May 17 – This could be a year of singular importance in the history of international accounting. A new directive from Brussels provides a basis on which natural capital funding undertaken by corporations could ultimately be reflected as an asset on balance sheets.
Such ecosystem conservation funding is urgently needed, as Earth’s natural capital is eroding at an alarming pace – and with that our future prosperity. According to the World Economic Forum, around half of global GDP is at risk due to its dependence on nature. And we are likely to experience the effects much sooner than expected. The World Bank has found that ecosystem degradation could reduce global GDP by up to 2.3% annually as soon as 2030.
For these reasons, the implications of reflecting natural capital funding on corporate balance sheets is far from an academic or abstract matter. What the directive means in practice is that corporations will be encouraged to take action beyond a mere duty to uncover potential ecological or social misconduct.
Instead, corporations will be incentivised to make investments into ecological conservation and improvement. This reflects a significant paradigm change from requiring companies solely to play “defence” to directing them towards playing “offence” in combatting climate change-related systemic risks.
This is the thrust of the Corporate Sustainability Reporting Directive (CSRD), which the European Council approved in November 2022, with the EU Green Deal providing the necessary legal framework.
The European Sustainability Reporting Standards (ESRS), which detail the implementation of the CSRD, contain a broad definition of sustainable investment. As long as disclosures ensure transparency and comparability, these reporting standards have an important effect: they encourage companies to document investment in nature regeneration and conservation in their revenue-generating activities as well as operational and capital expenditures. A case can also be made to include disclosures on investments outside the company’s supply chain.
The knock-on effects of the new reporting regulations could be a game-changer. The mandatory requirement for sustainability information to be audited adds a new dimension to corporate risk assessments that may ultimately warrant reflection in financial statements.
Before natural capital funding can be reflected on corporate balance sheets, such investments must meet the criteria of relevant accounting standards. Outside the United States, the most commonly used standards are the International Financial Reporting Standards (IFRS), which are governed by the International Accounting Standards Board (IASB).
Developing a consensus within the accounting and legal communities on the capitalisation of natural capital funding could unleash investments into nature at an unprecedented rate. The determining factors to reach such a consensus are that the value, context and comparability of individual “assets” can be readily established.
Given a now well-established – and increasingly accepted – relationship between ecosystem demise and global economic risk, there is reason to place an economic value on specific activities that enhance natural capital.
According to the IFRS, investments qualify as an intangible asset as long as they are identifiable, controllable, their costs can be reliably measured, and they provide for probable future economic benefits.
Economic benefits associated with natural capital funding can be presumed with sufficient probability, given the willingness to pay for risk-mitigation. On this basis, companies will assess the cashflow impact of investing in natural capital. The effects do not stop there, however. Investments in natural capital may soon factor into how insurers as well as debt and equity providers assess corporate risk.
Suitable candidates for insetting – where companies implement decarbonisation and nature-positive solutions within their value chains – are most commonly those active in the food or energy industries. Enhancing insetting activities is critical in the overall effort to combat climate and ecosystem risk as it addresses emissions and ecosystem effects directly caused by commercial activity, rather than relying on offsets that aim to net off such effects through interventions outside of value chains.
But the parties for whom natural capital enhancement can be a risk-mitigation strategy go beyond those with nature-related risk in their own value chains. Institutional investors and insurers are also potential sources of natural capital funding, given their systemic view and core focus on risk reduction.
Moving forward, the capacity to verify and monitor the state of natural capital will be of great importance to supply chains, which are increasingly challenged by productivity losses and high volatility in yield quality and quantity due to the degradation of natural capital.
Thanks to substantial technological innovation, the effects of investments into nature – for example, to improve water quality and retention, reduce pollution, mitigate climate change, maintain and improve biodiversity, and preserve and restore full landscapes – can now indeed be measured and monitored.
New appraisal procedures supported by Earth observation, bio-acoustics, eDNA and machine learning enable increasingly robust, continuous status assessments of ecological health of individual plots of land anywhere on the planet. This enables comparability and, ultimately, the establishment of a new asset class.
These technological advancements go some way towards fulfilling the IASB’s requirements for classifying natural capital investments as intangible assets. Moreover, efforts by the Task Force on Nature-related Financial Disclosures aid in the process by aiming to standardise information, which can then more efficiently be utilised for balance sheet considerations. From here on forward, the status of natural capital will be clearly identifiable and measurable.
Ever since the formation of the Intergovernmental Panel on Climate Change (IPCC) 35 years ago, its reports have shaped much of the global discussion about combatting climate change. These reports have created a keen awareness about rising emissions and the effects of rising temperatures. The same degree of painstaking attention now needs to be paid to the health of our ecosystems.
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