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Environmental Accounting and the New Wealth of Nations
Hassan Masum, 9 Oct 05

We've talked before about inclusive wealth, green GDP, the GPI, indicators, the triple bottom line, ecosystem services, and ecological and environmental economics. But to get from a good idea to implementation is tough, conceptually as well as politically. The Handbook of National Accounting: Integrated Environmental and Economic Accounting 2003 - also known as SEEA 2003, and written "under the joint responsibility of the United Nations, Eurostat, IMF, OECD and the World Bank" - gives a remarkable in-depth treatment of the whole area.

I discovered this excellent resource in Where is the Wealth of Nations?, a recent report in which the World Bank estimates natural, produced, and intangible wealth in a range of countries, and finds econometrically that many are not on a sustainable path:

The large share of natural resources in total wealth and the composition of these resources make a strong argument for the role of environmental resources in reducing poverty, fighting hunger, and lowering child mortality. The analysis in this volume proceeds from an overview of the wealth of nations to analyze the key role of the management of wealth through savings and investments. It also analyses the importance of human capital and good governance and engages finance ministries in developing a comprehensive agenda that looks at natural resources as an integral part of their policy domain.

Though flawed, this report is notable for the issues it tackles as part of the World Bank's environmental economics initiative. As the authors acknowledge, their econometric modeling is a work in progress, yet reading the details gives an appreciation of how difficult it is to do this well. And Chapter 9 (Developing and Using Environmental Accounts) is a good survey of the current state of play in this crucial arena.

Accounting for the depletion of natural assets is a key step in valuing and preserving them. But it's hard. How much is an intact forest or clean atmosphere worth? SEEA 2003 and the other resources I'll mention highlight progress toward answering such questions - and toward building an eco-accounting framework that will make sustainable economic activity the lowest-cost default option.

Background: Environmental Valuation

Making money is a key driving force for most people and organizations - a basic survival instinct in a world where money represents a kind of vital life force. Valuing ecosystem services in financial terms, then, can grab the attention of decision-makers in a way that rhetoric or impassioned pleas can't hope to match. More, implementing systemic incentives to minimize environmental harm will shape the daily activities of every individual and business, as doing the right thing environmentally becomes the cheapest course of action.

Discussions of some of the issues in environmental valuation include, the RAND report Nature's Services (see particularly the section on ways to value a wetland), and Ecosystem Services: Benefits Supplied to Human Societies by Natural Ecosystems. But getting from discussion to generally accepted accounting measures for valuing ecosystem services is turning out to be a massively complex undertaking.

Robert Costanza co-wrote the classic 1997 Nature paper, "The Value of the World’s Ecosystem Services and Natural Capital" (from which the oft-quoted US$33 trillion ballpark estimate for global ecosystem service value). Though the paper has received much criticism of its methodology, it did serve to put the issue onto the public radar with that dramatic dollar figure. Costanza now heads the Gund Institute for Ecological Economics at the University of Vermont, where you can see an intriguing mock-up of an Earth Shareholder Report:

The Earth Shareholders Report (ESR) will summarize and communicate to a broad range of individuals, interest groups and governments around the world the extent and importance of “non-marketed” ecosystem services, human capital, and social capital. It will be modeled after a typical corporate shareholders annual report, and will describe how to manage human activities on the earth if it were run as a “business” accounting for all four types of capital (human, social, natural, and built/financial).

Gretchen Daily edited the 1997 book, Nature's Services: Societal Dependence on Natural Ecosystems,with contributions from 30 scientists and social scientists. She also co-wrote the more action-oriented The New Economy of Nature. A quotable quote:

Ecosystem services are absolutely essential to civilization; they are priceless. Yet their lack of a price - they are typically not traded in economic markets - has contributed to a widespread lack of awareness of their very existence, and to a corresponding misimpression that the ecosystems that supply them lack value.

Just as one cannot capture the full value of a human life in economic terms, it would be absurd to try to estimate the value of nature in strictly economic terms...But estimates of the lower-bound, marginal value of nature's goods and services - in the trillions of dollars - are critical to informing decision-makers."

