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March 1992

Natural capital and invisible interests in natural resources. (environmental accounting)

by Rubenstein, Daniel B.

    Abstract- A macro-'green' accounting model is designed for the management of environmental clean-ups and aims to address the environmental accountability of organizations. The proposed model is based on a determination of the physical quantity of resources utilized by society. The contamination of the Love Canal waste landfill by Hooker Chemical Co is used to illustrate the inadequacy of existing and traditional accounting methods in facilitating the accounting of costs and expenses incurred in environmental clean-ups. The macro-green accounting model is further elaborated upon using the Hooker Chemical Co incident.

Throughout World War II and into the 1950s, Hooker Chemical Company buried thousands of steel drums containing chemical waste--mainly dioxin--in a landfill site by the Love Canal, in upper New York State. Some 25 years later, the drums had corroded, and toxic gases were rising to the surface. It was a nightmare, not only for residents of the housing project that had been built on the site, but also for Occidental Chemical Corporation, which had taken over Hooker in the late 1960s.

Many of Occidental's senior managers were probably war veterans, raised in an era and business culture that held productivity and prosperity next to godliness. Their social contract with society was to produce and do it profitably. There was no clause that even mentioned the environment. In the 1980s, however, largely in reaction to Love Canal and other disasters, U.S. courts began to question the very premise of the contract. As a result, Occidental may have to meet an estimated $260-million clean-up cost, and company management may feel it is being unfairly tried for a crime it did not commit indeed, for an act that was not a crime when the chemicals were dumped.

Nevertheless, in October 1990, a Buffalo jury began reviewing yellowed documents from Hooker's archives, trying to determine whether the company was aware of the risks involved in disposing of the chemicals the way it did. One document, an internal report written by a Hooker manufacturing analyst in April 1945, clearly describes the author's concern about a "potential future hazard" and a "quagmire at Love Canal that will be a potential source of lawsuits." New York State's lawyers believe this and other papers prove that Hooker's executives had been warned for years about possible contamination of the affected land, a portion of which the company later donated as a site for an elementary school.

For their part, Occidental's lawyers say the hazards always have been greatly exaggerated. Their main defense is that, back in the 1940s and 1950s, Hooker's disposal techniques were "state of the art." Accordingly, it would be wrong to measure the company's actions then by what is now known about toxic chemicals. Thomas Truitt, Occidental's chief lawyer, puts it, "You cannot be judging the conduct of people 40 years ago by today's standards, especially when half of them are gone and they can't explain anything."

The reality is, however, that judges, juries, legislators, and the public are judging the past by today's standards. For more than a decade, the courts have been hearing an ever-increasing number of environmental lawsuits and defining an entirely new social contract between business and society. What is emerging is nothing less than a revolutionary new concept of corporate accountability. Moreover, it is a worldwide phenomenon, and its magnitude would be difficult to exaggerate. In the U.S., for example, the Environmental Protection Agency has now identified some 27,000 hazardous waste sites, with an estimated average clean-up cost of $25 million each, or a total possible cost of $675 billion. In Western Europe, the clean-up bill is expected to be at least $65 billion. And from Eastern Europe we are getting reports of major environmental crises, such as Chernobyl in the Ukraine, which will also cost billions to remedy.

In all, the world is now likely facing at least a trillion dollar environmental obligation, for which society is trying to sort out responsibility, to determine who's going to pay for what. A key problem is that accountants of the world don't yet really know how to account for clean-up costs and the related liabilities. As a result, investors are surprised to see undisclosed clean-up costs drain corporate resources. Environmentalists aren't getting a clear picture of how corporations are meeting their newly defined responsibilities as stewards of the natural resources they use. And voters cannot tell whether their governments are setting appropriate fees for resource extraction and implementing adequate environmental protection laws. In the U.S., the SEC has recently challenged a number of registrants when it appears the registrants have sufficient information to make reasonable estimates of probable environmental clean-up costs but may not have done so. These are but a few broad indications of the information needs that we have so far been unable to meet. And it is with these and other needs in mind that I propose to discuss three fundamental concerns. First, using Hooker as an example, I will discuss the failure of traditional methods to meet the accounting needs raised by that trillion dollar environmental obligation. Second, I will briefly discuss some macro-"green" accounting models. And, third, again using Hooker as an example, I will ask the reader to consider a new accounting model, in which I suggest a way to bridge the gap between macro-green accounting and the micro realities of a company's bottom line. If you find parts of my model outrageous, all to the good, for I am presenting it here as a deliberate provocation--an illustration of my belief that, if we are to resolve the information crises outlined earlier, we are going to have to start thinking the unthinkable.


