Many of the things that you can count don’t count; many of the things that you can’t count really count.
Albert Einstein
Accounting is not a topic that generally sets the world alight. But there is one area where it should, and that is where it literally could set our world alight by threatening our survival as well as prosperity. No less an issue is at stake in relation to accounting for our environment and natural capital.1
At present, for the most part we do not account for the environment and natural capital. We count our financial and material assets but not some of our most vital and basic assets that help us breathe and live. Why does this matter? How can accounts destroy or save our planet?
The answer is that we have become transfixed by accounts and base our lives around them. We assiduously record what we do as an asset and liability and then reward people on the basis of the profits and losses that they create. The cost entries of our accounts have become the compass of our existence. The problem is that those entries in accounts are often simply wrong. The compass is a source of inaccurate fascination that is steadily guiding us to a precipice that threatens our survival. The mistake we are making is in recording activities and transactions without taking proper account of their effect on our environment and natural capital. The consequence is that we are recording profits where there may be none and failing to report them where they may be substantial.
A simple example will illustrate the point. Consider a company that is considering building a manufacturing plant or drilling for oil in the middle of the Amazon rainforest. At present it records the cost of the land it purchases, the buildings, equipment, and other supplies it acquires and the people it employs. It then records the revenue that it earns from the production of the plant or the oil it extracts and the profits that result by subtracting the costs of the inputs. What it fails to recognize is the destruction of the rainforest. It incurs a cost in chopping down the trees and earns income from selling the timber but the impact of the destruction of the trees on the environment, the Amazon forest ecosystem, the carbon capture, or the water table remain unrecorded.
The reason it does not record these is that it is not paying for them or rewarded for them. Its balance sheets and income statements only incorporate items that affect the financial performance of the firm. If there is no effect on the company’s earnings and expenditures then there is no entry. The company is not misleading anybody; it is doing what it is expected to do. It is just that in the process of doing what it is required to do, it is misleading everybody.
It is not only in relation to natural capital and the environment that these issues arise. Suppose that the company was not only cutting down the forests but also employing workers at below a living wage or, worse, below a subsistence level. If it is breaking the law then its profits are clearly being overstated because there is a possibility that it will be fined for its employment practices. If it is not, then there is no apparent cost to the firm in continuing what it is currently doing.
Or to take a third example, suppose that the firm’s activities are destroying the existing communities within which it is operating, undermining the local infrastructure and endangering the health of the people in and around its plants. Again, if it is breaking the law then it may incur a cost but otherwise it will not.
In all these cases, so long as the firm is operating within the law, the firm’s profits are not affected by its actions and the consequences of them for the environment, natural capital, human capital, or social capital are not reflected in its accounts. These are effects for which it is not being paid or penalized and should not therefore be reported in its measured performance. Put another way, accounts conventionally capture the legal liabilities and claims of what the firm does. They do not incorporate activities for which there is no legal liability or claim. These fall outside the boundaries of the firm and have no place in its financial reporting.
The nature of the accounting therefore naturally corresponds with the Friedman doctrine described in the Preface. Firms’ sole objective is to maximize their profits subject to upholding the law and social norms. So its accounts should reflect what contributes to or detracts from that and exclude everything else. There is therefore an internal consistency in the way in which the firm is conventionally conceived and its performance is measured. It is not possible to alter one without altering the other. It is no good wishing we measured company profits differently so long as the purpose of the firm is to maximize profits, and there is no point in changing the purpose of the firm if we continue to measure its performance just in relation to profits. Moving one involves moving both.
While internally coherent, the conventional approach is logically inconsistent. To see this, consider its long-run consequences. Consider a company that is profitable, growing, exploiting its natural capital, paying its workers below a subsistence wage, and destroying its local community and infrastructure. What will happen to it? The answer is it will thrive but not survive. According to its financial accounts, it will be doing splendidly and it may continue to do so for some time to come. But it will eventually run out of the natural, human, and social resources that it requires for its existence. That follows immediately from the observation that it is depleting finite resources necessary for its survival at a faster rate than they are being renewed.
The survival of firms depends as much as we do on the maintenance not only of physical and financial capital but also of natural, human, and social capital. The long-run growth of the firm requires the balanced growth of all of its capitals not just material and financial capital.
