NAL INCOME AND ENVIRONMENTAL ACCOUNTING CHAPTER 8: NATIOI Chapter Focus Questions How do traditional national income accoun' well-being? present a distorted view of 9 etter reflect the tal quality? en” measures of national g measures How can traditional measures be adjusted to importance of natural capital and environmen What is the potential for alternative “gre welfare? 8.1 GREENING THE NATIONAL INCOME ACCOUNTS Taking natural capital and environmental quality seriously affects the way Wve evaluate meggures af national income and well-being, Can we say that a nation with @ higher per-capita income is necessarily better off than a similar country with 2 lower per- Conia national income? Of course, the overall well-being of a nation is dependent upon many factors besides income levels, including health, education levels, social cohesion, dnd political participation. But most importantly for our purposes, a nation’s well-being is also a function of natural capital levels and environmental quality. Standard measures of gross national product (GNP) or gross domestic product (GDP) are commonly used to measure a country’s level of economic activity and progress in development.’ (See the appendix to this chapter for an introduction to national income accounting.) Macroeconomic analyses and international comparisons are based on these measures, and they are widely recognized as important standards of economic progress. Many analysts have pointed out that these measures can give a highly misleading impression of economic and human development. To be fair, GDP was never intended to be an accurate measure of a nation’s well-being. But politicians and economists often place disproportionate importance on GDP, and act as if maximizing such measures is the primary objective of public policy. But maximizing GDP may conflict with goals such as maximizing well-being, promoting social equity, or protecting the environment. While GDP accurately reflects the production of marketed goods and services, it fails to provide a broader measure of social welfare. Some of the common critiques of standard accounting measures include: "The difference between GNP and GDP concerns whether foreign earnings are ir GDP includes all earnings within a country's borders, even the earnings of foreign citizens and2 Volunteer work is not accounted for. Standard measures don't count the benefits of volunteer work, even though such work can contribute to social well- being as much as economic production. Household production is not included. While standard accounting measures include the paid labor from such household activities as housekeeping and gardening, these services are not counted when they are unpaid. No consideration is made for. changes in leisure time. A nation’s GDP will tise if, ceteris paribus’, total work hours increase. However, no accounting is made for the loss of leisure time. Defensive expenditures are included. An example is expenditures on police protection. If police expenditures are increased to counter a rise in crime levels, the increased spending raises GDP, but no consideration is made for the negative impacts of higher crime rates. The distribution of income is not considered. Two nations with the same GDP per capita may have significantly different income distributions and, consequently, different levels of overall well-being. Non-economic contributors to well-being are excluded. GDP does not consider the health a nation’s citizens, education levels, political participation, or other social and political factors that may significantly affect well-being levels. {mn our study of environmental issues, we must add another major criticism of standard accounting measures—they fail to account for environmental degradation and resource depletion. This issue can be important especially in developing nations, which depend heavily on natural resources. If a nation cuts down its forests, depletes its soil fertility, and pollutes its water supplies, this surely makes the nation poorer in some very teal sense. But national income accounts will merely record the market value of the timber, agricultural produce, and industrial output as positive contributions to GDP. This may lead economic policy-makers to view the nation's development in an unrealistically rosy light—at least until the effects of the environmental damage become apparent, which in some cases may be decades (see Box 8.1). fwe are measuring social welfare with, so to speak, the wrong ruler, we may obtain policy prescriptions that could actually make a nation worse off, rather than better off. Economic growth alone does not necessarily represent true economic development, and may even lower human well-being if itis accompanied by growing inequity and environmental degradation. The attempt to define better measures of development has led to new proposals to adjust or replace traditional accounting measures