Natural capital and economic growth

(Draft version 08/31/05)

Tanja v. Egan-Krieger and Ralf Doering

Department of Land Economics
Grimmer Str. 88
D-17487 Greifswald, Germany
Tel.: +49 3834 864127 / Fax: +49 3834 864107
doering@uni-greifswald.de

Abstract
In ecological economics the term ‘natural capital’ is widely used. But it is problematic to use
an economic concept of ‘capital’ to describe ecosystems with their wide range of functions,
services and values. In the history of economic thought (especially in neoclassical economics)
the capital concept was used for manufactured capital, seldom for soil, not very often for
natural resources (renewable and non-renewable) and never for ecosystems. So especially
‘nature’ was ignored in neoclassical economic growth theory since the beginning. The same
happened with some very little exemptions in the so-called endogenous growth theory.
The paper starts with a short introduction into the history of natural capital in
economic theory (classical and neoclassical economics) and its use in modern and new
economic growth theory. Especially problematic is the homogenizing view on capital and the
use of market values as indicator of wealth (with GDP as indicator). Different from that is the
demand of a constant natural capital stock in Ecological Economics. But here again a
homogenized assumption on natural capital is problematic and the theory of funds can be used
as an alternative as the definition of natural capital by Ott & Doering shows. The use of
individual funds (not exceeding critical boundaries (SMS)) must be accompanied by
investment in other funds of natural capital. In the last section we outline thoughts on a way
forward to integrate ‘natural capital’ in economic growth theory.

Keywords: Natural capital, Economic growth theory, History of economic thought

 1. Introduction
Ecological Economists discuss economic growth as one of the main explanations for the
overuse and destruction of natural capital (NC). Two main reasons are identified: First, the
externalisation of environmental costs in growing old and new industries (Booth 1998),
second, the material throughput necessary to produce goods and services (Daly 1996, Daly
1999, Lawn 2001).
The first reason is also main area of analysis in environmental economics (based on
neoclassical microeconomic theory), by discussing incentives to internalise these externalities.
One measure to reach this is to ‘let the prices speak the environmental truth’, to increase
prices via taxes or other instruments. Problem is that many environmental problems can’t be
treated as externalities. The irreversible loss of rare species from habitat destruction, for
example, is not reparable with some money from higher resource prices. Methods to measure
the value of these rare species, to incorporate that in the calculation of costs and benefits from
a project, are problematic because of their public good character. Therefore, this valuation
often fell short. Nevertheless contingent valuation studies, for example, provide helpful
information’s how people value non-market functions and services of ‘nature’.1
The second main reason, the limitation of the resource base, was also an issue in neoclassical
economic growth models (Solow 1974, Hartwick 1977). The models predict that in the long
run there will be a substitute for every scarce resource due to rising prices. However, these
results depend on the production function used in the models. Also fast technical progress will
provide us with the instruments to reduce material input during the growth process (more
efficient use of resources). But is this optimistic view on the world really justifiable? We
believe that there is at least a big question mark behind it.
D. Pearce introduced the term natural capital in 1988 to underline the importance of nature’s
functions and services in the production process. But till today, there is only little research on
what natural capital really means. There is also still a gap why modern and endogenous
growth theory are able to ignore natural capital or to say it differently, what was the reason to
use models with a ‘one-capital-good’ economy, including everything in K in the production
function.
We try to fill these gaps a little bit by analysing, firstly, the development of economic growth
theory till today. In this process we describe the homogenizing view on capital with the
example of the modern growth theory (reasons for non-scarcity of resources) and the problem

1
Problematic is the estimation of the world’s total value of nature’s functions and services by Costanza et al.
1999 (Ott & Doering 2004).
of monetary valuation of nature’s functions and services with the example of the new or
endogenous growth theory. After that we outline the definition for natural capital developed
by Ott & Doering (2004). An outlook what this definition can mean for economic growth
theory follows.

Natural Capital in the history of economic thought

It was D. Pearce who invented the term Natural Capital in 1988. In his view natural capital is
an important part of our assets. Since then especially Ecological Economists use it broadly to
underline the importance of nature’s functions and services for human survival. Parallel to
stressing the importance of natural capital there are critical views on economic growth as
indicator for improvement in our standard of living. The criticism reflects often on the effects
of economic growth on the environment (external effects, destruction of ecosystems, etc.). For
the analysis here we choose two main problems:
1) The use of one homogenizing category of capital in economic growth theory and also the
homogenizing view on natural capital.
2) Nature’s functions and services are often not valuable in monetary terms and therefore
ignored. But results of growth models depend, for example, on assumptions on value
based price increases.

