Externalities such as pollution can substantially change a company’s profitability when included on a balance sheet
Hazy conditions in Mumbai: Externalities such as pollution can substantially change a company’s profitability when included on a balance sheet © Hindustan Times/Getty Images

Accounting pioneers are enabling stock markets to take account of the impacts companies have on society and the environment by incorporating these factors into financial statements.

While companies are under ever greater pressure to demonstrate that their activities are sustainable for the environment and society, traders often struggle to discern the value of the information provided. Maybe it is too vague, or it does not fit in with the here-and-now time horizon of stock markets.

The new approach uses technology to gather data and then calculate a monetary value for “externalities”, the costs of a company’s activities that it does not bear itself.

In one of a flurry of initiatives in this area, Pavan Sukhdev, an environmental economist and head of the international arm of UK conservation body WWF, last summer launched an investor-oriented platform that calculates monetary values for companies’ non-financial externalities. The venture, I360X uses data-gathering technologies such as “cognitive” search engines that can use artificial intelligence to tag data sets.

Taking the example of air pollution, Mr Sukhdev says I360X gathers data on wind conditions and populations to identify where the pollutants a company emits might land and whom they might affect. The information is combined with World Health Organization data to calculate the risk of respiratory diseases being caused by the pollution. A monetary cost is then attached to the probability of ill-health based on factors such as local healthcare fees and lost lifetime productivity.

“For any company, we can work out the health cost of the air pollution they produce at the press of a button,” says Mr Sukhdev. “The reason we can do all this is because we’ve spent years preparing the algorithms, modelling, databases, data cleaning, valuation methodology.”

The technology searches out data on social, natural, human and financial capital before automatically ascribing a monetary value to each in line with predetermined rules. The I360X platform comprises more than 17,000 equations and can draw on more than 15m data points.

By bringing non-financial ­factors on to corporate balance sheets, the profitability of many stock market favourites suddenly looks “very different”, says Ronald Cohen, a veteran venture capitalist who chairs a separate accounting initiative at Harvard Business School.

Writing in the Financial Times last July, Sir Ronald cited the example of two big chemical groups, Sasol and Solvay. With revenues of $12bn a year each, he said both were portfolio stalwarts for mainstream investors. Cost in their environmental impacts, however, and $17bn and $4bn were wiped off their respective bottom lines.

“When these [non-financial] numbers appear, I’m confident that investors are going to engage with those companies that have transition paths to better, more sustainable business models and will desert those that are blind to this need,” Sir Ronald says in an interview.

Investors will still allocate capital to companies with a strong performance record, but the picture provided will be fuller and more reflective of emerging risks, he argues.

Success also relies on the revised valuations standing up to scrutiny. To that end, Sir Ronald is championing the Impact Weighted Accounts Initiative led by George Serafeim, a professor at Harvard Business School, to develop a robust methodology. Building on work by organisations such as the Sustainability Accounting Standards Board and the UN-backed Global Reporting Initiative, the partnership has developed five preliminary design principles.

These include determining the number and specificity of the social and environmental impacts under consideration, and principles for calculating the financial value ascribed to each impact and the effects on wider society.

The Harvard Business School initiative released estimates of environmental impact for 1,800 companies, with numbers for product and employment impact to follow.

The initiative’s stated aim is to produce line items on financial statements that “supplement the statement of financial health and performance by reflecting a company’s positive and negative impacts on employees, customers, the environment and the broader ­society”.

Impact-weighted accounting relies on data-mining and machine-learning technologies to scrape ESG information from company reports, regulatory databases and other data sets available on the public internet, says Prof Serafeim. “It’s a giant data generation and data platform exercise,” he adds.

Hurdles remain, notably gaps in the data. No amount of scraping the internet can turn up information that companies often do not count, much less publish. Artificial intelligence techniques, such as those that turn natural language into data, can help fill the voids, but they are no substitute for verifiable facts.

Yet tech-enabled efforts to value corporate externalities are still a welcome development, says Carmine Di Sibio, global chief executive of professional services firm EY. For chief financial officers and investors alike, they present a novel way to assess companies’ current profitability and their resilience to emerging social and environmental risks.

The next step is to agree an “accepted method” for monetising such impacts, says Mr Di Sibio. Work is already under way on that, he says, pointing to cross-sector accounting initiatives such as the Value Balancing Alliance and the Impact Management Project.

“Investors are looking increasingly at the total impacts of a company [and] articulating these impacts into a language that investors, business leaders and political leaders understand helps the comparison with other financial metrics,” says Mr Di Sibio.

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