CEO Farid Baddache and Raphaël Hara of Ksapa provide a timely and much needed insight into understanding Triple Capital Accounting – from a briefing paper available at Ksapa publications.   

Understanding Triple Capital Accounting, by Farid Baddache, CEO Ksapa and Raphaël Hara. With kind acknowledgements to Margaux Dillon and Ksapa.   

The case for expanding accounting schemes

The world has faced an unprecedented health crisis in all probability linked to Man’s environmental impact. Climate change and our relationship to nature resultingly appear as critical issues for our 21st century, particularly for the current decade. Consider the recurrence of economic and financial crises. Ever-increasing wealth inequalities. Our growing awareness of environmental risks (such as climate change and biodiversity loss). So many considerations have come to challenge the sustainability of our economic and financial models.

The Stockholm Resilience Center indeed stresses how the smooth operation of our Earth system we depend on hinges on various regulatory processes. These include the atmospheric concentration of greenhouse gases, the oceanic power of hydrogen and the integrity of the biosphere. Through the pressures and disturbances human activities exert on these processes, the resilience of the Earth system is now at risk. This ultimately threatens our planet’s capacity to sustain desirable living conditions for the human species.

Issues of social equity are likewise coming to the fore. Meanwhile, the current pandemic shock enshrines the decoupling of economic activities with the evolution of financial markets.

As a result, the last few decades have seen the emergence of tools intended to reposition the role of companies in society (such as the impact business status). Others seek to rebalance activities through a better considering of their socio-economic and environmental impacts, both positive and negative. That is, for instance, how environmental taxes and environmental quotas markets came into being. Most measures nevertheless remain driven by economic considerations (from taxes to markets and labor costs, etc.).

While non-financial reporting is rapidly evolving, accounting standards reforms still have a way to go before they fully account for socio-environmental issues. It remains that accounting offers a reading and therefore a prime comprehension tool for key economic players. As such, its fundamentals and core methods guide corporate and investment policies. For that same reason, these methods are grounded in a highly capitalistic vision (in the financial sense) of the company. It indeed echoes an economic outlook fairly foreign to valuing socio-environmental externalities. Among often overlooked considerations, the intangible capital that lies in socio-environmentally responsible management or positive contributions.

With the rebalancing of our priorities in view of our current climate and social emergency, there has been a growing collective will to direct private resources toward achieving the UN Sustainable Development Goals by 2030. Given how it acts as their primary compass, it is crucial that accounting fully integrates human and natural assets. That is precisely the goal of triple capital accounting.

In other words, triple capital accounting is designed to reflect corporate activities’ impacts, not just in terms of financial capital but also on natural and human assets (such as the environmental and psychological impacts of work, accidents, etc.). At its core, triple capital accounting is based on a strong sustainability principle across all environmental and societal matters. If its activities damage the environment, then a company must account for the maintenance expenditure entailed by the corresponding environmental restoration efforts.

In that regard, triple capital accounting mimics a key principle of traditional accounting, namely capital preservation (for example, through the depreciation or provision for risks and expenses in general accounting). From a sustainable development perspective, the firm must preserve not only the financial capital but also the natural and human capital upon which its production system depends. Including natural and human capital in liabilities indeed guarantees the conservation of such assets with the same scrutiny as with financial capital. Because it so essential to maintain the integrity of this capital as well, all capital is considered independent and non-substitutable.

As a result of its accounting, a business is thus driven by three sources of capital: financial as well as social and environmental. Bearing in mind key nuances depending on the chosen models and methodologies, triple capital accounting expands a company’s understanding of its own assets. It effectively allows firms to present itself in a new light, or perhaps highlight an aspect of their business model investors or stakeholders previously undervalued.

A direct application in the CARE-TDL model

The French CARE-TDL model – Adapting Accounting for the Environmental Renewal based on a Triple Depreciation Line. Developed by Professor Jacques Richard, the model is subject to growing interest from various public and private organizations.

The CARE-TDL model explores the operational modalities of capital conservation by applying a principle of depreciation across all three sources of capital (hence the Triple Depreciation Line). In so doing, the model is designed to fully integrate the costs (or expense) of maintaining human, financial and environmental capitals in corporate accounting. The liabilities linked to natural and share capital debt thereby include a loan to be repaid to financial backers. In essence, the model addresses profit generation without incurring damages to corporate human, environmental and financial capital.

