Metrics for a New Century

I believe most companies do good work – they solve problems of one kind or another, they make life better and more enjoyable.  And many of them are learning how to do so in a way that does not place an undue burden on the biosphere – the thin layer of earth, water, and air in which all known life exists.  They are discovering growth opportunities through sustainable business strategies.

In my last post (The NOC worldview vs. the IOC worldview), I suggested that we need new metrics to measure the value generated by corporations as viewed through the lens of sustainability.  Discounting a pro forma cash flow to calculate NPV generates a very good proxy for the monetary value of that cash flow, but that accounts only for the financial capital given off by the corporation.  There are several more dimensions that should be taken into account when assessing value.

First (as previously mentioned – Redesigning Capitalism), financial capital is just one of at least three types of capital; natural capital (primarily in the form of natural resources) and social capital (in the form of improved quality of life and longevity, of healthy societal systems, etc.) are also important and valuable.  But the brand of capitalism currently employed globally accounts only for financial capital.  Natural capital is taken for granted and assumed to be essentially infinite; if a critical resource gets used up, it is assumed that a suitable substitute will always be available.  The capacity of the Earth to absorb our wastes is also considered to be infinite and free (as long as it’s not in our back yard).  Social capital is pretty much ignored; if it is accounted for at all, it is somehow translated into how such developments affect measures of financial capital.  Any effective value measures should account for all three types of capital, not just one.

Second, most people’s and most societies’ value systems encompass far more than just the generation of financial wealth.  As I said in the last post, if corporations’ actions affected only the global financial system, I wouldn’t have a problem with valuing them based solely on financial metrics.  But industries around the world affect our lives, the lives of future generations, and our environment in a multitude of ways, along dimensions in which our value systems may or may not align with simply maximizing financial return.  It is complex; there are tradeoffs to be made requiring far more than an NPV calculation.  Many enlightened companies understand this and are changing how they think about strategic planning.

As we transition from the labor-constrained economy of the past several hundred years to the resource-constrained economy of the current century, we need better metrics for measuring corporate value.  As a public service, I am putting forward the following straw man for consideration and feedback.  It is qualitative at this point, so I’m cheating a bit by describing this as a system of “metrics.”

To put it in a nutshell, I suggest that we take the approach currently used by accountants when conducting a financial valuation of a business, and apply that same logic when assessing the total impact (and therefore the real value added or eroded) on society by corporations’ activities.  When valuing a business, an accountant looks not only at the pro forma cash flows and income statements, but also at the balance sheet – the list of assets and liabilities in the company’s possession.  A company that generates revenue simply by selling off its assets isn’t really generating value.  A company that takes on liabilities – say, by going heavily into debt – and counts the proceeds as revenue would be violating generally accepted accounting principles (GAAP).  If assets are eliminated or degraded and/or if liabilities are taken on, valuing a company requires judgment regarding whether the value generated on the Income Statement more than offsets the degradation of the Balance Sheet.

So let’s consider the planet we live on to be our collective “balance sheet.”  It holds a wide variety of assets (air, water, iron, wood, food, etc.), and it comes with

liabilities (toxins, diseases, dangerous animals, violent storms, etc.).  If we take into consideration all three forms of capital – financial, natural, and social – the benefits generated by any activity that consumes natural resources would have to more than offset the fact that future generations are left with a depleted stock of resources (assets).  Likewise, those benefits must also more than offset any liabilities incurred (environmental degradation, the generation of harmful waste products, etc.).  If the benefits generated exceed the negative impacts on the “natural balance sheet,” the activity is valuable; if not, the activity erodes value and should not be undertaken.  For example, we might be willing to accept a significant amount of environmental degradation in exchange for the prospect of eliminating a deadly disease; a higher-definition TV, on the other hand, might justify only a much smaller erosion of natural capital.

Social capital is more nebulous, but we should be able to agree on certain positives and negatives (societal stability is positive, poverty is negative, widespread health and longevity are positive, freedom to live life as one chooses is positive, extreme disparity in quality-of-life is negative, accountable government is positive, etc.).  Once high-level objectives under the Social Capital heading are agreed, we can discuss the tradeoffs qualitatively.

When attempting such an assessment, natural capital and social capital should not be discounted the way financial capital is.  It makes sense to discount future cash flows because if I have cash today, I can invest it and have more cash tomorrow.  Not so with resources like iron, natural gas or fish populations (which, once they’re used up, are gone), or even clean air and clean water (which don’t get used up, but which are every bit as important to have in the future as they are today).  Regarding social capital, I hope we can agree that improving the social fabric of our current society at the expense of future generations is not an acceptable approach.

All of this of course begs the question: if we’re not going to simply convert everything into present-day dollars (which is what the overly simplistic benefit-cost analysis does), how do we decide whether a certain set of benefits outweighs the loss of resources and the erosion of the quality of the biosphere?  And even if we can agree on an equitable way to make these judgments, aren’t we assuming we can foresee what the benefits, loss of resources, and environmental degradations will be?

Let’s take the second issue first.  No, we should not assume that we can predict what all the consequences of our actions will be.  Rather, we should try to imagine what the consequences could be – how good, how bad, how severe, how mild.  Once we have an idea of these ranges, then we need to consider the probabilities associated with them, whether there are potential scenarios we absolutely must avoid, whether there are contingency plans we might want to develop before proceeding, and whether there are options we might want to keep open for a while.  Planning for flexibility is a very good way to deal with an uncertain future.  Note that this isn’t just the best way to think about technology advancement vs. environmental degradation issues; it’s the best way to think about any complex issue.  Note also that the fact that we aren’t sure about potential second- and third-order effects of our actions is no excuse for pretending they don’t exist and/or failing to consider them.

Regarding how to weigh benefits against “natural balance sheet” losses, I don’t claim this will be easy.  Assessing tradeoffs between competing objectives never is.  It requires thinking, not just calculating.  The benefits associated with an activity may be highly uncertain, and human history is littered with examples of unintended negative consequences that resulted from well-intentioned initiatives.  But that’s no reason to dumb the valuation process down.  Just because you’re good at algebra, you don’t try to turn everything into an algebra problem.  The world is a complex place, made more complex by human activities.  Pretending that we can appropriately value projects, companies, and public initiatives using simple financial calculations is an exercise either in laziness or self-delusion.  The only reasons we’ve got away with it so far are 1) we inherited an enormous natural balance sheet loaded with assets – far more than we thought we could ever consume – and 2) the time scale on which we pay for the environmental degradation liabilities was always believed to be far into the future.  Neither of those situations is true today.  Companies that realize this and adjust their thinking accordingly will be advantaged relative to those that don’t.

When making these tradeoffs, we’re going to have to exercise judgment.  The basis of that judgment should be to assess our industrial activities (as best as possible) from the perspective of whether they leave future generations better off or worse off, not just whether they generate an attractive discounted cash flow today.  This is difficult.  In a complex world, we cannot know for certain what the ultimate consequences of our actions will be.  Experimentation will be important, so we should err on the side of allowing new ideas to be tested.  There will also undoubtedly be fierce arguments about what constitutes “better.” However, I prefer to think of these arguments as “discussions” – and discussion is good.

This is what the current move toward sustainable business practices is all about.  Ultimately, we want to leave for future generations a financial, natural, and social environment that is at least as good as the one we enjoy.  Modifying accounting’s “income statement vs. balance sheet” approach to incorporate all three types of capital when valuing projects, corporations, and/or public works seems like a good start toward accomplishing this objective.