2.1. Homogenizing view on capital and modern growth theory

For Adam Smith “procuring the rude produce annually required for the use and consumption
of society” (1865: 147) was the important area for the use of capital. All other three sectors,
manufacturing, transportation and retailing, depend on it. Additionally Smith described
agricultural products as a combination of human labor and “the power of nature”, accepting
services of NC. Ricardo also pointed out: “Rent is that portion of the produce of the earth,
which is paid to the landlord for the use of the original and indestructible powers of the soil”
(Ricardo 1951: 76). So land including its services was seen as the important production factor
at that time.
From the beginning of the 19th century as a result of the technical progress in
agricultural use systems, labor and capital could be more and more invested in other sectors.
Already at this early stage of industrialization it was clear that long-term economic growth is
related to technical progress. Improvement of productivity in agriculture, often combined with
a reduced need for human labor, allowed shifting net investments from agriculture to other
sectors now responsible to generate income for the growing population.2

2
Still today one reason for the need of economic growth is related to labor saving technical progress (‘if we not
grow 2% we will have a higher unemployment rate’).
 Conversely in some sense to the assumption of the importants of land, natural products
were seen as ‘gifts of nature’. And here the classical economists are not different from Marx
or the early marginalists (Jevons 1871, Walras 1954 and Menger 1871). Marx saw thread not
used as bad cotton (Marx 2001). This interpretation of resources and the decreasing
importance of the agricultural sector in the newly industrialized countries paved the way to
the assumption that land can be combined with manufactured capital in one overall ‘capital
stock’. It was presumably I. Fisher who introduced this interpretation for the first time. He
declared all stocks, which creates a stream of wealth, as capital. There is in principle no
difference between 100 $ as a rent on land or a return on capital (Fisher 1906: 56). Also
natural (renewable) resources, as a stream of wealth from a stock, are now integrated in this
definition.3

Capital Resources
Classical Land Labor
Economists

Fisher 1906 Capital (K) Labor

Fig. 1: Capital in neoclassical capital theory

Fisher’s understanding of Capital as one homogenizing category now dominated neoclassical
and modern growth theory from the beginning of the 1940s.
Ecological Economists are not alone in criticizing this homogenizing view on capital
stocks, assuming that the human production process depend on irreplaceable goods and
services from NC. This homogenizing view is still part of an unsolved controversy in capital
theory (Cambridge Controversy with the reswitching debate (Birner 2002, Harcourt 1972)).
To this Birner (2002) commented: “… that the K of the production function that modern
economists so confidently and fully rely on for their theoretical and empirical work can only
be used in conditions where there is only a single, homogenous capital good. One does not
need to have a degree in economics to know that in reality this is not the case. (…) The fact
3
But as gifts of nature only mining or harvesting costs are matter.
that production functions with the same aggregate K figure prominently in all current
textbooks of macroeconomics is worse than curious: it is deeply worrying”.

2.1.1 Modern growth theory and the ‘Limits to growth’ debate

Modern growth theory began with papers of Harrod (1939) and Domar (1946). Fisher’s
capital definition was an integrated part of their assumptions. Stiglitz and Uzawa later
justified the one aggregated capital stock: “The economies which the modern theory of
economic growth attempts to describe are essentially advanced, industrialized economies.
Hence, capital and labour are the two inputs upon which attention is focused. Land, with few
exceptions, is ignored, but technical progress is crucial“ (cited from Luks 2001: 176). This
‘crucial’ technical progress is exogenous, means falls as ‘manna from heaven’.
Basically two types of production functions are used to describe the production
process; the CES- and the Cobb-Douglas-Production function. The latter is a special case of
the CES with an elasticity of substitution of 1 between the production factors. Because of the
determining that economic growth is related to the growth of K, objective of economic
activity is a higher production potential with more manufactured capital reflected in a growing
GDP (more consumption goods in the future).
The beginning of neoclassical (modern) growth theory is then related to papers of
Solow (1956) and Swan (1956). Solow used the Cobb-Douglas-Production function with
σ = 1 . As Lim pointed out, for developed countries this Production function fits very well for
most of the time (Lim 1996: 58ff.).
Y = K α Lβ with α + β = 1
Only the limits to growth debate at the beginning of the 1970s (Meadows et al. 1972) led to
models including non-renewable resources separately from K. One of the most important
contributions was a model of Solow published in 1974.
With some changes and supplements Solow used his originally growth model also to
describe non-renewable resources in the production process (Solow 1974a). Instead of only K
and L he included also R in his Production function.
Y = f ( K , L, R )

