Heroic Accounting

(Illustration by Andrea D’Aquino)

As concerns mount about social and environmental sustainability, an unlikely planetary hero has emerged: the accountant. A growing collection of investors, academics, and business leaders have proposed that better accounting practices can overthrow what Financier Ronald Cohen calls “the tyranny of profit” and set capitalism on a more sustainable track. This new “Impact Accounting” promises to tabulate every way that individual companies influence planetary welfare—including economic profit, employment, social equity, biodiversity, and climate—and translate all of them into a single measure of impact, represented in dollars and cents. According to Cohen and Harvard Professor George Serafeim, the resulting “impact transparency will reshape capitalism…it will redefine success, so that its measure is not just money, but the positive impact we make during our lives.” Another Harvard Professor, Rebecca Henderson, expresses the plan concisely: “Accountants hold the key to the salvation of civilization.”

Powerful interests seem to agree with impact accounting’s potential. The European Union, the World Business Council for Sustainable Development, and a consortium of multinational corporations are all developing impact accounting methods, as is the Capitals Coalition, a group of 380 entities, including The World Bank, Walmart, and the UN Environment Program. Several consulting firms—led by KPMG, BCG, and PWC—have developed their own methods for valuing a company’s total impact. And a Harvard University research initiative focused on “Impact Weighted Accounting” has an advisory board that includes leading figures from asset management, banking, advocacy, philanthropy, and academia.

But while proponents of “Impact Accounting” promise that it will reshape capitalism itself, what of the corresponding risks? Despite its many flaws, our current system of capitalism has brought about enormous improvements in life expectancy and living standards; systemic changes could bring about harm as well as improvement. Yet, we can find no evidence that advocates for impact accounting have evaluated the potential risks inherent in their proposals. Here we undertake such a review and conclude that while these proposals are alluring, their enactment is both impossible and perilous.

The Allure

Those concerned with growing social and environmental challenges have long hoped that more complete measurement and reporting of firm impacts would lead to a more sustainable form of business. For example, more than 25 years ago, John Elkington suggested that companies shift from measuring a single “bottom line” of corporate profits, to a “triple bottom line” comprised of social, environmental, and financial impact. But while Elkington had hoped that doing so would “provoke deeper thinking about capitalism and its future,” he discovered that, in practice, the information often went unused. It is, he recently admitted, “far from clear that the resulting data are being aggregated and analyzed in ways that genuinely help decision-takers and policy-makers.” As a result, three years ago, Elkington issued a “recall” of his original proposal.

Proponents of impact accounting believe they understand why ideas like the “triple bottom line” have failed to bring about substantive change, and they believe they have a solution. They note that even if corporations disclose a range of impacts, the information they provide comes in a dizzying array of measures: tons of CO2, grams of dioxin, liters of water, accident rates, customer satisfaction scores, and so on. They contend that, to cut through this diversity of units, managers focus only on actions that have a dollar value. For this reason, proponents of Impact Accounting propose to translate social, human, and environmental impacts into dollar values to elevate heretofore minimized impacts. This will, they contend, allow financial, social, and environmental impacts to be “meaningfully aggregated and compared,” displayed “in the same accounts,” and processed using “existing finance and accounting tools.” The result, they predict, will be an easing of administrative barriers, a release in pent-up demand for action, and a rebalancing of the objectives of business. Total impact, rather than profit, will become the new “bottom line”.

Impact accounting promises rewards for all stakeholders: Social and environmental activists will get insight to better direct their advocacy; investors will be better able to assess risk to improve asset allocation; managers will better understand tradeoffs and be released from tendentious debates over private and public objectives. With each firm’s impacts known and tabulated, it will be possible to create “impact weighted accounts,” enabling investment vehicles neatly tailored to fit consumer preferences with respect to private and public returns.

To skeptics, proponents insist that there is precedent. “Such a change is not a fantasy,” Sir Ronald Cohen writes in his book Impact, “it has, in fact, happened before.” As evidence, he points to the standardization of accounting practices that occurred after the stock market crash of 1929. Though much debated at the time, according to Cohen, the benefits of these changes are now widely acknowledged; “The same will one day be said about impact weighted accounts.”

