Corporate financial reporting is rooted in centuries of practice and is largely tone deaf to shifting societal and environmental priorities. Every company has an impact on society and the environment, and those impacts come with costs – either positive or negative. Thus, companies have a citizenship duty to reflect those costs in their financial reports, and the state has a role to play to ensure everything balances. The research of Benoit Lascols, director of Accounting for Externalities, seeks to find ways to link business and citizenship.
Is a company’s balance sheet healthy if that company is financially profitable, employs thousands of people, pumps millions of dollars into the economy, but pollutes the environment and harms the health of its workers? What if a figure was on that balance sheet that reflected the benefits versus the harms of that company? These are questions central to the issue of social costs, externalities, and Benoit Lascols’ quest to define a new value for sustainable reporting.
The methods of measuring a company’s worth have changed little over the past couple of centuries, but the societal and environmental priorities in which companies operate have shifted considerably. Companies whose products harm others face increasing regulation, and environmental activists target companies – even entire sectors – that pollute the environment. Social awareness around climate change has probably never been higher, and increased public access to data and information means transparency and accountability make it easier to hold companies to account.
Companies with an eye on brand reputation speak to environmental, social, and corporate governance. They boast impressive corporate social responsibility programmes in marketing campaigns and dedicate pages to their projects in shareholder reports. But is it enough, considering social costs and sustainability of activities?
” Externalities – whether negative or positive – fall into three categories: environmental, social, and economic. “
Every company – be it a resources conglomerate or a local café – impacts either negatively or positively on the environment and society in general. If those impacts are outside of an agreed transaction between parties, they are termed ‘externalities’. For example, a customer buying a cup of coffee is an agreed transaction; the externality is the environmental impact the manufacturer of that coffee produces in getting the product to market. In essence, according to Lascols, externalities – whether negative or positive – fall into three categories: environmental, in that they deplete or enrich natural resources; social, in that they impact on human connections, including health, education, safety, justice, and culture; and economic, in that they correspond to economic flow.
Whereas we can sometimes measure these impacts, they largely escape our current valuation system, and little is done to include them in financial reporting. Lascols proposes a new type of financial statement, one that accounts for a company’s externalities. Given the shifts in social and environmental priorities, it certainly makes sense; but it’s easier said than done.
Guiding principles
Measuring a company’s economic health boils down to four standard financial statements reflecting the balance sheet, profit and loss, cash flow, and changes in equity. Together, these financial statements provide a common set of rules that enable companies to compare performance. Importantly, the information on them is quantifiable. What is harder to measure is the more qualitative impact a company has on society and the environment. A company may carry figures it spent on a school feeding programme, but miss, or purposefully exclude, the negative impact its manufacturing has, say, on groundwater.
If companies are to include such externalities in their accounting, they need to have universal principles for their evaluation. According to Lascols, three basic principles should guide the process.
Firstly, let’s consider a planet with limited resources as a closed system, as environmental economists define it. Therefore, we should apply the fundamentals of the first law of thermodynamics: any withdrawal of resource stock induces a social cost equal to the reconstitution of the withdrawn stock. In essence: any damage to the environment comes at a commensurate cost which society must carry to maintain natural and common wealth.
Secondly, what is done for natural resources can be done with social resources such as education, security, and justice. The equilibrium between economic activities and society is maintained by taxes covering these social needs. Companies could therefore reduce their taxes by decreasing their social costs which generate externalities, and must be incorporated within the balance of externalities.
Thirdly, someone needs to be the arbiter of general interest – to weigh up the private costs of a company and the social costs of its externalities, monitor them, and have the necessary authority to demand that those balance. Lascols argues that the state – with its laws, taxation, and justice systems – must be the guarantor of this balance between private and public interests.
Putting figures to externalities
If externalities are to be balanced and included in any ‘new’ financial reporting system, we need to equate them with the ideas of positive and negative outcomes. A negative externality exists when any depletion is not compensated. Then a social cost arises: it is equivalent to the effort that should be given to restore the initial wealth. Conversely, a positive externality arises when we contribute to the social wealth. Then the costs engaged (private costs), are covering more than the social cost, and a social benefit emerges. Sponsorship is a form of direct contribution to society, involving private cost without social cost.
