Environmental capital and sustainable income in Ethiopia

ABSTRACT

Conventional GDP measurements often overlooks the significant contribution of the environment to a country’s long-term economic performance, leading to inaccurate assessments and the concealment of important environmental and economic benefits. The aim of this study is to estimate the level of environmental capital and sustainable income. To determine the contribution of environmental capital to GDP, the concept of the neoclassical growth model was used. This analytical approach begins by defining the two types of capital inputs, such as: human capital and environmental capital used in the production of final goods and services. The study found that the total share of environmental capital in GDP was 32% over the study period, while the contribution of environmental capital to gross national production fell from 39% in 2000 to 29% in 2018. The gap between GDP and sustainable GDP estimate also widened between 2003 and 2011. A comparison between GDP and sustainable GDP shows that environmental resource damage can account for up to 15.5% of GDP, leading to an overestimation of GDP. The decline in the share of environmental capital may have long-term implications for the potential of low-income countries to grow sustainably. Therefore, policymakers need to pay adequate attention to environmental capital investments to ensure the long-term sustainability of the economy. Institutions directly involved in GDP estimation also should have been transformed to a more comprehensive and environmental integrated GDP measurement.

KEYWORDS:

• Depreciation
• national income
• GDP, Environmental capital: human-made capital
• Resource Depletion

Public Interest Statement

This paper estimates the amount of environmental capital and sustainable GDP for Ethiopia using the concept of a neo-classical growth model. The study found that the contribution of environmental capital to gross national production fell during the study period, and the gap between GDP and the sustainable GDP estimate also widened. The decline in the share of environmental capital and the increase in the gap between GDP and sustainable GDP may have long-term implications for the potential of low-income countries to grow sustainably. Therefore, institutions directly involved in GDP estimation should also have been transformed to a more comprehensive and environmentally integrated GDP measurement.

1. Introduction

Ethiopia’s economy grew at a strong, widespread rate of 9.4% per year from 2010 to 2018. Most of the growth came from industry, particularly construction, and services. Ethiopia’s real gross domestic product (GDP) growth slowed to 6.1% due to ongoing political unrest and the COVID-19 pandemic (World Bank, 2023). Agriculture supports the growth of the Ethiopian economy; It accounts for 80% of export revenue and employs around 75% of the economically active workforce (Neglo et al., 2021; USAID, 2020). Private consumption and government investments are responsible for demand-side growth, with the latter playing an increasingly important role (World Bank, 2018).

Ethiopia’s GDP growth is driven by agriculture, dominated by smallholder farmers, and the services sector, which contributed 39.5% and 39% of GDP, respectively, while the contribution of the industrial sector, mainly driven by the construction sector and small processing plants with limited capital, contributes 14.6% to the GDP (World Bank, 2020) (See Figure 1 below).

Figure 1. The share of economic sectors in the GDP.

Source: World Bank (2020)

Figure 2 below shows that the agriculture and services sectors contributed equally to Ethiopia’s GDP; before 2014, the contribution of the agricultural sector was higher than that of the services sector, although the latter recorded a decline from 44.6% to 31.1%. However, after 2014, the contribution of the services sector dominated. The industrial sector contributes to GDP ranging from the lowest of 9.4% in 2012 to the highest of 27.3% in 2018.

Figure 2. Trends in the share of economic sectors in GDP.

Source: World Bank (2020)

A constant increase in the world’s population, a severe strain on land resources due to an over-reliance on food production, and a significant expansion of companies producing poisons and chemicals are leading to deforestation, excessive use of fossil fuels, and carbon dioxide emissions, which can also have a detrimental effect on the impact economic growth (Shen et al., 2021; Zhao et al., 2021), whereas effective and sustainable use of natural resources can promote economic growth and job creation (Ntanos et al., 2018). Long-term economic growth rates are also determined by labor accumulation, man-made capital, the environment per capita, and technological progress (Ntanos et al., 2018). The relationship between the economic growth rate and environmental investment spending is a critical issue that needs to be thoroughly studied (Azam, 2019; Azam et al., 2019).

