Natural Capital – Putting a Price on Ecology

The   principle is one of balance. It is the explicit recognition that both economy and ecology are intimately intertwined and originate from the same root. Economics is a human activity and therefore a part of a social system which is itself embedded within the wider ecological system of the planet. For most of human history, we have lived within ecological limits but with the beginning of the modern era, the technological success stemming from the achievements of the human mind has caused humanity to separate further and further from nature.  When living creatures create such distance from their environment that they live as if there are no ecological consequences to their actions, this sets up great vulnerabilities within society.

An economic system in which stakeholders of corporations and governments plunder the natural resources of the planet while generating more and more waste is not only a grand illusion, but also a prescription for it’s own eventual downfall. Ultimately, the earth is our one and only home and our economic systems must be completely redesigned so that it no longer neglects this home.

logo natural capital declaration 
The National Capital Declaration is a global initiative launched by the financial sector at Rio 20+ to plot a course for the financial industry to recognize natural capital as the underpinning of any economy. It therefore seeks to rectify the artificial economic system today which fails to account for nature, which results in great harm being done to the environment.

THE NATURAL CAPITAL DECLARATION

The Roadmap to a Green Economy

We the undersigned financial institutions wish to acknowledge and re-affirm the importance of natural capital in maintaining a sustainable global economy. This declaration calls upon the private and public sectors to work together to create the conditions necessary to maintain and enhance natural capital as a critical economic, ecological and social asset. We present this declaration to the world community at Rio+20*, as a private sector finance response to the conference theme of working towards a green economy. This declaration has been developed based on an extensive consultation process with the financial community over the course of 2010 and 2011, including meetings in London, Nagoya, Hong Kong, Munich, Washington D.C. and São Paulo.

The Importance of Natural Capital

Natural capital comprises Earth’s natural assets (soil, air, water, flora and fauna), and the ecosystem services resulting from them, which make human life possible. Ecosystem goods and services from natural capital underpin productivity and the global economy. They provide services worth trillions of US dollars per year in equivalent terms and constitute food, fibre, water, health, energy, climate security and other essential services for everyone. Neither these services, nor the stock of natural capital that provides them, are adequately valued in terms comparable to manufactured and financial capital. Despite being fundamental to our wellbeing, their daily use remains almost undetected within our economic system. Using natural capital this way is not sustainable. The private sector, governments, all of us, must understand and account for our use of natural capital and recognise its true value in maintaining economic growth and sustaining human wellbeing today and into the future.

Leadership from the Financial Sector

Financial institutions are an integral part of the economy and society. As the engine of global economic growth, the financial sector can provide some of the tools required to support a transition to sustainable development and eradicating poverty by providing loans, equity, insurance and other financial products and services needed by companies, governments, organizations and individuals that consider social and environmental externalities. Since virtually every economic activity can have an impact on natural capital either directly or indirectly, through a supply chain, financial institutions have considerable indirect ecological footprints through their customers and directly through their purchasing decisions. These impacts can lead to material financial risks, but also to relevant business opportunities.

At present many financial institutions do not sufficiently understand, account for and therefore value, the risks and opportunities related to natural capital in their financial products and services (loans, investments and insurance products) and in their supply chains. Building this knowledge, as well as appropriate valuation and risk management tools, to take natural capital into account within financial decision-making, are important early steps to be undertaken by the financial sector.

As members of the financial sector, we consider ourselves key stakeholders in future discussions about valuing and protecting natural capital and we recognise that we have a key role to play in the reforms needed to create a financial system that reports on and ultimately accounts for the use, maintenance, and restoration of natural capital in the global economy. However, we must do this in consultation with government and supported by appropriate legislation and regulation.

Why Government Action is Essential Now

Because natural capital is a part of the ‘global commons’ and is treated largely as a free ‘good’, governments must act to create a framework regulating and incentivizing the private sector – including the financial sector – to operate responsibly regarding its sustainable use. We therefore call upon governments to develop clear, credible, and long-term policy frameworks that support and incentivise organizations – including financial institutions – to value and report on their use of natural capital and thereby work towards internalizing environmental costs. This can be done by:

  1. Requiring companies to disclose the nature of their dependence and impact on natural capital through transparent qualitative and quantitative reporting;
  2. Using enforceable fiscal measures to discourage business from eroding natural capital, while at the same time offering incentives to companies that integrate, value and account for natural capital in their business model;
  3. Endorsing and implementing international agreements, including but not limited to, those agreed through the Convention on Biological Diversity;
  4. Setting an example through requiring public spending and procurement to report and eventually account for its use of natural capital;

We welcome the World Bank’s Wealth Accounting and Valuation of Ecosystem Services (WAVES) initiative and encourage governments to participate.

