Is Your Balance Sheet An Effective Management Tool For Today And Tomorrow?

Sissel Waage and David Meyers

Water challenges, climate change, and other such issues are changing the business operating context like nothing we’ve ever seen before. Future-oriented companies are beginning to consider and account for impacts – with the plan of out-competing laggards to this change in context and business measures.

20 May 2015 | CFOs and accountants should be bracing themselves for shake-ups in the coming years – Sarbanes-Oxley type shake-ups, but orders of magnitude more complex, in part because the dynamics of these bubbling changes are more diverse, more widespread, and less well-tracked by the average CFO and accounting team than were the accounting issues that Sarbanes-Oxley addressed.

But they’re not hidden. The Intergovernmental Panel on Climate Change (IPCC) has been highlighting them for decades, and the Carbon Tracker Initiative crystallized them in 2013 for fund managers when it pointed out that most fossil fuel “assets” are, in fact, liabilities. Last year’s Risky Business report pointed out that “Damages from storms, flooding, and heat waves are already costing local economies billions of dollars,” in the words of co-chair Michael Bloomberg.

Yes, the climate is changing, in dangerous and disruptive ways, with further pressure coming from water challenges and corporate water risk, as made clear by the CEO Water Mandate and maps by WRI’s Aqueduct Tool, among many others.

These risks are staring us all in the face, but few companies have accounted for them – although anyone who owns shares in fossil-fuel companies can tell you that the market is beginning to take notice.

Fortunately, a small set of business leaders see the proverbial writing on the wall and have set to work on the next generation of corporate accounting.

For example, sportswear giant Puma developed the Environmental Profit and Loss (EP&L) statement, which is being integrated by its parent, Kering, across all its brands (including Gucci, Stella McCartney, Volcom, and many others). The B Team, co-founded by Jochen Zeitz, Kering’s Director and Chair of the company’s Sustainable Development Committee, has committed to scale these efforts across the business world. Novo Nordisk has published an EP&L. Also, the social business Pants to Poverty has developed Accounting in 3D”, in collaboration with Trucost and GIST. Dow is assessing ”nature’s value to a company, in detail and with monetization that makes integration into financial spreadsheets feasible.

And, for those who say that it will be impossible to change accounting without a standardized format, the response is that efforts are already well-underway as Natural Capital Coalition is supporting the development of a protocol” for corporate natural capital accounting. (Also noteworthy is that work is underway at a country scale on integrating environmental issues into a System of National Accounts (SNA). Splicing environmental issues into Gross Domestic Product (GDP) is being piloted by the World Bank within the Wealth Accounting and Valuation of Ecosystem Services partnership.

Sarbanes-Oxley may turn out to have been a small shift compared to bringing environmental and social issues internal to businesses. Externalities may be on the cusp of being internalized.

At core, the drivers are simply a matter of demand and supply—in this case demand on and supply from ecological, hydrological, and atmospheric systems. Global demand for nature’s services”—such as clean water, wild fish, timber, fertile soils, and many other goods and services—is growing, after years of undercutting the ability of natural systems to produce the supply of these services. Simply put, ecosystem malfunction risk is real. Understanding impacts on, as well as the need for investments in, green infrastructure is key to maintaining a stable business operating context.

In response, forward-looking companies have begun to integrate their impact—such as in the form of EP&L findings—into the classic accounting terminology.

The next step is to complete the full accounting equation: Assets = Liabilities + Equity. With such further developments, accounting will be transformed by creating “Environmental Balance Sheets” (EBS) to complement EP&Ls. An EBS would expand thinking about “environmental assets” far beyond the current approach, including wastewater treatment, smokestack scrubbers, and ‘hard’ / built infrastructure to cut pollution. A real Environmental Balance Sheet would include the functioning ecosystems that provide the services on which a company relies. Just as Kering’s EP&L traces impacts back to the raw material tier, an EBS will take account of the stocks of natural capital on which a company depends and impacts throughout its supply chain. In this way, an EBS would document positive outcomes from corporate investments in watershed protection and function—such as payments for watershed services that Coca Cola is making, or biomimcry-inspired design that eliminates the need for toxic, bio-accumulative, persistent compounds.

With an Environmental Balance Sheet, companies could book asset payments that they are making in restorative land management to ensure long-term access to water. Previously accounted for only as philanthropy, verified reforestation and forest protection projects—work that sequesters carbon, cuts erosion, improves water filtration into underground aquifers, while maintaining biodiversity and local community benefits—would become valuable assets to companies. The corporate finance team could count investments in environmental assets to offset environmental liabilities. In addition, annual benefits produced by that asset—such as carbon credits, stable water supply, and other returns—could balance the environmental losses as recorded in the EP&L and could be used directly by local facilities (especially in the case of water).

Environmental Balance Sheets would enable corporate leaders to put good behavior where it belongs—on the balance sheet— because it delivers real long-term business value to a company.

Measuring long-term, environmental impacts (both negative as well as positive), and attaching values for social and environmental aspects within corporate accounting will transform how companies perceive of and act to avoid impacts. ‘Balancing’ these costs through investing in green infrastructure or product / production redesign would provide incentives to capture the value for companies managing their businesses more sustainably. The financial return on sustainability will become obvious, and corporate managers would be incentivized to act on information now available in the public domain that, if ignored, could cause PR debacles, lost sales and market share.

The bottom line is that accounting was developed to give management an accurate picture of the company and to provide investors with an honest basis for deciding whether to buy in. An Environmental Balance Sheet would do a better job of reflecting corporate impacts, risks, and prospects than current approaches.

The tinder is in place. And the sparks for change are all present. It’s a good time to begin the conversation with your CFO and accounting team.