Systematically, Solow separated stocks of non-renewable resources now from the overall
capital stock (Fig. 2).
 Fisher 1906 Capital (K) Labor

Solow 1974
K R Labor

Fig. 2: Capital in Solow’s growth model

For simplification he assumed constant labor supply and analyzed, under which circumstances
growth is possible with a decreasing stock of resources.
Y = K α R 1−α
Assuming a Cobb-Douglas-Production function for K and R economic growth is possible
with fewer and fewer input of R. The per capita income from Y remains stable if there is
enough investment in K (respectively manufactured capital). In another article Solow stated
that a σ ≥ 1 is “the best educated guess at the moment” (Solow 1974b). But the main
problem is still, that, except he separated R from K, he changed hardly anything because of
the assumption of nearly total substitutability.4

2.1.2 Solow/Hartwick-rule
Hartwick (1977) also analyzed the conditions for a constant production level of the economy
with a decreasing availability of non-renewable resources. The afterwards so-called
Solow/Hartwick-rule demands the investment of the resource rents in substitutes.
As a basic assumption Hartwick used the Hotelling-rule, including the assumptions
that all reserves are known, all owners are price takers and that an auctioneer, knowing
everything on reserves, future demand and supply, keeps everything in equilibrium. The result
of Hotelling’s (1931) model for the optimal use of oil resources is that the resource price
increases with the market interest rate. In the case of perfect markets the resource price then
also equals the marginal productivity of the resource and the interest rate equals the rate of

4
In reality, this changed nothing at all. In the meantime there is some evidence that the elasticity of substitution
is less than 1 in many cases. For Canada a study came to the conclusion that σ = 0,25 for the substitution of
energy resources (Bataille 1998).
marginal productivity of capital. This leads, following Hartwick by using the original
production function Y = K α R 1−α of Solow, for the growth rate of Y to:
γ Y = [ s − (1 − α ) ]Y / K
The quotient Y/K is in the long-term equilibrium constant (the main result of the neoclassical
growth theory). A constant income over time is then possible with the following savings rate:
S=1-α
The investment of the resource rents in manufactured capital (= the Solow/Hartwick-rule)
guarantees constant per capital income. Income from the resource use will be replaced with
income from a growing stock of K.
It is also possible to use the Solow/Hartwick-rule in models including non-renewable
and renewable resource use. The results are similar. Investment of the resource rents from the
use of the exhaustible resource in manufactured capital; at the same time keep the input of the
renewable resource constant (Hediger 2004). So, again, the production process can go on
forever with fewer and fewer resource inputs. This raises critical questions what happens if
the elasticity of substitution is less than 1.

2.2 Monetary valuation of nature’s functions and services and the endogenous growth
theory
The second main point in this analysis is the role of monetary valuation of goods and services,
including public goods. This point is especially crucial because of the use of an indicator for
public wealth, the GDP, who demands market prices for tradable goods and services. Public
goods, including nature’s functions and services, are often not easily valuable in monetary
terms and rarely tradable on markets! Except its limited meaningfulness, because a lot is not
measurable, the GDP dominates our understanding of public wealth in the meantime.
In modern welfare economics the assumption of the highest present value of future
utility is often combined with the assumption that consuming is equivalent to gaining utility.
The indicator for future utility is then the possible amount of consumption goods in the future
(U(C(t)) in combination with GDP as indicator). Nature’s functions and services are rarely
‘market goods’ and therefore not part of the GDP. This is closing a cycle. On one side welfare
is interpreted as the amount of consumption goods measured with market prices, on the other
side natural capital, also with a lot of direct consumption qualities, is not measurable with
market prices and therefore not included at all.
Resources so far seen as free gifts are only measurable with their short-term supply
and demand dimension or with their mining costs. Again, only in their dimension as resources
sold on the world market measurable within the GDP.
 So, when in neoclassical growth theory now all is covered under one production factor
K (see Fig. 1), with the assumption that everything is substitutable within this factor, and the
problems of the GDP as an indicator for welfare this lead to a systematic underestimation of
the role of natural capital in the production process.