Both of Daily's books were published by Island Press, which has brought out other books on ecosystem studies and positive environmental solutions. One that I've heard praised is Ecological Economics: Principles and Applications, which is being adopted as a university text. (Island Press also publishes the printed reports of the Millennium Ecosystem Assessment, a critical background resource.)

Of course, there are by now a large number of academic papers in the area. For example, "Market for Ecosystem Services" has several useful tables (e.g. "Valuation of ecosystem services – when, why and how?", "Avoiding common pitfalls to valuation", "Examples of payments for watershed functions", and "Instruments to promote ecosystem services"). And "Ecosystem Service Valuation and Watershed Resources: An annotated literature review" is a nice bird's eye view of the issues, pros, and cons of a number of papers.

We'll give the last word in this mini-survey to a call to action from "Aggregate measures of ecosystem services: can we take the pulse of nature?":

...Ecosystem services occur at various scales and are quantified by different metrics, making aggregation into a single equation dependent on creative and thoughtful scholarship (and unavoidable value judgments). Furthermore, the services included in the equation will need to be weighted relative to each other and to account for the tradeoffs of increasing one service at the expense of another...The indicator must be clear, concise, easily explained, and retain enough information to highlight the most important aspects of ecosystem services. A great deal of basic research – by ecologists, economists, statisticians, policy experts, and others – will be necessary for the creation of an aggregate indicator. We need to examine what is gained and what is lost through aggregation, in order to ensure that an aggregate indicator provides additional benefits that a suite of disaggregated measures will not.

The challenges associated with this task are formidable, but are not insurmountable. Today’s widely accepted economic indicators were developed over decades, not days...

The World Bank weighs in

Okay, sounds good - but how far along are we in the task? The World Bank and SEEA reports give a peek into the current state of affairs. In the World Bank report's own words:

A major focus in this analysis is on placing economic values on stocks of natural resources and changes in the values of these stocks. This information is used to illuminate the role that natural resources play in development, particularly in poor countries. The analysis suggests that changes in natural resource management are needed in order to increase economic benefits, and the need for these changes will lead to reforms of policies and institutions.

...Expanding the measure of wealth to include natural resources raises an important set of fiscal issues concerning revenues, expenditures, fiscal space, boom-and-bust cycles, and the quasi-fiscal impact of state-owned enterprises (SOEs). Dealing with these issues will not likely turn finance ministers into environmentalists, but a sharper focus on the fiscal aspects of natural resources can have a substantial impact on macrobalances and economic performance in many countries.

Well, it sounds good...but how is the value of natural capital estimated?

In general, the estimation of natural capital takes place in two consecutive steps. First, the net yearly revenue from the resource is calculated. In the second step, revenues (or rents) are projected into the future to compute their net present value. For example, in order to estimate oil stocks, the year 2000 net oil rent is calculated and future rents are estimated based on today’s rent and the remaining duration of the reserves. The stream of rents is then totaled using the social discount rate. A similar procedure is used to estimate the other subsoil assets. The calculation of forest resources requires taking into account the sustainability of the resource rents. Unsustainable exploitation of forests is picked up by reducing the number of years over which the current income can be pursued. Overextraction of timber may then result in higher income today, but for a shorter period of time.

Clearly there are flaws here. Due to the econometric measures used, natural capital winds up being a small financial fraction of the total wealth in developed countries. But these estimates do not adequately factor in key ecosystem services, like a stable climate (though a $20 / ton CO2 penalty modifier is mentioned). Further, the financial estimates do not seem to account for the enormous price shock vulnerability of key commodities like oil, for which demand is relatively inelastic. (If oil supply keeps up with demand, prices remain low, and so does the "wealth" component of oil. But if demand outstrips supply and there's a large price rise, the same commodity becomes worth a lot more in financial terms. Prices are highly contingent.) And there's a 25-year discount horizon, with a 4% / year discount rate...should the value of future well-being count so little in choosing today's course of action?

One could go on, but there are a lot of positive points in this work as well, and the report explicitly recognizes some of its own shortcomings - suggesting, for example, that future work should include a wider variety of natural resources and ecosystem services.

