A New Baseline: Where do we budget from here?

Tuesday, November 17, 2020 - 14:45
AIM Blog Faculty of Finance A New Baseline: Where do we budget from here?

Creating a budget is guesswork.

This is in no way a critique of this particular financial practice or of the finance function as a whole, which requires significant expertise and knowledge from its practitioners. This is merely a recognition that budgeting requires forecasting what the future looks like, and while these predictions are based on real and objective data, they are assumptions by definition nonetheless.

If there is anything recent history has taught us, it’s that a lot of predictions that are promised to be safe and reliable end up showing that they should have been taken with a large grain of salt. If you’ve recently been experiencing déjà vu back to the 2016 US election, you fully understand this.

Now you might say that forecasting election results in the world’s most divisive nation (or accounting for a global pandemic and ensuing economic recession) is entirely different from creating an organisation’s annual budget. This is true, but much like calculating changes in climate and forecasting local weather, while they are distinct practices, the former has an immense impact on the latter. Simply look how the US Stock Market has fluctuated alongside the current election.

On the topic of climate change, that too will have significant ramifications on local, national, and global economies and all budgets will need to account for the impact of climate change to be accurate. Deloitte recently released an extensive report on how the Australian economy will shrink or grow depending on the actions we do or do not take to combat climate change. The findings of the report can be summed up as:

  • If no action is taken and climate change continues unchecked, by 2070 Australia’s economy will have shrunk by $3.4 trillion and more than 880,000 jobs will be lost
  • If Australia chooses to forge a new growth pathway that reaches net zero emissions, by 2070 our economy will have grown by $680 billion and over 250,000 jobs will be created

And here, taken from this same report, is why factors such as climate change must be taken into consideration for financial budgeting:

“The growth in the global economic system is currently contingent on emissions intensive activity…Most current economic models and their trajectories of trend growth assume unconstrained emissions. This is economic baseline on which most decisions are made – government and business alike. But this baseline does not account for the economic consequences of unmitigated climate change or the world’s response to it – both due to damages, and/or inevitable policy responses to mitigate the impacts…Understanding and accounting for the longer-term effects of climate change on productivity, potential output and economic growth is critical to knowing the path of growth.”

No matter how micro or macro a level you are looking at, modelling the future means looking back at the past to understand previous trends and create expectations, but this can lead to a damaging interpretation of status quo. Of being stuck in the negative, traditional perspective of this is how things have always been done. It is a strict fallacy to conflate what has worked previously with what works best or most accurately.

The baselines that we use to make budgets have changed before and will continue to do so. Some of the causes for future change are known, such as dramatic alterations in the Earth’s climate. Other factors are unknown or more obfuscated or less predictable. That does not make them any less real.

If tomorrow is even half as unprecedented and disruptive as so often claimed, financial practitioners and everyone else responsible for the creation and execution of budgets will have their work cut for them.