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Figure 1: Economies are part of social systems, which are embedded within ecosystems (Source: Gerry Marten )

Figure 2: Social systems interact with ecosystems (Source: Gerry Marten )

As we all know, human beings are just another species on the planet. The remarkable success of our brains, resulting in the invention of technology has allowed our species to skyrocket to the top of the food chain and transform our environment in ways no other species have.

   

Figure 3: Rapid growth of humans as the dominant species on the planet (Source: Gerry Marten )

Human activity has now become so dominant on the planet that one species, homo sapien has now managed to sequester up to 40% of all Net Primary Production.  Agriculture has allowed us to feed billions of people but it has an ominous shadow side which can lead to collapse of our civilization. It is heavily dependent on fossil fuels, both for fertilizers and mechanization and our monoculture system is highly vulnerable to global warming and resource limitations. Our ingenuity has allowed us to terraform the entire planet to suit us. While scientists debate whether geo-engineering is safe or not, agriculture and fossil fuel combustion are two geoengineering experiments which have led to the precarious modern industrial civilization we now find ourselves in. The agricultural revolution, the discovery of cheap (but dirty) energy and continual technological advance have all led to explosive, exponential population growth. Unfortunately success can be the very cause of our failure. Like a cancer that has found it’s perfect host, our ingenuity has created optimal conditions for rapid population growth. We are now like an uncontrolled cancer, devouring its host faster than its immune system can successfully battle it.

It is the successful engineering of solutions to remove any negative feedback mechanisms which seek to keep our population growth in check which has led us to consume ever greater resources and create ever greater amounts of pollution. Yet in hindsight, the ultimate irony is beginning to reveal itself; what we took for progress is in reality a progress trap of monumental and unprecedented proportion.

Assigning a Cost to Previously Unpriced Natural Capital

The  movement is in full swing. Carbon Tracker is assigning a CO2 emissions to unburned future carbon reserves and by so doing, introducing a new term in climate change economics, unburnable carbon. Their study, revealed the stark reality that 80% of all known fossil fuel reserves must remain in the ground if we are to avoid catastrophic climate change. What Carbon Tracker has discovered and revealed is what the fossil fuel industry had already known and wanted to keep secret because it means that their future reserves, and the earnings tied to them are in great jeapordy. Perhaps this is one of the major reasons the fossil fuel industry has been spending billions on lobbying and climate denial campaigns – they know full well that their very economic lives are at stake.

Another major development is the pricing of previously unpriced natural capital. By doing this, polluters and the public can see exactly how much damage corporations are and have been getting away with. The natural consequence of these revelations will be economic reform that will allow the markets to make pollution so costly that there is no economic possibility for pollution ever again.

 

Figure 4:  More detailed view of Economy / Ecology relationship (Source: TEEB/Trucost, NATURAL CAPITAL AT RISK)

Like any other species, when we create resource shortages or pollute our environment excessively, we place our species survival at risk. The activities of human civilization are unique however, in that the scale of harm we are doing is unprecedented in the natural world. While our own survival is at risk, we have also imperiled many other species.

In spite of the achievements of humanity, human civilization is not above the laws of the natural world and we must contextualize our crisis in ecological systems reference framework so we can look at the options we have. In particuliar, our excessive resource consumption and environmental pollution has not been internalized into human economic activity.  This lack of integration has resulted in organizations externalizing their ecological costs. It is clear that these costs must now be factored in so that we can look at their value to human society from a more holistic perspective.

TEEB Study Associates Cost to Natural Capital

The TEEB for Business Coalition is a global, multi stakeholder UNEP-sponsored platform for supporting the uptake of natural capital accounting in business decision-making. The groundbreaking study entitled Natural Capital at Risk: The top 100 Externalities of Business released April 2013 from TEEB and Trucost, for the first time associates a monetary cost to natural capital.