To a large extent, thinking the unthinkable means coming to terms with a central premise of the new social contract that is emerging. There is now a new class of "stakeholders," including people yet unborn, who can exercise common property rights in a company without investing a dime in it. This has, quite accurately, been described as an accounting nightmare. And, in my view, the only way out of it is to rethink the narrow definitions of asset and liability that were drummed into us in school.

Consider the Hooker Example

In 1940, Hooker bought the steel drums that were subsequently corroded from a local supplier. The purchase was accounted for in monetary terms, was conducted according to a well-defined contractual relationship between buyer and supplier, and all the parties to the transaction were clearly identifiable. The same applied in the purchase of the landfill site, which was recorded as an asset, at historical cost. There was no further accounting for the dumping event. Under our current definition, only explicit contractual obligations to shareholders, suppliers, and others can be recorded as liabilities. Accordingly, since there was no transaction with future generations, the potential liability of dumping toxic wastes at a landfill site would not be recognized at the time of dumping.

The problem here is a failure to recognize the natural capital contributed by society in the form of free goods such as air, water, and other prerequisites for industrial activity, which are lent to businesses for use, rather than consumption. This is the basis of judgments the courts are now handing down. As a result, Occidental may face a quarterbillion-dollar liability to homeowners and other stakeholders who suffered as a result of the Love Canal contamination. That is, the courts may establish that these hitherto "invisible" stakeholders had an interest in Hooker's operations, even though it went unrecognized during the 1940s and 1950s.

The unfortunate fact is that, as we enter the 1990s, such interests are still largely unrecognized by accountants. Currently, the key pronouncements governing our accounting for hazardous waste and similar items are the rules for contingent liabilities. In the statements of Occidental for 1989, disclosure of contingent liabilities associated with the Love Canal clean-up rated only about half a page. There was no real disclosure of the estimated loss or range of losses. The statements were largely silent on whether any accruals have been booked, and even on whether an estimate of loss is possible. And this is but one of many possible examples of the need to find a way to account for the trillion dollar environmental obligation mentioned earlier.

An overview of the uniqueness and scope of this need is to be found in Figure 1, which compares and contrasts environmental accounting obligations with traditional ones. Quite clearly, their unique attributes make environmental obligations inherently difficult to account for under any accounting rules. They take a very long time to settle. Bear in mind the lawsuits stemming from the Exxon Valdez accident; they involve a high degree of interdependence with other users of common-use property, entail great uncertainty, and require complex estimations where there is no accepted basis of valuation.

There are no well-defined, "explicit" contracts outlining the rights, benefits, and obligations of the parties concerned. In other words, accounting for environmental obligations is not based on our traditional concepts of private property and stewardship of the interests of the shareholders. Rather, it is based on the still evolving concepts of shared resources and stakeholder stewardship. To be sure, the courts that are establishing precedents here are still including shareholders, customers, and other traditional interests among the ranks of the stakeholders. But these people now have to share their rights with individuals, communities, and even plants and animals that may be affected by a company's operations. Figure 2 is my best estimate of these new stakeholders' information needs, which transcend traditional information needs of investors and creditors.


A growing number of accountants and economists are recognizing the deficiencies of accounting as currently practiced. Some believe the answer is to provide better information on the physical quantities of resources used by a society. Most are focusing on GNP and other forms of national income accounting.

