Thursday, November 22, 2012

A new collaborative report explores the preparedness of the accounting profession to respond to declining natural capital

ACCA (The Association of Chartered Certified Accountants), KPMG and Fauna & Flora International, have investigated the concept and existing use of materiality in light of the increasing significance of natural capital as a business risk. 

The new report entitled: Is natural capital a material issue? An evaluation of the relevance of ecosystem services to accounting professionals and the private sector will be officially launched at a briefing event held in London today.

Natural capital – the stock of capital derived from natural resources such as biological diversity, ecosystems and the services they provide – is in decline globally. The loss of natural capital exposes companies to a range of new risks and opportunities that can impact profit, asset value and cashflow. Civil society is increasingly concerned about the loss of natural capital, but are companies identifying and measuring these issues? When do they become material?

The report explores the current response of the accountancy profession to the increasing importance of natural capital as a business issue. It involved a survey of more than 200 accountancy professionals, interviews with CFOs and senior management from eight major companies, a disclosure survey of corporate reporting by 40 organisations in specific sectors, and desk-based research into relevant literature and work in the field.   

Key findings of the survey include:
  • Perceptions of Natural Capital as a risk are variable within the accountancy profession
  • Current disclosures on Natural Capital, as currently practised, are too limited to provide insights into risk management 
  • A handful of companies in high environmental impact sectors are reporting substantial detail on aspects of Natural Capital, but the majority are reporting little or no information due to the perceived immateriality of the issue
  • There are a number of barriers to corporate action such as the lack of a standardised business case, low or unclear market values for some aspects of Natural Capital and some accounting principles
  • 60 per cent of respondents agreed that the natural world was important to their business
  • More than half of the respondents had included natural capital issues in their company’s business risk evaluations at some point, and
  • Nearly half (49 per cent) of respondents identified natural capital as a material issue for their business and linked it to operational, regulatory, reputational and financial risks
Author of the report, Dr Stephanie Hime of KPMG’s Climate Change and Sustainability practice, said: 'Specific parts of Natural Capital are increasingly being recognised as critical and material business issues. This report aims to bring a new audience into the debate by focusing attention on what the accountancy profession can do to mitigate these risks.'

Head of Sustainability at ACCA, Rachel Jackson, said: 'ACCA strongly believes that considerations should be made by accountancy bodies to make their members aware of the need to account for natural capital within the company annual reports and accounts, as well as sustainability reports in order to avoid failures when anticipating future risk and their associated costs to business.'
A changing landscape of risks
The Principles for Responsible Investment show that 50% of company earnings could be at risk from environmental externalities – equivalent to 11% of global gross domestic product.5 In addition, full environmental costs of production in 11 key industry sectors could account for a considerable proportion of earnings (earnings before interest, taxes, depreciation and amortisation – EBITDA), this would have amounted to 41% in 2010 according to Expect the Unexpected: Building Business Value in a Changing World (KPMG, 2012).  It is becoming increasingly accepted that a significant volume of financial flows are not accounted for in corporate accounts. Furthermore, it is becoming clear that the costs of these externalities are being borne primarily by governments and society more broadly. At least some of these externalities will at some point be internalised. Thus, the links between BES and corporate value through impacts on share price are strengthening. Shareholders are becoming increasingly engaged on the issue. Alongside this, governments are exploring regulatory or policy changes to encourage the sustainable use of BES through the development of frameworks for national ecosystem services accounting and by evaluating the status and economic value of ecosystem services.

Natural capital and materiality
As shareholder attention on BES issues grows, these issues are beginning to feature in management disclosure and analysis – the qualitative part of the annual report and accounts, or within separate sustainability reports. There are also some instances where an item or issue might be measurable in financial terms and therefore included in the quantitative elements of the accounts.
• There have been planning restrictions as a result of impacts on natural capital and associated  decreases in company share price. For example, in 2012 the Canadian Gold mining company, Infinito  Gold, lost permission to develop a mine as a result of the potentially significant impacts on agriculture, forests and endangered species. This led to a decrease in share value of 50% and a reference in the annual report to material uncertainties regarding the company’s ability to continue as a going concern.
• Clean-up costs from the 2010 Gulf of Mexico oil spill and associated compensation claims for ecological damage have affected both BP’s balance sheet and its profit and loss. The company’s 2011 annual report included a $3.5 billion provision related to clean-up costs and a $7.8 billion provision related to litigation and claims associated with the spill.
• There have been delays in securing permission to develop as a result of concerns about natural capital. For example, Newmont Mining Corporation in Peru experienced significant delays as a result of concerns about the impacts of the mine on water availability. This not only resulted in costs associated with the delay, but also required an investment of approximately $150 million from the investment partner, Minera Yanacocha.
Over 30 countries now have some form of legislation in place to enable compensation for the impacts of development on BES. The emergence of national-level reviews of the status of BES in countries such as Brazil, India, the UK, Germany and the Netherlands may lead to further regulation as governments act to address the findings. In the UK, for example, a National Ecosystem Assessment showed that 30% of the UK’s ES were degraded or in decline. The UK has put in place a range of advisory groups and pilot projects to inform future policy action to address this decline.
The issue is changing from one of reputational risk, impacts on intangible assets and weak links to shareholder value, to one of operational, financial, and market risk and competitive advantage, all of which have greater links to shareholder value. Hence, for some sectors, BES loss is becoming an issue that can constrain corporate success through impacts on corporate value and corporate performance. Associated British Ports, the UK’s largest port operator, lost 10% of its stock market value after the UK government prevented its development of a container terminal. The decision was  made as a result of concerns over the potential impact on important wildlife.
Tools and guidance available 
A number of approaches, assessments and tools have been developed to assist the integration of BES risks and opportunities into business performance systems.  Business for Social Responsibility has undertaken a series of analyses of ecosystem-services-related tools and approaches which are useful sources of further guidance, such as the WBCSD’s Corporate Ecosystem Services Review (ESR) and the NVI’s The Ecosystems Services Benchmark.
Natural capital and materiality
Using the BES elements of natural capital rarely represents a direct cost of doing business unless they are used as a specific input into production, e.g. timber, but instead affects wider society in the form of environmental externalities. As a result, BES are often overlooked in traditional materiality calculations owing to low values or values that are not based on markets. For example, an analysis of the value of forest lost as a result of the Chinese construction and materials industries was estimated at US$12.2 billion annually. If this is compared with the unit cost of timber using the prevailing market price, it is clear that the price paid for timber by the Chinese construction market does not reflect its true cost in terms of lost ES such as watershed protection, erosion control and recreational opportunity.
The survey of ACCA members suggests that 82% of risks and opportunities highlighted in company assessments are short to medium term (up to five years) with only 11% perceived as affecting businesses in the long term
Interest among the traditional users of financial accounts is increasing
There is evidence that interest in these issues among the traditional users of financial accounts is growing..
• The Water Disclosure request from the Carbon Disclosure Project was supported by 354 investors with US$43 trillion assets under management.
• Eight investors and advisers, collectively representing £787 billion of assets under management, released a report highlighting the risks and opportunities associated with BES in the extractive sector.
• A coalition of 30 investor organisations representing over US$170 billion in assets urged the US Environmental Protection Agency (EPA) to initiate a review process under the Clean Water Act to evaluate the mine waste impacts of the proposed Pebble Mine on Alaska’s Bristol Bay watershed, which produces approximately half of the world’s commercial supply of wild sockeye salmon.