The significance of different capitals will vary depending on the activities in which firms are engaged. For some, material and financial capital are predominant. For others, in particular in the service sector, human capital is of greater significance. For those in the natural resource business, natural capital is a primary input. But in no firm can profits be sustained at the expense of finite capitals on which its survival depends.
What this points to is a notion of capital maintenance that goes beyond current concepts. At present, a firm’s profits are measured after subtracting the cost of maintaining its physical capital, namely the depreciation of its buildings, equipment, plant, and machinery. No account is taken of the cost of maintaining its natural capital, upholding the health and well-being of its workforce, or preserving the local infrastructure and communities within which it is operating. In other words, at present a firm can be highly profitable at the same time as it is entirely unsustainable because while it makes proper provision for preserving its physical capital, it makes no provision for the cost of maintaining its natural, human, and social capital.
The implication of this is that what a sustainable firm needs to do is exactly the same as what a responsible firm should do. It should account for the cost of maintaining not just its physical capital but all of its capitals—its natural, human, and social capitals. It should measure the depreciation of all of these capitals and record its profits net of the cost of maintaining and restoring them. If it fails to do so then it is simply mismeasuring profits and in most cases overstating them.
The importance of this is twofold. First by misstating profits, companies are misallocating their resources. To see this, return to the company building a plant or drilling for oil in the Amazon rainforest. By failing to account for the cost of preserving the environment and natural capital, the firm is reporting profits that simply do not exist—what might legitimately be described as ‘fake’ profits to contrast them with the ‘fair’ profits that are associated with sustainable activities. It may no longer be profitable for the firm to be undertaking these operations if its profits were correctly reported. We are at present promoting activities that should not be taking place because, while they appear to be profitable, they are not—they are fake.
Second, and equally important, by restating profits correctly we are stopping companies distributing profits to their shareholders that they do not possess. According to company law, companies cannot distribute more than their accumulated capital. Their accumulated capital comes from their retained profits. Their measured profits are therefore important in setting a bar on the amount that the company can pay to their shareholders. At present, distributions are excessive in relation to companies’ true profits because their profits are overstated. By correctly measuring depreciation and capital maintenance in relation to all relevant forms of capital then firms’ profits are appropriately restated and permissible distributable profits correspondingly reduced.
So at the very least, what a correct system of accounting does is to report profits after a proper provision for the maintenance of all forms of capital. That in itself will have a dramatic impact on the conduct of firms. But it is only one half of the story.
As noted in the preface, the determination of what is currently recorded in companies’ accounts is determined by a property view of the firm: What is the property of the firm gives rise to legal claims and liabilities. What falls within the legal boundaries of the firm is reported and what does not is excluded. Again it is an internally coherent concept but it is irrelevant.
It is irrelevant because the boundaries are not relevant. It is like defining the boundaries of a country as residing at its borders when it is a part of a union with neighbours that permits the free flow of people and goods across its borders without restriction. Its borders are a fiction, and so long as they are recognized as such they do no harm, but if they are not then they can be very damaging.
The legal borders of the firm are equally fictitious but are not recognized to be so and have thereby been extremely damaging. The reason that they are fictitious is that, regrettably, noise, smoke, polluted water, poverty, and personal distress do not recognize legal borders. They permeate where they wish with no consideration for where the law believes that they should not trespass.
The economic significance of this is that by defining the boundaries of the firm where they do not exist, we are excluding activities that should be included and including those that should not be. To go back to the example of the firm in the forest, we have already established that its profits should not be insulated from the havoc it inflicts on its environment, people, or communities. But nor should it be unrecognized for the good that it does.
At present, the firm gains no credit, or more seriously no reported asset, for improving the environment, for educating its workforce, or for contributing to the education and health of its local communities. It gets no credit because they are external to the firm and fall outside the legal boundaries of the firm where they would be recognized in its accounts.
This is nonsensical. If these assets contribute to the corporate purpose then they should be recognized as such. Their costs should be reported as human, natural, and social capital assets alongside material assets on which the company may or may not earn financial returns in the future. If it is not expected to earn a financial benefit of a value equal to the cost of the investment then it should write down the asset in the normal way, as it would do for a material asset. If on the other hand it can find imaginative methods of commercializing the asset employing the innovative management practices described in Chapter 5 then it will in due course earn a financial return that will further justify the expenditure.
