Why External Costs Matter in Meeting Sustainability Goals

external costs
external costs

With the majority of business leaders expecting their organizations to invest more in sustainability initiatives, it’s critical that businesses clearly understand if they are making an impact — and what kind of impact they are making. Businesses can’t simply appear to look good — they must do actual good. 

Over the past decades, the discussion over sustainability in the business sector has evolved. It is no longer just a trend to use for marketability but is now an imperative for businesses to survive and thrive. Moreover, customers, investors and governments expect companies to do their part in confronting not just climate change but also social and economic issues. For example, the United Nations’ Sustainable Development Goals (SDGs) include targets for biodiversity, health, labor, and education among goals for climate action. Furthermore, sustainability frameworks have adopted a broader and more encompassing view by including environmental, social, and governance (ESG) goals.

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All these highlight the importance for businesses to understand the interconnectedness of the different aspects of sustainability and measuring impact on multiple dimensions. Businesses need to look at external costs — costs not directly shown on balance sheets.

 

What are external costs?

In economics, externalities refer to results of business activities that affect entities not directly involved in the execution of the activities. Externalities can be positive, i.e., the impact is beneficial to external parties, or negative, i.e., the impact is detrimental to external parties.

External costs are negative externalities. From a business perspective, costs can be internal or external. Internal costs are expenditures that are directly shouldered by a business in the production of goods or completion of services. These can be in the form of payments for raw materials and salaries for employees, the monetary value of which are clearly set and reflected in product pricing and financial reports. In contrast, external costs are losses borne by entities not part of the business. Generally, in sustainability, external costs refer to effects of an economic activity on society and the environment that are not compensated by either the business or by the consumer.

External costs can be categorized based on types of externalities:

  • Based on source: Production external costs are side effects of manufacturing and production of goods. On the other hand, consumption costs are effects from how consumers use goods and resources.

  • Based on what is affected: Environmental external costs affect the environment and include pollution, greenhouse gas/CO2 emissions and drop in biodiversity. Social external costs affect human health and quality of life and include labor and human rights issues. Economic external costs affect local, national, and global markets and include increased real estate prices, revenue losses, and lost business opportunities.

 

How are external costs addressed?

External costs reveal the interdependencies of business activities, the environment, and society. For sustainability efforts to succeed, it is imperative that businesses and governments acknowledge, understand, and address external costs.

Governments and nongovernment organizations have long collaborated on ascribing monetary values to external costs to emphasize the magnitude of losses to society and the environment. From using the social cost of carbon to guide policies and levying a carbon tax, governments have sought to put a price on indirect business impacts based on available data from multiple organizations.

Sustainability reporting guidelines also now recognize that external costs are not limited to environmental effects. From the EU’s Corporate Sustainability Reporting Directive (CSRD) to the US’s Security Exchange Commission disclosure guidelines, reporting guidelines are cementing the need for transparency in the environmental, social, and governance performance of companies. Moreover, corporations will need to report on and be accountable for more than their in-house operations as reporting guidelines extend their scope to the whole value chain.

The business sector has long been contending with challenges in identifying and undertaking external costs. There have been proposals on how international businesses can implement the UN’s SDGs by assessing externalities as positive or negative externalities and extending them throughout the value chain. Businesses have also started valuing and accounting for external costs. Green accounting enables companies to link environmental costs to financial performance. Likewise, a full-cost accounting (FCA) approach reflects both environmental and social impact of a business and the effect of external costs on a company’s finances. Adopting such financial approaches also aligns with goals of meeting sustainability reporting guidelines.

Relevant to accounting is the concept of pricing and internalizing external costs, particularly on environment-related costs. Inability to price external costs remains a key barrier to further investing in more nature-positive business models due to unavailable and trusted data. Sustainable pricing has its own downsides, specifically an expected increase in the prices of goods. To consider social inequities in underdeveloped countries, some businesses are using purchasing power parity for pricing.

Reducing external costs across all levels of operations and the supply chain has a huge impact on sustainability. A circular business model, for instance, mitigates the effects of both production and consumption, including waste and resource depletion. This model seeks to recover the value of a product through recycling or reusing it. Businesses can encourage consumers to participate in the model as well, fostering a sustainable lifestyle instead of a consumerist one. Large companies have been developing circular models already. Tesco established a surplus marketplace for food suppliers to cut down on waste while Walmart created a resale marketplaces for consumers.

On the water conservation front, companies are looking to lower their water footprint. CPG companies have been exploring waterless products while agribusinesses are changing irrigation methods. In terms of social costs, businesses can enhance raw material traceability and choose suppliers that engage in fair trade to ensure compliance with labor and health regulations. Through carbon offsetting, businesses can also balance out external costs arising from operations by contributing to positive externalities.

 

Tackling external costs through analytics

The breadth of external costs of businesses can be overwhelming, and managing data on every component across the supply chain will definitely be challenging. Data and analytics helps businesses find a clear path toward sustainability goals.

With green analytics solutions, businesses can gain visibility into external costs across the value chain and identify risks and opportunities. Additionally, they can monitor net-zero KPIs aligned with SDGs on climate action, health, and energy, among others, to see areas where reduced emissions are also reducing external costs.

Clarity of purpose is good. Without clarity in where purpose is directed, however, clarity in success is not assured. Viewing sustainability from the lens of external costs emphasizes how addressing these costs is necessary for businesses to continue into the future.

Lingaro’s supply chain analytics practice provides sustainability analytics solutions that enable organizations to identify, measure, and track relevant data, KPIs, and metrics for calculating and reducing the company’s environmental and social footprint. Among these solutions are interactive reporting capabilities as well as visual reporting solutions powered by advanced analytics and cloud engineering that measure external costs across the value chain — from procurement, product packaging, manufacturing, inventory, transportation, and warehousing to logistics.

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