Environmental profit and loss: The new corporate balancing act

Does your CFO know that corporate accounting may be on the cusp of a seismic shift?

As concerns grow about climate change and water, among other environmental issues, internalizing externalities is the name of the game today — with the ultimate goal of creating incentives to avoid risks and create net positive corporate impacts.

Companies are starting to assess the issues in financial terms. For example, Puma developed the first Environmental Profit and Loss (EP&L) statement, and Kering is applying enhanced EP&L methodology across all its brands (including Gucci, Stella McCartney and Volcom). The Dow Chemical Company is assessing "nature's value to a company" (PDF) and teamed up with Royal Dutch Shell and Swiss Re to examine the business case for "green infrastructure."

In addition, the B team  — co-founded by former Puma leader Jochen Zeitz and Virgin tycoon Richard Branson as part of their "Future Bottom Line" Challenge  — seeks "to expand corporate accountability beyond financial gains to include negative and positive contributions to the economy, environment and society."

Corporate accounting and reporting never will be the same again as these efforts fully take off and are replicated.

Reasons for the change

Why are corporate leaders launching and leading this work? The reason is simple. Current corporate accounting has a significant omission that creates a blind spot for corporate risks in terms of understanding impacts (and dependencies) on natural systems. The consequence of this omission starkly was highlighted by the recent TEEB for Business Coalition's commissioned Trucost report, which identified $7.3 trillion in environmental externalities for certain businesses globally.

In response, corporate accounting methodologies that integrate environmental (and natural capital) measures provide business leaders with a useful decision-making tool about supply chain risk and opportunity.

As with all leading edge efforts, this work opens up new horizons. Notably, once the scale of the environmental impact is quantified, what do we do about it? What are the corporate decision-makers' options?

In answering this question, corporate leaders focus on the "mitigation hierarchy," widely accepted in the extractive industries. It recommends: 1) avoid impact, then after avoiding as much impact as possible, 2) minimize impact, and only after all reasonable measures have been taken, and finally 3) offset "residual" impact. Avoidance and minimization have been, and will continue to be, the principle paths to consider environmental impacts. 

For example, in the case of Puma, the EP&L revealed that 57 percent of the environmental impact occurs at the raw material production level (Tier 4), far fromcompany control. Operational and product innovation (avoid and minimize impact) will contribute to reducing these impacts, as was shown through Puma's incycle initiative, a collection of recyclable or biodegradable products.

New tools such as the Higg Index, which provides sustainability assessment tools for the apparel industry, also will support design and process innovation to reduce environmental losses.

Yet, for most companies, product and supply chain innovation will not eliminate all impacts or achieve "net positive" objectives or a balanced EP&L — particularly as long as fossil fuels are used, waste is generated and production is not closed-loop. Even with rapid and effective internal innovation, operational changes and deep engagement with suppliers, the "residual" losses remaining on most companies' "natural capital account" will remain significant.

The bottom line is that eliminating environmental losses and/or meeting the goal of creating net positive impact will be practically impossible unless companies invest in offsetting residual impacts, above and beyond avoidance and impact minimization.

So where are we with the theory and practice of offsetting?

The offsetting issue

At present, some corporate leaders focus (rightly so) on carbon offsetting, through voluntary and regulatory markets, including those related to forest carbon. For example, Puma has purchased REDD+ offsets and parent-company Kering has made an equity investment in the carbon offset company Wildlife Works Carbon. Other companies are engaged with internal carbon markets, wetlands banks, biobanking or payments for watershed services, as well as many other ecosystem service markets and transactions.

Yet, considered within the full set of companies around the world, corporate engagement with environmental markets and transactions that invest in natural capital is quite small. Two obstacles exist. First, environmental offsets are viewed by many within companies as a niche approach and complex domain, despite considerable "market infrastructure" built over the years to guide companies through this area of work. The second issue stems from critics who decry that any type of offsetting is a license for business as usual that simply enables companies to continue with significant environmental impacts. Neither hurdle is insurmountable, however.

What is needed is a way forward for companies that document significant environmental impacts (or "losses") in their EP&Ls or other corporate natural capital accounts. They need to have pathways to balance their books, or at least balance liabilities with positive environmental assets.

To balance corporate accounts that include environmental impacts, it will be essential to craft an expanded offsetting approach. We suggest a pathway forward that includes catalyzing the creation of a shared accounting methodology for environmental "losses" and environmental "profits" in terms of a system of standards, as well as measurement, reporting and verification (MRV). Such a common approach should build on the significant work to date within the following areas:

1. Biodiversity offsets such as the Business and Biodiversity Offset Programme, as well as considering materials from the relatively new Cross Sector Biodiversity Initiative.

2. Environmental markets, particularly within the forest carbon and REDD+ domains.

3. The growing body of tools and techniques for ecosystem service measurement and valuation  — as summarized in the BSR report "Measuring and Managing Corporate Performance in an Era of Expanded Disclosure." 

4. Work within the Natural Capital Coalition (rebranded TEEB for Business Coalition), the Corporate Eco Forum (PDF) and the Inter-governmental Platform on Biodiversity and Ecosystem Services (IPBES), among others engaged with these issues.

Once a common standard for measurement, reporting and verification of environmental losses is clear, it will be essential to put in place the "soft infrastructure" to enable application. A key element will include a network of service providers that can facilitate "offsets" (or natural capital investments) for corporations, including adequate safeguards. A range of service providers already exist with the necessary skill set, such as Ecosystem Investment Partners, EKO Asset Management, New Forests and Beartooth Capital.

Next steps

With the measurement and skilled advisory services building blocks in place, companies could chart their own pathway beyond negative environmental footprint and toward investing in projects that generate environmental profits. Clear shared definitions and methodologies for measuring and monitoring offsets, alongside appropriate approaches for social and environmental safeguards, would provide new incentives for corporate investment in natural capital.

The resulting investments in ecosystems, biodiversity and other natural capital or green infrastructure would not be philanthropic, but rather core to the business and a key element of the corporate strategy to "balance the books." As such, corporate finance teams will have incentives to seek out environmental "revenues" to offset residual losses.

For example, a forest carbon project could be assessed by a corporate finance team as an investment in an environmental asset. The company would not have to own the asset, only invest in its maintenance. And the ecosystem service credits could be verified by a third-party verifier as in the case of carbon credits.

With the expansion and deepening of work on building natural capital into corporate accounting, we have the opportunity to think more broadly about how to mitigate and reduce corporate environmental footprints. Let's not miss this opportunity to consider the full set of pathways (including concepts, standards and institutions) that could realign corporate incentives to come into synchronicity with investing in the green infrastructure upon which we all rely.

Scale photo by BrAt82 via Shutterstock