11.11.2022

An Introduction to Natural Capital

Natural capital is a valuation approach for the entire natural environment. It increasingly underpins policymaking in areas such as landscape architecture, land use change, energy, agriculture, forestry and rewilding, and is beginning to appear more regularly in a financial services context. This article introduces the concept and provides a perspective on some of the challenges that arise when trying to implement natural capital in a real-world context.

What is natural capital?

Natural capital can be defined as “the world’s stocks of natural assets which include geology, soil, air, water and all living things” [1]. This is a starting point, but natural capital is really a framework for placing financial values on all of these. Natural capital valuations measure the impact of human decisions on the natural world, beyond the conventional focus on financial impacts. It is an area of rapidly increasing interest for academics, policymakers, and some commercial firms.

Natural capital is inherently important wherever biodiversity is considered in policy or decision making. Because carbon impacts are one of the easier aspects of natural capital to evaluate and to value, and the prominence of carbon impacts in current regulatory change and rapidly evolving commercial activities, natural capital is increasingly prominent even in contexts where biodiversity is not yet as fully reflected as it might be.

Is it useful, or just hot air?

Natural capital can be a useful framework in many contexts. For example, a business or community may be looking to reduce the material- or energy-intensiveness of its operations, either by producing the same with less, or producing more from the same inputs. This may be daunting but can improve the financial sustainability of the business or community. Good examples of incorporating the concept include a recent proposal in Shetland for sustainably producing fertiliser and biodiesel, and two firms in Finland aiming to repurpose textile waste into new clothes [2, 3].

Where does the concept come from?

In the early 1970s, the view emerged that finite limits on natural resources may impact economic and development outcomes. The Club of Rome published the book “Limits to Growth” [4] which is credited as bringing these topics sharply into focus. The term “natural capital” itself was first used in EF Schumacher’s “Small is Beautiful” [5].

The concept first came to prominence in UK policymaking in the Thatcher era, in David Pearce’s “Blueprint for a Greener Economy” book series. More recently it was a core concept in the 2021 Dasgupta Review [6], the benchmark official UK paper on biodiversity.

Is its meaning clear?

No, and this is a major issue. It is a concept that has been adopted by economists and politicians from across the political spectrum. There is a frantic race globally to try to define how different types of natural resource should be valued, and competition between major industries to ensure that they are treated favourably.

Trying to value the natural world in financial terms is very complicated and may be either objectively impossible or self-defeating. The Dasgupta Review attempted to simplify this problem by using an “ecosystem services” approach. In simple terms, wherever a financial value can be readily placed on a service humans receive from the natural world (e.g. through its value to industry), it is valued that way; the rest of nature is valued at zero. The ecosystem services approach is very different from the headline definition of natural capital, but it is easier to calculate this way than by finding a more holistic method.

What can go wrong?

Evaluating what nature is present in every hectare of a country and what role that nature plays in the ecosystem within that hectare, the surrounding area, and the wider world is challenging. The data to do so accurately largely does not exist. Extrapolating data from small samples, for example from Sites of Special Scientific Interest (SSSIs) or other low-density surveys, to much larger areas is prone to error.

Furthermore, individual industries may produce their own papers documenting claims of how ecologically beneficial their industry is. Where the alternative to using this existing information is to do extra work, which there may not be budget for, these claims can become adopted as fact in an official assessment.

An assessment might take information about an industry that is partially reliant on ecosystem services but also involves a lot of human resources and financial capital and claim that the full profits, or even full revenues of that industry arise from ecosystem services and so should be included in natural capital. Another industry may be assessed in terms of its profitability to shareholders, ignoring the value generated for workers, leading to inconsistencies.

If central government policy (e.g. grants and subsidies) is assumed to be fixed and a conclusion is drawn about the usefulness of that activity in that context, and then used to shape future policy without looking at what potential value that activity could have under different policy regimes, this could have unintended consequences such as a self-confirming spiral of poor policy.

Natural capital modelling is inherently complex. Models involve simplifications but these can introduce performance issues. Creating simple scales of a given sector having low/medium/high or low/medium/high/very-high dependence on a given ecosystem service, as World Bank and World Economic Forum reports have done [7,8], may introduce excessive discretisation and distort conclusions.

Even defining how dependent a given sector is on a given ecosystem service is prone to oversimplification. For example, electronics and hardware manufacture is not inherently heavily exposed to flood risk, but Thailand’s role as the largest global producer of hard drives combined with its heavy exposure to flooding (e.g. 2011) indicates that in some cases the industry is highly dependent on ecosystem services that provide natural flood reduction/protection.

At the other end of the spectrum, large arable farming “feels” inherently highly exposed to the effectiveness of these natural flood reduction/protection services, but this exposure varies hugely by site between valley arable (e.g. Sindh, Pakistan; highly exposed) and plain/prairie arable (e.g. Ontario, Canada; less exposed). Any valuation system that does not account for these distinctions, such as Table 2 in [7], will be exposed to substantial misevaluations and invalid conclusions. Policies based thereon risk being easily arbitraged by commercial parties. But any model that captures such distinctions is likely to be critiqued for being too complex.

Concluding remarks

Actuarial skills could help to address some of the challenges within this complex field, whether through model design or by assessing cashflows and risks over long timeframes and discounting them appropriately to give suitable present values. Actuaries could also assist in, ideally, establishing robust approaches and best practices, or at least in explaining the risks of taking long-term decisions based on existing natural capital assessments. Natural capital therefore represents another segment of the climate sphere where actuarial skills naturally lend themselves to adding value and could provide another opportunity for actuaries to work in new areas well beyond traditional areas of practice.