Furthermore, if the purpose of the company involves furthering human, natural, or social capital then the attainment of those objectives will be benefits in their own regard, compensating for lower financial returns. In other words, recognition of non-material assets should reflect their contribution to both financial performance and the achievement of corporate purposes more generally.
No wonder economics depicts homo economicus as unremittingly self-centred and selfish when all it records is his contributions to being so. At the moment we do not recognize that which is good but unrewarded and acknowledge that which is rewarded but bad. There are therefore two failures of existing systems of accounting. First they attribute profits where they do not exist and destroy value; second, they fail to acknowledge assets where they exist and create value. As a result, they are both an overstatement and understatement of performance, and therefore wrong.
Thus far we have discussed accounting in the context of firms and corporate accounts. But these problems are as important and potentially even more so at a national and international level. National accounts are a record of the economic activity of a nation. They report its output, income, and expenditure and are key to macroeconomic policy. In particular, they were integral to the emergence of demand management as a tool of macroeconomic policy in the second half of the twentieth century.
The basis on which national accounts are constructed is the goods and services that a country produces, the income that its inhabitants earn, and the expenditures they make. They therefore report what is produced, earned, and spent. As in the case of corporate accounts they record earnings net of the cost of maintaining the physical capital of the nation but, as in the case of corporate accounts, they do not record the cost of maintaining other forms of capital—natural, human, and social capital. As a result, growing national income can be associated with declining natural, human, and social capital. It is as if the landlord of a property records her rental income without acknowledging the deterioration in her properties and thereby misperceives both her true wealth and disposable income.
There is a second and potentially even more serious consequence of the preoccupation of national accounts with flows and not stocks and that is a failure to measure public-sector debt and borrowing requirement correctly. Companies do not talk about their debt or borrowing requirement, at least not in the way in which the public sector does. They refer to their net assets—net of their liabilities—and their net income or profit as the changes in their net assets.
The public sector cannot do the same because it does not systematically measure its stock of public assets and investments. It should but currently does not record natural capital as a national asset and expenditure on it as a national investment. It should but at present does not measure public-sector net wealth as the difference between the stock of public assets and liabilities, and the public-sector net surplus as the change in public-sector net wealth.
The consequences of this are twofold. First, national accounts mismeasure national income and output. They overstate it by failing to make provision for the cost of maintaining natural capital. Second, they fail to record natural capital assets and therefore understate net national wealth, the accumulation of net national assets, national saving, and public-sector net surpluses.
The problem is not by any means restricted to natural capital. The same is true of human and social capital because neither they nor public-sector investments in them are recorded as national wealth or contributions to its enhancement. In fact, as Chapter 10 will describe, the absence of national balance sheets has still wider repercussions because the public sector does not even record its stock of material capital—its infrastructure—comprehensively.
As a result, resources are allocated inappropriately. Too few are devoted to public-sector investments that enhance our national wealth in human, social, natural, and infrastructure assets, and too many to restraining public-sector borrowings that give false impressions of the deterioration of our national wealth.
Precisely how large the mismeasurement and overstatement have been is difficult to say because until recently there have been few attempts at measuring natural, human, and social capital. This deficiency has increasingly been recognized and more comprehensive forms of accounting have been developed to measure national well-being, i.e. human, social, and natural capital, as well as material and financial capital. In particular, accounting for our natural capital (our environment and ecosystems) has risen to prominence and become the subject of national and international initiatives. For example, a System of Environmental-Economic Accounting (SEEA), a joint initiative between several international agencies, has created a common framework for the adoption of natural capital national accounting by national governments.
It is early days in the production of reliable estimates but the 2012 Inclusive Wealth Report2 has produced a set of estimates of measures of natural capital in twenty countries over the period 1990 to 2008. It tells a sobering story in relation to natural capital. In nineteen out of the twenty countries there has been a decline in natural capital—the only country to report an increase was Japan because of a rise in its forest cover. Separate estimates by the UK Office of National Statistics for the United Kingdom report a decline of natural capital of 4 per cent in just four years over the period 2007 to 2011.3
Failure to account for the cost of maintaining natural capital is resulting in both over- and understatements of countries’ true income and wealth. The Inclusive Wealth Report records that in six of the twenty countries in its analysis, declines in natural capital led to a decrease in overall wealth that includes human and natural as well as material capital.