2.2.1 Endogenous growth theory

Over time it was clear that models in modern growth theory with their reliance on exogenous
factors, like population growth or the rate of technical progress, were not able to explain
economic growth very appropriately. However, with one overall capital stock some of these
assumptions are necessary. The development of the new growth theory led then to the
abandonment of K as the only capital good.
The new or endogenous growth theory, starting point was a paper by Romer in 1986,
identifies two other capital stocks now also responsible for economic growth and a constant
capital productivity5: knowledge (KC) and human capital (HC). Investments in education and
research generate higher growth rates and innovations lead to a constant marginal productivity
of manufactured capital. Especially this last point is also crucial for the further analysis of
natural capital in the new growth theory. If it is possible to move innovations in the direction
of technologies using fewer resources or energy it seems possible to realize ‘economic
development’ (H. Daly (1996) instead of only growth of GDP) without further loss of natural
capital. Fig. 3 (see next page) now illustrates the different capital stock used in the new
growth theory.
Still natural capital is not included as a separate capital stock in the models. Clearly a
step forward, the models in the new growth theory include other assumptions which are very
critical. Kurz & Salvadori (1994) criticize especially two assumptions:
1. The assumption of maximizing the long-term utility of an immortal individual (staying

for society) with PV = ∫ e U (C (t )) dt . Solow himself criticizes this as totally

−δt

unrealistic depending not only on the assumption of a social discount rate δ (see Ott
2003 for the problems of a social discount rate).
2. Romer (1986) used knowledge capital as the only capital stock, Lucas (1988) assumed
only human capital. Land, natural resources or labor are assumed as not scarce in these
models. Except of different capital stocks from the modern growth theory
(manufactured, knowledge and human capital instead of K), the models require also

5
Which is observable and differs from results of the modern growth theory (Y/K = const.).
 the assumption of a single capital stock.

Rents

Solow/Hartwick R K Labor

Endogenous
growth theory
R MC HC KC Labor

Rents

Fig 3: Capital in the endogenous growth theory

Additionally models with the re-introduction of other capital stock aren’t able to explain all
reasons for growth today and in the past either. The integration of services and functions of
nature and the input of natural resources is still missing (Daly 1999).
For our analysis here, so far, the use of resources and land as part of natural capital
was essential. There are now mainly two aspects of interactions of the economy with the
environment, which are analyzed in the endogenous growth theory starting in the mid 1990s:
the use of resources in the production process and the influence of pollution on economic
growth (general overview in Pittel 2002).

2.2.1.1 Endogenous growth and natural resources

In a working paper Smulders and Bretschger (2003: 1) wrote: “limited substitution of man-
made capital for non-renewable resources may be the main obstacle to sustainable
development”. This is opposite to the assumptions in the models of Romer, Lucas or Rebelo
(1991) that resources are not scarce. As solution Bretschger & Smulders used the standard
argumentation of the endogenous growth theory: “To eliminate hypothetical solutions for
substitution, we focus on market outcomes to find whether market incentives are strong
enough to produce a sustainable level of investments in knowledge capital” (2003: 2).
The result of the model is not surprising. “We have used a multi-sector framework in
which differences in substitution opportunities across sectors cause labour to move from
production to research & development when the resource stock decreases. Poor
substitutability in the sector that competes for skilled labour input with the research &
development sector turns out to be favourable for growth” (Bretschger & Smulders 2003: 19).
A little further they concluded: “strong dependence on resources in the sector that implements
the innovations is bad for growth”. Reason is a price increase for resources for this sector
when fewer resources will be available.
At the end sectors with a higher dependency on resources will close facilities and
workers will move to other sectors with less dependency like research & development. This is
a remarkable result because it predicts that economic growth may/will take place in sectors,
which use fewer and fewer resources. But it is not really a surprise. Not because of the logic
behind it, higher prices for resources will stimulate the search for alternatives, but the way
they reach this result, which depend on two crucial assumptions (Bretschger & Smulders
2003: 6-7):

1) Resource prices develop along the Hotelling-path.