Other portions of the report cover the concept of "adjusted net savings" (a savings macroindicator adjusted for factors like natural resource depletion, and reported in the World Bank's World Development Indicators and Little Green Data Book), prudent investment of assets in resource-rich countries vs the so-called "resource curse", per-capita vs gross wealth, and human capital.

Environmental Accounting and SEEA 2003

The closing chapter on Developing and Using Environmental Accounts is a good overview of different approaches. A sample:

Economic sustainability can be defined as strong or weak, reflecting controversy over the degree to which one form of capital can substitute for another. Weak sustainability requires only that the combined value of all assets remain constant. Strong sustainability is based on the concept that natural capital is a complement to manufactured capital, rather than a substitute. An indicator of sustainability, therefore, requires that all natural capital is measured in physical units. A less extreme version of strong sustainability accepts some degree of substitutability among assets, but recognizes that there are some critical assets which are irreplaceable. The corresponding measure of sustainability would be partly monetary (for those assets, manufactured and natural, which are not critical and for which substitution is allowed) and partly physical, for natural assets, which are critical.

...Two methods have been used to value assets: net present value (NPV) and net price. The NPV method of valuation requires assumptions about future prices and costs of extraction, the rate of extraction, and the discount rate. It is often assumed that net price and level of extraction remain constant, although when information is known about planned extraction paths, or expected future prices, this information can be incorporated. A wide range of discount rates have been used by different countries.

In much of the early work on environmental accounting...the net-price method was used to value assets rather than NPV. The net-price method simply applies the net price in a given year to the entire remaining stock. The revised SEEA recommends NPV, and this method has become more widely used than the net-price method in more recent work.

...The purpose of most monetary environmental macroeconomic aggregates has been to provide a more accurate measure of sustainable income. The first approach revised conventional macroeconomic indicators by adding and subtracting the relevant environmental components from the SEEA, the depletion of natural capital, and environmental degradation (O’Connor 2000). Most economists and statisticians accept the adjustment of NDP for asset depletion, in principle, even though there is not yet a consensus over the correct way to measure it. However, some economists and statisticians have criticized environmentally adjusted NDP (eaNDP) for combining actual transactions (conventional NDP) with hypothetical values (monetary value of environmental degradation). If the costs of environmental mitigation had actually been paid, relative prices throughout the economy would have changed, thereby affecting economic behavior and, ultimately, the level and structure of GDP and NDP.

Let's turn now to SEEA 2003. According to the UN: "It brings together economic and environmental information in a common framework to measure the contribution of the environment to the economy and the impact of the economy on the environment. It provides policy-makers with indicators and descriptive statistics to monitor these interactions as well as a database for strategic planning and policy analysis to identify more sustainable paths of development."

In this case, I found the wordy UN document style to be an advantage - the concepts are laid out clearly and in detail, and the range of opinions on many open issues seems to be fairly well covered. An excerpt from the first chapter gives the flavor of discussion:

1.23. Natural capital is generally considered to comprise three principal categories: natural resource stocks, land and ecosystems. All are considered essential to the long-term sustainability of development for their provision of "functions" to the economy, as well as to mankind outside the economy and other living beings. It is helpful to consider these functions as falling into one of three groups:

Resource functions cover natural resources drawn into the economy to be converted into goods and services for the benefit of mankind. Examples are mineral deposits, timber from natural forests, and deep sea fish;

Sink functions absorb the unwanted by-products of production and consumption; exhaust gases from combustion or chemical processing, water used to clean products or people, discarded packaging and goods no longer wanted. These waste products are vented into the air, water (including sea water) or are buried in landfill sites. These three destinations are often referred to as "sinks";

Service functions provide the habitat for all living beings including mankind. Some aspects of habitat are essential, such as air to breathe and water to drink. These are called survival functions. If the quantity and quality of survival functions are diminished, biodiversity of species is threatened, not excluding the human species. Some service functions are not essential in the same way but improve the quality of life, for example by providing a pleasing landscape for leisure pursuits. These are called amenity functions and affect mankind only (or at least are the only ones measurable to us in human terms).