By placing a monetary cost on unpriced natural capital, the report demonstrates that were natural capital priced, the natural-capital destroying activity of some well known business activities would render them unprofitable. Their revenue would be unable to cover their natural resource use and pollution costs were natural capital costs to be internalized rather than externalized . Businesses and investors can take account of natural capital costs in decision making to manage risk and gain competitive advantage. In particular, for these businesses rendered unprofitable in the new model, investors can see the risk they are exposed to. As global business trends are moving towards adoption of such models, investors must make a decision about these investments.

The current paradigm of a debt-based monetary supply forces companies to continue growing to service their debt and this places continually growing business demand for natural capital. Continual resource demand coupled with falling supply due to environmental degradation and events such as extreme weather, sea level rise, species migration, biodiversity loss, species extinction, drought, are contributing to natural resource constraints.

Government policies to address the challenge include environmental regulations and market-based instruments which may internalize natural capital costs and lower the profitability of polluting activities. However, due to intense industry lobbying, regulation has failed to materialize, in spite of decades of international effort. This has made significant contributions to resource constraints by allowing environmental degradation to approach nonrecoverable tipping points.

In the absence of regulation, these costs usually remain externalized unless an event such as drought or extreme weather causes rapid internalization along supply-chains through commodity price volatility. Companies in many sectors are exposed to natural capital risks through their supply chains,especially where margins and pricing power are low. Trucost’s analysis found that the profits of apparel retailers were impacted by up to
50% through cotton price volatility in recent years. Another example is price volatility in wheat due to droughts in recent years.

The World Economic Forum recognizes that ‘water supply crises’ and ‘failure of climate change adaptation’ along with several other environmental impacts constitute economy-wide threats facing the global economy.

STUDY CONCLUSIONS

1. Trucost’s analysis has estimated the unpriced natural capital costs at US $7.3 trillion (13% of global economy in 2009)

This breaks down to six key indicators:

  1. land use,
  2. water consumption,
  3. GHG emissions,
  4. air pollution,
  5. land and water pollution,
  6. waste

for over 1,000 global primary production and primary processing region-sectors under standard operating practices, excluding unpredictable catastrophic events. Since the global economy was worth $56.1 trillion in 2009, this equates to 13% of global economic output in 2009. Risk to business overall would be even higher if all upstream sector impacts were included. All impacts are in 2009 prices and reflect 2009 product quantities, the latest year for which comprehensive data was available.

2. No high impact region-sectors generate sufficient profit to cover their environmental impacts.

Therefore if unpriced natural capital costs are internalized, a large proportion would have to be passed on to consumers. The risk to agricultural commodity prices is particularly striking, where the natural capital cost is universally higher than the revenue of the sectors. However, within sectors, there is significant variation between countries based on energy mix, yields (impacting land use), fertilizer and irrigation rates.

3. The scale and variation in impacts provides opportunities for companies and their investors to become more competitive by optimizing their activities and those of their suppliers

As the 2012 U.S. drought shows, these impacts are likely to be increasingly internalized to producers and consumers through environmental events. Therefore those companies that align business models with the sustainable use of natural capital on which they depend should achieve competitive advantage from greater resilience, reduced costs and improved security of supply.

 Notable Natural Capital Costs

The following tables compare region-sectors based upon 3 variables:

  1. Natural Capital Cost – the newly defined monetary cost associated to a previously unpriced natural capital
  2. Revenue
  3. Impact Ratio –  The Impact Ratio = Natural Capital Cost / Revenue. A ratio less than 1 means the sector is profitable even after internalizing ecological impact (rather than externalizing it as is done today). An impact ratio greater than one means the sector is NOT profitable after internalizing ecological costs.

THE GLOBAL 100 EXTERNALITIES

The value of the Global 100 externalities is estimated at US$4.7 trillion or 65% of the total primary sector impacts identified.

