Published on August 25th, 2015 | by Sandy Dechert8
Wall Street: Not Nice To Fool Mother Nature With Zero-Sum Externalities
August 25th, 2015 by Sandy Dechert
In this year of major climate decisions, we need to remember who’s really responsible for global warming and the problems it is causing. Yes, climate change derives from industrial activity, but few of us realize exactly how much. A study called Natural Capital At Risk has now come close to quantifying the amount. It’s high enough to say that very few, if any, of the US Fortune 500 companies would be solvent if the environmental costs of their activities were added to the current prices of their products.
Oil and gas occupy the pinnacle of the world investment pyramid. Generations ago, when homeowners with stock accounts looked at their mounting monthly expenses, they could breathe a sigh of relief and say, “Oh, well, there’s always Standard Oil [now Exxon].” In other words, inflation might outpace salaries and ordinary investments, but petroleum stocks would always stay ahead in the money game. Despite some massive changes in other types of goods, stockholders still covet the profitability of “black gold.”
Not far behind oil and gas on the blue chip profitability list are some apparently disparate industries: mining, electronics, meat and meat products, and tobacco. These particular areas have one thing in common, the study has found. Their profitability directly results from the manufacturers routinely externalizing some of the production costs. Consider the following example from the transportation industry:
Manufacturers transfer the resource extraction and air quality costs of making trains, boats, and planes to the community and the environment. They also fail to account for expenditures in terms of terminal infrastructure, corridor creation, and ongoing use of resources (noise, highway stress, increased traffic, more air pollution) in their profitability equations. In effect, they pass on these expenses to the community and/or the environment by leaving them outside their analysis.
Yet although these costs are difficult to quantify, they really do constitute part of the true outcome of industrial activity. In other words, the accounting process itself, which routinely leaves out “externalities,” allows someone else to pay part or all of the costs of production. And even worse—it’s currently impossible for the people, their governments, or the environment to recoup them.
(The success of the Dutch citizen suit legally requiring Holland’s government to act on climate promises, settled in June, is the first notable instance of anything resembling this type of action. It still exempts the industries that emit pollution, but at least it requires government to use its collective power for the good of the public and the environment.)
The Trucost Natural Capital At Risk study, which was carried out two years ago to little fanfare on behalf of The Economics of Ecosystems and Biodiversity agenda of the United Nations Environmental Program, examines the money earned by the biggest industries on Earth. It uses the models displayed above.
The method takes off from an examination commissioned by the Principles for Responsible Investment group and the UNEP Finance Initiative in 2011. That study examined the concept of universal ownership and outlined why environmental externalities matter to institutional investors:
Large institutional investors are, in effect, ‘Universal Owners’, as they often have highly-diversified and long-term portfolios that are representative of global capital markets. Their portfolios are inevitably exposed to growing and widespread costs from environmental damage caused by companies. They can positively influence the way business is conducted in order to reduce externalities and minimise their overall exposure to these costs. Long-term economic wellbeing and the interests of beneficiaries are at stake. Institutional investors can, and should, act collectively to reduce financial risk from environmental impacts.
It estimated annual environmental costs from global human activity at 11% of global GDP (2008). The world’s 3,000 largest publicly listed companies were responsible for about one-third of this environmental damage. The proportion of company earnings possibly at risk from natural capital costs in an equity portfolio weighted according to the MSCI All Country World Index exceeds 50%.
Natural Capital At Risk contrasts the industry profits with 100 different types of environmental costs, considered under the general headings of water use, land use, greenhouse gas emissions, waste pollution (to see details of the waste factor, click graph at right), land pollution, and water pollution. It makes the following conclusions:
- The global 100 environmental impacts by sector and region result in costs totaling US$4.7 trillion, or 65% of the total primary sector impacts identified in this study.
- The majority of costs are due to greenhouse gases (36%), water consumption (26%), and land use (25%). Addressing impacts from these pollution sources could also result in notable environmental costs savings.
- The top five impacts are GHGs from coal power generation in Eastern Asia and Northern America and iron and steel mills in Eastern Asia, land use from cattle ranching in South America, and water use in wheat farming in Southern Asia. Prioritizing action to reduce impacts in these sectors could significantly reduce natural capital risk.
The report demonstrates that factoring externalized costs into the equation, none of these currently respected industries actually makes a profit. They all make someone else pay part or all of their costs. These include not only their mistakes (Deepwater Horizon, pipeline “mishaps,” rail and truck disasters, production of huge amounts of hazardous and extraordinary waste, etc.), but also loss of resources, decreased land productivity, tremendous effects on human health, skyrocketing medical costs, and the diminution of amenity.
The chart below looks at the total economic value of water across the board.
An egregious example of water misuse is the Nestlé corporation pumping limitless water out of parched California and turns around and selling it back to those affected by drought, at a profit of approximately $4 billion per year. Here are other discrepancies (click to enlarge):
Says Michael Thomas in a report for exposingtruth.com:
The huge profit margins being made by the world’s most profitable industries (oil, meat, tobacco, mining, electronics) is being paid for against the future: we are trading long-term sustainability for the benefit of shareholders.
In fact, industries in which the environmental costs greatly exceed revenue consistently lose money in terms of both ecological damage and strain on their communities. The indirect costs “downstream” from these industries are even higher. Here are the top five sectors whose supply chains suffer the highest indirect impacts:
Another inequity dwells in the fact that the environmental impacts of any industry may result in huge environmental losses in related but not necessarily obvious activities. For example, consider cattle ranching and farming in South America (see above table). These activities carry an environmental cost 18 times higher than all the revenue they bring in. Not only are they inefficient in and of themselves: the World Bank tells us that animal agriculture causes 91% of Amazon rainforest destruction.