As the production process increases, more energy and input materials as well as higher waste emissions can be expected. Increasing exploitation of natural resources, waste accumulation and pollutant concentrations would exceed the carrying capacity of the biosphere, leading to environmental degradation and a decline in human well-being (Arora et al., 2018; Siwal et al., 2021). The depletion of natural resources would mean the end of economic growth (Zallé, 2019). The environment has both direct and indirect effects on growth (Li et al., 2020). The direct pathway occurs when the environment provides raw materials and resources, while the indirect pathway occurs when ecosystems provide services such as carbon sequestration, water purification, flood risk reduction, and nutrient cycling between ecosystems (Crowe & Rotherham, 2019). Economic growth can be hindered by nature’s limited supply of raw materials and its limited ability to act as a sink for human pollution. As a result, excessive use of natural resources and services will ultimately endanger economic activity (Muscat et al., 2021). To protect the environment and even economic activity, economic progress must reach its full potential and the global economy must move toward a stable state (Daly, 2018).

Traditional GDP estimates have been used to assess a country’s socioeconomic well-being and appear to be a common tool for measuring economic growth (Dynan & Sheiner, 2018; Trinh, 2017). However, this national accounts-based measure of economic performance as a measure of socioeconomic well-being does not take environmental damage into account. Mensah and Ricart Casadevall (2019) explained that vital social growth includes the resources needed to repair past environmental damage or to promote conservation and improvement of the environment in the future. Most often, GDP measurement does not take into account the services that the natural environment provides for the functioning of an economic system, i.e. the human system, and is therefore aimed at a long-term unsustainable development path (Tou et al., 2019). For example, deforestation, the depletion of natural resources and the depletion of the ozone layer can have negative impacts on sustainable development and ultimately on GDP as a measure of social well-being (Brusseau, 2019). Kassa et al. (2018) have also shown that poverty leads to the depletion of natural resources and emphasize the importance of competent and effective environmental management that strikes a balance between economic growth and environmental protection. Thus, environmental quality and natural resource management are necessary not only to achieve long-term economic growth but also to eradicate poverty (Masron & Subramaniam, 2019).

Several previous studies have been conducted to examine the factors of economic growth and the relationship between economic growth and the environment. Most of them used the traditional GDP measurement as an indicator of economic growth. For example Adem et al. (2020); Mensah and Ricart Casadevall (2019);Bryant et al. (2020);Ruiz and Guevara (2020) have sought to show how the environment and economic growth are related. Kong et al. (2019); Liang and Yang (2019) and Marques et al. (2018) have also attempted to develop a context that can recognize the influence of the environment on development. Hausknost (2020) also discovered that a monotonous increase in environmental degradation along with economic growth requires strict environmental laws and even restrictions on economic growth to maintain a sustainable level of economic activity within the ecological life support system. The continuous increase in environmental degradation as a country develops shows that measures to increase economic growth also quickly damage the environment (Stern, 2017).

The prior studies on the relationship between economic growth and the environment has been conducted using the conventional GDP estimate, which ignores the various benefits that the environment can provide. The misuse of conventional GDP accelerates the use of natural resources, damages ecosystems and reduces their services (Ahmad et al., 2020). Healthy ecosystems provide essential services such as biodiversity protection, carbon storage, air purification, water quality management and flood protection, but these are not taken into account in traditional GDP (Balasubramanian, 2019). Traditional economic indicator of GDP often does not take environmental aspects into account. It focuses solely on economic performance and does not consider other factors that impact sustainability and green growth prospects. This raises questions about the effectiveness of the measurement in assessing a country’s sustainable economic progress.

Conventional GDP estimates often only reflect material and static positions and do not indicate environmental-economic connections (Giovannini & Rondinella, 2018). Sustainability of growth does not scale because it does not consider the costs of environmental degradation and public health costs that are directly related to economic activity (Rees, 2021). Furthermore, it is a poor measure of social welfare and a poor international comparison of countries’ living standards because it only records production and consumption and always improves as more valuable goods are produced (Aitken, 2019). Conventional GDP can still be used as an indicator of a country’s economic health and living standards, but it can overstate overall economic health and living standards.

The conventional national accounts-based measurement of economic success as a measure of social welfare does not take environmental costs into account. The services that the natural environment provides to the functioning of an economic system are often ignored in GDP estimates. The lack of studies measuring sustainable GDP and the need to assess environmental capital in relation to the Ethiopian economy warrant an attempt at a study. Besides, this study provides valuable insights into the development and measurement of sustainable GDP and shows how sustainable income estimates can accurately reflect the overall well-being of a society. It supports previous research and serves as a basis for future studies that use sustainable GDP as an indicator of human well-being. The study also provides an overview of Ethiopia’s economic situation, considering the influence of nature and sustainable GDP estimates. Therefore, this study aims to re-examine Ethiopia’s economic performance by estimating the level of environmental capital used in the production and sustainable income. The following critical questions were derived from the problems:

• Doe the share of environmental capital grows or shrinks over time?

