To be of use, green accounting has to be accepted by global community as the framework for measuring output at firm as well as national level
Two meanings of sustainable development
Monday, 3 July 2017
One is associated with sustainability of development through proper market practices. In this sense, a sustainable development is one which, once started, will continue on its own without the need for external support. For instance, a poor man may cross the poverty line with the initial state support. His development will be sustainable only if he could continue his journey to prosperity even after the state support is withdrawn. For this, an essential requirement is the presence of an appropriate incentive system to motivate him to work hard and smart through the market mechanism.
Sustainable development from the point of ecosystems
The other notion of sustainable development is related to the use of non-renewable natural resources and the unaccounted costs that development processes would inflict on economies at local, national and global levels. The argument here is twofold.
First, the non-renewable natural resources will exhaust when more and more goods and services are produced to satisfy human demand. When a commodity becomes scarce, its market price should move up to reflect its scarcity. But the market price of a non-renewable natural resource may not reflect its true price on account of market malpractices, state subsidies, information imperfections and monopolies on both buying and selling sides etc. Thus, when the value of production is calculated by using prevailing market prices, it may underestimate or overestimate its true value.
Second, all production processes contain non-reversible unaccounted costs such as damage to environment, unintended consequences etc. These are not taken into account when production values are calculated either at the firm level or at the national level. To that extent, the accounted value of production in financial accounts or national output tends overestimate its true value.
In economics, these are called externalities. If they are large and continue to be present, the development that takes place would collapse on itself since the market mechanism cannot sustain it continuously. When external benefits are present, they cause underproduction. In the opposite, when external costs are present, the result would be overproduction. Such a development, it has been argued, is unsustainable and above all, does not augur well for people’s well being. The widely used notion of sustainable development emanates from this second meaning.
Measuring output at micro and macro levels
The value of output produced in an economy is measured at both micro level and macro level. At micro level, it is done by firms by keeping accounts and ascertaining final profitability. At macro level, the value is ascertained by estimating the value of the total output which should be equal to the value of income earned by people and the value of expenditure incurred by them. These are not mutually exclusive valuations. In fact, the macro level valuation is pretty much dependent on micro level valuation. Hence, if firms do not record the use of non-renewable resources at their true prices or do not account for unseen costs, the macro level valuation too does not reflect the true value of the production undertaken.
Problem of unintended consequences
Take for example, a soft drink manufacturing plant. If it uses underground water resources brought to surface by sinking deep tube wells, its cost of water is simply the actual cost it has incurred to bring that water to the ground level. However, when a large quantity of underground water is tapped within a short period, it not only brings about a number of unintended consequences but also involves hidden costs. The unintended consequences are that riverbeds as well as ordinary wells get dry causing innumerable problems for the people living in that area.
The hidden costs arise from the possibility of the underground water table receding further to the bottom of the earth due it being tapped on a massive scale. Since it takes thousands of years to replenish an underground water deposit, such costs are not reflected in the current market prices. Hence, it involves an awkward development model where the present generation borrows resources from the future generations for its own well being, but dishonours the repayment obligations. This led the UN appointed Brundtland Commission to define sustainable development as one that ensures the meeting the needs of the present generation “without compromising the ability of future generations to meet their own needs”.
Valuation of output at firm level and national level
The method of calculating the output of a firm is based on the accounting standards prescribed by accounting bodies of different nations. They are not based on valuation methods that take into account the costs on account of unintended consequences or those that are hidden.
The output at the macro level is measured as per the guidelines given in the System of National Accounts (SNA) updated and released by the United Nations from time to time. SNA too calculates the value of output of a nation, commonly known as Gross Domestic Product (GDP), based on prevailing market prices. GDP could be converted to a net output, known as Net Domestic Product (NDP) by taking out the depreciation of the real physical assets used for production. Hence, GDP or NDP does not take into account the costs on account of unintended consequences or those costs that are hidden or unaccounted for.