The Challenge

Pointing to precedent disguises the revolutionary nature of what is being proposed. Central to the logic of impact accounting is a fundamental change in where and how economic alternatives are evaluated. Our present market economy emphasizes distributed evaluation and decision-making, operating like a set of networked computers: Buyers and sellers at the nodes evaluate the merits of an exchange, and information on the agreed price passes throughout the network, causing the entire economic system to adjust to better deliver what consumers want. Impact accounting, in contrast, substitutes something like a single mainframe computer: Experts deep within its core calculate the true value of each exchange to sellers and buyers, to third parties, and to the planet as a whole, and then punch out coefficients and values for managers to use in making improvements. Such centralized calculation would allow more interests to be considered, but would also require enormous processing power. So much so, that most economists believe that it is impossible to solve the “economic calculation problem” (i.e. the efficient allocation of production to meet consumer desires) in a centralized way.

Proponents parry concerns about the feasibility of impact calculation by pointing to the success of financial accounting, but, here too, this comparison is misleading. Current accounting practices focus on tabulating information that has an observable market price, such as the price of inputs needed for production and revenues from products sold to consumers. Only occasionally, and with great difficulty, must accountants try to estimate the value, or “shadow price” of something lacking an observable price. The reverse is true for impact accounting: Because almost all impacts lack an observed price, each would have to be laboriously estimated.

Consider the difficulties involved with estimating just three critical elements of a company’s total impact: consumer benefit, external impact, and the effects of changes in practice.

1. Consumer Benefit

The first and most critical step in accounting for all corporate impacts is the evaluation of the benefits that consumers derive from products and services. When a consumer buys a good for less than they value it, they are made better off, and the efficient production of this “consumer surplus” is a main benefit of our present economic system. Unfortunately, as four leading economists recently admitted, “obtaining convincing empirical estimates of consumer surplus has proven to be extremely challenging.” Because consumers don’t reveal the value that they place on an item or service, calculating their surplus—the value minus the price paid—would require reading the mind of the consumer. While our current economic system works without analysts knowing consumer valuations, impact accounting requires estimating effects of products and services on all stakeholders, including consumers. How will impact accountants solve this problem?

Because the Harvard Impact Weighted Accounting Initiative (IWAI)—has been commendably transparent about its methods, we can answer that question. The IWAI reports reveal the plan to measure consumer benefit as one element of the impact a firm creates through the sale of its products. To do so, the IWAI group assumes that total consumer benefit decreases with price, increases with the utility the consumer derives and is amplified by the number of consumers served. They use a heuristic to avoid the tricky problem of calculating consumer perceptions of utility. First, they separate goods and services into two types, basic or luxury, and make the assumption that basic products deliver more utility than luxury ones. As justification for their approach, the IWAI uses an appeal to reason through a “thought experiment”: “Consider the impact of designer handbags and water … Water would be viewed as more impactful because of the inherent goodness of the product. While water is a basic need that provides sanitation and prevents dehydration, a designer handbag is a luxury item with lower inherent utility.”

On the surface, this heuristic makes sense, but its clumsiness quickly becomes apparent on application. Consider, for example, the IWAI’s analysis of the airline industry. Their report observes that airlines often serve “leisure travel destinations” and they conclude that all airline travel is a luxury good. Yet a single airplane includes people traveling for many reasons: for a major family event, to tend to someone ill, to interview for a job, or to take a “luxury” vacation. Nor, on closer consideration, is it clear that travel to a “leisure” destination results in less consumer benefit. Some “basic” needs, such as interviewing for a job, can now be satisfied via an online meeting, while leisure activities, such as a family vacation, may have no ready substitute—Facetime with the grandparents is not the same as visiting. So, in contradiction to the IWAI’s heuristic, consumers may get more benefit from “luxury” travel, such as a family vacation, than from a trip to satisfy a more “basic” need, such as interviewing for a job.

This example also reveals the potential for mismeasurement to cause harm. Suppose airline managers were to heed IWAI’s analysis and attempt to improve their total impact score by ceasing to provide a “luxury” service, such as flights to leisure destinations like San Juan, Puerto Rico. Doing so might make their impact account look better, but would in fact cause real harm, since tourists flying to Puerto Rico bring in much needed dollars to the local economy. Should airline managers instead refuse to fly vacationers to make more room for travelers with “basic” needs? No, the money vacationers spend on airline tickets allows airlines to offer service to those with more “basic” reasons for traveling, such as health-care professionals. Without the scale economies allowed by vacationers, flights would be far more expensive, and more “basic” needs would go unmet.

Possibly to mitigate the bluntness of their basic/luxury distinction, the IWAI group also adds “effectiveness” measures to refine the consumer impact of each product or service. In the airline industry, for example, they measure flight delays, baggage mishandlings, and the airline’s safety record. But while these measures may be important, they do not resolve the problems discussed above, nor do they capture even a small part of the attributes that influence consumer benefit, such as location served, flight schedule, flexibility, connections, travel time, check-in convenience, comfort, and other amenities. To obtain “convincing empirical estimates” of consumer benefit, the value of each of these aspects would need to be measured accurately, and for each airline.