Given its goal is to account for capital maintenance costs, CARE takes up Hicks’ definition of profit and extends it to socio-environmental issues. Profit therefore corresponds to “the maximum amount that can be spent over a period of time while maintaining capital in the same timeframe”.

The CARE model is grounded in a capital conservation principle, which raises the question of defining capital in terms of what precisely should be preserved. The CARE-TDL model therefore operates around the following 6 axioms:

• Social Axiom 1 (SA1) = At least three capitals deserve to be preserved, which are of a natural, human and financial nature.
• SA2 = Preserving these assets requires a precise investigation dovetailing the specificities of the structure in question (soil analysis, employee well-being, etc.). Key indicators must thus be identified for each asset and lead to the definition of appropriate conservation thresholds.
• Accounting Axiom 1 (AA1) = For the sake of preservation, all three capital assets are recorded as liabilities on the balance sheet. Their use implies an obligation for the company to safeguard them as well.
• AA2 = Their use necessarily implies deterioration. All three capital sources are therefore included as resources but are systematically depreciated.
• AA3 = Asset use and preservation must be reflected in financial statements, particularly balance sheets and income statements.
• AA4 = CARE’s guiding principle is that the measurement of any capital is determined by the cost of its preservation.

In the example of the left-hand side balance sheet, human capital corresponds to the debt owed to the employee over the considered period (for instance 10 each year for 10 years), effectively outlining a budget. Natural capital is likewise listed as a debt owing to the cost of its maintenance (100) over the course of 10 years (1,000). It is however different from the price of purchasing land. Bearing in mind the annual depreciation of 100 across all three sources of capital and a sale of 400, the resulting profit would stand at 100.

With regards to the conservation of capital (see second balance sheet example), we assume profits (100) are fully distributed. The remaining cash (300) will therefore be allocated to the renewal (reinvestment) of each type of capital as a direct of the principle of strong sustainability. Should the firm “forget” to reinvest accordingly, its managerial fault is immediately visible. Conversely, conventional accounting would see to it that profits be higher, despite the fact this surplus occurs at the detriment of the natural or human capital.

These examples demonstrate that the purpose of the CARE-TDL model is not to attribute value to nature or to damages caused, but to finance the preservation of both ecosystems and people. Methodologically speaking, CARE-TDL follows 4 successive steps, as detailed below (Novethic):

The CARE-TDL operational roll-out starts with the definition of human and natural capital. This initial step, along with the following, requires extensive stakeholder engagement, raising the question of updating corporate governance schemes.

External stakeholders must indeed be involved in the governance processes in order to aptly define assets under consideration, representative indicators as well as safeguarding scenarios. Stakeholder dialog also allows teams to design and verify their approach to developing a triple-capital balance sheet. Target stakeholders typically include employees, non-profits, water and soil treatment agencies and scientists, among others. This process is what CARE refers to as its Theory of Extended Capital Holders. By making employees partners in the management of their company, it ultimately redistributes the relative weight of each capital holder.

Before any effective accounting can take place, a company must acquire a sound understanding of the socio-environmental issues linked to its activities. This depends on nurturing a strong ecosystem of stakeholders. Bearing in mind the lengthy processes of accounting and change management associated with the CARE method, such a transition can only happen in phases. It indeed starts a pilot project (as a proof-of-concept), which can later be extended to the entire organization once the implementation methodology is sufficiently refined.

Though the CARE-TDL model guides long-awaited structural changes (expanded vision, impact measurement, new governance systems, etc.), it comes with its own limitations. Because it so clearly depends on preservation costs to account for natural and human capitals, the CARE-TDL method fails to encompass the positive externalities of the regenerative economy. In effect, should the land upon which an investor sets up their operation be degraded from the get go, focusing on maintenance costs no longer makes sense. That investor would in fact have to finance land regeneration to exploit it. While this would eventually result in positive externalities, it cannot be translated into the CARE-TDL framework.

Additionally, CARE-TDL operates on the basis of capital budgeting. Its vision is inherently ex-ante. Meanwhile, many of the ecological and human impacts of economic activities are only identified after the fact. The CARE-TDL could not convey a retroactive vision of the impacts of economic activity without fundamentally challenging its maintenance costs principle.

Other methodologies – sample examples

• The Triple Bottom Line (Elkington)

Unlike the CARE method (based on a strong sustainability principle and a triple depreciation line), John Elkington’s method is based on weak sustainability principle, complete with a triple revenue line. Much in the same way as with CARE, this method investigates people and environmental dimensions on top of conventional profit. In so doing, its goal is to measure the total cost of corporate business models.