So how should we put this right? The proper way to account for both corporate and national accounts is to do two things. The first is to recognize the liabilities associated with eroding human, natural, and social capital—a ‘do no harm’ principle. The second is to record the costs associated with enhancing human, natural, and social as well as material and financial capital as assets—a ‘do good’ principle.
Put very simply the first implies that if you earn 100 and have to spend 20 on restoring the fabric of your properties, your income is 80, not 100. Correspondingly, if national income is 100 and the cost of restoring natural capital to its condition at the start of the period in question is 20 then net national income is 80 not 100 as currently reported.
The second principle implies that if the 20 you spend actually improves the quality of your properties then the value of your property has appreciated by 20. Correspondingly, if 20 is spent on enhancing the quality of natural capital, for example cleaning up rivers and lakes, then that should be reflected in a higher value of natural capital assets. Get credit where credit is due but not where it comes from the damage you do.
Natural capital is very special because nature is very special. The hand of man has touched many if not all forms of natural capital but nevertheless what distinguishes natural capital from its material counterparts is that it also largely comprises nature. Where that nature is living it gives natural capital a unique and important feature in relation to its material counterparts—its ability to regenerate and sustain itself. When we consume material capital we use it up. When we consume at least some natural capital, as if by magic, we have as much of it as when we started.
That is the power of renewables. Provided that we do not consume too much of them then their regeneration property means that we do not have to maintain them. They maintain themselves. That makes natural capital an incredibly valuable form of capital. There are few other forms of capital (knowledge and information perhaps being two) that have an infinite life and do not depreciate in value when consumed.
Furthermore, the enduring nature of some aspects of natural capital, such as the world’s mountains and the prospect that the sun will continue to rise tomorrow, mean that there are many elements of natural capital that we do not have to depreciate. Our consumption of the rays of the sun does not impinge directly on its ability to continue to emit them, and the enjoyment that we derive from the existence of mountains does not affect their enduring presence.
The significance of this is that we do not have to set aside an amount for the maintenance of some forms of renewables. We do not have to determine a measure of capital consumption of these non-depleting assets. In contrast those forms of renewable that we are over-consuming, and in particular those that are at risk of potentially serious or catastrophic collapse, do need to be maintained and restored. It is those renewables that are at risk of deterioration or collapse that should be the focus of investment by companies and governments, and it is these that require a depreciation and maintenance charge in both corporate and national accounts.
The first stage of righting the wrongs is to determine which forms of natural capital are at risk because of overconsumption or exploitation. The second stage is to determine the cost of preserving and restoring those forms of natural capital back to a level at which they can regenerate themselves. That cost might be the expenditure needed to protect natural capital or it might be the value of productive activities forgone in the process of protecting the natural capital. So, for example, the company producing or prospecting for oil might plant additional trees or move its production elsewhere. That is the maintenance expenditure.
The restoration cost is the cost of not just putting the existing wrong right but going further in restoring the natural capital to a state in which it can regenerate itself. So the company may invest in the Amazon forest to restore ecosystems that are in decline. By bringing the condition of the ecosystem above its critical level, these larger expenditures now may avoid the need for repeated expenditures in the future to prevent further decline.
An important assumption underlying these maintenance or restoration costs is that existing natural capital has to be protected. There is no room for substitution of one form of capital for another or the offset of deterioration of natural capital in one location by investment elsewhere (for example, in nature reserves in place of natural habitats). No substitution sounds like a restrictive and extreme requirement. Its justification comes from the fact that the party most affected by today’s decisions about natural capital—future generations—is the one with no voice on the matter. The only way in which they can be given a say is by preserving natural capital as it is today, leaving them to determine what to do with it when they inherit it. We are in essence trustees of natural capital for future generations.