GDP and NDP
GDP or NDP came under attack on two factors. First, it was argued that neither measure could be used as an indicator of human well being. Second, it was held, of course quite correctly, that neither measure would reckon the costs emanating from the decline in the resources or damage done to future production capacity of an economy.
Shortcomings of GDP as a measure of welfare
Human wellbeing is dependent on a number of factors which are not counted in any GDP or NDP calculation. These calculations do not even reckon the full value of all the goods and services that are produced in a country. Due to obvious statistical issues, they reckon only the outputs that are traded in the market at a price. Thus, any good or service that is not traded in the market or does not have a price is excluded in the calculations.
Accordingly, goods that are produced with human labour, physical resources and technology application but self-consumed without offering in the market or any self-produced service are not included in GDP or NDP calculations. Obviously, they therefore underestimate the quantum of the output of goods and services produced in an economy. But for human well being, both types of goods that are produced – that is, traded in the market and self-consumed – do make a contribution. Therefore, GDP or NDP calculations based on the guidelines offered in SNA came under criticism on account of their underestimation of the true value of the output that would make a contribution to human well being.
Use of natural resources and environment
All economic activities – production, distribution and consumption – involve the use of natural resources and environment. Since no economic activity could be undertaken without them, they could be considered as essential inputs.
Natural resources go into economic activities as raw materials. Environment is used in order to dump the undesired waste matter that is generated when producing a desired product. When computing the value of the output of a firm or the total output produced in a national economy, the value of the raw materials is reckoned in the calculations at the prevailing market prices. If those market prices reflect true value of raw materials, then, the values reckoned in calculations too reflect true values. To that extent, there is no necessity for making any adjustment to financial accounts of a firm or GDP of a nation. However, if they do not reflect true values, then, the calculations made by using prevailing market prices would either overestimate or underestimate the values necessitating an adjustment to those numbers.
Environment is used as a dumping ground
In the case of environment, the waste matter produced in an economic activity is not reckoned as a part of the value of the calculations made either at the firm level or at the national level. Firms simply dump it in the environment and do not incur a cost in doing so. Hence, there is no necessity for them to account for such disposal.
However, simply because a firm dumps waste matter to environment does not mean that it would lead to environment pollution imposing a cost on whole society. That is because Nature has its own assimilative capacity to convert waste matter to a beneficial matter and release back to environment. Environment pollution occurs when such waste matter is dumped in environment overstretching the assimilative capacity of Nature.
Need for adjustment of GDP
Thus, the need for adjustment to firm level accounts or GDP/NDP at the national level arises only in two extreme cases. The first is when the market prices of raw materials used in economic activities do not reflect the true value of such raw materials. The second is when Nature fails to convert the waste matter dumped in environment to beneficial matter which invariably leads to environmental pollution.
This latter situation arises when Nature’s assimilative capacity is disrupted either by human action or by Nature’s own reactions. Human action takes the form of unplanned dumping of waste matter, causing destruction to Nature’s agents or dumping of waste matter in large quantities fuelled by population growth and race to produce more goods and services. Nature’s reactions take the form of earthquakes, landslides, volcano eruptions, floods, droughts, storms, tsunamis, or forest fires.
Birth of green accounting
These are distortions caused to market system. Obviously, they cause a reduction in the quality of life of people. Since the traditional accounting methods adopted by firms or orthodox GDP/NDP calculations do not reckon them, they do not become meaningful indicators of measuring the welfare levels of people in society. Since Western countries became overly concerned about the depletion of natural resources and the oncoming environmental pollution, there was a public outcry that adjustments should be made to firm level accounts and national level GDP/NDP.
The solution was found in what is now known as ‘Green Accounting’, a term coined by Economist Peter Wood in mid 1980s. Peter Wood argued in a number of writings that a new model should be developed to reckon the costs inflicted on the earth arising from depletion of resources and environmental pollution. What it means is that firms should depart from the traditional accounting systems that do not incorporate these costs and national accounts should be recalculated incorporating them in the calculations.