The report also covers how much money these companies would be losing if they were actually paying to reduce their environmental impact. It comes to a few general conclusions:
- Business, government, and the public can take claims that companies are “environmentally responsible” (like Nestlé’s “water to be shared and enjoyed by everyone, at anytime”) with a grain of salt.
- Consumers can explore and adopt activities focused on downstream solutions by actively campaigning against egregious offenders (voting with our wallets).
- Citizens can demand that government ensure its laws and regulations protect real humans and the world environment rather than forwarding corporate persons and illusory financial profit.
The Trucost report has some quantifiable suggestions for industry, investment, government, and individual action as well.
The scale and variation in impacts provides opportunities for companies and their investors to differentiate themselves by optimizing their activities and those of their suppliers. As the recent 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.
The distribution of US$7.3 trillion in natural capital costs across sectors and regions analyzed in this study demonstrates that some primary-producing suppliers are more exposed to impacts than others, and there is potential to reduce risk…. Increasing impacts in some region-sectors, and declining impacts in others, is likely to widen gaps in exposure to costs across and within sectors, with knock-on effects on profitability and market share.
The natural capital cost of large-scale farming is universally higher than the value of the sectors’ revenue. However, within sectors, there is significant variation between countries based on yields (affecting land use), fertilizer application and irrigation rates. Exposure to price volatility in agricultural commodities is reflected in the sectors most at risk through their supply chains. Furthermore, as the ripple-effect of crop price rises due to the recent drought in the United States shows, it is likely that these impacts will be increasingly internalized to producers and consumers. The implication is that companies that change their business models and sourcing strategies to reduce natural capital costs have a significant opportunity to gain competitive advantage in the future.
The scale and variation in impacts across sectors indicates that there are opportunities for companies and their investors to differentiate themselves by optimizing their activities and those of their suppliers or holdings. They can incorporate analysis of significant “hot spots” where risks are concentrated from natural resource use, pollution and waste into strategic, operational, and financial decision-making to develop a ‘natural capital-smart’ approach. The foresight to reduce impacts and increase resilience to external costs will become a growing factor in the ability to maintain returns.
In other words, it’s time we all started re-internalizing those undervalued “externalities.” See the TEEB report for specific recommendations.
Appendix: Background on TEEB and its consultants
TEEB’s most important work in environmental economics is probably the groundbreaking 2010-2011 study led by Pavan Sukhdev, a senior banker from Deutsche Bank, on biodiversity loss and ecosystem degradation in economic and human welfare terms. The G8+5 Environment Ministers commissioned it in 2007 at a meeting in Potsdam, Germany. Those serving on TEEB’s advisory board include Achim Steiner, Executive Director of UNEP, Ahmed Djoghlaf, Executive Secretary of the Convention on Biological Diversity and one of the two diplomats charged with clarifying and condensing the draft Paris agreement on climate change, Nick Stern, Professor of Economics and Government and Chairman of the Grantham Research Institute on Climate Change and the Environment at the London School of Economics; and Herman Mulder, former Director-General and Head of Group Risk Management of ABN AMRO Bank in Amsterdam, Netherlands.
The group has also supported financing the Reducing Emissions from Deforestation and Forest Degradation and REDD+ programs and the Green Economy Initiative, assessing economic sectors where “greening” might lead to traditional economic growth (prosperity and job creation). Specifically, these sectors include agriculture, buildings, cities, fishery, forests, industry, renewable energy, transport, tourism, waste management, and water, as well as their enabling conditions in finance, domestic, and international policy architecture.
The Teeb consultants (Trucost) provide data and insight to help clients understand the economic consequences of dependence on natural capital. Environmental data experts united in 2000 and headquartered in London, with regional offices in New York, Paris, and Hong Kong, Trucost works for companies and their advisors, the investment community, governments, academics, and thought leaders worldwide. Its business is to make estimates about the hidden costs of unsustainable consumption of natural resources by companies.
Just last week, The Globe and Mail (Toronto) published an article by industrial and accounting experts that cited the UNEP/Trucost analysis and called for Canada’s huge natural-resource wealth to be included on balance sheets. Among Trucost’s work earlier this year:
- Carbon Matters: A Review of Listed Companies’ Carbon Disclosure and Performance in Hong Kong, July 17, 2015, commissioned by the British Consulate-General Hong Kong,
- Reality bites: Facing up to the global food production challenge, June 2, 2015, briefing on how we can use natural capital accounting to answer some of the big questions around sustainable food production.
- Defining green capital, May 19,2015, a spotlight on the rapidly growing green bond market and explanation of its tangible benefits for companies.
- Making the Business & Economic Case for Safer Chemistry, May 16, 2015, for the American Sustainable Business Council and the Green Chemistry & Commerce Council.
- State of Green Business 2015, February 6, eighth annual State of Green Business report.
- Building for prosperity: Accounting for the environment in the construction industry, February 2, 2015, briefing on how the construction industry can manage growing environmental challenges like carbon emissions from building materials and use of green energy in buildings.
- Natural Capital Risk Exposure of the Financial Sector in Brazil, February 2, 2015, commissioned by the German development organization GIZ and Brazil’s Conselho Empresarial Brasilei ro para o Desenvolvimento Sustentável to provide with an understanding of detail the relevance and magnitude of the natural capital risks engaging Brazilian financial institutions through their funding and investments.
With Ecolab in November 2014, Trucost launched a free tool to help businesses assess their water-related risks in financial terms. In June of last year, UNEP and Trucost teamed with the Plastic Disclosure Project to produce a report, Valuing Plastic: The Business Case for Measuring, Managing and Disclosing Plastic Use in the Consumer Goods Industry. In it, they articulated the business case for companies to measure, manage, and disclose information on their annual use and disposal of plastic. The Trucost team also helped the UK government compile its guidelines for mandatory carbon reporting.