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Geoff Wells
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growing, admittedly on a small base, at more than 30% per year over the past decade;
and American corporations are coming to terms with the fact that they cannot, with
impunity, ignore consumer preferences for environmentally safe and friendly products
and services, even manufacturing processes. Monsanto presents perhaps the most
spectacular example of the consequences of American hubris, in its attempt to export
genetically-modified seed stocks to Europe, whose consumers, and therefore whose
national governments, have been fiercely resistant to such productsa miscalculation
(or culpable myopia) which even now, after a fruitless expenditure of millions of
public relations dollars, and its takeover and corporate relegation by Pharmacia,
Monsanto still seems unable to understand or accept.
To put it bluntly, a modern company ignores the environmental dimensions of its
business at its peril. Accounting theory and practice now has to reflect that new
reality.
Cost efficiencies are, nevertheless, still central to the way in which companies
think about the environment. There is nothing unreasonable in such a focus. Once
systematic analysis of business operations and processes is undertaken, it generally
becomes clear that environmental costs are a far greater percentage of total costs than
had been realised. Typically, this underestimation is a consequence of lazy accounting
practice. Overhead accounts become general dumping grounds for costs that are out
of the ordinary, or difficult to classify (in my experience, accountants are not, as a
rule, comfortable in having habitual practice challenged, and in having to think things
through from first principles). Environmental costs are scattered across overhead
accounts, and, because they are not consolidated and appropriately classified, are not
even identified for what they are. As a result, they cannot be effectively managed.
Thus the financial returns potentially available from waste reduction, energy
conservation, raw material initiatives, through identification of lower polluting
materials or reprocessing, or lifecycle cost reductions are typically not captured, or
captured only partially.
An example of a systematic attempt to capture internal costs and benefits arising
from its environmental programme comes from Baxter International, a US company
producing, developing and distributing medical products and technologies, with
annual revenues in excess of US$5 million. In 1995 Baxter developed an
Environmental Financial Statement, the purpose of which was to report on the total
of financial costs and benefits that could be attributed not only to the environmental
programme itself but to the environmentally beneficial activities across the
corporation. This financial statement identifies costs associated with the companys
environmental programmes, such as pollution controls, waste disposal, remediation
and clean-up; savings, through cost reductions from the prior year to the report year;
and a line item called cost avoidance relating to additional costs other than the report
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years savings that were not incurred, but would have been incurred in the report year
if the waste reduction activity had not taken place. The environmental bottom line is
then calculated as the sum of savings and cost avoidance less costsin Baxters case,
a healthy surplus. Note, however, that the focus of the analysis is entirely internal
the entity assumption is maintained, and no external environmental impacts of the
business is consideredbut it does demonstrate that by explicitly considering
environmental dimensions of a business, and by capturing its impact in the accounting
structure, actual cost savings can be made.2
It should be noted that intangible cost reductions are even less likely to be
identified and secured. Present outlays to avoid future expenses, such as landfill,
clean-up, customer boycotts, product recalls, and regulatory infractions, are not
common practice because conventional financial analysis doesnt support them.
Relatively few companies have begun to think about the potential upheaval in their
cost profiles and cost reduction strategies in the carbon emissions caps and trading
environment that is rapidly approaching. BP Amoco is a notable example to the
contrary: for the past several years it has been adopting in its global operations
strategies to maximise cost efficiencies and capture competitive advantage in this new
environment.