1.24. According to the capital approach, the long-term sustainability of development is seen to depend upon the maintenance of natural capital (in addition to the other forms of capital). If stocks of natural capital decline to the point where they are no longer able to adequately provide the functions listed above, any pattern of development that relies on these functions is not sustainable. Of course, this is not to say that some other pattern of development is not possible, only that change will be required to either 1) eliminate the need for a particular natural capital service or 2) find a means of replacing the natural capital service with a service of produced capital.

1.25. Even if many researchers accept the basic idea that sustainable development requires maintenance of natural capital, the relationship between natural capital and other types of capital remains a matter of debate. Although there is agreement that all forms of capital are important when considering sustainability, there is a divergence of opinion as to whether the various forms are complements or substitutes (especially as to whether natural capital can be replaced by other forms). Many researchers argue that produced and human capital are very often, if not always, substitutes for natural capital. Society has, they note by way of example, employed produced and human capital to devise chemical fertilizers that substitute for the natural fertility of soil. Even soil itself can be replaced in a limited way through the use of hydroponics. History is full of similar examples where technological advancement has allowed substitution of scarce resources with those that are more abundant. Many would claim there is every reason to believe that such advancement will continue, even at increased rates, in the future.

1.26. Others argue that the possibilities for substitution are more limited, even completely absent in some cases. Many forms of capital, they argue, are of value only when combined with another form. For example, a fishing fleet (produced capital) is essentially worthless unless combined with healthy fish stocks (natural capital) to exploit. In this case, the fishing fleet and the fish stocks are said to be complementary. But this is just a limited example of complementarity, where a subset of one type of capital is complementary with a subset of another type of capital. Another possibility is that a certain form of capital provides a service that is essential to the functioning of the entire planetary system and for which there exists no known substitute. Although examples of this type of capital are few (and there may be no absolute example), global atmospheric systems that provide the services of protection from solar radiation and climate regulation come close.

1.32. Strong sustainability requires that natural capital stocks be maintained intact independent of other forms of capital. In practice, this requires invoking certain principles for the use of natural capital. Inherent in these principles is the notion that prudence should be applied when making decisions about natural capital. Our limited scientific understanding of the environment requires that this be so. While it may eventually turn out not to be necessary to maintain a particular form of natural capital, it is dangerous to assume this and foreclose future options. Sustainability, we are reminded, is a problem over the long run as much as or more so than one concerning the current period. The caution called for by strong sustainability is often expressed in terms of the "precautionary principles" expressed below:

Renewable resources should not be used in excess of their natural regeneration;

Non-renewable resources should be used prudently and efficiently with care that the same function is available to future generations, say by technological development or shift to use of renewable resources;

Sink functions should not be used beyond their assimilative capacities;

Activities which cause deterioration in service functions should be avoided or at least minimised.

The report goes on to discuss issues in environmental accounting in almost 600 pages of detail. Green geek paradise!

Toward Worldchanging green accounting

Accounting for the environment is a critical idea, but there are a lot of conceptual issues involved in working out a stable and comprehensive system. Doing environmental economics properly will be hard, and traditional green economics metrics are only an interim goal. What would a truly Worldchanging version of environmental accounting look like?

I believe it would have to build on the work of Herman Daly and others in Ecological Economics. As Brian Czech wrote in a comment here earlier:

...ecological economics is distinguished from "environmental" economics (a subset of neoclassical economics) on a number of fronts. I’ll mention two:

1) Ecological economics begins from a different starting point; i.e., natural sciences including especially laws of thermodynamics and principles of ecology.

2) Ecological economics deals with far more than "pricing" natural resources. Its primary emphasis is SCALE, the size of the human economy relative to the ecosystem that sustains it. Thusly recognizing a limit to economic growth, it goes on to address the issue of DISTRIBUTION (of wealth), which must be equitable enough for social stability and a sustainable outcome. Finally, like neoclassical (including environmental) economics, it deals with the ALLOCATION of resources (this is the "pricing" issue) for the sake of efficiency.

