Despite its best efforts, industry continues to generate and discharge enormous amounts of wastes that pollute the natural environment and impose damages on households and other enterprises. Economists call these damages "externalities" because their costs typically fall not on the firms that discharge the wastes but on those that suffer the damages. Consequently, accounting systems don't ascribe these costs to their sources or even record them systematically.
Increasingly, however, companies are being forced to internalize these environmental costs, either through stricter environmental regulations or through liability for damages caused to others. Accurate measurement of a company's true environment-related costs now offers a wide range of benefits: It provides management with a benchmark for tracking performance relative to peers or its own past performance. It can also serve as an external benchmark for investors concerned about the environmental performance of companies as well as their finances. Not least, it can serve as a measure of a company's environmental exposure and the financial risk originating in its environmental performance.
But what tools are available to adequately measure these costs? Trucost, Ltd., a financial research firm based in London, has created databases estimating these externality costs for many of the world's largest corporations. Trucost estimates the firm's emissions and wastes by using the firm's own information sources or others, then assigns each category of emissions a monetary value by multiplying its physical quantity by a notional price based on economic estimates of the marginal damages of an additional ton of emissions. Aggregated over all the firm's business units and emissions, the result is an estimate of the external environmental cost imposed on the rest of the economy by the firm’s operations.
Complementing this effort, the consulting firm Stern Stewart has popularized a measure of value added (EVA or "economic value added") that incorporates the firm’s cost of capital. This measure subtracts from the company’s net operating profits after taxes an estimate of the cost of its capital stock, recognizing that equity capital as well as debt and long-term leases has an economic cost. This measure uses the concept of the "weighted average cost of capital", dependent on the firm’s asset structure and riskiness. EVA measures the company’s financial surplus after accounting for the costs of the capital it has used in its operations.
The authors of this article have combined these measures to produce a measure of true value added, "TRUEVA," which subtracts from the firm’s operating surplus not only its costs of capital but also the environmental damages it imposes elsewhere in the economy. True value added recognizes that a company produces not only useful products for which customers are willing to pay but also wastes and emissions which impose damages and which victims would rather avoid.
Measuring the Impact of Industry
TRUEVA is the first tool, to our knowledge, that estimates the net contribution of industry on a company-by-company basis. Company level specificity is useful not only because investors are interested in the exposures of individual firms but also because true value added varies substantially across firms even within narrowly defined industrial sectors.
To illustrate, let’s take a look at a sample of large U.S. electric power companies. Environmental damage costs have been estimated conservatively; only air emissions of carbon dioxide, sulfur oxides, and nitrogen oxides have been included, though power plants also emit large quantities of harmful particulates and trace elements of mercury and other toxic substances. Damages per ton have been estimated conservatively from the economic research literature. (For example, marginal damages of $14 per ton of CO2 is the mean of a nearly comprehensive sample of peer-reviewed studies of the economic impacts of climate change.)
For each company, the first column of data shows net operating profits after taxes in millions of dollars, NOPAT, in 2004. The next column shows Stern Stewart’s estimate of economic value added, EVA. A few companies in 2004 were not earning their cost of capital and generated negative value added. The third column, return on capital, represents each company’s NOPAT divided by its capital stock. The fourth column shows true value added, once the environmental damage costs created by the companies’ emissions are subtracted out. Remarkably, by this measure few electric power companies were adding value to the economy. The damages they imposed exceeded the surpluses they generated, often by a large margin. American Electric Power and the Southern Company, two very large, coal-based power generators, imposed net costs of $8.7 and $6.7 billion respectively in 2004. The final column shows each company’s true return on capital, which, in some cases, is very negative. These companies must be regarded as quite exposed to future restrictions on greenhouse gas emissions and tighter air quality restrictions based on health, acid rain, visibility and other concerns.
This measure provides useful guidance both for management and for investors. It enables management to track progress in environmental management in a practical, dollars-and-sense format. The overall goal is to improve true value added, reducing potentially costly environmental exposures without unduly burdening EVA. TRUEVA incorporates both in a single environmental measure. For investors, it provides insight into the financial magnitude of environmental risks and exposures that appear nowhere in companies’ financial records and enables investors to screen for environmental and economic performance with an integrated financial benchmark. TRUEVA deserves wide attention from managers and investors.
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Robert Repetto is Professor in the Practice of Sustainable Development at the Yale University School of Forestry and Environmental Studies, where he teaches graduate courses on environmental and resource economics. He has been a Fellow of the Tim Wirth Chair at the University of Colorado, an advisor to Stratus Consulting, Inc., an environmental consulting firm, a professor in economics and public health at Harvard University, and has worked on development planning and economics in India, Bangladesh and Indonesia. He holds a PhD in economics from Harvard and a MSc in Econometrics from the London School of Economics.
Daniel Lopez Dias currently operates both as the Head of Methodology for Trucost Plc, an environmental research organization based in London, U.K., and as a PhD student at the Gund Institute for Ecological Economics at the University of Vermont, where he works on developing and implementing corporate environmental accounting and sustainable investment frameworks. He has previously worked for the Environmental Investigation Agency, an environmental NGO. Dias holds a master's degree in Environmental Assessment and Evaluation from the London School of Economics and a bachelor's degree in (Marine) Zoology from the University of Bristol.