Risk management and liability reduction is an associated arena of environmentallydirected business strategy. Resource depletion, product liabilities, pollution, and
waste can generate significant contingent liabilities for rectification, legal defence
(against class actions, for example), fines, and penalties. There is no question that the
legislative and regulatory component of the societal framework within which
contemporary business functions is targeting fundamental aspects of business
operationsprocesses which may have funded a companys profitability for decades
and is being administered more strictly. Penalties for infractions are being raised
across the world, as societys expectations of company performance become greater
and less prepared to countenance environmental damage. The most notable example
of this liability, of course, is Exxon Corporations Alaskan oilspill, which cost more
than US$ 3.5 billion in clean-up, fines, environmental mitigation, and monitoring and
subsequently more than US$5 billion in punitive damages claims by commercial
fishers and native Alaskans. Closer to home, the BHP Ok Tedi copper mine has
turned a mountain into a basin, and flushed 70 million tonnes of waste a year down
the river system to sea. In the process, the riverbed has filled up with sediment,
flooding up to 2000 square kilometres (the size of greater Sydney), wiping out its
rainforest canopy, ruining the subsistence plots and destroying the wildlife of the
region. The land and watercourses of the lower Ok Tedi river have become a heavymetal toxic waste dump. It remains to be seen whether the $80 million settlement of
the class action launched on behalf of the Ok Tedi villagers will be the end of the
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matter, as the company jettisons its holding in the operation into a Singapore trust for
the benefit of the 30,000 villagers affected in both livelihood and health; one would
have to be sceptical.3
Clearly, when one attempts to manage and report on risks of this magnitude, the
tools of risk management and financial modelling are manifestly inadequate. That is
the result of an almost total lack of comprehension of the enormous costs of
miscalculating the environmental risks, with their associated physical and social
consequences.
As an example of what might be called the progressive corporate view of
environmental performance, we might look to this statement, taken from the oil and
gas industryan industry which, more than most, has been faced with the realities of
environmental challenges:
Oil and gas companies cannot continue to achieve financial success without also
achieving environmental excellence, and they cannot achieve environmental
excellence by evaluating and rewarding performance based strictly on short-term
financial indicators. Environmental performance, environmental multiplier, and
international environmental taxes will help oil and gas companies integrate
environmental performance into their management evaluation and rewarding
systems. For many oil and gas companies, current performance appraisal process
only incorporates a fraction of all environmental costs. The less tangible, hidden,
indirect costs such as potential legal liability, future regulatory compliance, and
the economic consequences of changes in corporate image linked to
environmental performance, are largely ignored. When evaluating management
performance, a company must consider total costs, including all internal and
external environmental costs. To do otherwise can lead to poor environmental
decisions which eventually will adversely affect the company's long-term
profitability.4
Again, however, note that the emphasis of such a comment is on the entity, rather
than on its social context. Total costs here means total costs to the entity, not total
costs produced to both entity and society. We may have an uneasy feeling that,
particularly when dealing with such vast environmental and social impacts as those of
Exxon Valdez and BHP Ok Tedi, the entity assumption that is fundamental to
accounting theory has become comprehensively breached; an observation to which we
will return.
In recent years, and increasingly in contemporary business, environmental
strategies offer not just cost reductions but competitive advantages in the market. As
noted, this is the result of a sustained and deeply-based upsurge of consumer
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future, by the company itself. That is, they are costs picked up by the society at large.
In large part, this is due to limitations in conventional accounting and costing rules,
which in turn have their foundation in financial accounting theory, with its
underpinnings in political economy theory. Some of these limitations are as follows5:
(1) Financial accounting focuses on the information needs of those parties
involved in making resource allocation decisions about the entity
predominantly stakeholders with a financial interest in the entity. This limits
access to information by people who are impacted outside the financial
parameters of the entity; that is, the public at large.
(2) The basic principle of materiality has tended to preclude the reporting of
environmental information, given the relative difficulty of identifying and
quantifying some categories of environmental costs and benefits.
(3) Measurability is an associated limitation. The recognition criteria of financial
accounting require an item to have a cost or other value that can be measured
financially and reliably. Most attempts to assign value to external
environmental impacts move quickly into estimates, with their associated
controversies concerning methodology.
(4) In financial accounting expenses are defined to exclude the recognition of any
impacts on resources that are not controlled by the entity, unless fines or other
cash flows result. This is because the notion of expenses is linked to the notion
of reduction of assets; and assets are defined in terms of future economic
benefits controlled by the entity.
(5) Conventional accounting does not account for the full cost of production
because it assigns no monetary costs to the consumption of natural resources
such as air, water and land fertility. Social costs and related benefits are
ignored.
(6) Accounting rules may penalise environmentally responsible behaviour. Unless
this behaviour is reflected in a higher price for its products, it may result in a
lower net profit and lower earnings per share.
(7) Conventional accounting does not have a mechanism for recording green
assets, or their consumption; monitoring the use of green assets; distinguishing
between the costs of renewable and non-renewable resources; or providing
accounting incentives for protection of the environment.
