From An Economic Perspective: Factoring Externalities To Slow Down Global Warming
In the 1970s, the Potomac Associates joined with the Club of Rome and the MIT research team in the publication of “The Limits to Growth”. The team examined the five basics factors - population, agricultural production, natural resources, industrial production and pollution that would eventually limit growth on planet earth. It appears untenable if you bring these five factors forward in today’s Industry 4.0 that unfolds the use of latest technologies that revolutionise our factories to be more efficient and productive. Hence, critics may disagree that there is a limit to economic growth.
On this, I would just single out pollution for special mention. Most countries have enjoyed high economic growth, which resulted in polluting the environment and contributing to climate change and rising sea levels. More than half a century ago, pollution was raised as a major concern amongst the five factors, but only in recent times, the COP26 Conference 2021 in Glasgow has a climate pact to limit global warming through the containment of temperature rise to not more than 1.5 degree Celsius.
To understand what took so long to reign in pollution, we turn to Economics 101 that addresses “Externalities”. Externalities refer to a condition when the production or consumption of goods and services imposes costs and/or benefits on others which are factored in the prices of goods and services. But this is not so under today’s pricing models. They do not capture both positive and negative external costs in the equation.
Pollution comes under negative externalities. Generally, companies make business decisions based only on the direct costs of production. Not covered are the indirect costs arising from pollution such as the degradation of the environment and higher health care costs and foregone opportunities when pollution harms activities like tourism and recreation. Such indirect costs are not borne by the producer or polluter, and therefore not transferred to the consumer. On the other hand, there are also positive externalities from factories that produce. For instance, vocational schools will be established to train workers and supporting industries will be established to serve the plants.
Holistically, the total costs (that include the external costs) of the production are larger than the direct costs of production. When there are gaps between the two, the market outcomes may not be efficient. That is, when externalities are not accounted for in the production of goods, there is market failure - the goods are under-priced leading to over-production. Thus, global economies thrive through high economic growth, but contribute to pollution. Externalities need to be factored in the pricing models. If organisations had taken responsibilities to factor in externalities, global response would not be so demanding today to reigning in pollution.
While externalities appear to be a good concept, there are challenges in quantifying externalities. Without an acceptable method of measurement, this poses difficulties in factoring such costs in the pricing.
More importantly, does internal audit have a role in bringing such externalities to the attention of their management and boards? Can we as internal auditors, affect business decisions and heed the global call towards sustainability and zero carbon? Can this be addressed under ESG auditing or audit advisory? I’d love to hear your views.
“4 Rs - Reduce, Reuse, Recycle and Recover to save the planet”
Eric Lim is currently the Deputy Executive Director of The Institute of Internal Auditors Singapore. He was also the Institute’s Past President. He values internal audit’s independent assurance role as well as taking an economic perspective when evaluating problems so as to add value to internal audit.