in order to take into account resource and environmental factors. In this chapter we will discuss the estimation and application of several of these alternatives. * Ceteris paribus, @ Latin phrase, means “other things equal" and is used by economists to make clear ‘what assumptions are used as the basis of an analysis.Box 8.1. The Rise and Fall of GDP “For decades, academics and gadflies have been critical of [GDP], suggesting that it is an inaccurate and misleading gauge of prosperity. {It} has not only failed to capture the well-being of a 21st-century society but has also skewed global political objectives toward the single-minded pursuit of economic growth. Environmental and sustainability indicators offer a few good examples of how big the challenge is. A relatively easy first step, ... would be to build in a “depletion charge” to G.D.P. for the natural resources — oil, gas, timber and even fisheries — that a country transforms into dollars. At the moment, we don't do this; i's as if these commodities have no value until they are extracted and sold. A charge for resource depletion might not affect G.D.P. in the United States all that much; the country is too big and too thoroughly based on knowledge and technology industries for the depletion costs of things like coal mining and oil drilling to make much of an impact. On the other hand, in countries like Saudi Arabia and China, G.D.P. might look different (that is to say, lower) if such a charge were subtracted from their economic outputs. But environmental accounting gets more difficult. “We can put monetary values on mineral stocks, fisheries and even forests, perhaps,” [Columbia University professor Geoffrey] Heal says. "But i's hard to put a monetary value on alteration of the climate system, loss of species and the consequences that might come from those.” On the other hand, Heal points out, you have to decide to measure something difficult before you can come up with a technique for measuring it. To Heal, making a real and rapid effort at calculating these costs and then posting the information is imperative. According to Heal, we have no sense of how much “natural capital" — our stocks of clean air and water and our various ecosystems — we need to conserve to maintain our economy and our quality of life. “If you push the world's natural capital below a certain level,” Heal asks, “do you so radically alter the system that it has a long-term impact on human welfare?” He doesn’t know the answer. Yet, he adds, if we were to pass that point — and at present we have no dials to indicate whether we have — then we couldn't compensate for our error through technological innovation or energy breakthroughs. Because by then it would be too late. ‘Source: Gertner, 2010,Efforts to develop “greener” accounting measures are relatively new. Interest in inclusion of the environment in national accounting began in the 1970s and 1980s, several European countries estimating physical accounts for natural resources such as forests, water, and land resources.’ In 1993 the United Nations published a comprehensive handbook on environmental accounting, which was revised in 2003 and further systematized in 2012." The 2003 System of Environmental and Economic Accounts (commonly referred to as SEEA-2003) considers four basic approaches to environmental accounting:® 1. Measuring the relationships between the environment and the economy in both directions.® This approach seeks to quantify the ways various economic sectors are dependent upon natural resources, as well as the way the environment is impacted by different economic activities. For example, one might seek to estimate how much air pollution results when different industrial sectors increase their production levels. These accounts combine monetary data with information on the flow of materials, pollution, and energy in an economy. A key motivation for this approach is to determine how closely economic activity is linked to material inputs and pollution outputs. 2. Measuring environmental economic activities. This approach measures expenditures on environmental protection and the impact of economic policies, such as taxes and subsidies, to reduce environmental damages. 3. Environmental asset accounts. This approach collects data on the levels of various types of natural capital, such as forests, minerals, and groundwater. As we'll discuss later in this chapter, these accounts (also called natural resource or satellite accounts) can be kept in either physical units or monetary terms. 