Burgess COMMENTARY

Peter Burgess

Pricing Externalities: Redefining Profit to Reflect Reality

According to Webster’s dictionary, profit is defined as “the excess of the selling price of goods over their cost.” Simple definition, yes, but complex to calculate when the cost is uncertain or hard to measure.

Some costs, such as the depletion of natural resources or the health impacts of polluted air and water, are all too often assumed to be zero when in reality they may be high. So high, in fact, that the “profit” reported by some industries may not be profit at all—but instead, a loss of irreplaceable resources essential to our future well-being and economic prosperity.

Defining the Indefinable

A new report authored by Trucost in conjunction with The Economics of Ecosystems & Biodiversity Coalition (TEEB) is a notable attempt to quantify the monetary value of natural systems and determine the impact of incorporating business “externalities” into company balance sheets.

Natural Capital at Risk: The Top 100 Externalities of Business ranks the top 100 impacts in each sector, broken down by region, and evaluates the value of unpriced natural capital. While authors acknowledge that the methodology has limitations and can only provide a “high-level” indication of natural-capital risk, the findings are sobering:

• Primary production and processing industries may cost the global economy around $7.3 trillion a year in terms of the economic costs of greenhouse gas emissions, loss of natural resources, loss of nature-based services such as carbon storage by forests, and air pollution-related health costs.
• Coal-fired power in Eastern Asia and in Northern America rank first and third, respectively, in terms of impact—estimated at $770 billion annually. These consist of the damaging impacts of GHG emissions, and the health and other damage caused by air pollution. In both instances, these social costs exceeded the production value of the sector.
• Other high impact sectors include agriculture in areas of water scarcity and in areas of high production and land use. Cattle ranching in South America and wheat/rice production in Southern Asia also rank high in terms of impact.
• The majority of environmental externality costs are from greenhouse gas emissions (38%) followed by water use (25%); land use (24%); air pollution (7%), land and water pollution (5%) and waste (1%).

In my view, the fact that externalities are ignored in all the dominant metrics of modern economy and society is just plain stupid ... but that is the way it is.

I am prepared to accept that for a very long time, externalities were unimportant relative to the main purpose of economic activity. In the stone age cave man era, feeding, clothing and housing were essential to survival ... and by the time Adam Smith described the way the economy worked most economic activity was carried out by individuals and quite small organizations. The interaction between different economic actors produced markets.

By this time bigger cities were creating social problems ... pollution, congestion, water systems, sewer systems, etc. Rules and regulations for all sorts of things have emerged over time, because they were needed for society to survive.

With huge enterprises and scale, it is time for the externalities of all global issues to be incorporated into the metrics of economics and accountancy. This may not be easy, but it is essential. My approach to this is the concept of standard value, something like standard cost in cost accounting. A standard value approach may not be perfect, but valuing important externalities at zero is completely wrong ... which is what happens when externalities are ignored.

FaceBook has profiles on about a billion people. The technology to handle huge amounts of data are available. There is no technical reason why there cannot be profiles on billions of economic activities.

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