• How far does the actual income differ from the sustainable income?

Finally, the content of the paper is structured as follows: in the second section, the method of the study is presented. The results and discussion are presented in section 3 and 4, respectively, and the conclusion, policy implications, limitations, and suggestions for further studies are presented in Section 5.

2. Methods

2.1. Conceptual framework

The natural environment is an important part of any economy as it provides various resources. As shown in Figure 3 below, the white inner circle represents the economy while the large gray circle represents the environment. The environment contributes a variety of goods and services to the economy. First, the environment provides a variety of raw materials such as minerals, metals, food, wood, and cotton for production and consumption by businesses and households in the economy (Worlanyo & Jiangfeng, 2021). The second task of the environment is to absorb waste products such as CO2 from companies, power plants, and families (Koul et al., 2022). The environment therefore serves as a waste sink. Waste can be solid, airborne, or watery. Third, the environment provides people with direct access to amenities such as the beauty of nature, which brings them joy and satisfaction (Ahmadiani & Ferreira, 2019). Although these amenities are not essential for survival, they provide people with pleasure and a feeling of luxury.

Figure 3. Interaction between environment and economy.

The economy has benefited from the environment with natural resources, facilities and waste absorption, but on the contrary, it releases a variety of waste emissions into the environment, which reduces the accumulation of environmental capital. The economy’s net investments also have an influence on this. Thus, by assessing only market interactions between consumers and producers, GDP overlooks changes in the natural resources upon which community survival and well-being depends. As a result, GDP not only neglects to assess important dimensions of quality of life but also encourages activities that are detrimental to long-term societal well-being. Ecosystems provide benefits such as habitat biodiversity, reducing flooding, improving water quality, and storing carbon dioxide and oxygen. However, these are not considered in market economies, leading to an overestimation of a country’s actual income, as they are not counted in GDP.

2.1. Theoretical framework

2.1.1. Estimation of environmental capital

Solow (1986) understands environmental capital as a production factor similar to human-made capital such as machinery and equipment. In this sense, the production of GDP is a function of labour, human-made capital and environmental capital. In the Solow model of economic growth, the aggregate production function of an economy is assumed to have a Cobb-Douglas form with constant returns to scale, as shown in Equation 1 below:

(1) $\mathrm{Y}=\mathrm{A}{\mathrm{L}}^{\mathit{\lambda }}{\mathrm{K}}^{\mathit{\theta }}{\mathrm{E}}^{\mathit{\delta }}$(1)

Where Y denotes the gross domestic product of an economy, which is a function of the total amount of labour (L), human-made capital (K), and environmental capital (E).

Environmental capital refers to natural resources and assets such as gold, oil, gas reserves, etc. that have been used to generate national income. On the contrary, unproven natural resource endowments were not treated as environmental capital. ‘A’ represents the technological advancement of an economy, while λ, δ, and θ denote the share of labour and human-made and environmental capital in the national income, respectively.

The labour share of national income (λ) can be computed using equation 2:

(2) $\mathit{\lambda }=\left(\mathrm{WL}\right)/\mathrm{Y}$(2)

Where w represents the shadow wage rate and L is the number of the employed labour force. Similarly, the share of human-made capital in the national income (δ) is calculated using equation 3.

(3) $\mathit{\delta }=\left({\mathrm{P}}_{\mathrm{K}}\mathrm{K}\right)/\mathrm{Y}$(3)

Where ${\mathrm{P}}_{\mathrm{K},}$ denotes the shadow price of human-made capital (the real rental price of human-made capital). Once the values of $\mathit{\lambda }$ and $\mathit{\delta }$ are obtained, the share of environmental capital ($\mathit{\theta }$) can be derived through deducting (1- $\mathit{\lambda }$ -δ) due to the assumption of constant returns to scale. Therefore, the amount of the environmental capital (E) can be estimated using equation 4 and 5 as follows:

(4) $\mathit{\theta }=\mathit{Environmental}\mathit{Gross}\mathit{Domestic}\mathit{Product}\left(\mathit{EGDP}\right)/\mathit{Y}$(4)

(5) $\mathit{EGDP}=\left(\mathit{\theta Y}\right)$(5)

2.1.2. Determination of sustainable income

A simple analytical estimate of aggregate demand is essential to determine the level of environmental capital investment required to ensure sustainable income growth. It shows a supposed functional form of aggregate demand or national production in a particular economy.