4. Adjusting existing accounting measures to account for natural capital degradation. This approach seeks to monetize the damages associated with the depletion of natural resources and environmental quality degradation, as well as identify defensive expenditures made in response to, or in order to avoid, environmental damages. This approach essentially takes existing national accounting measures and makes a monetary deduction to represent environmental damages. Note that these approaches aren't necessarily mutually exclusive—we could theoretically implement all of them simultaneously. While many countries have adopted one or more of these accounts, no country has fully implemented the SEAA-2003 provisions. We should also note that all these approaches either adjust or complement standard accounting measures, such as GDP. In this chapter we will focus mainly on the last two of these approaches. In addition, we will consider proposals for entirely {See Hecht, 2007, for @ history of environmental accounting, United Nations, et al., 2003; European Commission, et al., 2012. ’Smith, 2007. “This approach is referred to as "physical flow accounts" or “hybrid accounts".5 new national welfare measures that seek to provide a fundamentally different perspective on measuring national welfare. Before we delve into specific measures, itis important to note that there universally-accepted approach to environmental accounting. While various measures have been developed and implemented, there is no uniform standard for alternative national accounting. We will consider the future of environmental accounting at the end of the chapter. 8.2 ENVIRONMENTALLY-ADJUSTED NET DOMESTIC PRODUCT Perhaps the most basic approach to green accounting is to start with traditional measures and make adjustments that reflect environmental concerns. In current national income accounting, it is commonly recognized that some of each year's economic production is offset by the depreciation of manufactured, or fixed, capital such as buildings and machinery.’ In other words, while economic activity provides society with the benefits of new goods and services, each year the value of previously- produced assets declines, and this loss of benefits should be accounted for. Thus national accounting methods produce estimates of net domestic product (NDP), which starts with GDP and then deducts the annual depreciation value of existing fixed capital. For example, in 2010 the GDP of the United States was $147 trillion. But the depreciation of fixed capital in this year amounted to $1.9 trllion.* Thus the NDP of the United States in 2010 was $12.8 trillion. Taking this logic a step further, we realize that each year the value of natural capital may also depreciate as a result of resource extraction or environmental degradation. In some cases, the value of natural capital could increase as wel if environmental quality improves. The net annual change in the value of natural capital in a country can simply be added or subtracted from NDP to obtain what has been called environmentally-adjusted NDP (EDP). So we would obtain EDP as: EDP = GDP - Dm — where Dm is the depreciation of manufactured capital and D, is the depreciation of natural capital. This measure requires estimating natural capital depreciation in Depreciation is simply a measure of the loss of capital value through wear-and-lear. For accounting purposes, it can be calculated using a “straight-line” formula according to which, for example, a now machine is estimated to lose 10% of its original value each year over ten-year period, or using more ‘complex valuation methods. "Estimates of fixed capital depreciation are obtained from tax records. Businesses are not taxed on the Value of their fixed capital depreciation — thus they have a strong incentive to claim this deduction.6 monetary terms, rather than physical units such as biomass volume or habitat area. The methods discussed in Chapter 6 can theoretically be used to estimate such values, but obviously estimate all types of natural capital depreciation in monetary terms is a daunting task that would require many assumptions. Thus the estimates of EDP that have been produced focus on only a few categories of natural capital depreciation. One of the earliest attempts, at green accounting estimated EDP for Indonesia over a 14-year period, 1971-1984.° This pioneering analysis deducted the value of depreciation for three categories of natural capital: il forests, and soll. The values of GDP and EDP over this time period are displayed in Figure 8.1." 15 — ion Rupiah (thousands) fo7d 7 1973, 1975 1977) 1079 1981, 1983) ==-G0P EDP Figure 8.1: Indonesian GDP Adjusted for Resource Depreciation, 1971-1984 Source: Repetto et al., 1989. The results present several important points that will continue to be relevant as we proceed through this chapter: Natural capital depreciation can amount to a significant portion of GDP. According to this analysis, EDP is normally about 20% lower than GDP. In other words, natural capital depreciation offset about 20% of total economic "Repetto, etal, 1989. The analysis actually refers to EDP as "NDP*," which they called “adjusted net domestic product.” But {0 avoid confusion with the more common usage of the term “net domestic product" ~ only deducting for fixed capital depreciation — we call their environmentally-adjusted values EOP.