Natural Capital at Risk: The Top 100 Externalities of Business

Earlier this year the TEEB for Business Coalition, a global coalition of pioneering organizations on natural capital, published a report entitled ' Natural Capital at Risk: The Top 100 Externalities of Business.'

The report, prepared by Trucost, a research firm focused on natural capital valuation, estimates the global top 100 environmental externalities are costing the economy world-wide around $4.7 trillion a year.

Environmental externalities represent the economic and social costs of greenhouse gas emissions, loss of natural resources, loss of nature-based services such as carbon storage by forests, climate change and air pollution-related health costs that we don't pay for.

The Trucost environmental model condenses the environmental externalities into six key environmental performance indicators (eKPIs ) to cover the major categories of natural capital consumption: water use, greenhouse gas (GHG) emissions, waste, air pollution, water and land pollution, and land use.

The majority of environment related externality costs are from greenhouse gas emissions (38%) followed by water use (25%); land use (24%); air pollution (7%), land and water pollution (5%) and waste (1%).

These eKPIs were then quantified by region across over 500 business sectors. The study ranks the top 100 impacts in each sector, broken down by region to provide a platform for companies and investors to assess exposure to unpriced natural capital, both directly and through supply chains and holdings.

It also highlights sector-level variation in regional exposure to impacts to identify opportunities to enhance competitive advantage. Impacts across all six eKPIs were combined by region and sector to create a ranking of the top region-sectors globally.

Who are the biggest natural capital environmental freeloaders?

1. Coal-fired power in Eastern Asia and in Northern America rank first and third, respectively estimated at US$ 453 billion per annum in Eastern Asia and US$ 317 billion in North America.
• These consist of the damage impacts of GHG emissions, and the health costs and other damage due to air pollution. In both instances, these social costs exceeded the production value of the sector.
• The other highest impact sectors are agriculture, in areas of water scarcity, and where the level of production and therefore land use is also high. Cattle ranching in South America, at an estimated US$ 354 billion ranks second. Wheat and rice production in Southern Asia rank fourth and fifth respectively.
• Iron, steel and ferroalloy manufacturing ranks sixth at US$225 billion. Cement manufacturing globally accounts for 6% of CO2emissions, and Eastern Asia produces an estimated 55% of the world's cement, so it is not surprising that it comes in at seventh.

No high impact region or sector generates sufficient profit to cover their environmental impacts. Subject to adaptive capabilities, this will cause them to pass on these costs to customers.

Put another way, these high impact business sectors would operate at an economic loss if the true costs of the environmental damage they cause from natural resource use and pollution costs were accounted for.

But that's only part of the price tag of what we take from nature but don't account for.

The report's authors estimate that the world's primary production sectors, (agriculture, forestry, fisheries, mining, oil and gas exploration, utilities) and primary processing sectors (cement, steel, pulp and paper, petrochemicals) account for externality costs totaling US$7.3 trillion, which equates to 13% of global economic output in 2009.

The report estimates the cost of these externalities at close to US$2.1 trillion for the top-3,000 listed corporations (UN Principles for Responsible Investment, 2010), says the report.

Global economic direction and resource use are the underlying drivers of this. Corporations today account for two-thirds of our economy and resource use, and most of the global stressors of planetary boundaries (emissions, freshwater use, land-use change, chemical pollutants, etc.) in reality are the negative externalities of 'business as usual'.

The growing importance of how the wealth of 'natural capital' can be better managed to ensure long-term prosperity will be a key topic of discussion at GLOBE 2014, the next in the celebrated GLOBE Series Conferences on the business of the environment taking place in Vancouver Canada, March 26-28, 2014. Reserve your place now. Check here for more details.

But these externalities have grown too large to ignore and the pace of natural capital depletion can't be sustained. The pace of this over exploitation is such that planetary boundaries are being approached. Some scientists believe that global biodiversity, nitrogen and climate thresholds may already have been breached.

Growing business demand for natural capital, and falling supply due to environmental degradation and events such as drought, are contributing to natural resource constraints including water scarcity.

Environmental externalities represent a business risk

Many of these natural capital externality costs are found in the developing world, but the resulting goods and services are being consumed by resource intensive supply chains around the planet - thus it is a global challenge for a globalized world.

Although internalization of natural capital costs has only occurred at the margin, 3 billion new middle class consumers by 2030 will cause demand to continue to grow rapidly, while supply will continue to shrink. The consequences in the form of health impacts and water scarcity will create tipping points for action by governments and societies. The cost to companies and investors will be significant.

Water is a classic example of the escalating business risk associated with the externality costs of natural capital depletion. The global natural capital cost of water consumption by the primary production and primary processing sectors analyzed in this study is estimated at US$1.9 trillion. The top 100 region-sectors accounted for 92% of these costs, which are concentrated in agriculture and water supply.