The importance of this is reinforced by the fact that the purposes to which we believe that natural capital can be best put today may be quite different from what future generations value the most. There is an option value of deferring decisions about the deployment of natural capital to future generations. For example, forests may at one time have been most valued for the fuel that they could provide, whereas today their recreational and carbon sequestration benefits may be more highly prized. Furthermore, the complexities of understanding the nature of ecosystems and the environment suggest that we should err in the direction of caution, imposing restrictive rather than lax rules on preserving them as they are.
A less restrictive approach is to consider categories of similar forms of natural capital that together should be conserved but which individually need not be. So, for example, the total stock of a particular species might be critical to its survival while its prevalence in a certain location is not. Or access to recreational land within a specified radius of an urban conurbation may be important while its situation in an existing locality is not. In other words, it may be possible to ‘offset’ detriments of one form by enhancements of another. While vulnerable to abuse, properly administered offsets offer a pragmatic resolution to purist restoration.
An important aspect of the approach described here is that it does not involve valuing natural capital. It involves identifying where natural capital is deteriorating or in danger of deteriorating but it does not put a price or value on that deterioration. It simply states that it is the responsibility of companies, landowners, and nations to put that deterioration right and not record a profit or income without having incurred the cost of putting it right.
This is about measuring profit and income correctly and it is as applicable to human and social capital as it is to natural capital. There should be no gain where it inflicts pain on employees, communities, or future generations—the pain should be borne by the perpetrator not the victim. Profit should only be acknowledged once it has been corrected for the cost of remedying the pain it has inflicted on others, be they employees, suppliers, customers, communities, nations, or the unborn.
There is no attempt at evaluating the value of these different types of capital. Neither a company’s nor a nation’s balance sheet includes the value of its human, natural, or social capital. These are important exercises that the Inclusive Wealth analysis attempts to undertake. They are important in establishing the scale, location, and distribution of different forms of capital. How large are human, natural, and social relative to financial and material capital? Where are they most prevalent and deficient? How are they changing over time?
These are important but difficult questions. They are difficult because of the scale of the exercises. For example, they involve identifying not just natural capital at risk of deterioration but all forms of natural capital, in principle sunlight and mountains as well as fish stocks and forests that are being exploited. They require prices to be attached to almost immeasurable concepts, such as the value of a particular species in the valuation of natural capital or social cohesion in social capital.
The scale and complexity of these exercises lead to scepticism and cynicism about their relevance and reliability. In particular, they raise concerns about economists’ preoccupation about knowing, in Oscar Wilde’s words, ‘the price of everything and the value of nothing’. They arouse fear that attaching a price to natural capital is the first stage in creating a market in it, which leads to it being traded for financial gain—and with much justification.
Economic principles have led to a preoccupation with the application of economic valuations to accounting. These are often described in terms of ‘marking to market’. The problem is that markets only exist for a small proportion of the activities in which companies and countries engage. Most are not priced, and, as a consequence, resources are erroneously allocated to activities, such as takeovers and sales of public assets, that augment market values at the expense of other parties whose capital losses are not equivalently reflected in market valuations.
That is not what is being suggested here. Instead, income and profit should be measured correctly to preserve and protect human, natural, and social capital against exploitation for illusory profit. The scale of the task is much more manageable because it only requires capital at risk to be identified and costs of remedying deterioration, not prices and values, to be determined.
This is not to diminish the significance of market values. They play an important role in the identification of value creation and the allocation of resources. But market values do not equate to firm values. The values of the firm encompass more than their market values and reflect the interests and non-observable valuations of other parties as well. That is why unrestrained markets in corporate control can be so damaging and why the contemporaneous existence of both liquid stock markets and block holders provide such a powerful means of combining the information content of markets with the promotion of the long-term success of the corporation as a whole.
Once we have measured profit correctly after the cost of putting wrongs right and alleviating the pain inflicted on others—fair profit—it provides an appropriate basis on which to measure gains from improvement. The reason is simple. Profits are not fair where they come at the expense of others (fake profits) so where they are fair, they have been earned without detriment to others.
