Making corporations account for harm
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Jeremy Nicholls is a founder of and now an advisor to Social Value International and the author of The Accounting Paradox. Here he talks to Critical Takes about why companies should be required to account for the harms they inflict on society and nature as costs on their balance sheets.
This would make companies with destructive business models less profitable, he says, and incentivise investors and lenders to take their money elsewhere.
Including:
· Why it’s a problem that companies aren’t required to account for social and environmental harms (to 06:04).
· How to bring accounting standards within the public interest (to 16:03).
· The politics of accounting reform (to 21:00)
· How to bring people on board who aren’t accountants?
This transcript has been edited for length and clarity.
Diarmid:
Hello. This is Critical Takes on Corporate Power, and I'm Diarmid O'Sullivan.
If you look at the accounts of a multinational corporation, you will see a dense thicket of numbers and notes which fills many pages and is almost impossible for the untrained eye to make any sense of. These accounts are drawn up according to rules which literally define what the corporation has to account for, but accounting rules have very little to say about the harmful impacts of a business on society or nature.
So I'm delighted to be talking to Jeremy Nicholls, who is a founder of and now an advisor to Social Value International, about why that's a problem and what can be done about it. Jeremy, thanks very much for making time to talk.
Standard financial accounting does not require a company to account for the costs of social and environmental harms which it causes: at least that's how I understand it. Could you talk us through why that's a problem?
Jeremy Nicholls:
It's a massive problem because however boring we might think accounting might be, its superpower is to have allowed it to scope some costs out of the frame of what gets accounted for, almost without noticing, and it's built up over the years.
So there are some costs obviously that you [a company] include: your wages, your suppliers, things like that, but it's not a requirement to include the consequences of emitting carbon on people's lives or the consequences of destroying natural environments or overuse of water or unpaid labour in your supply chain or whatever that might be, because they're not scoped in as costs.
The consequence of that is that capital markets will move to invest in those activities which make profits based on one measure of profit, whilst not accounting for the increasing aggregation and accumulation of all those costs which pile up and pile up until we call them systemic or externalities and they start to undermine and threaten our very existence as a economy, let alone a society.
Diarmid:
How do you think accounting standards need to be changed so that companies do have to account properly for negative externalities? Let's use AI and data centers as an example. What should accounting standards require a tech company to report on in its accounts which it doesn't have to at the moment?
Jeremy Nicholls:
It’s very hard, without being in the weeds of all that, to say it's this cost and that cost that was specifically missing from this particular company's costs.
But the issue is not actually accounting standards, although that might seem bizarre. Accounting standards are quite extraordinary, and they do allow companies to take account of these kind of issues.
The main way in which we consider costs is what might be a legal obligation. You know, you have an obligation to pay, you have no escape from that. You have to pay it, otherwise you'll find yourself in court. Accounting standards are brilliant because they allow the directors to construct an obligation. It's not legally enforceable but it means that the directors can make a public statement where they take responsibility for something that has happened. And if a third party believes and expects that they will meet that responsibility, then broadly you have met the requirements of what would be a constructed obligation and would appear as a cost.
That's there already. The problem is that it's not something that all businesses are expected to do as a matter of course. So of course, why would you? So it's not that we need to change the accounting standard, we need to change the framing of the standards in which to pick that up.
There is this even more obscure document for non-accountants called the Conceptual Framework for Financial Reporting, which tells you how to produce accounts. It tells you that as users of accounts, as investors, we expect financial returns. And that sounds so obviously correct that no one then pauses to think. But what it means is that there's no caveat. If there were any caveats, then you'd have to take those caveats into account.
So the AI companies would then be expected to account [for example] for issues around data centres and the use of water, that is probably the biggest one that we all know about.
If you expected now to be using water that was above an area's capacity to provide water to the rest of the inhabitants, then you would have to recognize that you were doing harm, and that you would be having to build that cost of compensating for that harm into your accounts, and you would be expected to construct an obligation to do so.
Now, there are also other harms in the system, and the extent to which you would be including those harms would depend on the other amazing thing about accounting which is that it doesn't say it needs the right number. It says it needs a reasonable estimate.
That Conceptual Framework document specifically says accounting is mainly made up of estimates and models, which is brilliant. But nonetheless, there's a level of estimation which is not good enough. And so not all harms would appear in the accounts, in the calculation of profit on day one. Some would and others would not.
So it's hard to say “for AI “it would be this list”, but you could start thinking about it and saying, "Well, let's just take the water issue or take the carbon emissions.”
You could start to imagine quite quickly that if all businesses were required [to report] – on the basis of us as investors expecting financial returns, subject to paying compensation for any harm done - then the accounting standards would have to be applied within that frame of reference.
