Fixing the Broken Compass: Finding Our Way to Natural Capitalism

In 1999, Rocky Mountain Institute co-founder and chief scientist Amory Lovins co-authored a piece for the Harvard Business Review entitled “A Road Map for Natural Capitalism.” It aimed to come up with a new economic model that took the needs of sustainability into account. This article laid out the business logic for solving environmental problems while also generating a profit for the companies involved – true win-wins, in other words.

“The real problem with our [current] economic compass is that it points in exactly the wrong direction,” he wrote. “Most businesses are acting as though people are still scarce and nature abundant… But the pattern of scarcity is shifting; now, people aren’t scarce, but nature is.”

If we are to solve perhaps the greatest challenge that global capitalism has created – climate change – it is essential that we reconcile our prevailing economic model to place more emphasis on the importance of natural capitalism. Here’s how:

The first step is to build pricing signals into the market that reflect shifts in scarcity such as the external factors burdening our natural world. We are already making progress here.

Assigning a price to carbon is perhaps the most obvious – and contentious – way to mobilize market forces to help tackle climate change. It’s interesting that most citizens of developed countries happily pay for trash collection services and don’t refute the need for waste companies to treat their refuse before releasing it into the environment, and yet applying a similar logic to carbon is still seen as controversial. Nevertheless, a number of states are taking a stand, and it’s reassuring to see early experiments in carbon taxes and cap-and-trade schemes in Canada, China, the European Union, New Zealand and on both seaboards of the U.S.

Even without government, recent research from the Carbon Disclosure Project showed that an increasing number of U.S. companies are now placing an internal price on carbon when evaluating potential projects — citing climate change risk. Businesses and investors are calculating their possible returns on certain assets with a notional carbon price in mind, acknowledging that formal pricing is likely to become a reality eventually.

Make no mistake: whether enforced by local government policy, encouraged by a long-promised global deal on climate change in Paris in 2015, the result of prescient corporate planning, or simply in response to an extreme weather event like the one that recently put portions of New York City under 10 feet of water, the march towards putting a hard financial value on carbon emissions is underway and gaining momentum, whatever the critics would like to think.

Increasing the transparency of risk

Pricing externalities like carbon is the surest long-term way to modify corporate and market behavior, but, in the meantime, better acknowledging the investment risks of both established and emerging energy assets can also be a powerful incentive to help repair Lovins’ proverbial “broken compass.”

At an individual project level, investing in energy efficiency projects can offer a bond-like consistency in financial returns, while also mitigating against the ongoing volatility in fuel prices. These assets therefore effectively create a natural hedge against market dynamics. Contrast this situation with a new coal-fired power station, for example, which is not only vulnerable to fluctuating fossil fuel prices but also to the very real possibility that, over the next 40 years of its life, regulatory changes or a punitive carbon price could significantly erode its economic viability — dramatically impairing its current worth in the process.

These are all very rational approaches to risk and valuation, but, increasingly, carbon-intensive assets could also become stranded if investors lose faith in their economic potential. Consider, for example, the current push by college students to make their universities divest fossil fuel investments. If this increasing social push for institutions to shift their portfolios away from these assets gains momentum, fossil fuel businesses may suddenly find themselves facing much higher capital costs, and new investments in carbon-intensive assets could become unprofitable.

This situation becomes even more disconcerting if we consider the potential implications of a single, international carbon budget designed to restrict global warming to within the “acceptable” 2 degrees Celsius band. Such a cap on total CO2 emissions would effectively dictate that two-thirds of the planet’s remaining known fossil fuel reserves should stay in the ground. This in turn would represent a massive balance sheet risk to some of the most powerful economies and corporations in the world. Acknowledging these risks entails not just a punitive discounting approach, but also a dramatic write-off in value.

Letting the market sort itself

As with any revolution, retooling our economy to address the opportunities and challenges presented by natural capitalism will create both winners and losers. New technologies will break through; new businesses will prosper; new skills will be in demand; new rules will emerge; and new fortunes will be made. At the same time, however, there will be losers: certain established technologies will be rendered obsolete; some established businesses will struggle; skills from a previous industrial age may become redundant; old rules will be revisited; and a certain proportion of economic value will inevitably be eroded, even as new sustainable economies emerge to fill the gap. Throughout the process, there will also be a natural tendency to defend the past.

Successfully honoring natural capital means we will need to challenge our instinctive defense mechanisms that defer to the known and the proven. Doing so means unwinding some of those supportive policies and presumptions that have made the current carbon extraction industries and businesses some of the most financially- productive in the world. We will also need to be prepared to write-off established assets that no longer produce true value because of their environmental impact. We will have to accept that formerly great icons of success, titans of an earlier age, may tumble. Ask those who ran mainframe computer companies or former telecoms monopolists about the cost of disruption and paradigm shift. A similar value shift is inevitable in the world of energy as well – indeed, it is already underway, as unpalatable as that thought might seem in certain quarters.

In 2009, Royal Dutch Shell executives Gert Jan Kramer and Martin Haigh argued that new forms of energy take a very long time to become material sources of global power supply. But there are signs that this reality is changing, too. The logic of the past, where growing energy supply generally required massive capital projects with correspondingly long lead times, is being overturned before our eyes.

Solar panels on the roof of a family home require a much simpler capital sign-off process – generally around the breakfast table – than coal-fired power stations or fracking wells; they come in handy, modular, “as needed” chunks; and they can be implemented in weeks, not years. More dramatically, returns on investment in energy-efficiency projects often filter through within months, rather than decades, and these projects are gaining traction everywhere from China’s commercial sector to European and U.S. real estate markets. A single LED lamp is not a revolution – but large-scale roll-out of LED lamps is.

Fixing the broken compass

So, what are the implications of these various trends? The happy reality is that industrial upheaval may already be gathering pace, even without the stick of a high carbon tax or dramatic shift in the perceived risk of traditional, fossil-based investment assets. The largest utility firms in Europe, increasingly brought to their knees by the emergence of decentralized power, were recently forced to beg the European Commission for mercy.

Their balance sheets no longer represent a basis for investments in large-scale energy projects. And their customers are increasingly embracing a future of renewable distributed power, selling energy from one home to another. Electric cars, long the laughing stock of Detroit, Houston and Wall Street alike, achieved a 12 percent market share in Norway last year.

Could it be that a new energy economy, founded on a far more thoughtful and far-sighted approach to managing our planet’s resources, is already emerging? It is certainly a predictable outcome and modern capitalism should take note. Those who design their business models and encourage their industries to embrace this shift should be positioned to prosper disproportionately in a brave new world where natural capitalism reigns.

This blog post originally appeared on Triple Pundit.