Because different product impact measures are bespoke to each industry, the complexity of determining consumer surplus grows exponentially. For example, to determine the product impact for the consumer-packaged food industry, the IWAI calculates the impact of seven categories (affordability, underserved, health and safety, positive effectiveness, negative effectiveness, emissions, and recyclability). As is the case for airlines, luxuries (like ice cream) are penalized relative to staples (such as grains). To determine affordability, the IWAI “divide[s] the revenue from food stamp programs by industry assumptions on annual per person meal cost to identify the number of food insecure individuals reached…[and]…then multipl[ies] the number of food insecure individuals reached with the averted health costs associated with food stamp program access to estimate the underserved impact.” Got it? And this is just one example of the judgements and extrapolations needed to measure one element of consumer surplus in one industry.

2. External Impact

Another necessary step to arrive at firm impacts is the valuation of harms or benefits done to third parties. Estimating these “externalities” is extremely difficult, making a consensus value hard to reach, even among highly trained analysts. Consider the harm done by greenhouse gas emissions: literally hundreds of scholars have estimated the impact of CO2, yet no consensus is in sight. The Trump administration priced the social cost of carbon between $1-$7/metric ton, while the Obama administration arrived at a price of $42/ton. Nobel Laureate William Nordhaus estimates the price at about $40/ton, but economists Nicholas Stern and another Nobel prize winner, Joseph Stiglitz, think this is far too low, and estimate $100/ton. How would impact accountants adjudicate different estimates of the cost of these impacts?

Estimating the external cost of carbon is easier than it is for other externalities. For most pollutants, their impact depends on the medium (air, land, or water) into which they are released and their location, as well as the organisms present. Fluoride, for example, is a pollutant that is harmful to some aquatic organisms, but it is also added to drinking water to promote stronger enamel in human teeth. To measure the cost (or benefit) from Fluoride emissions from a production facility, accountants would need to know where and how they occur and what organisms are present. And Fluoride is just one of thousands of pollutants. How would these impacts be valued?

If anything, the challenge of measuring externalities is even greater for unpriced social costs. For example, how should labor treatment be measured and valued? This problem is very familiar to one of the authors of this essay, who worked as the Chief Operating Officer for Timberland. Fashion goods are produced using distributed and complex supply chains. Companies may be able to evaluate working conditions at their first-tier suppliers, but often little is known about secondary or tertiary producers. Even dedicated impartial NGOs, such as the Fair Labor Association, cannot accurately determine conditions in individual factories. So how would impact accountants, miles removed, calculate and price the effect of a tangle of shared production facilities and then allocate to a single company impacts ranging from excessive overtime to incidents of child labor to pregnant women working in close proximity to solvents?

3. Impact of Changes

Remarkably, the computing challenge of impact accounting is not surmounted even if consumer surplus and external impacts are somehow valued, because two remaining problems stand in the way. To provide effective guidance to managers about how to improve the impacts of their company, impact accountants would need to measure the value of the potential changes each company could make, and update all estimates for every real change in the broader economic system.

Consider the need to calculate the effect of potential changes. On the surface, it might seem that measurement of a company’s current impact would be enough to guide managers, who could simply follow a heuristic of reducing bad impacts and increasing good ones. Unfortunately, economists have long understood that a simple rule to do less bad can ironically cause more harm. A classic example involves a company that both pollutes and makes large profits: reducing prices will increase consumer benefit leading to more sales and more pollution; raising prices will reduce consumer benefit and production, but pollution will decline. Knowing which to do, and how much, requires detailed understanding of the relative merits of all of the options available to the company, and to calculate these values, impact accountants would need to evaluate how the broader economic system would respond to the proposed change.

The problem of measuring the value of possible changes is further aggravated by the dynamism of modern economies: economic conditions are always changing, so impacts would need to be updated constantly. Following a summer hurricane, travel to Puerto Rico might be dominated by passengers seeking to fulfill more “basic” needs, as physicians and electrical power workers replace spring-breakers. New information about social impacts would also require recalculation, and every new technical innovation would require a reassessment: an improvement to jet engines could change the environmental impact of an airline, or a new technology enabling virtual reality might influence demand for travel and the mix of passengers. Because the economy is a complex and connected system, each change would require recalculating all effects and the merits of all potential changes.