Diarmid:
Then that you need some mechanisms for determining how costs are accounted for. For example: if a data centre's going to use up lots of water, you need some way of assessing how to put that cost into the balance sheet because otherwise what you'd get is companies freestyling and coming up with their own ideas of what the cost is. And in a lot of cases obviously there's a strong incentive to make that cost as narrow as possible.
So it seems to me that what you’re really talking about is changing the purpose of accounts, so that they're not just about maximizing financial value, but also that they need to go hand in hand with some standardized way of agreeing how the compensation [for harms] would be calculated.
The users of accounts can then look from one company to another and see that the same kind of cost is being accounted for in the same way, because we know that accountants are incredibly creative at coming up with different ways of constructing things to make sure that they get the best result for them. So it does imply that looking again at the purpose of accounting standards would be part of a bigger process of thinking about how you account for these harms.
Jeremy Nicholls:
I think the important thing is the principle that the accounting system that we've created sits within a public interest mandate. Although it sits underneath a particular foundation and a set of structures of complicated governance, in the end those standards are mandated by national governments, and they're mandated within a public interest.
If the public interest is to have financial returns after compensating for any harm that has been done, that would be the principle and then it's up to the accounting profession to work out: okay, given that that's our starting point, how do we start to develop useful information which balances the kind of various tensions that you're talking to in terms of accounting for the harms that have been done?
It’s easy to get lost in the argument of “oh, this is very difficult to measure and very difficult to value and blah, blah, blah” but I think the principle's really important because if you start with that, then the kind of yin and yang between the businesses that produce accounts and their auditors that audit them on behalf of the users of those accounts is a very powerful way of working quite quickly towards a reasonable estimate, a reasonable standard.
As I said, you'd probably start with something like carbon emissions because that's probably one of the most developed.
As one example, I think it was around 1999-2000, mining companies at that point didn’t have to estimate the closure costs of a mine in the accounts. Obviously that cost was going turn up at some point and it was deemed this would be useful information.
So there was a year when every mining company suddenly had to decide what the closure costs of its mines were going to be. And that could have been in 50 years’ time, you know? It's like: “I have no idea. And I don't really know whether you're talking about the turning the lights off cost or the land remediation cost or the cost of harm done to the communities where there's now unemployment. You know, what's the boundary for this?”
And so everybody had to get going. But it only took a couple of years of all those businesses producing accounts and their auditors signing them off and then grappling with these issues and the information being shared because it's now transparent, that you standardize that within a range of what is acceptable as a reasonable estimate.
And I think we'll be able to do that with some harms tomorrow and other ones later and that is part of a transition. The reality is if you make such a fundamental change to the accounting system and the way that profit is calculated, you shift what is profitable and you can't do that super quickly.
Diarmid:
That's a really fundamental point: when you change the accounting system, you change what is profitable. And once companies are doing this in a relatively standardized way, then presumably the driver of change is that for investors and lenders, some companies are simply less profitable because once the true damage that's being done is put back onto the balance sheet as an obligation to pay compensation, then it just becomes less profitable.
Jeremy Nicholls:
Absolutely. And you know, competitive markets are brilliant. Capital markets can be brilliant, but they've been playing to the wrong tune, you know? If we shift the tune, then they'll move money to other businesses and new businesses will start. That's the nature of a competitive economy. Businesses that weren't competitive last year will suddenly become competitive because they can provide goods and services into a market without creating all these harms which now have to be costed.
It's not just that they're costed in the previous year's accounts. If you go into your bank manager and say, "I'd like to borrow some money," you'd be creating your forecasts, which would include forecasts of your expected harm.
Tobacco is often put up as an example [of why this can’t be done]. “We didn’t know the harm that was being done until much later, so the initial forecasts of the tobacco companies wouldn’t have included those harms.” Maybe not, but we knew much sooner [about those harms] than when it actually became public and we knew much sooner than the consequences before we actually did anything about tobacco. So those costs would've started appearing in tobacco companies’ accounts [through] that push and pull between the accountants and the auditors, considerably earlier than they were. We'd have been able to make decisions to highlight the fact of the relative unprofitability of the tobacco industry much sooner than we did.
If we don't move that lever, then we're just adding information around the edges of an existing metric which allows us to invest in businesses which are undermining our society.
Diarmid:
So the really big initial challenge, then, is at the level of principle. Basically changing this deep-rooted understanding of what accounts are for and … who the users of accounts are. We as concerned citizens are also users of accounts. In reality not many people are actually going to read the accounts because it’s bloody complicated, but there should be intermediaries who do that.