Suppose the gross domestic product and environmental depreciation cost for a given period (t) are denoted by $\mathit{GD}{P}_t$ and depreciation of environmental capital ($\mathit{DE}{C}_t$. Thus, the sustainable income of an economy ($\mathit{SGD}{P}_t$ can be defined as:

(6) $\mathit{SGD}{P}_t=\mathit{GD}{P}_t-\mathit{DE}{C}_t$(6)

Barbier and Burgess (2019) and Alexopoulos et al. (2018) argued that the adjusted value of national income can be maintained if the stock of environmental capital is not reduced and the cost of environmental depreciation is less than the rent generated by the stock of environmental capital. This stable state is one where all lost assets (e.g. human and natural capital) have been restored through investment and where positive returns net of depreciation are maintained.

Consider first the standard definition of $\mathit{GD}{P}_t$ in the context of aggregate demand in equation 7:

(7) $\mathit{GD}{P}_t=\mathrm{C}+\mathrm{I}+\mathrm{G}+\mathrm{X}-\mathrm{M}$(7)

Assume that C and I are the only variables whilst the remaining terms are constant as stated in equation 8 and 9.

(8) $\mathit{C}\mathit{\hspace{0.17em}}=\mathit{\hspace{0.17em}}\mathit{\alpha }\mathit{\hspace{0.17em}}+\mathit{\beta Y}$(8)

Where: α= autonomous consumption and β= marginal propensity to consume

(9) $\mathit{I}=\mathit{\varphi Y}$(9)

Where ϕ is the proportion of I to Y ($\mathit{GD}{P}_t$). If we assume that (α+G+X-M) is equal to a constant φ, then the definition $\mathit{GD}{P}_t$ becomes:

From equations 7 to 9, the $\mathit{GD}{P}_t$ can be restated in equation 10.

(10) $\mathit{GD}{P}_t=\mathit{\phi }+\mathit{\hspace{0.17em}}\left(\mathit{\beta }+\mathit{\hspace{0.17em}}\mathit{\varphi }\right)\mathrm{Y}$(10)

Consider now the definition of sustainable $\mathit{GD}{P}_t$, namely, ($\mathit{GD}{P}_t$ - $\mathit{DE}{C}_t$). If γ denotes the proportion of depreciation ($\mathit{DE}{C}_t$/$\mathit{GD}{P}_t$), then sustainable $\mathit{GD}{P}_t$ is computed using equation 11.

(11) $\mathit{SGD}{P}_t=\mathit{\hspace{0.17em}}\left[\mathit{\phi }+\mathit{\hspace{0.17em}}\left(\mathit{\beta }+\mathit{\hspace{0.17em}}\mathit{\varphi }\right)\mathit{\hspace{0.17em}}\mathit{GD}{P}_t\left]\mathit{\hspace{0.17em}}-\mathit{\gamma }\right[\mathit{\phi }+\mathit{\hspace{0.17em}}\left(\mathit{\beta }+\mathit{\hspace{0.17em}}\mathit{\varphi }\right)\mathit{\hspace{0.17em}}\mathit{GD}{P}_t\right]\mathit{\hspace{0.17em}}$(11)

The difference between real income and sustainable income is $\mathit{EGD}{P}_t$ i.e. $\mathit{GD}{P}_t$-$\mathit{SGD}{P}_t$. So, if an economy wants to continue benefiting from the environment, it must invest to restore all the gifts nature has provided.

2.2. Techniques of estimation and data sources

2.2.1. Methods of analysis

The study employs descriptive data analysis techniques. Graphics like as pie charts, line graphs, and tables are descriptive statistical approaches that are used to concisely illustrate the macroeconomic performance and trends of the variables under examination. Some descriptive statistics summaries, such as mean or percentage, are also provided. Finally, variable of adjusted sustainable GDP is calculated by deducting depreciation of environmental capital from the conventional GDP.

2.2.2. Data sources

The main data sources for conducting this study were the World Bank, Penn World Table and the International Labour Organization (ILO) for a period from 2000 to 2018. This study has a time series segmentation spanning 19 years from the period 2000 to 2018 (see Table 1).