UN framework of SEEA
In the present calculation of national accounts based on SNA, what is taken into account is the consumption done by economic agents and the value of the man-made physical capital. In view of the deficiencies of this approach, it has been suggested that GDP/NDP should be calculated by reckoning the damage done to environment and the use of natural resources.
The approach suggested is known as System of Environmental and Economic Accounts (SEEA) adopted by UN Statistical Commission in 2012. It contains, according to UN, a set of “internationally agreed standard concepts, definitions, classifications, accounting rules and tables for producing internationally comparable statistics on the environment and its relationship with the economy”.
SEEA is complementary to SNA and uses the same framework with orientation to environmental factors. However, it is a comprehensive manual which has been revised from time to time for adoption by member countries. So far no country has fully migrated to SEEA; some countries like India have started to work toward that goal. Sri Lanka too had commenced work on green national accounting in 2012 under the aegis of Ministry of Mahaweli Development and Environment. But, there is no evidence that any substantial work has been done to realise that goal as per the framework suggested by UN.
Environmental Domestic Product
SEEA has been converted to green accounting to generate a new measure of income called Environmental Domestic Product (EDP). The point of departure has been an adjustment of the Net Domestic Product (NDP) compiled as per SNA by incorporating two new concepts. In the first place, the investment in NDP has been defined as man-made capital called Net Accumulation of Produced Economic Assets (NAP.ec). In contrast, the use of Nature’s endowments has been designated as Net Accumulation of Non-Produced Economic Assets (NANP.ec) and added to NDP. From NANP.ec, the value of Natural Assets, designated as Net Accumulation of Non-Produced Natural Assets (NANP.n) has been subtracted to derive the net use of environment in the production process. The resultant measure has been called EDP.
Problems of EDP
Several problems arise when this measure is used in practice. First, the valuation of NANP.ec and NANP.n poses a problem. If there are market equilibrium prices of both these assets, then, there is no problem. However, in the absence of such prices, those prices have to be estimated by using a concept similar to the calculation of shadow prices. Such calculations are based on assumptions and could vary from one analyst to another. Hence, they may not generate an internationally, or even locally, comparable set of estimates.
Consider, for example, the issues involved in measuring the value of a kilogram of rice under the new system. Under traditional accounting and SNA, it is just ascertaining the price tag for a kilogram of rice in the market. But under SEEA, it is necessary to estimate the value of non-produced natural resources used in the production of that kilo of rice such as the use of naturally available water, say, rain water or water from a deep well. Then, it is necessary to take out from this value the damage done to environment in the process of producing this kilo of rice. These are not easy tasks. They require realistic assumptions, comprehensive data, and appropriate estimation methods. But at the end, after the estimations have been made, they may be subject to dispute by other analysts.
It also gives room for firms to manipulate accounts and overestimate or underestimate profits or losses. Second, such calculations at company levels will make it difficult for income tax authorities to levy correct taxes since there is no uniquely accepted set of accounts as in the case of the financial accounts prepared by following the traditional methods. Third, SEEA is not an indicator of welfare of people as has been admitted by UN handbook. Accordingly, it also suffers from the same weaknesses which SNA has. The biggest casualty will be income tax authorities who now have to base their tax collections on an estimated value of profits instead of actually earned profits.
Need for moving from hype to reality
It is apparent that green accounting is still only halfway through and not final. Because of practical difficulties, no country has so far moved into green accounting, though a basic framework has been suggested by UN. To be practically useful, further work has to be done making it simple and thereby acceptable to firms as well as to nations. UN has suggested that further research in this area should be conducted.
To be of use, green accounting has to be accepted by global community as the framework for measuring output at firm as well as national level. So far, there is no indication of the world making a joint move to reach this consensus. Until such time, it will just remain hype without practical use.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, could be reached at email@example.com.)