One person and one company illustrate this particularly poignantly. Thomas Midgley was an American mechanical engineer and chemist who was the recipient of a glittering array of prestigious awards and prizes including the Nichols Medal in 1923, the Longstreth Medal in 1925, the Perkin Medal in 1937, the Priestley Medal in 1941, and the Willard Gibbs Award in 1942, and he was elected President of the American Chemical Society. These awards were in recognition for the work that he did leading teams of researchers at General Motors that made two major and highly profitable inventions. The first was ethyl, which used lead in petrol to avoid ‘knocking’ in internal combustion engines, and the second was chlorofluorocarbons (CFCs) to replace toxic and explosive substances previously used in air conditioning and refrigeration systems. He was therefore responsible for the adoption of new technologies that radically improved the functioning of combustion engines, air conditioning, and refrigeration. But those very same inventions were also the cause of the release of large quantities of brain-damaging lead and ozone-depleting CFCs into the atmosphere that have afflicted the lives of generations of people around the world ever since.
Thomas Midgley did not live to witness the full effect of his inventions because in 1940 at the age of 51 he contracted paralysing polio and died tragically when he became entangled and strangled by an elaborate system of strings and pulleys that he designed to help others lift him from his bed. However, his employer General Motors not only survived but thrived on the back of profits from inventions that arguably, once account is taken of the cost of cleaning up the mess, generated none.
One of the most important benefits of distinguishing between fake and fair profits is its promotion of purpose. This might sound odd given previous assertions in the book that the purpose of business is not to produce profits. That is certainly true so long as profits are fake in being earned at the expense of another party. But if they are fair in being measured net of the cost of cleaning up any mess associated with them then they reflect a true social benefit.
The purpose of the company determines the allocation of expenditures between different activities and capitals and in particular between material, human, natural, and social capital. A firm that regards human, natural, and social capital as critical to its activities should record these assets as equivalent to the material capital that is currently reported. It should record the cost of maintaining these assets alongside its material capital and it should augment the value of these assets as it invests in them. The degree to which it can convert them into financial returns depends on the extent to which it is able to internalize the external benefits through the innovative business practices of Chapter 5, forming partnerships with relevant parties including the public sector.
Likewise, an increase in net wealth of a country with at least the maintenance of all forms of capital—human, natural, social, as well as material—represents a welfare enhancement without detriment to any party. The criteria for evaluating maintenance and enhancement of capitals depend on a country’s prioritization of public policies and determinants of human and natural rights. These might, for example, include rights to a living wage, access to clean water, free education, free health care, and preservation of forests and species. These fundamental requirements determine maintenance expenditures needed to sustain net wealth before enhancements are acknowledged.
In exactly, the same way as a company should not be credited with a profit before it has provided for the maintenance of the capitals required for the achievement of its purposes, so too a nation state should not record a net income before it has provided for the maintenance of the capitals fundamental to its citizens’ well-being. Conversely, just as a company should be credited for the expenditures it makes to enhance the capitals associated with the fulfilment of its purposes, so too a nation should be credited in its public-sector accounts for investments that augment the capitals it values. A failure to do both of these results in an overstatement of corporate and national profits and income, and an understatement of private- and public-sector net accumulation of assets that contribute to the realization of their respective purposes.
Chapter 10 will describe in the context of infrastructure investments how the corporate form provides a natural vehicle for coherent and consistent accounting across public and private sectors. In both cases, capital is recorded at cost not economic value. It is the cost of maintenance of capitals that is subtracted from corporate profits and national income, and expenditures on capital investments that are recognized in private- and public-sector balance sheets.
The relevance of this extends well beyond just conservation and preservation. It is about creation of benefits for man, nature, and society as well as investors and how the measurement of income and profit should reflect the benefits that employees, species, and communities as well as shareholders derive from it.
Unless there is recognition of the costs incurred in enhancing the education of employees, cleaning up rivers, or improving social cohesion and trust then there will be no incentive to undertake them. These are benefits that employees, future generations, and societies derive but which organizations and institutions cannot currently capture in their accounts.
They are what economists describe as externalities—benefits that accrue to one party from activities undertaken by another without the latter being rewarded for the former. We might reasonably expect or require companies and nations not to record profits or income where there are none but we cannot require them to show profits where they earn none. Costs of cleaning up the mess should legitimately be included; the benefits of beautifying it even more cannot be, at least not in existing financial statements.