Valuing ecosystem services and corporate decision making
Fifty per cent of company earnings could be at risk from environmental externalities; this is equivalent to 11% of global GDP according to Universal Ownership: Why Environmental Externalities Matter to Institutional Investors (PRI & UNEP FI, 2010).  Emerging statistics such as these are encouraging governments to explore incentives to persuade investors and companies to manage and minimise such externalities (which include ES). In addition, tough commitments made at the international level at the COP 10 Nagoya (2010) have made the protection of biodiversity a key commitment for some countries. With increasing regulation and civil society interest in this issue, effective valuation of BES will become increasingly important for providing an accurate picture of corporate performance for decision making and performance.

Companies that value their impacts and dependencies on BES will be able to make more accurate assessments of the value of assets and liabilities, and to spread costs and realise preferential cash flows or to contribute to the development of appropriate tax regimes.
Current approaches to valuing natural capital 
Most elements making up natural capital (namely BES) are not traded, making it difficult to determine their value through markets. Certain techniques can, nonetheless, be applied to estimate their value, although these are not widely used by the accountancy profession. Hence, BES issues do not routinely feature within the financial figures.
One of the most commonly used models for understanding all components of social well-being, and hence all constituents of value, of BES is the Total Economic Value (TEV) framework.  The TEV framework details all aspects of value that can be considered in terms of both use (i.e. the parts of ES used for production, etc.), and non-use (i.e. the parts of ES that have a value simply because they exist).
Case study: Exploring ecosystem valuation to move towards net positive impact on biodiversity in the mining sectorThe mining company, Rio Tinto, has a policy goal of net positive impact on biodiversity in its operations. As part of its offset strategy in Madagascar, the company is supporting the conservation of areas of lowland forest to compensate for the impacts of its mining operations in the country.  Rio Tinto has worked with the IUCN (International Union for Conservation of Nature) to assess the monetary value of this project. The study has shown significant net economic benefits associated with conservation ($17.3m). It also showed that many of the benefits accrue globally (e.g. carbon storage, wildlife habitat), while many of the costs are born predominantly by local communities (e.g. reduction in access to forest resources).  In doing so, the project highlighted the need for Payments for Ecosystem Services (PES) schemes to address the imbalance between those receiving the benefit of such schemes and those bearing the cost. It also demonstrated how a private company can use economic valuation to manage its environmental footprint.
Case study: Oil exploration in an area of high biodiversity valueThe Italian oil and gas company Eni operates the Villano oil field in the Ecuadorian Amazon. A significant challenge of the project is related to its location in an area of extremely high biodiversity value.  In order to minimise the company’s impacts on the forest, the plant has been constructed as if it were an offshore platform. Oil is transported via an ‘invisible pipeline’ that is hidden from view under the forest. Drilling platforms are only accessed by helicopter, avoiding much of the deforestation that would be caused by construction of access roads. Overall, an estimated 15,000 trees were saved from being cut down through the project’s environmental management plan.
Case study: Taking a first step to quantifying and disclosing natural capital impactsDuring 2011, the German sports brand, Puma, calculated that the environmental impacts of its operation amounted to €94.4 million in 2010. The company valued greenhouse gas (GHG) emissions and water use within its first statement. The exercise showed that 92% of Puma’s environmental impacts are located in its supply chain and that 36% of GHG emissions and 52% of water consumption are associated with the production of raw materials such as leather and cotton. Although this exercise relies on valuation techniques, the results are not included within the financial accounts of the company and, therefore, have limited impact on shareholder returns. Beyond the marketing benefits of such an initiative, the programme provides Puma with much greater visibility of its operations and creates a business case for focusing on supply-chain issues. The company is working with suppliers to reduce negative externalities and to reduce costs and risks within its supply chain. The benefits of the exercise have been significant enough for its parent company, PPR, to implement the environmental profit and loss across its brands (which include Gucci, Yves Saint Laurent and Alexander McQueen) by 2015.

The Association of Chartered Certified Accountants (ACCA)
Press Release dated November 9, 2012

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