2) Between skilled labour and resources they assume an elasticity of substitution of 1 by

using a Cobb-Douglas-Production function. This means nothing else as that the
research & development sector are more or less independent from resource use.
This list can be continued. They seem aware of the problem but integrated some of the
‘normal’ assumptions to get the result of possible future growth.6

2.2.1.2 Endogenous growth and pollution

A second main issue in the new growth theory is the influence of pollution. In this case
models address the negative impact of emissions on the utility function (reducing functions
and services of natural capital) or the production process. Smulder (1999a) is interested in the
relation between environmental quality and economic growth. He assumed that the level of
pollution has a negative influence on the production of final goods. For his model he used the
following production function:

Y = ( aN ℵ )( TL L ) K β ( TP P )
α ω
with α + β + ω = 1
„…where N is environmental quality, L is labour input, K is capital, P is natural
resource use or pollution, TL (TP) is labour augmenting (resource-augmenting) technological
progress, aN ℵ is the total factor productivity term that depends positively on the quality of
the environment, and α, β ⋅ and ⋅ ω are the production elasticity’s of labour, capital and
resources respectively (they are all positive)” (Smulders 1999: 4).
6
Birner (2002: 129 ff. for Levhari’s proof (Levhari 1965) that reswitching in capital theory can’t occur)
demonstrates that this is not unusual in theory development. From a certain point on economists introduce this
kind of assumptions to reach a mathematically feasible result. In some cases there is then no plausible economic
interpretation anymore. Other authors like Dasgupta (1995) or Heal (1998) use ‘heroic oversimplifications’ to be
able to stay within the neoclassical theoretical framework.
 Due to the use of a Cobb-Douglas-Production function, a constant (or increasing)
production level is possible with less and less of P. The interesting point in Smulders
argumentation is that he demands ‘investment in the environment’. These investments lead to
a lower use of a renewable resource, in this case the ability of the atmosphere to absorb
pollution. Integrated is also a consumptions function of the atmosphere. Good air quality
improves the standard of living, which leads to better results in the production sector (over the
input of L). Smulders integrated in some sense functions and services of ‘natural capital’.
However, in his analysis of different results for different cases Smulders had to use
standard assumptions at some point as well. So he assumed an elasticity of substitution of 1
between consumptions goods and ecological services “which is a necessary condition for
balanced growth to be optimal (…)” (1999: 6). Also the use of terms is not clear at every
point in the analysis. The optimal level of environmental quality is the ‘golden stock of
natural capital’.
The objective of Smulders model is to show conditions under which a society is
possibly invest in environmental quality. From there it seems only a small step to accept
natural capital as one necessary capital stock for society with a need for investment or at least
avoiding of further loss. However, Smulders only argued with the absorption capacity of the
atmosphere for pollution, in this case SO2.
A necessary condition for investments in environmental quality is a low social
discount rate and increasing productivity of the input of natural resources in sectors
responsible for pollutions. Another condition can be high amenity values for a good air
quality. Then people are willing to invest in abatement efforts. This last point is an argument
to accept also non-market values as part of the investment decisions. But it seems a little bit
grotesque, that now higher investments in abatement technology are reflected in a higher
GDP7, the better air quality not.
So far the endogenous growth theory seems to be a step forward. There are also some
models, which include many of the assumptions necessary to address the importance of
natural capital for the production process. Toman (2003) described one of these models and
necessary conditions: “The foregoing discussion of shadow prices focuses on an
intertemporally efficient program for consumption and investment. We can use the same
framework to highlight what goes wrong when market and institutional failures cause
divergence from an efficient path. Consider first the case in which environmental values are
not fully internalized in market prices. In effect, when [the shadow price for environmental
7
There are estimations that premature deaths and costs of illness grew to 20% of urban income in 11 major cities
of China (Worldbank 2000: 84).
quality] is being undervalued. Looking at the other shadow price expressions, we see that
undervaluation of the environment leads to:
- excessive investment in productive plant (…) and therefore too much final output
- under-investment in byproducts management capacity (…)
- under-investment in environmental remediation capacity (…)
- indirectly, too much natural resource extraction (…)”.
The main problem seems to be, again, ‘undervaluation’ of environmental quality. Also his
analysis of distortions in natural resource markets include many price influencing effects,
which lead to overinvestment in K and overuse of resources.
Make the prices right, set the right market incentives was Toman’s answer to solve our
problems. His idea of an investment in environmental quality depends heavily on the right
‘valuation’. The promising demand of Toman that investments in natural capital are necessary
ends with the usual assumption that our models are adequate but the circumstances on
markets are the problem. From the standpoint of Ecological Economics, assuming that we
have not a relative scarcity of resources but an absolute, this seems not adequate to solve our
problems of decreasing stocks of natural capital.