Whereas we can measure private costs by associating the expenses and investments of a company in relation to the sources of externalities, social costs are harder to nail down. However, they can be broken down by assuming that every withdrawal needs to be compensated by an equivalent, and any nuisance needs to be captured and then include the following: damage costs related to a company’s activity (including negligence); ongoing control costs associated with constraining the effects of the externality; replacement costs for externalities related to resources; and taxes that should be paid.
Lascols envisages these externalities expressed as variables on a societal ‘financial statement’, where positive externalities are assets, negative externalities liabilities, a social cost is a credit, and a private cost is a debit. These can be further broken down and expressed on a balance sheet, complete with values, to ensure the positive and negative externalities balance (Figure 1).
” In the face of shifting societal and environmental priorities, companies need a way to measure up to those priorities and compare their performances. “
Challenges and opportunities
Lascols acknowledges two challenges to his premise: the issue of complexity and the state’s role as regulator. Reducing the complexity of externalities to figures on a spreadsheet would involve multiple levels of monitoring, compiling, and authentication; getting all stakeholders to agree on the procedures and values will, in itself, be a Herculean task. But should that deter consideration?
Secondly, the presumption that the state is in the ideal position to act as the guarantor of the balance of externalities invites scrutiny. Lascols admits that states do not systematically defend the common interest. Political agendas steer any state. However, given that every stakeholder in the equation has an agenda, we must ask: if not the state, then who else? The reality is that the state is the only actor available to manage the common interest and that has the measures in place – regulations, taxes, and pure muscle – to affect the necessary counterbalances.
What these challenges shouldn’t do is deflect focus away from the opportunities offered by the concept of balancing externalities. In the face of shifting societal and environmental priorities, companies need a way to measure up to those priorities and compare their performances. Furthermore, shareholders and the public need to be able to pressure companies to perform with societal and environmental sustainability as fundamental values in their annual financial statements.
Environmental economics questions an economy dependent on its environment and as a subsystem of a larger whole constrained by physical limits. The balance of externalities defines an economic value in such a system.
If what you envisage as a standard for sustainable reporting is to become a reality, where is the best place to start?
Sustainable reporting is one brick for defining a new value in the economy: sustainable value. As price is a value resulting from a confrontation of offer and demand, sustainable value should define the global depletion of a system on our society and on the environment. The starting point is to recognise the need for a new value that can monitor our economy, and then – thanks to what has been done by GRI, SASB, and TCFD – enhance each impact in terms of social costs. The balance of externality is the continuation of the efforts engaged in corporate social responsibility, and a target for comparing the impacts that companies have on society and on the environment.
References
- Lascols, B, (2021) Accounting and Reporting for Externalities: Balance of Externalities. Sustainability and Climate Change, 14 (2), 115–121. doi.org/10.1089/scc.2020.0051
- Lascols, B, (2021) Opinion | L’économie, un bateau en pleine tempête, sans boussole et sans carte. Les Echos, www.lesechos.fr/idees-debats/cercle/opinion-leconomie-un-bateau-en-pleine-tempete-sans-boussole-et-sans-carte-1330753
- Lascols, B, (2021) The weakness of our economic model. [online] Accounting for Externalities. www.accountingforexternalities.com
10.26904/RF-139-2022275886
Research Objectives
Benoit Lascols aims to bridge the gap between financial information and common resources provided by our environment and society.
Bio
Benoit Lascols is the director of Accounting for Externalities, whose goal is to link business and citizenship. He is an engineer with a degree in environmental sciences, and an MBA from IAE d’Aix en Provence, France. He has worked on projects related to environmental and social responsibility in corporate financial reporting for 15 years, and is helping to draft a standard for sustainable reporting.
Contact
E: benoit.lascols@wm-up.com
W: accountingforexternalities.com