= Se 7 production. Thus GDP presents an overly-positive assessment of social welfare. Measuring the growth of GDP to illustrate changes in social welfare may not produce accurate results, Over the time period covered in Figure 8.1, GDP grew at an annual rate of 7.1%. However, EDP only grew at an annual rate of 4.0%. So this case demonstrates that only looking at GDP to determine the trend in national welfare may lead policy makers to conclude that growth is robust. But accounting for environmental degradation shows that much of the apparent growth was at the expense of the environment. Monetization of natural capital needs to be approached carefully. In Figure 8.1 there is a noticeable spike in EDP in 1974, Does this indicate an appreciation of natural capital and an environmental improvement? Not necessarily — this spike is mainly a result of a dramatic increase in world oil Prices which resulted from the 1973-1974 Arab oil embargo, rather than a change in the actual cil reserves in Indonesia. Similarly, in Some years the total volume of timber decreased but since the market price went up the overall value of timber resources increased. However, this masks the physical degradation of timber resources. So if we measure the value of natural capital at market prices, we may lose important information regarding the actual physical stock of those resources. ‘A more recent attempt to measure EDP in Sweden looked at a broader set of natural resource categories, including soil erosion, recreation values, metal ores, and water quality."’ The results found that EDP in Sweden was about 1-2% lower than NDP. for 1993 and 1997. The author notes that while the overall adjustment may seem relatively minor, the analysis didn't consider all potential environmental damages, such as climate change and loss of biodiversity. Also, looking at the effects of environmental degradation on the overall economy fails to recognize that some sectors are particularly affected, such as agriculture, forestry, and fisheries. Another study estimated the value of changes in forest resources in India in 2003." Based on timber and firewood market prices, the results indicated that while the overall stock of timber decreased, EDP was actually slightly higher than NDP. Again, this illustrates the potential distortionary effect of looking only at adjustments in monetary terms without looking in more detail at the actual physical environment. * skanberg, 2001. ® Gundimeda, et al, 2007.8 BOX 8-2; INCORRECT ACCOUNTING LEADS TO INCORRECT POLICIES If economists accept conventional GDP estimates, then their policy recommendations are likely to be wrong in the case of natural resource dependent economies. Output estimates may be exaggerated by 20% or more and true estimates of capital formation may turn out to be nil or negative. Factor productivity estimates are thrown into question when neither the products nor the inputs are measured correctly. Capita/output ratios will be incorrect if they ignore rapid liquidation of natural capital. Sophisticated macroeconomic models based on such data will give highly questionable results for guiding long-term development. International trade will tend to align domestic with international prices. But international prices are often distorted by agricultural subsidies, political and military interventions, and the failure to internalize externalities. As a result, natural resources are likely to be sold below full environmental cost. The impact of natural capital depletion will be especially large in estimates of national saving and investment. Estimates of "genuine saving’ by the World Bank indicate that many countries’ net saving and capital formation may in fact be negative, a clear indicator of unsustainability. ‘The export of natural capital also distorts exchange rates, and creates a bias against non-resource-exporting sectors, including manufacturing. Methods used to estimate exchange rate overvaluation will not be reliable when proceeds from the unsustainable export of natural assets finance an import surplus. _ In this case, an apparent stability of the domestic price level will be illusory, masking significant damage to non-resource exporting sectors which must compete with artificially cheap imports. In the balance of payments accounts, a trade deficit may be concealed, or appear to be a surplus, since the proceeds of natural capital exports are recorded incorrectly in the current account. "Greening the national accounts is more important for economic than for environmental policy . . especially for those countries whose natural resources are rapidly eroding, and the erosion is counted misleadingly in GDP as value added. Once the accounts are greened, macroeconomic policies need to be re-examined.” Source: Saleh El Seraly, "Green