So you’d have to win that argument on principle. And then there's a very long, and I imagine very contested process of hammering out which costs go onto the balance sheet, how those costs are calculated and so on.
I don’t know what happens in the case of harms that just inherently very diffuse or affect large numbers of people. If you’re talking about pollution within a defined area, you could theoretically measure what's been damaged, work out what the cost of compensation is, and codify that in some way that has to go onto the balance sheet.
But a lot of harms, like plastic pollution, have a global effect. Can accounting standards actually pull those kinds of very diffuse harms onto the balance sheet?
Jeremy Nicholls:
If you take one of the existing estimates in the accounting system, it's the measure of depreciation. If I buy a building, then it's not going to last forever so I don't put the whole cost in my profit this year. I spread it out over the number of years that that building's expected to last.: whether it’s 50 years or 45 years or 40. It also depends on how much I spend maintaining it.
Not every single business calculates its own unique depreciation rate for each of these things that it's bought. We standardize it. Those are very broad estimates that accounting uses all the time. So there's no a priori problem with doing some high-level estimate.
The question remains, though: is that estimate still leading to useful information for these users, which might come back to “who are these users?” but is it useful information? And this is really important: that useful information acts within a public interest. It’s useful to me as an investor, but within a framing of the public interest.
There is an interesting question here as to whether it is a reasonable estimate for the public interest or is it a reasonable interest for the investor?
Diarmid:
Because the investor's only concerned about whether they're going to get their money back with a profit, whereas the public has much bigger concerns …
Jeremy Nicholls:
... so it's a bigger issue. And I do think that the estimate needs some specificity to the particular business. Because if we want to move capital markets so that the money flows to those businesses which create less harm, and you introduce a standard that all businesses get the same 10 per cent cost, they're not actually giving capital markets any particularly useful information. You know, just as a general cost.
We do that through tax at the moment, and that has its problems and its issues, but it’s the way that we go: "Look, we're all in a society. Everyone's got to contribute to that society. We're all members of the club. We'll all pay our tax, and we'll use that resource to deal with those addresses."
But we’re not talking here about the equivalent of a tax. We're talking about costs of doing business. They're costs of you running your business, and therefore to some extent that cost needs to be specific to your business.
Now, there will be some costs which fall outside that because they cannot be what accountants would describe as “faithfully represented”. So this is not going to fix all of these issues, but if you imagine the fact that at the moment capital markets are moving money without addressing very many of these harms at all, I think it would be unfortunate to let the perfect drive out the good. Let us at least get going with the right principle and the right approach to starting to address many of these harms. And we'll start reducing them fast.
We know that the world is kind of at the edge and we know that we need to make these changes pretty quickly and that we haven't been making them quickly despite all our best efforts. And I think if we could start to grapple with these fundamentals around what is the purpose behind accounting, what are our expectations, then we have the chance of making these decisions at the speed we need to.
And if we start to do a few, then everyone will go, "Oh, well, we did that and the market's moved, and competitive markets being what they are, isn't that great? And now we'll do some more of this because this seems to be actually creating change that we need.” So I'm wildly optimistic about we can move through the gears.
Diarmid:
How in political terms does this actually happen? Because any attempt to redefine what accounting standards are for, to say that the users of accounts are not just providers of capital, [will face] huge resistance, including from within the profession.
And even if we get to the point of saying “yes, we need to do this”, then we go into this process you’ve described of gradually building out the elaboration of what exactly companies have to report. The business lobbies will be fighting tooth and nail to influence that on every point, and obviously they will trying to keep the reporting obligation as narrow and as flexible as possible.
So what kind of coalition do you think might be needed?
First to win that point of principle about what accounting standards are for, who they're for, and then the question of building up what will probably be an enormous mass of detail about how different things should be accounted for and what these standardized approaches look like.
Jeremy Nicholls:
You're right that within any significant change there are winners and losers. If your business model is particularly dependent on not having to pay these costs, then you're going to be a potential loser, so you will resist it in the interests of your fiduciary duty.
We find ourselves in a difficult situation. If you're a big fan of a competitive market economy, you're a big fan of new businesses that don't exist yet, and they don't have a voice. Whereas the ones that do, who are hanging onto those issues, are your main potential resister of change.
I don't, to be honest, necessarily see the [accounting] profession [as an obstacle]. When we've had these conversations with individual people within the profession, it’s kind of “yes, this makes sense.” …
It's always difficult for institutions because they get into that set of governance and fiduciary duties and responsibilities. But at an individual level, the conversations we've been having are extremely positive around this. It’s not that it doesn’t make sense, particularly in the context of the specific public interest in efficient markets. If you want efficient markets then you don’t really want externalities, and externalities arise because we're not including these costs. It’s kind of ironic.