Thinking about the question from a different angle, it's clear that some level of ecosystem services is essential for a sustainable high quality of life, so any actions that cut into that "life support" level of services could simply be forbidden, and not subject to pricing regimes. Past that life support level, pricing would kick in as an efficient allocator of effort and resources, but with full-cost accounting that includes externalities and long-run effects. Since major uncertainties will likely persist with respect to climate and ecosystem impacts of industry, actions with greater downside risks would require long-term mitigation insurance or escrow funds, which would feed through automatically into accounting measures. (There would thus be built-in incentives to understand ecosystem and climate impacts better, especially if there were complementary advances from rhetoric-based to evidence-based policy.)

My guess is that, for a really satisfactory solution, this will have to be combined with a better understanding of "valuation" itself. For instance, we don't seem to have a good theory of how something as basic as money itself would work in the case of complementary currencies. It may well be that "ecological accounting" in a sustainable, advancing, zero-waste economy will require new kinds of monetary instruments - e.g. currency units that are directly tied to commodities, or futures tied to sustainable energy and material outputs. When our currency automatically "understands" sustainable resource and ecosystem service levels, and our accounting measures include long-range costs and benefits of actions, it will become natural to do the right thing environmentally...and our ingenuity can be redirected toward ever-greater levels of efficiency, human achievement, and ethical and lifestyle progress.

Although money and economic systems are human constructs, they take on the character of physical law due to their ubiquity. We're engaged now in a great collaborative venture to realign the fiscal infrastructure with underlying resource and ecosystem service values. Done right, accounting could help shape the fate of our planet.

(Thanks to Jamais Cascio for suggestions!)

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This is great for business! I can imagine the Congolese threatening to cut down their entire pristine rainforest, unless the West pays the price it puts on such forests in its sophisticated green accounting schemes. "Tonight, we will slaughter ten thousand undiscovered species, unless..." Ultimatums, blackmailing... This is the way to go! Finally, the Congolese can cash in some themselves. (The Europeans and the Americans cut down all their forests ages ago, after which they colonized us to cut down ours; why would we take this sustainability nonsense from them now? For once we can cash in, and Whitey comes here to tell us we can't! )

(I remember the Papuan Government doing something similar recently: we won't cut down our forests, if you give us carbon credits and more; if you don't, these trees are pulp.)

Posted by: Lorenzo on 9 Oct 05

they already do this, ie give us aid $$ or the forest gets it, so business as usual in that regard. A difference would be if environmental capital prices are included in commodity prices (& the benefits of the environmental assets prices are distributed in ways to assist development which is a whole other institutional problem)... to achieve this there would have to be international trade & national accounting standard agreements or the countries using ecological pricing in trade commodities would be at a competitive disadvantage. International Ecological Trade Agreements!! I'd eat my hat!

Daly & some other ecological economists recommend that rich countries stop all economic growth & poor countries are allowed to grow. I'll eat my gloves too when that happens

Posted by: Sturt's Desert Pea on 10 Oct 05

Daly & some other ecological economists recommend that rich countries stop all economic growth & poor countries are allowed to grow. I'll eat my gloves too when that happens.

Well, it has happened in a sense. Europe and some other rational states have voluntarily forced themselves to pay for global warming and greenhouse gasses, by a treaty called the Kyoto Protocol, which excludes developing nations from sharing the burden (which comes down to what you're saying).
The USA and other irrational nations didn't want to commit, because it's "bad for business".

So unless the irrational states of this planet are struck by lightning or divine intervention, not much will change. We tried, and we're doing it alone, but it would have been nicer if we had succeeded in getting more people on board.

I'm sure Europe will be at the forefront of recognizing green assets as a crucial accounting component, but it always has to fight against the irrational states who continuously block economic and environmental justice and sanity.

Posted by: Lorenzo on 10 Oct 05

Ah sweet innocence how touching.

Did it ever occure to you that maybe these irrational nations simply came to a different conclusion and as such are reaching for a different goal with a different deadline.

Did it ever occure to you they may be right?

What is the value of a forest if in 30 years it will be a desert no matter what.

What was the value of a coral reef if it will die tommarrow and be reborn elsewhere?

What is the value of the rainforest if the rain goes away?

What is the value of an unpolluted river if it will be a dry riverbed 20 years from now?

What is the value of a frog if all its kind will be dead by xmas and some other frog will slowly take its place evolving to fill in the nooks it left behind?

Posted by: wintermane on 10 Oct 05



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