GreenBiz Reads

A birds'-eye view of the value of natural capital

A sunrise hot air balloon flight over the Yarra Valley in Victoria, Australia. The utility Yarra Valley Water published the first integrated profit and loss report quantifying its positive and negative natural, social, human and financial impacts in monetary terms.

The following is an edited excerpt from "Greener Products: The Making and Marketing of Sustainable Brands, Second Edition" by Al Iannuzzi (CRC Press, 2017).

Companies have an enormous opportunity ahead: Consumer demand for products is set to grow significantly over the next 20 years with the increase in middle-class consumers, especially those in emerging markets, who will require food, clothing, housing and transport at levels never seen before.

At the same time, this presents an enormous challenge for businesses to provide these products and services against a backdrop of increasingly scarce resources, such as water. Successful business models will be those that understand the value of the natural systems that provide these resources — commonly referred to as natural capital — and how these systems can be managed as part of the production of greener products and services.

Nature is an important part of the global economic engine and the brands behind it. For example, the U.S. forest products industry is 4 percent of the total U.S. manufacturing GDP, makes over $200 billion in products annually and provides about 900,000 jobs, according to the American Forest and Paper Association.

Nature also provides services to businesses, such as the clean water that a pulp and paper-making mill might require, which are much harder to value.

But in 2013, executives at the U.N.-backed organization the Economics and Ecosystems of Biodiversity set out to quantify just how much the economy relies on goods and services from nature. The landmark study, Natural Capital at Risk — the Top 100 Externalities of Business, found that primary production and processing industries (agriculture, forestry, fisheries, mining, oil and gas exploration, utilities; primary processing industries: cement, steel, pulp and paper and petrochemicals) cost the economy around $7.3 trillion a year in terms of the economic costs of environmental impacts, things such as greenhouse gas emissions, loss of natural resources, loss of nature-based services such as carbon storage by forests, or air pollution-related health costs. At a cost of about 10 percent of the $75 trillion global economy, nature’s contribution is vital to future business growth and viability.

The analysis was the first to quantify and value "hot spots" — areas of greatest environmental impact for the economy, broken out by region and commodity. The highest environmental costs are associated with energy generation and food production. These costs include the damage to society from impacts of greenhouse gas emissions, the health costs and societal damages from air pollution (for instance, asthma or crop damage), or water pollution from the excessive use of fertilizer which creates a cost for businesses or communities who have to pay to treat the water so they can safely use it.

Topping the rankings are coal-fired power in Eastern Asia (ranked first with $453 billion in environmental costs) and in Northern America (ranked third with $318 billion in environmental costs). Another high-impact sector is agriculture, especially in water-scarce areas and where production and land use is also high. For example, cattle ranching in South America at an estimated $354 billion, ranks second while wheat and rice production in Southern Asia rank fourth and fifth, respectively.

Even though many of these natural capital costs occur in the developing world, the resulting products are consumed by supply chains in developed economies, making it a global challenge for a globalized world. Although the total costs in the Natural Capital at Risk analysis were strikingly high, perhaps the more surprising revelation is that the natural capital cost is higher than the total revenue of each sector. In other words, not one of the top 100 businesses would be profitable if they had to pay the environmental costs associated with production. 

The scale and variation in the natural capital costs across regions and commodities in the Natural Capital at Risk analysis show that companies have a very real opportunity to differentiate their brands, business models and greener product manufacturing processes by incorporating natural capital valuation to optimize their supply chains, sourcing decisions and product designs.

Historically, accounting systems have relied solely on traditional measures of financial wealth, for example, GDP as an economic measure or a profit and loss statement for a business. Increasingly, business leaders are recognizing that the profit margin (EBIT) before and after natural capital costs, based on top-two companies in value they create, should be measured by a wider set of measures than shareholder return on financial capital.

Six types of capital — financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital and natural capital — comprise the broader range of measures that are the basis for value creation (International Integrated Reporting Council 2016).

Part of the drive for this broader framework comes from stakeholders that want to know how brand owners impact them and their community. Investors, customers, citizens and regulators are demanding that businesses provide more transparency about how they manage environmental and social risks. Customers are demanding higher performing products that do not increase the environmental or social costs to their communities.

The value of a business’s reputation also increasingly depends on demonstrating a positive impact on society — beyond financial returns. Leading businesses are quantifying these broader forms of capital and value creation. As an example, driven by a desire to understand the full value it delivers to society, the large Australian water utility Yarra Valley Water published the first integrated profit and loss report quantifying its positive and negative natural, social, human and financial impacts in monetary terms.

Its approach was to consider "value addition" through a holistic lens: Measuring impacts across all capitals and categories of stakeholders affected — including employees, customers and society at large — and not just its shareholder, the Victorian Government. Value is degraded when pollutants are discharged into the environment, waste is sent to landfill and natural land is converted.

Value is created when society receives free benefits, such as when water is cleaned and recharged back to the environment, when ecosystem services are provided, or when vulnerable families receive waivers on water utility bill payments.

Natural capital and business value

Natural capital, one of the six forms of capital, is the stock of renewable and non-renewable resources (such as plants, animals, air, water, soils, minerals) that provide a flow of benefits to people and the economy. 

Some economic benefits provided by natural capital are valued; for instance, commodity raw materials such as wood. Other goods and services that nature provides are equally important to the economy yet not fully valued by markets; for example, clean water that a business needs to run its production processes or the clean beach that an airline might depend on to book seats to resort destinations.

The term natural capital cost is used here to describe the non-market value of the environmental resources that businesses depend on to grow revenue. Because these natural capital-related goods and services are not fully valued by markets and are not part of corporate finance accounting systems, they are typically not considered in most business decisions. Imagine a group of high-use commodities that drive enormous value in the economy, but where there are no price-setting participants because there is no market.

Then think about what the potential is for mispricing and dramatic price volatility of these resources and the implications for business performance. In the most extreme case, the resources disappear before the price can move because there is no price signal to curtail demand. That is the precise situation for the vast majority of the world’s essential environmental resources, from clean air and fresh water to natural habitats, landscapes and a stable climate.

The current situation results in inconsistent or incomplete decision-making that is based on anecdotal or subjective judgments about the importance of environmental resources to a business model or investment decision.

Why are businesses valuing natural capital?

Failure of climate change mitigation and adaptation is the No. 1 impact global risk, according to the World Economic Forum Global Risks Report 2016. Other high sustainability risks include extreme weather events, water crises, food crises and biodiversity loss, with the most severe risks faced by the most productive — and vulnerable — regions that company supply chains depend on. There are a wide range of business benefits to valuing natural capital, which include, for example, lower operational costs, avoiding regulatory risks, reducing lending costs or maintaining a social license to operate.

Making, using and disposing of products — even greener ones — have a range of environmental and social costs that in most cases are not reflected in their market price. Both the costs and benefits of different material options need to be considered to enhance the sustainability of these products. Applying environmental or "natural capital" valuations allows brand managers and product designers to measure and communicate environmental impacts in monetary terms.