For the reasons discussed above (and more), mainstream economists believe it is simply impossible to calculate, in a centralized way, how each economic actor should adjust their actions to improve human welfare. Indeed, the idea of such centralized calculation was put to the test, and rejected, in the middle of the twentieth century, when the rise of socialist and communist governments led to scholarly interest in the feasibility of central planning. Intellectuals of all stripes, including Leon Trotsky, weighed in; even Trotsky admitted that a “universal mind” could not be constructed and thus supported decentralized decision-making through the use of the price mechanism.

The Perils

Even though 20 years of non-financial reporting has yet to get to accurate measurements of carbon emissions, proponents of impact accounting argue that the difficulty of accurately calculating business impacts should not prevent us from trying. After all, they note that current accounting methods fail to include measures of consumer welfare, social impact, or environmental costs, and thus even inaccurate impact measures could be better than nothing. As Ronald Cohen puts it, with a quote he attributes to the economist John Maynard Keynes, “It is better to be roughly right than precisely wrong.”

However, aside from such appeals to common sense, proponents seem to have engaged in no analysis of the risks inherent in their plan. While they seek to reinvent capitalism, a system that—despite its many flaws—has raised human welfare to unprecedented levels, they seem not to have considered the potential for their proposals to cause harm. Yet even a cursory analysis reveals that impact accounting is both ethically and consequentially hazardous.

Our present economic system is based on the right of each individual to decide how best to pursue happiness. If a person decides that more value is created by flying for a vacation than for a job interview, he or she can do so. And these values, revealed by individual choices, cause the economic system to adapt to deliver what people value. Indeed, it is the effective delivery of these human desires that provides the moral underpinning of our free-market system. Impact accounting transfers some of the valuation role from consumers to experts. In an impact accounting system, these experts would decide how much consumers benefit from flying to various destinations, or from drinking a glass of water or buying a handbag. If the experts’ valuations accurately reflect those of each consumer, they will not cause the economy to change, because it is already evolving to deliver on this demand. If experts form different valuations, and these have any influence on economic activity, then they must dilute the economic power of individual choice. Such centralization of choice is perilous because it can lead to waste and to the further accumulation of decision-making power.

The implementation of impact accounting raises other risks, particularly around governing how impact valuations would be made. Creating valuations of every impact for every company will require the labor of many people, to measure, validate, and value company impacts. It seems probable that tens of thousands, maybe hundreds of thousands of analysts would be needed to create these measures. Clearly, they would be engaged in activities that influence the public interest. How would they be selected and governed? If they are selected by private interests, what gives them the right to make value judgments about things ranging from trans fats to guns to air travel? If they are selected by a democratic process, then the scale and scope of government will have to increase dramatically; government officials would need to decide the value of everything for everyone.

Even if we could address these encroachments on liberty and justice, the proposed mechanism presents other challenges. In the freer parts of the world, the notion of universal and equal suffrage is seen as the foundation of an equitable society. If we vote to impose a tax on carbon, we each get one vote. Now consider the mechanism of action for impact accounting. Its proponents argue that investors will influence corporate behavior by shifting their funds to firms with desired impacts, thereby lowering the company’s cost of capital. This mechanism would be undemocratic, disenfranchising the half of all US citizens who own no stocks. In practice, even if this mechanism was to prove effective, it would give outsized influence to a handful of individuals and fund managers with large holdings.

What about the consequences of impact accounting? As its proponents point out, the world is a mess, and perhaps desperate measures are needed to heal it. If Impact Accounting were likely to prove effective against climate change or inequality, we might be willing to limit our liberty or suffer injustice. Can we justify Impact Accounting on consequentialist grounds?

Unfortunately, impact accounting is likely to create more problems than it solves. We have already discussed the impossibility of accurately calculating corporate impacts, and the harm that inaccurate measures could cause. In fact, impact measures, accurate or not, could also be used strategically, to forestall more effective mechanisms for change, such as government regulation. After each new social or environmental crisis, we see proposals for how business can “self-regulate” to solve social and environmental problems. But though such proposals are often greeted with credulous acclaim, their promised impacts have been disappointing. From chemical safety to the environmental impact of ski areas, empirical evidence suggests that self-regulatory programs have primarily benefited member firms, at least in part by preventing governmental regulation.

According to David Pozen, the same is true for proposals that seek to use disclosure and increased transparency to improve corporate performance. Based on a century-long review of such proposals, he diagnoses an ideological shift: in the early 20th century, such proposals were used to advance progressive ideals, but by the end of the century they were used by those with more libertarian orientations to “head off stronger forms of regulation.” “In its actual application,” Pozen writes, “transparency has become increasingly associated with institutional incapacity and with agendas that seek to maximize market freedom and shrink the state.”