Water that is directly abstracted from surface or groundwater is rarely paid for adequately if at all, and its substantial value to society varies according to its regional scarcity. (See GLOBE-Net article 'Better by the Drop - The value of water in Canadian agriculture').

For example, droughts in various regions of the world have contributed to global wheat shortages and supply chain disruptions.

Libby Bernick, Senior Vice President, North America for Trucost told GLOBE-Net that water use for wheat farming in North America is ranked as #11 in the top 100 list of region-sectors.

Consumer demand for food indirectly drives the majority of environmental costs from natural resource use, pollution and waste in these primary producing industry sectors. The ability of companies in these sectors to absorb or pass on costs associated with those impacts will vary by region and by customer.

More broadly, notes the report, companies and their investors face both an opportunity and a significant problem with respect to natural capital depletion. Consumer demand is set to grow significantly over the next few years with the increase in middle class consumers, especially in emerging markets.

For example, Trucost's analysis found that the profits of apparel retailers were impacted by up to 50% through cotton price volatility in recent years. Economy-wide, these risks are sufficiently large that the World Economic Forum cites 'water supply crises' and 'failure of climate change adaptation' along with several other environmental impacts among the most material risks facing the global economy.

Food and timber processing, as well as leather and hide tanning, are the sectors most at risk from these costs being passed through their respective supply chains. The ability of companies in these downstream sectors to pass on natural capital costs will vary according to pricing power.

The report suggests the 10 sectors with the greatest overall impacts (direct impacts from their own operations plus indirect impacts flowing along the supply chain), which also have at least half of these estimated to be in their supply chains, are all involved in food production and processing.

Sectors ranging from soybean and animal processing to fats and oils refining and animal production are especially exposed to land and water use.

The impacts of natural capital depletion are being reflected in commodity prices. Over the past decade commodity prices erased a century-long decline in real terms, and risks are growing from over-exploitation of increasingly scarce, but un-priced natural capital depletion according to the report.

Alastair MacGregor, Chief Operating Officer of Trucost, who conducted the study states, 'Recent soft commodity price volatility due to drought, and its impacts on company profits, nation's trade balances and inflation has underscored the dependency of investment returns on natural capital. This trend will accelerate in the future on a number of fronts.'

What can businesses do to lower their risk factors?

Businesses and investors can take account of natural capital impacts in decision making to manage risk and gain competitive advantage notes the report.

The report shows that the scale and variation in impacts provide opportunities for companies and their investors to differentiate themselves by optimizing their supply chains and investment strategies.

For example, companies and investors can use information on the region-sectors that have the largest natural capital costs to assess the possible scale of direct, supply-chain and investment risks. Regional and sectoral variations also present opportunities for businesses to enhance competitive advantage, and for investors to improve relative returns.

Some recommendations for companies include implementing processes to measure and manage natural capital used; strengthening business models to mitigate exposure to global risks such as water scarcity, volatile energy and agricultural prices, rising GHG emissions and climate change impacts.

Recommendations for Companies

1. Focus on gathering primary impact data, and conducting primary environmental valuation studies, on likely hot spots in direct operations and in supply chains.
2. Identify existing mechanisms that could internalize natural capital costs and the probability and financial impact of these costs being internalized in the future.
3. Consider using valuations for EKPIs to apply 'shadow' pricing in procurement decision-making and financial analyzes.
4. Explore opportunities for adaptation and to improve resource efficiency, both internally and within the supply chain.
5. Evaluate options to change suppliers, sourcing location or materials, where existing suppliers are not willing to change.

Recommendations for Investors

1. Identify which assets are most exposed to natural capital risk, and which companies and governments are able and willing to adapt.
2. Identify the probability and impact of natural capital costs being internalized.
3. Build natural capital risks, adjusted for the likelihood of internalization, into asset appraisal and portfolio risk models.

Can accountants save the world?

Peter Bakker, President World Business Council for Sustainable Development commenting on the report observed, 'Now that we have this high-level assessment of where the priority areas are, we need to encourage companies to increasingly consider the value of nature in decision-making, and ultimately accounting and reporting. The results of such company assessments should also be shared so we can fit the pieces of the puzzle together to develop a standardized approach to account for nature

His comments were echoed by Pavan Sukhdev, Chair of the Advisory Board of TEEB for Business Coalition commented.

'We need undoubtedly to change how we do business, but we cannot manage what we do not measure - and at present only a handful of businesses measure their externalities. Resolving this is at the heart of the green economy and sustainability itself.'

'The accountancy profession is central to making better decisions when it comes to the impact companies have on the environment' Michael Izza, Chief Executive, Institute of Chartered Accountants in England and Wales (ICAEW).