One proponent of the physical quantity method is the London Environmental Economics Centre, which believes that to achieve effective management of a natural and environmental resource base, policymakers need access to a constant, reliable, and comparable set of data on the availability and use of the resources involved. Accordingly, they maintain that, as with all accounting systems, the objective of environmental accounting is to:

1. Prepare a balance sheet giving an inventory---quantity and value--- of the resources available at a given time;

2. Prepare an account of what uses are made of the resources, the sources from which the uses are derived, and how the resources are added to or transformed over time; and

3. Ensure that the resource inventory accounts and the movement accounts are consistent, so that the balance sheet in any year can be derived from the balance sheet of the previous year plus the changes that year.

The authors of this blueprint argue that, although we naturally think of accounts in monetary terms, in fact there is no reason why they should not be presented in physical units, as long as they present balances and movement in a clearly identifiable way, and as long as they achieve reconciliation between the different sets of inventory and movement accounts. Ks a practical example of this, energy balance sheets have been prepared.

This physical approach to environmental accounts tends to classify. resources by type, to establish base accounts, and to look at movements and changes in those accounts. The results demonstrate some interesting aspects of a country's environmental profile, as well as linkages between the environment and the economy, which are of general interest.

The crucial point is that much industrial activity is economically dependent on resources, such as water, air, soil, and their biotic components, as well as its being an interdependent part of the natural environment. Thus, not only the courts, but a growing number of economists, are maintaining that companies are or should be accountable for their stewardship of resources they need and use.

In a similar vein, theorists who are taking a monetary approach and are trying to link national income accounts to the use of natural resources are searching for ways to measure such factors as depletion of natural resources and the impact of environmental damage on the economic welfare of society. Its important as this conceptual work is, however, we really, won't begin to do what needs to be done until we have found a way to link these macro concepts with the accounting needs of a specific corporate entity.

Recognizing the need for research in this area, the UN Centre on Transnational Corporations is funding the development of an accounting model and method of reporting for sustainable income. The first objective will be to confirm stakeholder needs as identified in a recent study by the Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting. The next major task will be to redefine asset boundaries in a manner that will help quantify the extent to which an individual enterprise has made progress in reducing resource depletion and degradation. The researchers will be using a case study of a Canadian company involved in resource extraction and processing. The intended result is a set of accounts that measures an ability to deliver goods and services after a full accounting for environmental costs.

I call such an ability "ecopreneurship," and propose an approach to accounting that I believe is compatible. In a nutshell, this approach is an attempt to measure both the full costs of production and the costs of failure to come to terms with today's environmental requirements.

One of my starting points is that accounting for the concerns raised by that manufacturing analyst at Hooker in April 1945 might have helped prevent many of the clean-up costs that Occidental is now facing. That is, if Hooker had been forced to think about the potential costs, it might have made a better effort to develop methods of disposal, thus diminishing or eliminating the Love Canal situation at the very beginning.

Another underlying notion is that of sustainable development-- development which has been defined as that which "meets the needs of the present without compromising the ability of the future to meet its own needs." Translating this concept into accounting terms has led me, in turn, to the idea of a "natural asset trust account." The value of such an account would be set and then never change if the company practiced sustainable development and did not degrade the environment. Above all, establishing this asset would also involve accounting for the invisible stakeholders who have no explicit or monetary contractual relationship with a reporting entity.. In short, I now propose to describe how accounting for these invisible interests might have worked in the case of the land acquired by Hooker Chemical half a century ago.


Figure 3 illustrates how natural asset accounting would work. The first step would be to create a separate natural asset trust account that would be an integral part of Hooker's financial statements, and there would be full accounting for it in physical and monetary terms. The first entry in the trust account records would be the land--a natural asset valued at, say, $50 million, as at December 31, 1945. In principle, this valuation would be based on the higher of potential clean-up costs or the estimated discounted cash value of the asset's future productive value over its natural regenerative life cycle.

What this means in practical terms is that if Hooker had been using this natural accounting method, it would have looked at rents charged in 1945 for similar land, as well as the value of residential properties. It would have also imputed a rental value for the foreseeable future, based on assumptions of inflation, increases in value, and future economic activity in the area; and it would have discounted these values over the next, say, hundred years. In the case of a natural asset such as a forest, the regenerative lifecycle would be used.