While we don’t believe the leading proponents of impact accounting are seeking to prevent regulation, programs that begin with one intent often bring about another. We believe that executives will seek a favorable calculation of the company’s impact, and some may be tempted to use their financial power to influence estimates of corporate impact. Such manipulation has happened before, and in situations where misconduct was more likely to be detected and punished. Two decades ago, the world discovered that accountants had altered their evaluations of corporate debt structures to serve the interests of corporate executives at Enron, WorldCom, Tyco, Freddie Mac, AIG, and so on. A little over a decade ago, the world discovered that ratings agencies had misrepresented the true risk of mortgage-backed securities to retain clients who threatened to take their accounting business elsewhere.

For impact accounting, the risk of fraud and manipulation would be even larger, because analysts need not fear exposure from an eventual “settling up” of real and calculated value. When accountants at Arthur Anderson manipulated their assessments of off-balance-sheet-debt for Enron, they had to fear that the real value of this debt might eventually be revealed. When analysts at Moody’s adjusted their assessments of the risks in mortgage-backed securities, they had to worry that the true risk might eventually be known. But for measures of corporate impact, such fears will be removed. No market correction or cash crisis could ever reveal that assessments of social impact are inaccurate, and such measures will remain forever unverifiable.

What to Do Instead?

Calculating the financial impact of environmental externalities can be a useful tool for corporate managers. Several companies, including Puma and Kering, have been using a shadow environmental profit and loss statement for more than a decade. Though the measures can help managers determine where to prioritize remediation, they are imprecise.

At the system level, however, we already know of more effective solutions; we just need to enact them. If the external cost of carbon does not appear in a gallon of gas, then a tax should be added so that it does. If consumers lack information about their coffee or cocoa, we should demand that government require proper labeling. To ensure equal treatment of individuals or provide equal opportunities, we should pass laws or provide social services. To expand the options available to producers and consumers, government should invest in basic science.

We know that governmental interventions can alleviate our current problems because we have had success with them before. In the 1950s and 60s, the Cuyahoga River in Ohio caught on fire several times. Today, after the Clean Water Act and other regulations, the river supports fish and human recreation. In the 1970s and 80s, acid rain from coal-burning power plants harmed lakes and streams, but an amendment to the Clean Air Act helped reduce acid rain by 65 percent. In the late 1980s, an international agreement, the Montreal Protocol, phased out the production of chlorofluorocarbons and thereby solved the first global climate crisis—the destruction of the planet’s ozone layer. Governmental action has also enabled some progress on climate change: Subsidies of clean energy technologies have brought about revolutionary advances in renewable power and electric vehicles. Governmental regulations and programs have been effective in advancing social conditions, by requiring workplace safety, providing health care services, supporting the unemployed, and so on. It is a Reagan-era myth that “government is not the solution; government is the problem.” No, government is often an important part of the solution.

One common objection to the use of government regulation is that it takes too long, or that it is too hard to accomplish. We agree that our increasingly divided society makes political consensus difficult, but many governmental programs garner wide and bi-partisan support. According to a study by the Pew Research center, Americans of both parties support government spending on programs for environmental protection, assistance to the needy, health care, education, social security, and so on. Two-thirds of Americans think that government should do more on climate, including increasing taxes on corporations.

Moreover, it is often possible to jump-start national regulation with local initiatives, where consensus is easier to build. For example, actions by the state of California to curb vehicle emissions led eventually to national legislation. Requirements for smoke-free restaurants, beginning in Aspen, Colorado, helped speed a radical change in cigarette use. Local regulation legalizing same-sex marriage also helped bring about an astonishing change in public opinion. Today, same-sex marriage is legal in all US states.

Experts on the use of transparency and disclosure to bring about social change suggest that it can be most effective when it “catalyzes” government action. It is here where we hope that proponents of impact accounting will turn their efforts. In the US, our system for funding political activity allows business power to influence elections and avoid regulation, and the opaqueness of these actions allows company executives to claim leadership in sustainability, while simultaneously working against regulations that would support it. In some cases, business executives even claim to be champions of democracy, while working to weaken its foundation. Even if one believes that corporations should be able to play a role in shaping governmental policy, it seems untenable to believe that they should be able to hide what one hand is doing while waving the other for all to see. We believe that transparent accounting about political spending would be an important step in bringing about a more equitable and verdant world. This is where new reporting and better accounting could provide real help.

Read more stories by Andrew A. King & Kenneth P. Pucker.