3. The Theory of Funds and a definition for natural capital

So far only aspects of natural capital are integrated in models. What follows seems to be that
to define natural capital means the two outlined problems must be avoided: a homogenizing
view on capital stock, also natural capital, and a dependence on individual monetary
valuation.
Surprisingly, Pearce and others developed in the mid 1990s the genuine savings
approach as a portfolio-perspective on all capital stocks of a society (Atkinson et al. 1997).
This seems opposite to Pearce intention with the invention of the term natural capital8 because
it’s now substitutable with manufactured capital and again only the overall, combined capital
stock (and constant utility per capita over time) is relevant. Opposite to that, Ecological
Economists propose the constant natural capital rule (CNCR) because of the dependency of
humans and the production process on nature’s functions and services.
For the analysis here we follow the strong sustainability concept with the CNCR as
basic requirement. Natural capital is now one important stock in a bundle (e.g. manufactured,
social or knowledge capital) of different capital stock.
In contrast to manufactured capital, natural capital must then be characterized with
8
This is one indication of a lack of a clear definition of Natural Capital. As Akerman (2003) rightly pointed out a
clear definition may lead the way to a better understanding of the importance of Natural Capital between
neoclassical and ecological economists.
some peculiarities:

• That it consists of living things in most parts,

• That it is not only a deliverer of goods and services but that living things are part of
complex ecosystems with a broad variety of functions and services and

• That it is multifunctional.
To address these peculiarities Faber and Manstetten (1998, also Faber et al. 1996) developed
the theory of funds. Funds provide services, material or immaterial. There is a difference
between non-living funds, like sun, air or water, and living funds, which are characterized by
their productivity and the potential to be consumed. As a third category stocks can be seen as
the usable part of living funds, replenished by living funds generating a flow of a usable
amount of individuals or materials (Fig. 4).

Natural capital
consists of

Non-living funds Living funds Stocks

functions/services

Water, air, Species, habitats Renewable and non-

sun-ray ecosystems renewable resources

replenish replenish

functions/services functions/services withdrawal (material)

Economic/Human sphere

Fig. 4: Funds and stocks

For Faber and Manstetten stocks are not the main problem, that living funds are used as if
they are non-living funds is more problematic. Normally funds have an indefinite lifespan.
Although, organisms, as small parts of living funds, die, their ability to reproduce keeps the
funds in balance. The following figure illustrates this definition of natural capital. So, capital
can be separated in stocks and funds. Natural capital consists of stocks, non-living and living
funds. Stocks are unavoidable consumed while using them. The type of use can lead to more
or less damage. Living funds regenerate themselves. Sustainable use must therefore not
exceed the rate of regeneration.
Was does that mean for our acceptance of the CNCR? It doesn’t mean that we are not
able to use stocks anymore, as some critics argue (Beckerman 1994). If we use non-renewable
resources or parts of the living funds we must invest at the same time in natural capital to
preserve the services and functions (now delivered also by other funds). This concept is
similar to recommendations demanding the calculation of shadow projects in cost-benefit-
analysis to substitute the loss of natural capital with other natural capital (Hanley et al. 1997).
We can now also integrate the important assumption of the preservation of critical
natural capital. Individual stocks can be used as long as their functions and services are
preserved. Many are essential and not substitutable, clearly visible with the extinction of
species. At some point we must stop the use of specific funds to avoid their total devastation.
At this point not costs and benefits of further use but the most efficient way to preserve the
funds is to calculate (following the concept of standards invented by Baumol & Oates 1979).
The main idea here is that natural capital consists of different funds and stocks,
avoiding seeing it as one homogenizing category either (as Neumayer (2003: p. 8) with his
definition “Natural capital (…) is the totality of nature”) as illustrated in Fig. 5 and 6.