The net result of these deficiencies of conventional accountingthe structure by
which, in the current environment, we evaluate the performance of companies and
their managementmean that if an entity were to progressively degrade the quality of
water in its vicinity, with the resulting decimation of associated flora and fauna, then
to the extent that no fines or other related cash flows were incurred, reported profits
would not be directly impacted. In fact, the performance of such an entity could well
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generational equity; in other words, a concern with globally conceived social justice
an important component of subsequent environmental accounting theory with
which, however, I will not attempt to deal here. The Brundtland initiative was
followed in 1992 by a European Earth Summit, which released a document called
Towards Sustainability. This document, called for, among other things, a
redefinition of accounting concepts, rules, conventions and methodology so as to
ensure that the consumption and use of environmental resources are accounted for as
part of the full costs of production and reflected in market pricesa tall order, one
may feel, in the contemporary business environment, however admirable in spirit.
However, this document made the crucial connection between sustainability and
environmental accounting which has governed radical critiques since that time.
Whether this has been a helpful link is open to question. Sustainability is one of
those concepts, like freedom, which commentators think they intuitively
understand, but which, on closer examination, has widely different interpretations. It
has been noted that the decade that followed the Brundtland Report has done little to
clarify the concept of sustainability: it has been estimated that there are more than
5000 definitions now circulating in the literature. One recent commentator noted,
Sustainable development is a term that everyone likes, but nobody is sure of what it
means (at least it sounds better than unsustainable development). In response, it
has been argued that although there is a conspicuous lack of consensus on the exact
definition of sustainability, it carries a core meaning which is substantive and
important, in the same way that principles like democracy are widely defined and
implemented, but used sensibly in discourse.8
While granting the validity of this argument for some purposes, it doesnt work for
accounting. Accounting concepts need to be sufficiently defined to allow, and
measure, uniform practice. The kind of difficulty one can encounter is illustrated by
the NZ-based Landcare Ltd. approach to full cost accounting, which is explicitly
linked to sustainability, through the following definition:
. . .sustainable cost can be defined as the amount an organisation must spend to put
the biosphere at the end of the accounting period back into the state (or its
equivalent) it was in at the beginning of the accounting period. Such a figure
would be a notional one, and disclosed as a charge to a companys profit and loss
account.9
The problem with this definition, to anyone educated in the elements of biology, is
that the biosphere (itself difficult to define) is a dynamic system, which follows a
development trajectory. One would have to reframe the definition to include:
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. . .the amount an organisation must spend to put the biosphere at the end of the
accounting period back into the state it would have been in without the operations
of the company during the accounting period.
This in turn would require sophisticated modelling and measurement at a level which
is only now taking its first, tentative steps (for example, the modelling of the complex
global land, water, and atmosphere systems associated with global warming). It
sounds a promising approach conceptually, but it is, to all intents and purposes,
useless in practice.
One other observation on the theoretical challenges to financial accounting theory
as it attempts to meet the demands of environmental externalities. It seems to me one
could argue as follows: if it is to be required that companys should internalise the
costs of their operations on society at large (as in environmental and social impacts);
and that financial statements reflecting these costs are a truer representation of the
companys value: why should one therefore not require similar treatment of benefits
to the society at large of the external impacts of the companys operations, and similar
financial treatment of these benefits in the companys accounts? For example, would
one want to measure the social benefit of employment, which would be far greater in
a large company than in a small one? Or the multiplier effect in the economy of a
companys transactions with suppliers? And so on. Without having analysed it very
fully, it does seem to me that this is a question that may have to be answered, if
approaches to full cost accounting of external environmental impacts are to be
logically consistent. And the answer may lead to a re-configuration of the very idea
of a business. I will return to this notion in a moment.