This methodology would have led Hooker to a capitalized value which would have been reflected in the December 31, 1945 accounts. During the following year, there would have been no journal entries relating to the trust account, because there would be no economic activity pertaining to the and therefore no degradation of it, making accounting entries unnecessary.

However, for example by December 31, 1946, the situation had changed and Hooker started dumping waste on the land. Environmentalists and chemists estimated that, based on dumping throughout the year, the future productive value of the land was depleted by 20%. Accordingly, a depletion allowance would have been recorded in the trust account, with a corresponding entry of like amount due from Hooker. And, on Hooker's books, an expense for natural resource use would have been recorded. Hooker would have also recorded a corresponding liability to the natural asset trust account. Journal entries would have continued in a similar manner until the late 1960s, when Hooker was bought by Occidental. The accounts would show that, after over 20 years of dumping, the land is 90% degraded, based on the best scientific estimates available. The trust account record shows both this and a liability from Hooker. The underlying economic reality represented by these entries is that the land is now polluted, with limited future value, and that Hooker, whose dumping was responsible for the degradation of the land is liable to environmental stakeholders for clean-up costs. In real life, courts have only begun to confirm and codify such liabilities.

Going by the accounting rules that I am suggesting in this example, however, a revaluation of the natural asset account would have been required every time an asset was transferred from one owner to another. The purpose of this would have been to ensure that the investors were not given any unpleasant surprises years after the transfers. In the intervening years the intrinsic, productive value of the landfill site has risen. Because of a housing boom, land values around the area increased. Therefore, the economic loss suffered by environmental stakeholders has increased because the land could be used for residential sites and would be worth a lot more. However, the land is still 90% degraded because there has been no clean-up effort. Accordingly, a further depletion allowance is required.

The bottom line is that Hooker now shows a far greater liability than it would have under traditional accounting methods. It's important to get the account balance right, because the natural trust account is to be transferred, along with the physical asset, to the new company. And when Occidental's shareholders see this balance, they will know that they are assuming a significant liability--which would of course, have been factored into the purchase price.

Between 1969 and 1988, there is no accounting required for the trust account asset because there has been no further industrial activity. In short, the dumping has stopped, although the land is still 90% depleted. In 1988, however, the court ruled that the company may be liable for an estimated $260 million clean-up cost. Following the rule that the valuation of the asset should be at the higher of future productive value or the estimated clean-up cost, the natural asset account would again be revalued. In other words, Occidental would have to increase the amount payable to the account by $144 million.

Assume that during 1989, Occidental spends $50 million on cleanup and, in a sense, is now repaying its "debt" to the fund and the invisible stakeholders. The substance of the transaction is that they are trying to undo the damage of more than 25 years. Accordingly, $50 million is reclassified to the natural asset account to show the restoration of the assets productive capability. However, in addition to Occidental's $50 million, the State of New York spends $40 million on the cleanup, and this amount is credited to the natural asset account as well.

Finally, by 1995, the clean-up will be finished. The natural asset trust account has increased as clean-up costs have been capitalized and, ideally, it will remain at this balance, with minimal future depletion transactions, assuming that dumping does not resume.


The model I have outlined is, of course, only one possibility--one tentative step toward bridging the gap between green accounting and the information needs of individual companies and their stakeholders. Clearly, the model implies major methodological challenges and is subject to the test of reality. But what is most important in my view is the need to redefine accounting, which must move in the direction of expanded definitions of assets and liabilities and the inclusion of difficult but essential estimates of natural resource use in financial statements. Today, companies routinely account for complex estimates of pension liabilities, oil reserves, and actuarial valuations, and I maintain that basic accounting concepts can be modified to reflect the unique interests of environmental stakeholders. The details need to be worked out, but it can be done, I believe, if we make the all-important conceptual leap and redefine accounting as follows:

Accounting measures the resources consumed producing goods and services for trade and for promoting public welfare, as well the resources preserved, and wealth created for future use, in accordance with conventions mutually agreed upon by both the stewards of these resources and the stakeholders to whom they are accountable.

The challenge for the accounting profession in the next decade may be whether we rewrite the definition, or leave the task to a "green" legislature, committed to the tenets of sustainable development and ending an era of lowrent resources.

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