Natural Capital

CNC

2005 ? Time t

Fig 5: Development of natural capital over time

 Natural
Capital
CNC

Stocks/Funds

Critical level

1 2 …. n Periods

Fig. 6: The theory of funds

Ott & Doering (2004) developed a definition for natural capital using the theory of funds as
background. They choose a definition of natural capital with the aim to take the specialities
into account. With this definition they rejected to abandon the term because of the problems
to use the economic concept of capital with the argument that a new term may complicate the
discussion with economists and will not lead to a better use and preservation of natural
capital. Therefore the following definition was developed:
„Natural capital consists of all components of living and non-living nature, especially
the living funds, which allows humans and sensitive animals to follow their capabilities or
which create indirect functional or structural requirements for uses in the broadest sense for
that“ (ebd. p. 213-14).
First of all the concentration of humans and sensitive animals is interesting. This
position follows the sentience position in environmental ethics. This means moral obligations
for future generations and animals sensitive to pain. We have responsibilities to preserve
natural capital because our generation is obliged to bequeath a highly structured bequest
package of capital assets (Doering & Ott 2003).9

4. What is next?
One of the aims of this paper was an analysis of growth theory having a specific
understanding of natural capital in mind. It seems obvious that the new growth theory is a real
progress, at least from the perspective of their instruments. But so far most of the models are
not reflecting the understanding of natural capital outlined in Chapter 3 (theory of funds etc.).
The difference between economic growth theory so far and the definition of natural
9
We are not able to explain the ethical background behind this definition in this paper, the capability approach of
Nussbaum (2003) and Sen (1997).
capital in Ecological Economics is the assumption of only relative scarcity in neoclassical
economics. With the theory of funds we now can integrate the absolute scarcity of individual
funds. The understanding of capital stocks in general differs now from the growth theory. Six
capital stocks can be distinguished (Fig. 7). However, there is no model with the use of six
different capital stocks.

Fisher Capital (K) Labor

Manufactured Social
Capital Capital
Endogenous
Growth theory/ Knowledge Human
Ecological Capital Capital Labor
Economics
Natural Cultivated
Capital NC

Fig. 7: Capital in Ecological Economics combined with the new growth theory
Investments in natural capital are necessary as investments are necessary in human or
manufactured capital. The shortcoming of growth models is the problem of only dealing with
individual stocks with the need to assume constancy or non-scarcity of other stocks.
To overcome these shortcomings concrete scientifically proved, discourse rational
comprehensible and political manageable targets must be set for individual funds (fish stocks,
forests products, capacity of the atmosphere to absorb greenhouse gases, etc.). It is then the
obligation for economists to find the most efficient way to keep funds above (or below) these
agreed targets. This is opposite to the assumption of total substitutability in economic growth
models and that increasing prices will eventually lead to the preservation of resources or to
the development of backstop technologies. The problem seems the switch from models with
assumption of unlimited supply of raw material to models with inputs that are really scarce,
including functions and services of natural capital.
The agreement of targets for individual funds in scientific based, discourse rational
political processes would also overcome the necessity of monetary valuation of functions and
services of natural capital to be integrated in economic calculations of costs and benefits of
projects. The project, firstly, must show that it not violate target levels, and secondly, if that is
the case opportunity costs of an investment in natural capital elsewhere must be calculated to
substitute for the loss. If costs are too high or a substitution not possible the project must be
abandoned. So the CNCR holds without demanding the preservation of the status quo.
This strategy is not without some negative impacts. Resource and energy prices will
increase, but huge investments in renewable energy sources, at the moment to see in
Germany, will help to lower the costs for these systems because of the economics of scale.
Also other energy sources, like nuclear power plants, were subsidized heavily in the past and
now the supporter of that type of energy claim low costs for their energy. The high costs of no
action in the future (like from climate change) will surely exceed these short-term costs to
switch to a different energy use system.
We use the example of investing in renewable energy systems because for us climate
change is the most severe environmental problem in this century. Every ecosystem on earth
depends on the stability of the climate, a certain range of temperature, amount of rainfall, etc.
A dramatic change as predicted if we not reduce the emissions of greenhouse gases
substantially is fatal for most of our ecosystems on land and in the marine environment.
Therefore it seems obvious that we should also try to analyze under which circumstances it is
optimal to invest in NC in the sense of substitution of fossil fuels with renewable energy
sources.