Table 1. Description and measurement units of variables

Variable Name	Definition	Measurement Units
GDP	Real GDP in million	USD
C	Real consumption expenditure in million	USD
G	Real government expenditure in million	USD
I	Real Investment expenditure in million	USD
X	Volume of merchandise export in million	USD
M	Volume of merchandise import in million	USD
λ	% of labor share in the GDP	%
δ	% of human-made capital share in the real GDP	%
θ	% of environmental capital share in the real GDP	%
γ	% of environmental depletion	%
ECS	Environmental capital stock	USD
DEC	Depreciated value of environmental capital	USD

Source: World Bank, ILO and Pen World Table (2018)

3. Results

3.1. GDP components change over time

Personal consumption, gross investment, government spending and net exports are the four components of real GDP. The country’s real GDP grew from $472.465 million in 2000 to $702.9131 million in 2018. The results show that the country’s economy almost doubled over the entire research period. Consumption spending accounts for the largest share of total real GDP and follows a similar trend to real GDP. Production facilities such as capital goods and industrial machinery make up the majority of gross investment. This GDP component has been the second largest contributor to Ethiopia’s GDP since 2003 and showed an increasing trend throughout the study period. Government spending ranges from 11% in 2009 to 21% in the 2000s. The results showed that the year 2000 had the highest government spending. This could be due to the resources of the World Bank’s Structural Adjustment Program, which at that time constituted a large part of the national budget. Imports and exports have opposite effects on GDP. The country’s export volume increased until 2014 and after that it decreased, although it was higher than in 2014. This could be due to the political unrest in the country that has broken out since 2014. The country’s net trade balance, or the difference between the volume of exports and imports, was negative throughout the study period (see Figure 4).

Figure 4. Trends of real GDP and its component.

Source:World Bank and Pen Table (2000–2018)

Consumer spending accounts for the majority of GDP. Only ‘use economics’, or finished products and services, are measured by consumer spending. Average consumer spending accounted for 66% of total GDP during the study period, making it the most important economic factor. Figure 5 shows that that the lowest and highest shares of consumer spending were 63% and 80% in 2011 and 2002, respectively. Purchases from companies producing consumer goods are included in investments. A purchase that simply replaces an existing item does not contribute to GDP and is therefore not counted. Capital expenditure represented the third highest contribution to GDP before 2003. Later, the contribution of government spending was dominated by capital spending, with the largest share of capital spending occurring in 2015 and the lowest percentage in 2000. The proportion of investment expenditure increased continuously over the period under investigation. After 2003, government spending was the third largest contributor to GDP. The highest share of government spending was recorded in 2000 at 20%, while the lowest share was recorded in 2012 at 10%. The government spent more money while the economy was doing well before the recession. Ethiopia has a trade imbalance (of goods and services) with the rest of the world because it imports more than it exports. Ethiopia continues to import a large number of manufactured goods. The contribution of exports to Ethiopia’s GDP varies between 0.9% and 5%, while the contribution of imports is generally negative, with the largest import reported in 2014 at 20% (see Figure 6).

Figure 5. GDP share of each components.

Source: World Bank and Pen Table (2000–2018)

Figure 6. Over all share of GDP components.

Source:World Bank and Pen Table (2000–2018)

3.2. Estimation of environmental capital used in the production of the GDP

The computational approach specified in the research design is used to estimate coefficients for labour (λ), artificial capital (α), and environmental capital share (θ). The results in Figure 7 and Table 2 show that the average share of factors of production such as labour and human capital in Ethiopia’s GDP was 48% and 20%, respectively. Hence, the remaining 32% was provided by the environment in the form of gifts such as forests, minerals and other natural resources. The contribution of environmental endowments to gross national production fell from 39% in 2000 to 29% in 2018. However, the contribution of man-made capital to GDP has increased from 10% in 2000 to 27% in 2018 (see Figure 8).

Figure 7. share of factors of production in the GDP.

Source: Research findings, 2020

Table 2. Share of labour, human-made and environmental capital

Year	Lambda (λ)%	Alpha(α)%	Theta(θ)%
2000	0.52	0.10	0.39
2001	0.51	0.11	0.38
2002	0.51	0.13	0.36
2003	0.51	0.12	0.37
2004	0.49	0.18	0.33
2005	0.49	0.17	0.34
2006	0.49	0.19	0.32
2007	0.48	0.16	0.36
2008	0.48	0.16	0.35
2009	0.48	0.22	0.30
2010	0.47	0.22	0.31
2011	0.47	0.25	0.28
2012	0.47	0.28	0.25
2013	0.46	0.24	0.30
2014	0.45	0.27	0.28
2015	0.45	0.29	0.26
2016	0.45	0.26	0.29
2017	0.44	0.27	0.29
2018	0.44	0.27	0.29
Average	0.48	0.20	0.32

Source: Research findings.

