What If Externalities Were Internalized?

The gap between private financial interest and environmental sustainability and social flourishing is growing rapidly. But the organizations that oversee a financial system that supports private financial interest also operate in the public interest. An interest that we might assume includes environmental sustainability and social flourishing.

At least one of the organizations involved, the International Public Sector Accounting Standards Board is clear, in its Conceptual Framework, that the purpose of government is the maintenance and enhancement of wellbeing. And the users of public accounts are citizens, residents and service users holding governments to account for the maintenance and enhancement of wellbeing.

Financial value is measured by using international accounting standards which describe this value as profit, the surplus of income over expenditure. And it is this calculation that drives investment decisions – historical performance in creating profits based on financial statements, sometimes audited, and future expected performance based on financial forecasts.

Currently the costs that are included in financial statements exclude many impacts or dependencies, for example the use of unpaid labour in the supply chain, the depletion of natural capital, the use of carbon, any contribution to poor health outcomes, to widening inequality, and many of the list of the things described in the Sustainable Development Goals. Costs which are really costs of doing business and costs which reduce environmental sustainability and social flourishing represent harm being done to people. To be included in the financial accounts, these costs would have to meet a definition of expenditure, an obligation that the business has no alternative but to pay.

This is not to say though that the costs have vanished. They still exist; they are a consequence of the business model, only they are externalised. If they were included, profits would be reduced and there would be an immediate incentive to create products and services, and new business models, which do not contribute to these costs.

Meanwhile, the organizations that make up the financial ecosystem argue that they act in the public interest and have public interest statements on their websites, which generally define the public interest as including efficient markets. Efficient markets do not have externalities, and yet accounting standards are the basis for the preparation and auditing of accounts that give a “true and fair” view, even when the business is contributing to externalities and doing harm to others, which is not in the public interest. Something doesn’t add up.

It is clearly neither in the public interest for these costs to be externalized nor for investors to invest in businesses which generate these costs. Aligning financial value, and the calculation of profit would mean there was an expectation that accounts included obligations to cover costs of doing harm.

Accounting standards already allow for constructive obligations – obligations arising from directors’ statements and a valid expectation by a third party that the obligation to transfer an economic resource will be met. All we need is for directors to construct obligations for those externalities, and for auditors to consider the completeness of constructive obligations as part of their opinion on whether accounts give a true and fair view. Then financial value would be aligned with public interest.

What about the interest of the public, potentially different to the public interest, – or at least that subset of the public that are users of the accounts as actual and potential investors and providers of loan finance and other creditors?  The reason accounting standards measure profit as they do is because it is assumed that the expectation of the maximum number of primary users is financial returns, and nothing else. If they were interested in something else, then the accounts would have to measure that, using the same approach and logic as for financial returns.

Imagine if the user’s expectations were in financial returns and in doing no harm.  Then the public interest and the interest of the public would be aligned. Accounting standards would not need to change, only the framing of the purpose against which those standards are applied would change and with it an expectation that accounts would include relevant constructive obligations.

Finally, there is the question of the primary users. The list should include government.  Government might be one of the other creditors for outstanding tax or indirectly as a provider of loan finance, as some tax liabilities are paid a year or more after the completion of the accounts. From this perspective government is probably the biggest user of financial accounts and yet it is clearly not in their interest to have to spend tax received clearing up negative social or environmental consequences caused by a business, in whole or in part. Including government as a user would further support a change in purpose and the resulting alignment of financial value with the public interest – and be consistent with the Conceptual Framework for public sector accounting standards, emphasizing the role of government in enhancing and maintaining wellbeing.