Investment in MC + NC*

MC
Savings

Firms
Rents
Production
_ C, House-
*
Y=F(K, S, R(t)) Rents holds

NC
CNC L=const.

Consists of
Renewable Non-Renewable
Resources

CNC
* e.g. Investment in renewable energy systems

Fig. 8: Investments in Natural Capital

For a model this means, that we have the input of a non-renewable and a renewable resource
at the same time. To substitute the non-renewable can mean to invest in the enlargement of
the biomass production as a renewable energy source (Fig. 8).
The idea is now to analyse the case that it is necessary to invest at least the resource
rent in natural capital, consisting of the two resource types. Hediger analyses a model with the
integration of non-renewable and renewable resources. The assumption is that, to preserve the
‘social welfare potential’ of a society, a certain level of ecological services is necessary
because of the important role of amenity and recreation services for human beings. Essential
is then that an integration of resource use and pollution damage leads to a “more conservative
use of natural resources and of the environment as receptor of pollution” (Hediger 2004: 20).
In his opinion economic growth and improvements in environmental quality are possible at
the same time. We are not sure if he’s right, but an investment in natural capital may leave us
a chance to avoid some of the costs from climate change.

5. Summary and Outlook

In this paper we analysed natural capital in economic growth theory questioning two main
assumptions: the homogenizing view on capital stocks and monetary valuation of
externalities. Since Fisher (1906) introduced his definition for capital, resources and land
were combined with manufactured capital in one capital stock K in production functions,
especially in modern growth theory. In K everything is perfectly substitutable, therefore
resources (R) are never scarce. The development of models with manufactured capital and
non-renewable resources in the 1970s (Solow 1974, Hartwick 1977) changed nearly nothing
because of the assumption of a Cobb-Douglas-Production function with an elasticity of
substitution between R and K of 1.
In the new growth theory (and ecological economics of course) this assumption of one
homogenized capital stock was abundant. K was separated in as much as 6 different stocks
(manufactured, natural, cultivated natural, social, human, and knowledge capital). However,
growth models still only include a single capital stock, Romer’s model (1986) knowledge
capital, and Lucas model (1988) human capital, for example. The few models including
resources or environmental quality still depend for solvable equations on the assumption of
economic valuation of externalities (from pollution) or rising market prices for resources. The
problem is that many of the functions and services of natural capital are public goods (like
biodiversity) and therefore no market exists to reflect increasing scarcity.
We then outlined the definition of natural capital by Ott & Doering (2004) to
overcome the homogenizing view on capital by using the theory of funds. Additionally this
definition demands the development of target levels for certain funds within natural capital.
This defined limits, or critical stocks of natural capital, most be preserved, except price
signals may not indicate scarcity. Many studies on the preservation of biodiversity shows that
opportunity costs of preservation are often low. However, it is not clear yet how the setting of
target levels may take place or what follows for economic growth from the acceptance of
absolute limits. So far, growth models are not working with definite limits. Here future
research can show if economic growth seems possible in the case of necessary investments in
natural capital like substituting fossil fuels with renewable energy sources.
This paper shows that economic growth theory so far ignores more or less resource
scarcity issues but the new growth theory gives some indication what’s necessary in the
future: more efficient use of scarce resources and investment in sectors with low resource use.
At least these two areas are worth further analysis and research. The reason why it was
possible to ignore natural capital in growth models was the assumption of non-scarcity, or in
the case of scarce resources, the use of a production function, which allows the use of fewer
and fewer resource input (Cobb-Douglas-PF). Prices of resources didn’t reflect long-term
scarcity due to uncertainties and lag of information. So the assumption of increasing resource
prices leading to substitution is to optimistic because some resources or capacities of natural
systems to store waste may be scarce, and the ability of the atmosphere to store greenhouse
gas emissions is scarce already, before the prices reflect this scarcity. Therefore it is necessary
to set limits in cases, where we depend on functions and services of natural systems like the
atmosphere, before the outcome of changes threatens human survival.
There is still a huge gap in economic growth theory when it comes to natural capital.
So far only non-renewable resources and some externalities are relevant in models. With
growing awareness of the role of greenhouse gas emissions in global warming, the loss of
biodiversity, etc. this seems far from enough. We couldn’t fill that gap in this paper, we only
tried to analyse how far growth theory gets in the case of natural capital. There is plenty of
work left.

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