Table 1: Ranking of the top 100 Region-sectors

Table 2: Ranking of the 5 region-sectors by EKPI with the greatest impact across all EKPIs (measured in monetary terms)

 HIGHLIGHTS:

  • Region-sector impacts combined to rank the top 100 environmental impacts globally
  • Table 1 shows the top 5 impacts
  • GHGs from coal power generation in Eastern Asia contribute the largest environmental impact, followed by land use linked to cattle farming in South America.
  • The most significant impacts making up the US$4.7 trillion are GHGs (36%), water use (26%) and land use (25%)
  • Mono-culture farming and Water supply stand out as exceptionally unprofitable ventures
  • Energy production, especially coal power but also Oil & Gas are also unprofitable once ecological costs are internalized

 

THE GLOBAL 20 REGION-SECTORS

Table 3: Ranking of the 5 region-sectors with the greatest overall natural capital impact

Figure 5: Ranking of top 20 region-sectors across all 6 key indicators

HIGHLIGHTS:

  • No region-sector among the top 20 would be profitable, let alone cover its cost of capital after environmental impacts are taken into account. Average pre-tax profit margins for companies listed in the MSCI World Index before natural capital costs are included were found to range from 7% for iron and steel manufacturing, to 19% for crude petroleum and natural gas extraction.60,61 After natural capital costs are included, the range is -67% for cementmanufacturing to -1% for crude oil petroleum and natural gas extraction.
  • Impacts across all six EKPIs were combined by region and sector to create a ranking of the top region-sectors globally.
  • The impact of the Global 20 region-sectors is estimated at US$3.2 trillion or 43% of the total primary production and primary processing sector impacts
  • Natural capital costs were lower than output in just five of the 20 region-sectors, and higher than average sector profits in all cases
  • The extent to which agricultural sectors globally do not generate enough revenue to cover their environmental damage is particularly striking from a risk perspective. Reducing damage from cattle ranching and crop production, for example, would help mitigate risk from volatile input costs. Severe price fluctuations make critical commodities unaffordable, slow growth, provoke public protest and increase geopolitical tension. However, the sector can adoptan ecosystems approach to increase resilience to adapt to climate change impacts, while reducing greenhouse gas emissions – for example as outlined in initiatives e.g. “climate-smart” agriculture.

NOTES:

Combining the six EKPIs in this way is not intended to imply that the different EKPIs can be traded-off against each other. Across regions, the results are sensitive to the scale of production as well as the environmental cost per unit of revenue (impact ratio). Meanwhile across EKPIs, the results are sensitive to the relative value placed on them.

RANKING 6 PERFORMANCE INDICATORS (EKPIs) by IMPACT, SECTOR & REGION

These are for primary producers and primary processing sector in the top 100 region-sectors

  1. water use:                                                $1.900 trillion  and the top 100 region sectors account for 92% of total global cost
  2. greenhouse gas (GHG) emissions: $2.700 trillion and the top 100 region-sectors account for 87% of total global cost
  3. waste:                                                        $0.050 trillion and the top 100 region-sectors account for 99% of total global cost
  4. air pollution:                                          $0.500 trillion and the top 100 region-sectors account for 81% of total cost
  5. land and water pollution:                 $0.300 trillion and the top 100 region-sectors account for 86% of total cost
  6. land use:                                                   $1.800 trillion and the top 100 region-sectors account for 84% of total cost

CONSUMER SECTORS DRIVES NATURAL CAPITAL COSTS

Table 4: Ranking of the 5 consumer sectors with the greatest overall impact and at least 50% impact in their own supply chain

HIGHLIGHTS:

  • Food and timber processing, as well as leather and hide tanning, are the sectors most at risk from these costs beingpassed through supply chains
  • The 10 sectors with the greatest overall impacts (direct impacts from their own operations plus indirect impacts flowing along the supply chain), which also have at least half of these estimated to be in their supply chains, are all involved in food production and processing
  • Sectors ranging from soybean and animal processing to fats and oils refining and animal production are especially exposed to land and water use
  • While the location of operations and supply chains plays a role in the specific country of impact, consuming companies in developed markets often purchase from developing countries where impacts may be highEven a company that buys a product from a low-impact producer but where globally impacts for that product are high, is at risk from pass through of costs unless forward prices have been agreed
  • Companies may benefit from building long-term relationships with their suppliers to improve environmental performance and reduce both of their financial risks

COMPARISON OF SOME IMPACT RATIOS ACROSS SECTORS

 Table 5: Total direct environmental damage as a percentage of revenue for an illustrative selection of primary, manufacturing and tertiary sectors using global averages

HIGHLIGHTS:

  • Factory farming, mono-culture food and agricultural production is by far the worst, reflecting that if ecological impact costs are internalized, this industry would face extreme challenges to become profitable.