We are at the limits of what accounting can do. It has achieved a lot if it can help avoid the destruction of what man and nature between them have created. But to go further, to enhance what man and Mother Nature have produced, brings us back to the governance and management issues of Chapter 5, and the legal, regulatory, financial, and investment questions of Chapters 7 to 10. How can firms and other organizations capture some of the benefits that they create for others? How can governments incentivize companies to produce them?
What is required are means of sharing the benefits to ensure that firms and other organizations have incentives to produce them—to internalize the externalities. Are there new innovative ways in which firms can create mutual benefits for themselves and their employees, societies, and future generations? Chapter 5 argued that there are through the building of partnerships between different parties in an ecosystem and that the focus of management and public policy should be on identifying those innovations that create profitable beneficial outcomes—good companies doing well by making things better. We will illustrate with one organization that is engaged in just such an endeavour.
The Natural Capital Committee is a UK government committee that is promoting the protection and enhancement of natural capital in the United Kingdom. As part of its remit, it has piloted the adoption of the above principles of natural capital accounting with several companies and landowners, including the UK National Trust, which is dedicated to the conservation of the United Kingdom’s cultural heritage. One of its properties is Wimpole Hall situated in Cambridgeshire on an estate that covers 1,200 hectares of semi-ancient woodland, open parkland, semi-natural grassland, and enclosed farmland. This provides a habitat for twenty-five nationally scarce species, and the site attracts over 270,000 visitors a year.
Wimpole Hall farm, covering 400 hectares of the estate, is the largest lowland farm managed in-house by the National Trust. Prior to 2007, the management of the farm was contracted out and farmed at intensive levels. Informed by the results of a soil survey undertaken in 2008, which showed the soil to be in poor condition, the National Trust took the decision to take management of the farm in-house and convert it to organic farming. It was hoped that the change from conventional arable to organic, less-intensive farming would improve the quality of the soils, provide a richer habitat for biodiversity, and enhance the visitor experience. The farm now produces organic cereals, wheat, barley, and oats in rotation with other crops, such as beans, and rare native-breed livestock graze on the grassland. While the farm has to be financially sustainable, it is not managed to maximize profits, but rather to maintain and enhance the Estate’s agricultural history and landscape.
In conjunction with the National Trust, the Natural Capital Committee created a partial account of the Wimpole Estate’s natural capital assets, which include food provision, recreation, carbon storage, and wildlife. A natural capital balance sheet was constructed that reported changes in asset values and liabilities over the period of transition from traditional to organic farming. It showed that the natural capital assets annually provide a significant value both to the National Trust (£14.1m) and to society (£12.3m) against a relatively small annual input cost of £5.1m. Furthermore, the account reported that both private and external values were enhanced between 2008 and 2013 as a result of the change in land management with the value to society, in particular, increasing substantially (by £4.4m).
What this illustrated was both the practical applicability and significance of accounting for natural capital. In the absence of such accounts, the income of the National Trust was misstated (fake profits), and the private (fair profits) and societal benefits of sustainable farming were not recognized. Furthermore, the creation of natural capital accounts provided an inducement to cease activities that were detrimental to some and engage in activities that were mutually beneficial to all.
This example also illustrates another and broader point that, if profit maximization had been the sole purpose of the National Trust then a mutually social and profitable activity, namely putting the farm onto a sustainable basis, would not have been undertaken. Income was enhanced by converting to organic farming but not as much as it could have been, at least in the short term, had the National Trust instead harvested the farm for what it was worth and then sold it to the highest bidder. With a purpose that incorporated social and environmental as well as financial considerations, the full benefits of the redeployment of assets were recognized.
The above suggests some fundamental principles of accounting that have not been fully recognized to date:
In sum, there should be recognition of human, natural, and social capital exactly in conformity with existing accounting standards. In contradiction to this being in conflict with conventional accounting practices, it is a reflection of the deficiency of existing procedures in failing to apply standards consistently across different types of capital.
There is an urgent need to remedy the serious misrepresentation of company and country performance created by existing accounting conventions in reporting profits and income where there are none and failing to record investments and assets where there are some. These misstatements have resulted in a fundamental misallocation of resources in companies and nations towards material at the expense of human, natural, and social capital, and promoted purposes that have produced neither profits nor prosperity.