Let me turn now to a case study which nicely illustrates the main issues associated
with environmental accounting, as Ive laid them out here. A major Australian woolprocessing company (which shall remain nameless, for commercial-in-confidence
reasons) has been looking at the way it is handling in its accounts environmental
aspects of its operation. Wool processing is a dirty business. Essentially it involves
taking wool in its raw statetermed greasy wooland washing it with various
detergents and chemicals, then treating it in various ways for specific fibre
performance. There are two primary processes: combing and carbonising. Both are
directed to getting large contaminants, such as burrs, out of the wool: the first process
is, as the name implies, by physically combing the wool; the second, used on the
dirtier parts of the wool, such as skirtings, locks, bellies, and so on, employs acid,
which carbonises these solids to make them easier to eliminate. Effluent from
scouring (which is common to both processes) and from carbonising is treated, and
then, when it reaches the regulatory level of TDS, is allowed down the drain. At the
site of this particular processor, some of this effluent is first diverted to a large
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McKinsey), economic value added (developed by Stern Stewart), and cash flow return
on investment (developed by the Boston Consulting Group). These methods are far
from uncontroversial: there is continuing debate on the correlation of DCF valuations
with stock price, and on the significant management challenges associated with
driving VBM through an organisation. Nevertheless, they represent the ground on
which modern management is conducted. Moreover, discounted cash flows and the
use of net present value calculations are becoming commonplace in the external
reports of companies. Accounting standards in Australia enable the disclosure of
discounted cash flow information.
A first research question might therefore be: can discounted cash flow methods
capture the various dimensions of environmental business issues outlined above? In
June (2001) the European Commission produced guidelines on the recognition,
measurement, and public disclosure of environmental issues in the annual accounts
and reports of companies in the European Union. These guidelines focus on monetary
information and accept discounted cash flow and net present value as appropriate
measurement methodologies for environmental issues. There are at least two
important challenges to such an approach. The first is that the numbers to which the
DCF methods are applied are not historical: they are projected numbers, and they
arise from a comprehensive and detailed view of what the business will look like over
the next five or ten years. The valuation is only as good as the projections; and, as
any executive worth his or her salt will tell you, projections are hard to do well.
There is a systematic method for developing a view of the shape of the future
business: this is termed scenario analysis13. With respect to environmental issues, it
will include predictions of the likely trajectories of regulation and legislation,
environmental technology, the evolution of physical systems, consumer sentiment and
the form of demand, and so on. I repeat, this is very challenging, and most companies
wont take it on. But without it being done, and done well, DCF valuation techniques
dont have much validity. That will apply as much to environmental matters as it does
to any part of the business.
A further challenge arises from the discounting component of DCF methods. The
EC guidelines allow the present value measurement of environmental liabilities, even
if these liabilities will not be settled in the near future. However, it has been pointed
out that discounting the value of future liabilities in effect discriminates against future
generations. The structure of the numbers directs management attention, and
therefore resources, to environmental impacts that will occur in the immediate or
short-term future. It thus appears to contradict the basic notion of sustainability,
which, as we have seen, in its most widely accepted form looks for . . .development
that meets the needs of the present world without compromising the ability of future
generations to meet their own needs. The question that presents itself is therefore
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been exploring the idea that an important component of what is needed to further the
analysis may be a theory of business. This is to be distinguished from the economic
theory of the firm, or the financial accounting theory of the business entity. Such a
theory would start from the axioms associated with a commercial transaction, and
attempt to construct logically the structure of contemporary business. It may be that
with such a conceptual structure in place these deeper questionswhich we recognise
but tend to push to one side, as too difficult, or perhaps too threateningcan be
moved towards some kind of resolution. However, the consequences of such a logical
resolution, for the current disciplines of accounting and of management, may well be,
I would warn, intellectually provocativethat, at least, is the hope.
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Parker (1977)
Deegan (2000), pp. 335-337.
3
Pheasant (2002), pp. 25-31.
4
Tinius and Wang (2001)
5
Deegan (2000), pp. 306-310; Parker (1977), p.48.
6
Gray and Bebbington (1992), p.6.
7
Deegan (2000), pp.338-343.
8
Rigby, Howlett and Woodhouse (2000), p.5.
9
Gray and Bebbington (1992), p.15, quoted in Deegan (2000), p.344.
10
McTaggart, Kontes, and Mankins (1994), p.7.
11
Martin and Petty (2000), p.3.
12
Drucker (1964), p.xi.
13
Schwartz (1996).
14
Mathews (1993), p.26.
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