RANKING OF GLOBAL ECOSYSTEM SERVICES

  Table 6: Global distribution of weighted average ecosystem service value across all disturbed land

HIGHLIGHTS:

  • Global warming is the highest priority disturbance with food second

Analysis and Some Assumptions of the Model

The general approaches to valuation were those applied in the PUMA Environmental Profit and Loss account (EP&L), with identical water and air pollution approaches. An Expert Review Panel32, including some of the world’s leading academics in this field, found that the current methodology “is appropriate to support strategic decision making, provide insight into natural capital risks faced by business, highlight potential opportunities and act as a basis to communicate a company’s impact on the environment to key stakeholders, including customers and investors”.

Natural capital assets fall into two categories:

  1. those which are non-renewable and traded, such as fossil fuel and mineral “commodities”
  2. those which provide finite renewable goods and services for which no price typically exists, such as clean air, groundwater and biodiversity

This study monetizes the value of unpriced natural capital consumed by primary production

  • agriculture,
  • forestry,
  • fisheries,
  • mining,
  • oil and gas exploration,
  • utilities

and some primary processing:

  • cement,
  • steel,
  • pulp and paper,
  • petrochemicals

in the global economy through standard operating practices, excluding catastrophic events.

For each sector in each region (region-sector), it estimates the natural capital cost broken down by six environmental key performance indicators (EKPIs) that cover the major categories of unpriced natural capital consumption:

  1. water use,
  2. greenhouse gas (GHG) emissions,
  3. waste,
  4. air pollution,
  5. land and water pollution,
  6. land use

These 6 categories represent a total of 100 direct environmental impact variables.

How these impacts are embedded in the products of downstream sectors was estimated using Trucost’s Extended Environmental Input Output (EEIO) model. Double counting of impacts was limited by differentiating between:

  1. the consumption of ecosystem services (land and water use), and
  2. pollution impacts on the supply of these ecosystem services and human health (GHGs and other pollutants)

The magnitude of each impact per unit of revenue varies by region due to factors such as differences in production intensity and resource efficiency.

Trucost’s valuation of environmental impacts estimates the value of a natural good or service in the absence of a market price to allow direct comparison with financial performance and appraisal of potential profit at risk. This
approach provides insight into exposure to an increase in the private cost of natural capital following internalization. Valuations were derived from academic journals, government studies, and established environmental
economic techniques. Trucost applied the social environmental cost to quantities of each impact, except for nutrient pollution of water and hazardous waste where the abatement cost was used. Marginal costs are used
except for land use where the mean value is used. This reflects the assumption that business risk and responsibility today for water use and pollution relates to the marginal unit used/emitted, whereas for land use,
conversion from its natural state has occurred more steadily over a far longer period of time.

Air Pollution Assumptions

Figure: Limitations to air pollution valuation

  1. Although the impact on human health has been shown to dominate air pollution impacts, the limitation of impacts to the five categories may underestimate the true extent of the damage.
  2. Differences in ambient air pollution levels, which are not considered here, will cause average values to vary between locations even where all other factors are the same.
  3. The study did not consider varied dispersion of air pollutants and the use of national data may not be representative of the range of effects.

