given by nature’, rather than the product of costly investment, and they can be viewed as permanent, not transient, just so long as they remain healthy. ‘Depreciation’ in this context is an indicator of the risk of permanent damage, rather than a simple economic indicator of the cost of replacement. This is not least because there are commonly critical levels of biodiversity below which ecological function is disrupted, making replacement either economically infeasible or ecologically implausible. In the words a leading ecological conservation charity, ‘if biodiversity declines beyond a certain point, the natural functioning of the system can change in the short or long term in unpredictable, non-linear, and non-marginal ways’ (RSPB, 2018). In short, while the notion of financial capital maintenance is similar to that of the maintenance of natural capital, there is also a critical sense in which it is fundamentally different. While the depreciation of manufactured capital is unproblematic, the same is not true for natural capital that is allowed to depreciate below a critical, sustainable threshold.

The Obligation to Do the Right Thing

There is an important practical concern to guard against. Specifically, the concept of mutuality must not be appropriated so that, in substance, it means little more than (financially) sustainable shareholder returns (Milne and Gray, 2013; Deegan, 2013). The need here is to ensure that the business is itself pursuing a mutual purpose. No system of accounting can itself direct corporate behaviour. While an effective accounting system is indispensable for understanding and communicating corporate performance, and for enabling the corporation’s directors to be held to account for that performance, if the corporation is pulling in one direction, then the accounting cannot in itself pull it back. In short, mutuality in corporate purpose is a necessary prerequisite for mutual natural capital accounting to be effective.

To illustrate this point, consider the EU Non-Financial Reporting Directive (EU, 2014), which calls for ‘a non-financial statement containing information relating to at least environmental matters . . . (to) include a description of the policies, outcomes and risks related to those matters’ and ‘details of the current and foreseeable impacts of the undertaking’s operations on the environment, and, as appropriate . . . the use of renewable and/or non-renewable energy, greenhouse gas emissions, water use and air pollution’ and, in addition, ‘adequate information’ concerning ‘principal risks of severe impacts, along with those that have already materialized . . . (which) may stem from the undertaking’s own activities or may be linked to its operations.’ This seems more than comprehensive. It seems to be a legal requirement to take responsibility for natural capital impact seriously.

In practice, however, a ‘requirement’ such as this is problematic because it is inherently vague, and therefore subsumable to competing priorities. To illustrate, companies required to apply the EU Non-Financial Reporting Directive (EU, 2014: Section 9) ‘may rely on national frameworks . . . (or) the Global Reporting Initiative, or other recognized international frameworks’. In other words, there are no specific requirements. Indeed, even the selection of one framework over another allows significant room for management judgement. More problematically, there is actually nothing in the Directive that calls for the maintenance of natural capital, if such is not in the shareholder economic interest. The Directive can be interpreted simply as a rebottling of a conventional logic of shareholder value creation, in which a new form of environmentally aware legitimacy is called for in both product markets and capital markets, yet where responding to that call is grounded in economic self-interest rather than in environmental responsibility per se (Dowling and Pfeffer, 1975; Suchman, 1995; Deegan, 2014).

The message here is to be realistic about the alignment of corporate activity with mutuality. If there is not a ‘win–win’ in sustaining both financial capital and natural capital, then the corporation is not acting mutually. This is a question of corporate purpose (Mayer, 2018). Highlighting this point in a set of accounts will not in itself make the problem go away, and—in the absence of mutuality in corporate purpose—the risk is that sustainability reporting gives a false appearance, that the corporation is ‘taking seriously’ a commitment to natural capital when it is actually predisposed to its subordination. There is a clear need here for rigour and honesty in accounting, to ensure that mutual profit is reported in a way that is in itself true to the concept of mutuality, and that surfaces rather than hides difficult questions about the activities in which a business is engaged.

Conclusion

The argument in this chapter can be stated simply. The concept of mutuality requires that the maintenance of natural capital is an end in itself. This requires four things with respect to accounting. First is recognizing that natural capital maintenance cannot in principle be ‘trumped’ by shareholder primacy; mutuality implies that natural capital has primacy in its own right. Second is that natural capital maintenance must be defined, which requires a framing around impact rather than dependency, and a complete rather than partial view of impact. Third is recognizing that the maintenance of natural capital raises conceptual and practical challenges that are distinct from the maintenance of financial capital; this applies in particular to notions of depreciation and replacement. Fourth is acknowledging the institutional challenges of corporate purpose that set the scene for points one to three: stating the problem of how to do natural capital accounting is one thing, making it possible by means of mutual corporate purpose is another.

___

Notes

1. The other three leading global risks were cyberattacks, large-scale involuntary migration, and interstate conflict.

2. See, for example, the approach of the Task Force on Climate-Related Financial Disclosures (TCFD), which was set up by the G20 to make investor-oriented recommendations for voluntary climate-related financial disclosures, in mainstream reporting, that are positioned as consistent, comparable, reliable, clear, and efficient (2016).

3. See, for example, ‘corporate natural capital accounting’ (CNCA), which is designed to enable organizations to gather natural capital information in a coherent and (financially) comparable format, to help both companies and policymakers make better informed decisions about the management of natural capital (2018).

Richard Barker is professor of accounting at Saïd Business School, and tutor in management at Christ Church, Oxford University. An expert in financial reporting, Richard is a member of the Corporate Reporting Council, the UK advisory committee on accounting standards. He previously served as research fellow at the International Accounting Standards Board (IASB). Richard has degrees from Oxford and Cambridge and qualified as an accountant while working for AstraZeneca. He is currently researching issues of natural capital accounting, corporate sustainability, and institutional structures for regulating ‘non-financial’ corporate reporting. He serves on the Expert Panel of Accounting for Sustainability (A4S).

Published by Oxford University Press. Great Clarendon Street, Oxford, OX2 6DP, United Kingdom.

Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark ofOxford University Press in the UK and in certain other countries

© Oxford University Press 2021. The moral rights of the author have been asserted. First Edition published in 2021. Impression: 1.

Some rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, for commercial purposes, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization.

This is an open access publication, available online and distributed under the terms of a Creative Commons Attribution–Non Commercial–No Derivatives 4.0 International licence (CC BY-NC-ND 4.0), a copy of which is available at http://creativecommons.org/licenses/by-nc-nd/4.0/.

Enquiries concerning reproduction outside the scope of this licence should be sent to the Rights Department, Oxford University Press, at the address above.

Published in the United States of America by Oxford University Press198 Madison Avenue, New York, NY 10016, United States of America.

British Library Cataloguing in Publication. DataData available. Library of Congress Control Number: 0000000000. ISBN 978–0–19–887070–8. DOI:10.1093/oso/9780198870708.001.0001.

Printed and bound in Great Britain by Clays Ltd, Elcograf S.p.A.

Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.