Green accounting for sustainable development:

Much to be done to convert hype to reality

Keynote address delivered at Wayamba Universitys research symposium

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

 Sustainable development generally has two
meanings.

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state support is withdrawn.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.

Externalities

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 peoples 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 Natures assimilative capacity is disrupted either
by human action or by Natures own reactions. Human action takes the form of
unplanned dumping of waste matter, causing destruction to Natures agents or
dumping of waste matter in large quantities fuelled by population growth and
race to produce more goods and services. Natures 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 Natures 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 waw1949@gmail.com.)
Posted by Thavam