Accounting and Economic Policy.” Summarized in Hartis et al., 2001, pp. 33-36,8.3 ADJUSTED NET SAVING In addition to GDP, traditional national accounting methods also estimate saving and investment rates. These accounts provide some insight into how much a nation is saving for its future. Starting with gross savings, by governments, businesses, and individuals, net domestic saving is obtained after adjustments for borrowing and fixed capital depreciation. Thus net domestic saving could be positive or negative. For example, in 2010 the U.S. had a negative net domestic saving rate of—1.1% of national income. We can propose that how a country manages its natural resources and environmental quality also provides information about whether it is saving for the future, oF causing depletion that may make future generations worse off. Just as in the, caloulation of EDP, we can adjust net domestic saving to incorporate a nation’s Tanagement of its natural resources, The World Bank has developed such a measure, called Adjusted Net Saving (ANS)."* Unlike standard measures of national saving, ANS takes the broader view that natural and human capital are assets upon which the productivity and therefore the well-being of a nation rest. Since depletion of a non-renewable resource (or over-exploitation of a renewable one) decreases the value of that resource stock as an asset, such activity represents a disinvestment in future productivity and well-being."* An ANS analysis, particularly appropriate for developing countries, may show that what appears to be a development “success story" can conceal serious natural capital depletion and in some cases even a negative adjusted net saving rate. ANS is normally calculated as a percentage of national income, although it could also be expressed in monetary units. The calculation of ANS is summarized in Figure 8.2. ANS is obtained using the following steps:'> ‘+ Start with gross national saving + Make @ deduction to account for the depreciation of fixed capital to obtain net national saving. + Adjust for education expenditures. Unlike standard measures, ANS considers expenditures on education to be investments in the future of a society."® So ¥ Adjusted Net Savings is also called Genuine Savings. Bolt, etal, (2002), p. 4 * In addition to the steps presented inthe text, some calculations of ANS also include a deduction for pattculate matter emissions. " Gross saving already includes fixed capital education expenditures, such as spending on buildings and buses. However, wages and salaries are not included, nor are spending on books and other educational supplies. ANS adds in these non-fixed capital expenditures10 expenditures on education are added to net national saving to reflect investment in human capital. + Adjust for energy resource depletion. A deduction is made for the depletion of non-renewable fossil fuels—oil, coal, and natural gas. The deduction is calculated as the total market value of the resource minus its extraction cost. * Adjust for metal and mineral depletion. A deduction is made for the extraction of non-renewable mineral resources, including copper, gold, lead, nickel, phosphate, and several other resources. The deduction is again calculated as the total market value of each mineral minus its extraction cost. * Adjust for net forest depletion. Unsustainable depletion of a nation’s forest resources is considered a disinvestment in the future. As forests are renewable resources, it is possible that a country could actually increase its forest resources. Thus net forest depletion is calculated as the annual value of extraction for commercial uses such as timber and fuelwood combined with an estimate of the net change in forest area. * Adjust for carbon dioxide damages. Carbon dioxide emissions represent a disinvestment in a nation’s future as they contribute to climate change damages. nation’s annual emissions are multiplied by an assumed damage of $20 per ton of carbon." 6 Depreciation offhed capital Education sont Depletion VI Gos Na Na T Adjusted Adjusted ‘ating saving —savingplusnetsaving net saving educaton exuding ‘expenditure pallution damages ° Potton damage Figure 8.2: Calculation of Adjusted Net Saving ‘Source: World Bank, 2012 ” Some analysts would consider this a low value for carbon damages (see e.9. Ackerman and Stanton, 2011). We will consider this issue in Chapter 18.4 The World Bank has calculated ANS rates for most countries of the world. In Table 8.1 we see the results for several countries. For most countries, the environmental adjustments are relatively minor. For example, we see that the ANS rates of France and the United States are primarily a result of their respective net national saving and rates and education expenditures. But the environmental adjustments can be quite significant in some countries. The Republic of Congo, Saudi Arabia, Indonesia, and Russia offset relatively