Natural capital - importance to the Scottish economy: research

Appendix 3: Substitution

Materiality justification provided by ENCORE allocated a materiality rating of “medium” or “high” to a subset of industry processes, at least in part, because production processes could be substituted with physical capital. Using this subset of industry processes across 48 industries, the Method 3 index was then divided into “substitutable” and “non-substitutable” ecosystem services. If the ecosystem service was considered “substitutable”, the entire materiality score was included in the substitutability proportion of the Method 3 index.

The underlying scores of this index for the 48 industries are provided in Appendix Table 3, including the number of ecosystem services that were considered partially substitutable and the total materiality score (each ecosystem service was scored out of five). The overall Method 3 materiality score (92 out of 105 for agriculture) is apportioned into the materiality of partially substitutable ecosystem services (38 out of 105 agriculture) and non-substitutable ecosystem services (54 out of 105 for agriculture).

It is only the substitutable proportion of additional Method 3 expenditure that was converted to a measure of output and applied to the output multipliers. The expenditure realised in the economy estimated from Method 2 was subtracted from the expenditure estimates used in this approach.

Using this index, approximately 26% of Method 3 uplift (£873 million of £3.3 billion domestic expenditure in Scotland) was considered substitutable natural capital expenditure. It is noted that these results should be interpreted with caution. This analysis used the ENCORE data base which was not intended to be used directly as a substitutability assessment but to serve as a proxy value for key ecosystem services. However, it used a description which can be summarised as, “although less practical, production process can take place without the ecosystem service due to availability of substitutes”, to identify the ecosystem services that were or were not considered material. The intent of this assessment by ENCORE was to provide justification for the materiality, rather than to assess the extent that industry processes are substitutes for ecosystem services.

Some methodologies in the natural capital literature, such as replacement cost methods, seek to understand the value of natural capital using the hypothetical cost of physical capital to replace those ecosystem functions. Identifying ecosystem services in the economy that could possibly be considered “substitutable” is an approach used to estimate the value of natural capital that occurs within the production boundary of the economy. However, this typically provides a limited view on the value of ecosystem services – which are highly interconnected. For example, soil quality regulation can impact the quality and supply of water resources in a given location. Therefore, it is difficult to simply ‘substitute’ the ecosystem service with built capital by assuming the ecosystem service did not exist, as replacement cost methodologies do not account for potential flow-on impacts of removing that service.