The Environment Moves Front and Centre in Economic Modelling - Nick Whittle

A recent article by Paul Gruenwald, the Chief Economist at Standard & Poors, the credit rating agency, examines the burgeoning role of sustainability in economic research. Gruenwald highlights how a report on the economics of biodiversity for the British Government, led by Partha Dasgupta of Cambridge University, has overturned previous thinking on the structure and components of economic growth models, and offers a new methodology for the use of data and analytics in sustainable finance and economics.

The Dasgupta report embeds the economy and its growth within the environment, rather than treating the environment as an externality to economic activity, and shows that sustainable economic growth and prosperity are only achievable within a framework of informed, long-term management of nature and its resources. Thus, the bottom line for economic growth is redrawn to emphasise sustainable, rather than exploitative, development. This is in stark contrast to the previous modeling, which focused on economic expansion via the accumulation of human and physical capital — through education and training, and investment in productive assets — and the multiplier effects enjoyed from technological innovation and its resultant gains in productivity. These models routinely ignored the role of the environment in economic activity.

According to the Dasgupta report, there was a clearly unsustainable imbalance on a global level between 1992 and 2014, because while physical capital per capita roughly doubled, and human capital per capita rose by 13%, natural capital per capita declined by 40%, and market prices neither captured nor reflected the detrimental effects on the environment of economic activity. The pricing signals generated thus misallocated resources and led to environmental degradation. Economists and policymakers were consequently misled by conventional measures of GDP, which showed increased output per capita improving standards of living across the globe, because GDP growth data and modeling went unadjusted for environmental and ecological degradation.

Economic orthodoxy tells us that greater sustainable growth is created by taxing activities which harm the environment, such as the imposition of a carbon tax to balance the private cost of economic activity against the social cost, including environmental impact, thus modifying the price signal in the marketplace and reallocating finite resources in a more sustainable manner. However, by repositioning environmental and ecological impacts as central to economic activity, rather than regarding them as an externality, the private sector can transform itself from its classic role as an economic price taker. Though much remains to be done in terms of definition and accounting standards, particularly at a global level, the rapid adoption by major institutional investors of ESG principles and the integration of other sustainability factors into their analyses and decision making, is transforming performance measurement for all asset classes. This in its turn increases the adoption of sustainable best practices across industries and asset classes, delivering a rapid realignment in the allocation of capital and other scarce resources.

As Gruenwald points out, the parameters for prosperity in a sustainable world have changed. Under Dasgupta’s new modeling, the successful management of natural capital stock becomes a key component of economic growth, and other aspects of more classical economic modeling become less relevant. For instance, the demographic dividend of more labour leading to improved output no longer applies, since in a sustainable world higher output reduces natural capital. Economies which exhibit aging populations and lower demographic growth, such as Japan or Western Europe, and which have been penalised by classical growth models, are thus in a more favourable position, as they gain the breathing space to reallocate resources more efficiently. On the other hand, command economies such as China are beginning to recognise the need to transition to cleaner capital stock and lower environmental impacts, rather than their previous pursuit of policies which emphasised addition to capital stock and economic growth. The role of technology and innovation as productivity drivers must also change, to one of increasing economic efficiency while reducing the environmental impacts of economic activity.

In a world which brings the environment into the heart of economic thinking, rather than treating it as an externality, the priorities of economic planning and growth, and the policies which underpin them, face more sweeping change now than at possibly any time since the industrial revolution gave birth to the dismal science. Countries which embrace this radical recasting of economic activity to be at one with nature, will give themselves and their populations the best opportunity for long-term growth and prosperity gains.

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