There is potentially a massive interest from a public policy perspective and with anybody interested in the public interest of efficient markets, which may include regulatory bodies within that context. Our suspicion or wonder is whether we’ve got this disconnect between that public interest in efficient markets and the way in which accounts have been produced, and not noticed it.
So there's a big support there, I think, around that coalition. I would like to think and hope that increasingly there would be support around the indirect users of accounts. These are people who don't read them but get pensions from them, future and current generations.
There's support from the social justice issues of those people who are consistently concerned, putting their own lives at risk in their struggles to avoid and stop some of the harms we talk about. I spend a lot of my time saying we should stop saying “externalities” and start saying “harm”. But in actual fact, a lot of the people who are working in harm say we should stop saying “harm” and start saying “people losing their lives”. That’s the scale of some of these issues.
So there's a broad base. Also purpose-led businesses. It's not easy to [get a company to] take on costs voluntarily, but it's not hard to recognize that if everybody had the same level playing field, that wouldn't be a bad thing. And purpose-driven businesses get that. [And] some family-owned businesses, we find.
The larger the business, the larger the kind of complexity of its own internal legal and audit and accounting and members’ pressures. Our big challenge is to get a kind of awareness, debate, or conversation going … such that that coalition starts to emerge.
We increasingly think [accounting] includes the source code of our economic system. Literally a sentence, you know, that has the potential to change so many things, that have so many potential benefits if we can transition, then there is a wide coalition. There will be voices against because of short-term interest. But rather than worry about that, I think we should try and garner the interests and recognition of the issue of a wider “everybody else” kind of group.
Diarmid:
Let's finish off by talking about that question. I mean, this stuff is intimidating. I have no accounting training - my degree is actually in foreign languages - and I got into this as a campaigner working for NGOs, basically staring at the numbers and then asking people, and eventually I started to make some sense of parts of the accounts.
But it's incredibly intimidating if you're a campaigner and you're looking at this from the outside and you just don't know what you're looking at. You can see whether a company made a profit or not, but anything beyond that is very difficult.
So how do you go about bringing in what you call “indirect users of accounts”? All of these people who are affected by extractive business practices and harmful business practices, but are never going to read a set of accounts, will never develop the specialist knowledge. How do you go about persuading people that that's something that they need to campaign for when most of them, they're not even aware that it's there?
Jeremy Nicholls:
I don’t think we should expect people to. It’s just a basic recognition that because these costs are not included in the calculation of profits, capital markets move money into businesses which create harm. Not because anyone's interested in doing harm particularly – there’s not a great sort of incentive to go out and do that – but this is the consequence. It’s just making people aware that it doesn’t have to be like that. We could bring these costs on board. Not all of them, as we've been discussing, but substantively.
Accounting is a language. And a lot of it I find quite extraordinary, quite beautiful, to be honest, because it is quite rarefied, as you say, but nonetheless, it is extremely thought through and considered.
My big issue is the framing. It's just this one sentence which says “we expect financial returns”, where we forgot to say ”subject to those financial returns being in the public interest” or subject to some caveat that's aligned with what we need for the world to be sustainably growing, for many people who need their incomes to grow around the world.
But if you think about it from that perspective and approach it as a rarefied language which has its own beauty, it's worth its time.
I do recommend, quite geekily I suppose, that everyone reads the first 10 paragraphs of that Conceptual Framework and spends a bit of time thinking about it. You have to want to engage with it in the same way as you would if you were learning a language. You can't expect to open a book in a different language and just get the gist of it as you flick through. It does require a bit of engagement.
But I think the bigger message is not one of needing to be able to do that. The biggest message is that this is a point of principle. The, economic system in our society obviously depends on the way in which capital flows into new business ideas and new investments.
It’s not just we have technological breakthroughs. We have technological breakthroughs which can survive in the market, and we use the word “market” not remembering that's a place where people buy and sell things. And they can only want to buy them if they meet a certain price point. If we exclude a whole bunch of costs, then we're more likely to buy them. And if we included the costs, they wouldn't have bought them.
For our generation, you know, we've lived in a world where we have access to many goods and services which come with considerable external harms, and just maybe we're going have to find a world where we have different products and services in future generations which don't come with those harms. We've no idea what those products and services are, but we will love those products when we get them, just as we love the products we have now.
And our generation will have to learn to maybe not have the products and services that we've had, but we'll still be very happy. You know, it's a kind of a moment in time in a competitive market economy where that's how it works if it's working well.
Diarmid:
The proposition is a challenging one, but it's quite an upbeat note on which to end. So thank you very much for making the time to talk.
Jeremy Nicholls:
It was a great pleasure. Thank you.
The transcript ends here.