no-sustainability-without-balance-sheet

There is no sustainability without a balance sheet

Blog 14^th Dec, 2017

It could be argued that we are misusing the term “Capital” within Natural and Social Capital. Whilst at The World Forum on National Capital, most of the corporate applications of natural and social capital accounting are focused on the flows to and from the capitals rather than accounting for the capital itself. We believe that broadening the measurement to include the assets (capitals) and liabilities, from a balance sheet perspective, would support the uptake of natural and social capital accounting and provide insights into the current state of the capitals.

A financial balance sheet provides stakeholders with an understanding of what the company owns (assets) and owes (liabilities), and whether it is solvent and can meet short-term debts (i.e. working capital). A natural and social balance sheet would meet similar needs, highlighting whether a company’s operations are sustainable or unsustainable when assessed against predefined boundaries such as planetary boundaries. Measuring only flows is like measuring the activity of our economy with the GDP. We observe the level of activity, but we don’t know if this relates to a reduction of capital or not. We have the choice of either creating a flow by consuming the capital or by using only the interest generated by it.

Let’s take an example to illustrate our case, land natural capital. We used a case study in Africa for a perennial crop production to derive the capital value of the related land used. The valuation technique is based on the discounted future production value or, said differently, the fertility of the soil and its capacity to sustain production. And the underlying impact metrics are based on open sourced impact measurements. The discount rate used was estimated based on the soil erosion rate, which provided an interesting insight that the soil will be depleted in under 100 years. Land capital is indeed finite, not only in term of area, but also in term of quality. We can only identify this issue by measuring stocks (i.e. the asset from a balance sheet perspective). The results obtained shows that the current value of land natural capital is roughly 9’200 USD/ha (see figure below), which is far above market value (below 1’000 USD/ha).

Using scenarios based on agricultural practices, we estimated the value of land natural capital based on intensive production and best practices, adjusting mainly the discount rate in line with erosion rates and loss of fertility. Not surprisingly, intensive production decrease significantly the land capital, decreasing its current lifetime (see figure below).

This innovative valuation of land natural capital could have important implications depending on the link with the land and the business:

Land owned by the business: We can draw a direct connection between agricultural practices, land natural capital reported and even Profit and Loss because the productivity and the cost of production will vary according to the health of the soil. Indeed, a depleted soil will deliver less yield and will be linked to higher input costs to maintain the same level of production.
Land leased by the business: the lease relationship and conditions could potentially be influenced by the value of land natural capital. Indeed, if a company leasing the land uses good agricultural practices and maintain the value of land, it would be in the interest of the lessor to provide incentives.
Land not owned by the business, but which is used to supply goods purchased by a company: in this case, there is no direct link with the financial accounting of the company. However, most of the land used indirectly by agricultural/food companies falls in this category. If land natural capital is not preserved, business conditions could be affected leading to price volatility, security of supply and other negative factors.

To reflect the extent of this risk we analyzed two multi-national consumer goods companies that report the land used in their supply chain related to the production of agriculture commodities purchased. We calculated the value of their land natural capital and compared it to the companies’ book value (balance sheet). The results show the ratio between the land natural capital and the book value (balance sheet) is materially significant, reaching 70%. The analysis exposes the agricultural/food companies to land natural capital related risks. Said differently, book value could be under-valued by 70% if we wanted to account for the value of this land in financial reporting. This result shows the extent of the Value at Risk of agricultural/food companies towards land natural capital related risks.

Accounting for natural and social capital is not covered by the International Financial Reporting Standards (IFRS) or current non-financial valuation practices. We propose that alignment on the value perspective, scope and “balance sheet” stock accounting will need to happen if the private sector is to operate in a world defined by the Planetary Boundaries, the Sustainable Development Goals and the Paris Climate Agreement.