The need for consistent, decisive environmental accounting principles has been argued in professional circles for some time, but has perhaps never been better illustrated than in the aftermath of the Deepwater Horizon catastrophe. This need became clear to the chairman of the board of British Petroleum (BP) PLC when the calls from the crisis center in Houston woke him in the middle of the night at his home in Sweden. And it became clear to the tens of thousands of investors of BP PLC when they lost close to $100 billion in share value almost overnight.

The solution is to use the dollar values that ecological economists place on ecosystem services and factor this information into the traditional financial statements and securities filings of resource extraction companies. This information also needs to be disclosed in the annual reports of the regulators accountable for protecting large-scale ecosystems (LSEs) such as the Gulf of Mexico.

For simplicity’s sake, let us assume that leading ecological economists estimate the value of the Gulf of Mexico to be $500 billion. (For comparison, estimates of the value of the Mississippi River Delta fall between $34 billion and $670 billion.)¹ Based on best scientific evidence, ecologists then estimate that one-fifth of the overall ecological value of $500 billion will be lost in a catastrophic deepwater oil spill. The total cost of such a spill is then $100 billion for the loss of ecological values and approximately $50 billion for compensation payments and cleanup costs borne by the Coast Guard and government agencies. The total cost of a catastrophic deepwater spill is then $150 billion. The relevant costs are the insurance premiums required to insure against such a catastrophic loss. These charges will be allocated to individual firms drilling in the Gulf, based on an insurer’s estimate of the level of risk implicit in the drilling practices of each firm.

The starting point of this new system of accounting is to create an accounting entity, or a set of books, for the LSE, following the rules of what accountants call the “entity principle.” The entity principle defines a company as a separate and distinct creature, separate from its owners or managers. A new set of books is set up for the Gulf of Mexico. On the balance sheet is an asset of $500 million. In the liabilities and equity side of the books there is “citizens’ equity” of $500 million. But who is the “owner” of the Gulf of Mexico LSE?

The proxy owner of the Gulf is the United States Department of the Interior (the states have jurisdiction over the coastal and estuarine areas). The accounts for the Gulf of Mexico must be satellite, or supplementary, accounts linked to the traditional accounts of the Department of the Interior.

As noted, the relevant costs are the costs to insure the LSE. Let us assume that an annual insurance premium of $30 billion (to cover the risks of all oil companies drilling deep- and shallow-water oil wells in the Gulf) would be required to insure against the potential $150 billion catastrophe. The next step is for insurers to allocate this $30 billion insurance fee to the handful of companies operating in the Gulf.

The safer companies would get lower rates; the more reckless companies would get higher rates. BP PLC holds the largest portfolio of oil leases in the Gulf, so let’s assume that it would get an annual allocation of half of the $30 billion. BP PLC would thus record an accounts payable of $15 billion to the Gulf, and an expense for the same amount. This $15 billion charge would be made after “income after taxes” and would be shown as a below-the-line adjustment. This would be analogous to a payment by BP PLC to an independent trustee holding the assets of the company pension plan. This method is in keeping with the matching principle, which demands that a company match all revenues with corresponding costs, assuming the worst case.

In addition to this proposed accounting, the company’s annual report must include an ecological risk section. This section would address the following:

• Physical characteristics (i.e., data on the size and complexity of the LSE upon which the reporting entity is economically dependent). The nature and extent of the data provided should be commensurate with the potential scale of the reporting company’s effect on the LSE. Would the company’s effect be a onetime ecological catastrophe, long-term sustained ecological pressure, or both?
• Cumulative environmental effects (i.e., data on the cumulative environmental effects of human use of the LSE). There should be a discussion of the vulnerabilities of the LSE and of the consequences of exceeding its limits.
• Estimated costs of ecosystem damage (i.e., estimates of the full costs of an ecological disaster and of degradation by sustained exploitation of the LSE). These estimates should include all the costs of cleanup incurred by the reporting entity, the costs incurred by all state, local, and federal governments, the costs of litigation to both the reporting company and society, and the possible fines under an assumption that negligence may be proved in court. In addition, these costs should include estimates of the dollar damage to the ecosystem itself, and all life dependent on the LSE. The estimate should be in dollars and should address the person-years involved in cleanup and remediation, as well as give a qualitative description of the damage and destruction to ecosystems and society.
• Capitalized value of all ecosystem services (i.e., an estimate of the dollar value of the LSE and changes in that value over time). There should be mandatory disclosure of the total market value of ecosystem services (exploitation of fisheries, timber, renewable resources, etc.), disclosure of nonmarket values (carbon dioxide sequestration, wetlands cleansing or water quality, production of biomass and oxygen, etc.), and a statement on the ratio of market to nonmarket values.
• Synergistic effects of all human pressure (i.e., data on all significant, material users who are economically dependent on the LSE). The data has to be sufficient to allow readers of the report to estimate the total human pressure on the LSE from all industrial uses.
• Accountability for damage (i.e., mandatory disclosure of the cause and effect relationships between the specific reporting enterprise’s use of the LSE and the observed cumulative environmental effects).
• Costs/benefits of risk minimization/regulatory options (i.e., data on the estimated costs and benefits of different regulatory policy options for minimizing and mitigating the risks of potential damage to the LSE). The report must disclose the regulatory and oversight options chosen by the regulator and the risks associated with these options.
• Royalties compared to capitalized ecosystem values and risk costs (i.e., information on the royalties paid by users of the LSE to federal, state, provincial, or territorial governments, and the assumptions used in calculating these royalties). These costs can be compared by readers of the report to the potential cost estimates of a onetime disaster or sustained degradation of the LSE.
• Regulatory and oversight effectiveness (i.e., information on the effectiveness of regulatory interventions intended to minimize or mitigate risks to a given LSE).

These Gulf accounts should be an integral part of the books for the Department of the Interior and would keep track of the contribution of each company extracting oil in the Gulf of Mexico. These satellite accounts would show the insurance premiums needed, compared to the actual royalties charged. The royalties currently charged do not cover the costs of insurance or risk. This shortfall has to be disclosed to Congress.

If this accounting regime were put in place, it would have two immediate effects on capital markets. First, shareholders would be better able, in advance, to estimate the potential costs of ecological catastrophe. Second, there would be a better matching of costs and a clear incentive to invest in the best-available technology for risk minimization and mitigation. And Congress would have the information to hold the regulator to account.

References

1. Constanza, R et al. The perfect spill: solutions for averting the next Deepwater Horizon. Solutions 1(5), 17-20 (2010).