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Chapter V - Banking economics and environmental accounting
Operational difficulties of environmental assessments
Sectoral objectives
Investment cycles
Tangible returns
Competitive financial markets
Operational difficulties of environmental assessments
Banks are profit-making institutions operating in a competitive financial market place characterized both by incomplete information and the pressure of the work flow. Introducing a system of environmental cost-benefit analysis into banks' operating procedures would clearly have far reaching implications, on both practical and theoretical levels. With regard to the latter, there is the problem of mitigating the inherent clash between commercial gain and social need. While projects in the public sector should self-evidently be assessed according to the goals and objectives held in society at large, projects in the private sector will be evaluated from a shareholder's perspective, which is based on individual financial gain.
Since the present use of natural resources costs nothing (or nearly nothing), the private investor, in his role as a profit maximizer, will be loath to increase costs through accounting for previously free goods, and this could limit investment initiatives. Investors will reason that, while their own over-exploitation of the land, air or sea may have a detrimental impact on society at large, increased production can be achieved at no extra monetary cost to themselves. It is such reasoning that gives rise to the "tragedy of the commons" 17 and highlights inherent problems with regard to financial institutions assuming an active role in the protection and
17 This refers to the situation where no real care is taken especially for the future, of those resources which are freely available for; anybody to use. management of the environment.
The difficulty of banks introducing a form of environmental CBA into financial decisions is that this would clash with the basic and fundamental policies on which banks have traditionally worked. Three major criteria on which banks operate, and the form in which these impact upon the environment, must, therefore, be considered.
Financial institutions deal with each project individually and independently. Because of this, the financing of a project which could directly undermine the rate of return of another, would in all likelihood go ahead, despite the fact that the potential total rates of return are being reduced. Obviously, the clear felling of forests in the hills above farming communities will have an impact upon producers on the valley floor. However, the damage done by logging to farming communities is exogenous to a decision to finance a wood industry project. Banks, thus, in their method, lack a means of incorporating the interacting processes within economies. Finance institutions, like other sectoral organizations, tend to pursue sectoral objectives and to treat their impacts on the other sectors as side effects, taken into account only if compelled to do so. 18
18 G.H. Brundtland, Our Common Future, World Commission on Environment and Development, Oxford, 1987
Furthermore, it is relatively rare that a bank will be able to assess the impact of a given loan decision on the total rate of return. Bank loans are usually fragmented among numerous banks who, for competitive reasons, are unlikely to share information. It is likely that any bank denying a loan to a financially viable project, could reasonably expect that it would be financed by another bank less considerate of the environmental consequences. As banks often compete for loans they deem desirable, they often must act before the borrower seeks finance elsewhere. The creation of goals of sustainability, in contrast, requires the need for a constrained profit maximization model, as well as a holistic approach to development.
In the long term, banks would clearly benefit from a broader approach to lending, since a well managed environment gives rise to a healthy economy. However, while environmental cost-benefit analysis will give rise to benefits in the longer term, capital investment is largely dictated by short-term investment cycles. Banks do not, for example, like to support forestry projects because returns take a considerable time to accrue.
There is an opportunity cost to be taken into consideration here, whereby money invested in forestry could have been invested elsewhere, so that the longer trees take to reach maturity, the greater the opportunity cost will be. 19
19 There is a risk of overstating the long term nature of investments in forests, particularly those in tropical zones. S.M. Amatya reports that in Nepal trees are intercropped with a wide variety of food crops the year before the trees are planted and for three years after planting, providing the farmers with a steady income. Furthermore, with fodder trees harvest can begin much sooner than is the case with growing for firewood or; timber. In fact, fodder harvests can begin shortly after the end of the intercropping of trees with vegetables and grains. Unfortunately, there is no organized fodder market and most of the crop is used on farm. Amatya reports financial internal rates of return as high as 21% and economic rates of return as high as 14%. Nepali banks are lending at 15%. This is presumably some positive spread over the underlying inflation rate. Thus, while forestry is profitable, it is marginally so. Nepal is not the exception to the rule that there are generally better alternative borrowers who can offer banks better collateral and security than that of poor farmers, and can do so without the production risks (i.e., fire and storm) implicit in forestry. See S.M. Amatya, "A Case Study on Lending Policies Geared to Sustainable Agriculture and Forestry in Nepal" Paper prepared for FAO, Rome, 1991. The case for intercropping both food crops and trees is strengthened by research in India which has also established that "agroforestry schemes where wood and food are grown together on the same piece of land are key to sustainable land management in the fragile ecosystems prevailing in the country." See K.G. Venkatraman, "Case Study on Lending Policies Geared to Sustainable Agriculture and Forestry for Asia Pacific Region," Paper Prepared for FAO, Rome, 1991.
This warrants further explanation. A bank's source of profit is not only spread between the rate that they pay for deposits and the rate at which they lend, it is also partially fee based. Loan origination fees, for example, often increase banks' intermediation margins. Clearly, therefore, banks have a strong interest in increasing the velocity of the loan funds through short-term, rather than longer-term lending.
Furthermore, longer-term lending is subject to additional price and political risks, especially when the loan is for the production of an internationally traded commodity. Again, in the case of forestry, international prices are volatile and may be quite low when the trees are ready for harvest. There is also an inherent political risk in longer-term lending. Often domestic production incentives (such as tariffs on imports) are abolished during the duration of the loan.
Thus, the long gestation period of much environmental investment weakens its financial worth against that of a short-term and yet ultimately destructive investment.
Banks will grant a loan and the hoped for benefits of capital investment will subsequently be realized through the payment of the loan with interest. They thus work on the basis of receiving tangible returns (normally financial) from their investment plans, which have benefited the private individual or party.
Investing in, for example, watershed management, involves several extraneous factors. First, the benefits of such investments will accrue directly to the communities living downstream in the form of water quality, consistent flows for irrigation, and hydroelectric potential; and to the broader society in terms of preserving the beauty of the landscape, and providing recreational opportunities, but not directly to the borrower and consequently not to the bank.
Second, much lending is equity based. The decision to lend based upon the borrowers' guarantees and upon the borrowers' credit history is supported by banking tradition that holds that loan losses are lower in well collateralized loans. Frequently, banking laws impose a legal requirement as to the amount of collateral to back loans.
When exogenous factors such as environmental cost-benefit analysis are included in lending decisions, the collateral/loan size relationship alters. Environmental costs and benefits are non-financial assets that cannot be directly collected by a bank from either the borrower or the society. Let us say that, if a project to develop a fish processing plant were required to develop adequate disposal of waste waters, instead of dumping them untreated into a nearby river, the cost of the project would rise. The loan size would reflect this increased cost, but the collateral would remain constant. The benefits of such action on the part of the bank would accrue to the inhabitants who live in the watershed, and perhaps to the broader society that uses the river for recreation and transport. The cost to the bank is an increase in the risk/reward ratio of the loan.
Because of these three fundamental factors, problems in reconciling the aims of finance institutions with the creation of a sustainable economy clearly exist. Banks show a clear preference for investment with short-term horizons, supported by tangible and easily marketable securities; in a word, all the things that environmentally correct investment is not.
Banks confront a highly competitive environment. If one bank is not prepared to make a loan to a profitable project with unacceptable environmental consequences, certainly a borrower will approach another bank with the project. The same holds true for countries and regions. A region or country rejecting a project does so with the almost certain knowledge that the project will reappear in another country, or even in a different region of the country, that is less demanding and more willing to overlook the environmental degradation that may result from the project.