robust net nation savings by depleting their energy resources. So based on traditional saving measures, these countries may appear to be investing heavily in their future, but ‘once we account for their extraction of non-renewable fossil fuels, the ANS measure suggests they are actually disinvesting in their future. Chile is an example of a country that may be overly-dependent upon non-renewable minerals for its wealth. Uganda has a significant deduction for forest depletion — about 5% of national income. ] ‘Net Gross Forest National {Fixed Capital | Education | Energy | mineral [Depiati |carbon {country _| Saving [Depreciation (Expenditure |Depletion |Depletion | on [Damage | ANS lchite | 24.28 12.66 360] 026| -1432| 0.00! o3t| 0.08 \china | s3.89 10.08 10] -674| -1.70| 0.00] -1.26| 35.92 ene” zee8| -1408, 225| -7110| _000| 000 _-0.16 |s5.50 France 1874 13.86 505|-003| 000/000 9.80 india 38.17 849 siz] 486] -142| 0.78 24.64 Indonesia | 22.25| 10.66. 115| 1260 -1.38/ 0.00 “1.85 Russia 32.78 12.39 as4[ 2047 | -1.00| 0.90, 4.62 hvabia seza|__-1248 z19| ~4351| _0.00| o.00| -062| -1.08 lUgande 12.63, 142 327 o00| 0.00| -506| -0.15| 327 vce | 1260] -rag6| __470| -193| -o11| 000] 01] 107 Table 8.1: Adjusted Net Saving Rates, Selected Countries in Percent of GDP, 2008. Source: World Bank, 2012 The World Bank has also tracked ANS rates over time. Figures 8.3 and 8.4 present the results for several country aggregates. We see in Figure 8.3 that ANS in high income countries has generally been decreasing over the last couple of decades. Meanwhile, ANS in South Asia (which includes countries such as India, Bangladesh, and Pakistan) has shown a clear upward trend in the last decade. This reflects high Jevels of investment in these countries, but does not indicate that environmental2 depletion has declined. ANS rates in the Middle East and North Africa have fluctuated considerably, depending on oil extraction relative to domestic investment. High income south asio ‘ANS(Percent) | —Midsletoet and . NowthAtres as 20 —tatinamenea & Caribbean tat Asia & Paci LD—m—yn area Lf ANA oy ae PPR Dio oA PI Oh Sid ANS (Percent) 10 ‘igure 8.4: Adjusted Net Saving, 1982-2008, World Bank Country Aggregates Source: World Bank, 2012Oe 19 Figure 8.4 shows similar variation among other country groups. ANS rates are particularly high in East Asia (which includes countries such as China, Thailand, Indonesia, and Vietnam). This is because of very high savings and investment rates, but in many of these countries resource and environmental depreciation is also high (see Box 8.2). ANS rates in Latin America have been moderate — between 5% and 10% - over the last couple of decades. Finally, ANS rates in Sub-Saharan Africa have declined in recent years and have actually turned negative, with resource depletion. being significant in many of these countries. [Box 8.2. Environmental Accounting in China In 2004 China's State Environmental Protection Agency (SEPA) announced that it would undertake a study to estimate the cost of various types of environmental damage. The initial findings released in 2006 indicated that environmental costs equaled about 3% of China's GDP. The report was widely criticized because it failed to include numerous categories of environmental damage such as groundwater contamination. Shortly afterwards, Zhu Guangyao, the deputy chief of SEPA, released a separate report which concluded that environmental damage was closer to 10% of China's GDP—a value similar to what many observers were expecting. In a 2007 report jointly produced by the World Bank and SEPA, the health and non- health costs of air and water pollution alone were estimated to be 5.8% of China's GDP. (World Bank and SEPA, 2007) The results indicate that much of China's recent economic growth has been partially offset by increased resource depletion and pollution. Recognizing the costs of environmental damage, the Chinese government set targets in 2006 for such variables as energy consumption per unit of GDP, releases of major air pollutants, and total forest, cover. China's investment in pollution control and renewable energy is growing rapidly. However, the Chinese government's effort to develop green GDP measures have abated somewhat in recent years, and some of the targets that were set in 2006 were not met. Further analysis of the cost of pollution and resource depletion in China can help the government implement policies that achieve true human development. Past policies and decisions have been made in the absence of concrete knowiedge of the environmental impacts and costs. (New), quantitative information based on Chinese research under Chinese conditions [can] reduce this information gap. At the same time ...substantially more information is needed in order to understand the health and non-health consequences of pollution, particularly in the water sector. (World Bank and SEPA, 2007, p. xix)