Accounting for Externalities > Economy > Social cost and time

In science, there is often a time lag between perception, theory and experimentation. The EPR paradox, formulated by Einstein, among others, in 1935, highlighted an apparent inconsistency between one of the results of quantum mechanics and the principle of relativistic causality. In 1965, Bell, thanks to his inequalities, opened the way to an experiment to validate (or invalidate). This finally led, in 1981, to Alain Aspect’s experiment validating the absence of a hidden variable in quantum theory. So 46 years passed between the perception and the experimental validation of a theory. Thus progress is measured on the basis of two drivers: time and action.

In the field of risk prediction this is particularly true. But contrary to physics, where the gap between perception, theory and experimentation is, in general, due to a gap between thought and technology, the gap observed in risk measurement is inherent.
Let’s look at the impacts on the balance of externalities.

In accounting, it is possible to record two types of transactions: transactions that have taken place and are evidenced by an accounting document, and past events, or provisions, that concern past events, but whose timing or amount are not fixed. This is appropriate: many externalities are incurred before the precise date or impact of the external event has been determined.
They reflect probable expenses that should be related to the accounting period in which they arise in order to obtain a result that is as accurate as possible (principle of prudence). Provisions represent a probable loss or gain that is not definite but can be estimated
They must be valued according to the information available, and may therefore evolve until the facts are established: time affects the value.

In the case of measuring externalities, the aim is to measure external and indirect effects in advance.
Where the measurement of provisions concerns the private impacts (costs) of the company, the measurement of externalities is based on social costs and external effects:

There are therefore four major differences between a future externality and a provision:

  • the anticipated effects are relative to social (external) costs, the provision(s) are relative to private costs,
  • the evaluation of the (standard) social costs is not the responsibility of the company,
  • the mechanisms that lead to these social costs are more complex and more uncertain,
  • the consequences are on much longer time horizons,

This volatility, induced by revaluations, is a first barrier to internalization, and therefore a first reason to distance oneself from the concept of provision when talking about externalities. We will not go into further detail on this point, which we will have the opportunity to develop in greater detail in a later chapter. Nevertheless, this allows us to highlight the non-miscibility of the concept of externality in standard financial statements such as the balance sheet, for one reason: the effect of time on value.

Unlike the accounting event, which is fixed and can be traced over time, social costs can evolve as knowledge progresses and as innovations allow past effects to be absorbed.
To illustrate this point, let us take the carbon market, which applies to emission rights traded between firms. Let us assume that the price driver in this market is only the externality of a ton of carbon (not the case, as described in the previous article, but a simplifying assumption for the purposes of this example).

Let us assume on this basis that there can be two possible events:

  • evolution and confirmation of knowledge about the greenhouse effect and its consequences,
  • innovation allowing to reduce the quantity of greenhouse gases in the atmosphere,

Concerning the evolution of knowledge, this can be the discovery of a feedback loop in the CO2 cycle, or in the dynamics of marine currents that regulate our climate. Let’s imagine that these discoveries increase future externalities. What happens to the past amounts of CO2 released by the company?
Since the carbon cycle is long, it is highly likely that this carbon dioxide is still present in the atmosphere. It is therefore necessary to re-evaluate the resulting externality on the basis of past releases.

Concerning innovations, we can also consider innovations that allow to trap carbon dioxide with a social cost lower than the social cost of the consequences of global warming (not likely for energy reasons and dissemination of CO2 in the atmosphere). Therefore, the cost of implementing the innovation comes to substitute the social cost of the impacts of global warming. Once again, the life span of carbon dioxide in the atmosphere being very long, it is very likely that it is still in the atmosphere, and consequently that the social cost decreases and is in absolute terms a superposition of the real effects and the cost of implementing the innovation.

In both cases, it is therefore necessary to be able to evaluate the social costs on the basis of the knowledge accumulated on the subject. These developments are not the fault of the company, but of the public bodies in charge of evaluating social costs, and do not call into question the ethics of the company (as might be the case for a provision). Finally, it is necessary to always keep the basis for calculating the social costs (volume), in order to be able to evaluate the consequences as knowledge advances. Where the provision is generally confirmed by a court decision, the externality can be confirmed by science and progress: systems that are more inert and much less predictable than justice.

Nevertheless, science is a priori much less refutable. It is therefore necessary to be able to integrate future effects that would not have been accounted for in past generative events: a constant revaluation.
This constant revaluation is not in contradiction with accounting, which, via the principle of fair value, advocates the revaluation of assets by their market values, a market that sets its price according to the knowledge it possesses.

A certain prediction is based on absolute knowledge that does not exist. Nevertheless, it is progressing. This progress must therefore be integrated over time into the balance of externalities. Heisenberg, one of the fathers of quantum physics and its uncertainty principle summarized: “Even for the physicist, the description in plain language will be a criterion of the degree of understanding reached”. A simpler way would be to say that only time mixed with action allows progress.

The other maxim could be “Time is wise, it reveals everything” (Thales)

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