Greenhouse Gas Assumptions

  • The impacts of climate change are estimated to include:
    • reduced crop yields,
    • flooding,
    • disease,
    • ocean acidification
    • loss of biodiversity
  • The timing, magnitude and economic and social cost of these are modeled under scenarios, and linked to concentrations of carbon dioxide in the atmosphere. From that, the marginal cost of each metric ton of carbon dioxide or other GHG is adjusted for its global warming potential.
  • The level of GHG emissions per unit of output across the 532 sectors has been derived from Trucost’s database of company disclosures and organizations such as:
    • IEA,
    • United Nations Framework Convention on Climate Change,
    • Intergovernmental Panel on Climate Change,
    • European Commission,
    • U.S. Department of Energy,
    • Ecoinvent,
    • European Environment Agency,
    • United States Environment Protection Agency (EPA),
    • Asian Institute of Technology
    • general academic literature
  • Total emissions are based on emissions of seven individual gases which are converted to carbon dioxide equivalents (CO2e). These emissions factors were then multiplied by the level of output to estimate the total level of CO2e emissions for each country-sector.
  • Social cost of US$106 per metric ton of CO2e was used, which is the value identified in the UK Government’s Stern report as the central, business-as-usual scenario, adjusted for inflation to 2009 prices using a global weighted average consumer price index (CPI). This value was multiplied by the country-sector GHG emissions to calculate the GHG impacts in monetary terms.
  • Country-sector impacts were aggregated to create a ranking of the top 20 region-sectors with the highest GHG impacts
  • The uncertainty surrounding the estimation and valuation of climate change impacts is wide ranging and is covered in depth in the Stern Review.

Recommedations 

RECOMMENDATIONS FOR COMPANIES

  1. Focus on gathering primary impact data, and conducting primary environmental valuation studies, on likely hot spots in direct operations and in supply chains.
  2. Identify existing mechanisms that could internalize natural capital costs and the probability and financial impact of these costs being internalized in the future.
  3. Consider using valuations for EKPIs to apply “shadow” pricing in procurement decision-making and financial analyzes.
  4. Explore opportunities for adaptation and to improve resource efficiency, both internally and within the supply chain.
  5. Evaluate options to change suppliers, sourcing location or materials, where existing suppliers are not willing to change.

RECOMMENDATIONS FOR INVESTORS

  1. Identify which assets are most exposed to natural capital risk, and which companies and governments are able and willing to adapt.
  2. Identify the probability and impact of natural capital costs being internalized.
  3. Build natural capital risks, adjusted for the likelihood of internalization, into asset appraisal and portfolio risk models.

RECOMMENDATIONS FOR GOVERNMENTS

  1. Identify the distribution of natural capital risk across the economy, and look for hot spots of low natural capital productivity.
  2. Understand how business sectors’ global competitive position may change in the future as a result of natural capital costs.
  3. Develop policies that efficiently and effectively internalize these costs, avoiding sudden shocks in the future, and helping businesses to position themselves for a natural capital constrained world.

RECOMMENDATIONS FOR BUSINESS COALITION

  1. Coordinate business and investor collaborations to support uptake of the recommendations above.
  2. In particular, develop frameworks for companies and investors to apply standardized, systematic approaches to valuing the impacts of natural resource use and pollution based on standards consistent with the UN System of Environmental-Economic Accounting.10
  3. Facilitate dialogue between companies, investors and governments on natural capital risk.

Criticism to Natural Capital

What we get from nature is remarkable. And then you get the people who want to monetise that. If it’s valuable, what’s the value? What’s it worth? Which is the wrong question to ask, because, first of all, much of its value has to do with what is visceral to you. What does it mean to you if you hear the birds singing, or the birds all die? Second, as soon as you monetise something in nature, a cost-benefit analysis will come in. Nature always loses, because nature goes on for ever.

- George Lakoff

In his April 2014, Guardian article Can you put a price on the beauty of the natural world?, environmental journalist George Monbiot challenges the ethos of Natural Capital and cites examples that prove his point. He argues that with the false assignment of economic value to ecology, it will become more politically expedient than ever to dismiss ecological protection as politicians always find ways to game the system.

 Although Monbiot acknowledges something has to change because business  currently treats the natural world as if it is worth nothing, Monbiot is not so sure treating it within the natural capital paradigm is the solution either. A nature that is privatized will become the subject of speculation on financial markets and future decisions on how to use an area of the environment will be decided by market forces rather than the local community.

Monbiot cites examples from the United Kingdom which illustrates how natural capital is commodifying nature. Mobiot cites the latest report by the government’s Natural Capital Committee, whose chair, Dieter Helm, claims that “the environment is part of the economy and needs to be properly integrated into it so that growth opportunities will not be missed“. To Monbiot, this is wrong-headed thinking. The economy should be considered as part of the environment rather than the environment considered part of the economy. Just like carbon trading, this way of thinking makes it possible for companies to purchase biodiversity offsets while they degrade the environment.