In practice, it proves difficult to measure profits linked to corporate socio-environmental policies. This could take the form of an oil spill clean-up or an inclusivity program, for example. As a result, Elkington recently renamed his concept “People, Planet, Prosperity” to adopt a broader vision of companies’ economic impact. As such, they do not only exist to generate profits: by developing these activities, they positively impact the economic development of local communities.

• Universal Accounting (Saint-Front)

Universal Accounting seeks to measure the value created for players in any given territory, effectively making stakeholder engagement an integral component of its development. This entails stakeholders being clearly identified and their priorities listed. A process of co-construction is thereby initiated to design relevant indicators for each key issue as well as the corresponding measurement processes. The data is then translated into monetary figures and aggregated into income statements for each stakeholder. An overall profit and loss statement ultimately includes all proposed indicators.

At its core, the Universal Accounting model is primarily intended to monetize the impact of corporate responsibility programs. As such, selected indicators and strategies are divided into four accounting areas of governance: social rights, the environment and society. None can mutually compensate another, thus abiding by a strong sustainability principle.

• Environmental Profit & Losses (Puma, Kering)

The EP&L is an income statement designed to measure the environmental impact of supply chain activities to translate them into monetary values. This environmental footprint notably takes into account water consumption, carbon emissions, water pollution, land use, air pollution and waste production. The resulting data is then converted into monetary values to convey an overview of the costs of all corporate activities.

This method internalizes negative externalities and monetizes the cost borne by the environment for each activity. This is achieved by accounting for the ecosystem services on which a company depends on to function, in addition to the cost of direct and indirect negative impacts on the environment. This supports a comprehensive understanding of the magnitude of these impacts and their location along the value chain. On the other hand, the EP&L method singles out financial drivers and does not account for any societal considerations.

• Natural Capital Protocol (Natural Capital Coalition)

The Natural Capital Protocol was designed as a decision-making framework for organizations to identify, measure and evaluate their direct and indirect impacts as well as dependencies on natural capital. Until recently, natural capital was mostly overlooked in corporate decision-making processes. When it was taken into account, it was on an inconsistent basis and operating on an incomplete understanding of companies’ links to natural capital.

The Natural Capital Coalition addressed these challenges by providing a framework for businesses to identify, measure and evaluate their impacts and interdependencies with nature. Organizations are encouraged to optimize their decision-making processes accordingly. This tool indeed helps companies measure and embed natural capital considerations in existing processes, including those pertaining to their risk management, supply chain management or product design.

A path to progress

A consensus was reached around the notion that managing is measuring. The importance of measuring the socio-environmental impact of economic activities cannot be overstated, pushing businesses to seek a sounder appreciation and valuation approach on their positive impacts.

Triple capital accounting has been activated through various promising approaches, though most remain relatively exploratory. They also call for the development of a multi-step approach (POC, scaling test based on a team or share of activity, etc.). Implementing such accounting systems could however become a powerful lever for change, provided companies aptly address key challenges in managing complex and seldom comparable financial statements.

Progress therefore lies in identifying the shortest path to proven impact.

Useful links:

• Download the Ksapa Briefing Paper Understanding Triple Capital Accounting
• Discover Ksapa and their ESG solutions portfolio
• Link up with Farid Baddache and Raphaël Hara via LinkedIn
• Read a related article: Value Added Statements as a CSR reporting tool
• Download the CoBS publication Responsible Finance & Accounting

Learn more about the Council on Business & Society

• Website: www.council-business-society.org
• Twitter: @The_CoBS
• LinkedIn: the-council-on-business-&-society

The Council on Business & Society (The CoBS), visionary in its conception and purpose, was created in 2011, and is dedicated to promoting responsible leadership and tackling issues at the crossroads of business and society including sustainability, diversity, ethical leadership and the place responsible business has to play in contributing to the common good.  

In 2020, member schools now number 7, all “Triple Crown” accredited AACSB, EQUIS and AMBA and leaders in their respective countries.

• ESSEC Business School, France-Singapore-Morocco
• FGV-EAESP, Brazil
• School of Management Fudan University, China
• IE Business School, Spain
• Keio Business School, Japan
• Trinity Business School, Trinity College Dublin, Ireland
• Warwick Business School, United Kingdom.