Figure 8. Trends of environmental capital share.

Source: Research findings

3.3. Determination of environmentally sustainable income

The study used human-made and environmental capital data to calculate Ethiopia’s sustainable GDP, combining depreciation values of both. It also analysed the real GDP trajectory with the adjusted GDP, SGDP, to assess the potential sustainability of Ethiopia’s economy. The environmental costs of real GDP, sustainable GDP and depreciated environmental capital are shown in Table 3. Ethiopia’s GDP was overestimated by 15.5%, with an average sustainable GDP of $546.4353 million predicted for the study period. The study’s average excess value to GDP is $96.00982 million, based on an average environmental capital depletion rate of 15.5%. This means that GDP, which measures national well-being, was overestimated by 15.5%. This is because the real GDP calculation does not fully reflect the actual social welfare situation and the national income accounts figures are distorted.

Table 3. Environmental capital and sustainable income

Year	$\mathit{GD}{P}_t$	GNI (in million USD)	Theta (θ)%	Gamma (γ)%	$\mathit{DE}{C}_t$ (γ*GNI) (in million USD)	$\mathit{SGD}{P}_t$= $\mathit{GD}{P}_t$-$\mathit{DE}{C}_t$ (in million USD)
2000	472.465	469.0183	0.3854683	0.157688	73.95848	398.5065
2001	500.6444	497.5269	0.3791423	0.155284	77.25795	423.3865
2002	495.4428	492.0602	0.3619798	0.199872	98.34882	397.094
2003	482.5991	478.8994	0.3689697	0.312905	149.8499	332.7492
2004	545.6205	542.199	0.3280011	0.241464	130.9214	414.6991
2005	607.8424	606.0884	0.3360922	0.202184	122.5411	485.3013
2006	671.4266	669.7393	0.3243674	0.163934	109.7931	561.6335
2007	738.7218	739.2537	0.3579458	0.190903	141.1258	597.5961
2008	778.5781	779.1517	0.3544547	0.164096	127.856	650.7221
2009	751.5799	750.6149	0.3039529	0.144367	108.364	643.2159
2010	683.6947	681.223	0.3113236	0.139504	95.03342	588.6613
2011	607.8603	606.5383	0.2796412	0.153277	92.96812	514.8922
2012	616.9854	615.6151	0.2491539	0.131404	80.89409	536.0912
2013	647.0566	645.6066	0.2965844	0.123015	79.41917	567.6375
2014	680.4784	678.6088	0.2800927	0.118635	80.50675	599.9716
2015	713.0531	710.1552	0.2638395	0.108497	77.04935	636.0038
2016	742.9664	740.5396	0.2948691	0.09996	74.0244	668.942
2017	766.5281	761.9761	0.2938317	0.088529	67.45673	699.0714
2018	702.9131	699.7659	0.3256343	0.052615	36.81794	666.0952
Average	642.4451	640.2411	0.320808	0.155165	96.00982	546.4353

GNI: Gross National Income: Gross National Income (GNI) is the total amount of money earned by a nation’s people and businesses.

Source: Research findings.

The share of natural capital consumption in the production process and the level of sustainable income, considering the depreciation of environmental capital and the country’s average environmental depreciation rate, is 15.5%. This implies that environmental devaluation reduces the level of GDP. The question is: How can environmental degradation be reduced to achieve sustainable income growth? The overestimation of real GDP, which is 15.5%, suggests that the traditional measure for calculating real GDP does not consider existing environmental costs. Figure 9 shows the gap between real GDP and sustainable real GDP, i.e. the environmental costs of producing current real GDP. To maintain the current GDP estimate, investments must be made that can offset environmental costs (the average environmental cost is $96.00982 million). In Ethiopia, deforestation has been so severe over the last 40 to 50 years that forest cover fell from 40% to 3% in the early 2000s, but is now starting to rise to 5%.

Figure 9. Trends of GDP and sustainable income.

Sources: Research findings

4. Discussion

Pollution, climate change, deforestation and the degradation of natural resources are all concerns for the global economy. Previous studies have debated whether or not economic development can be achieved while addressing these challenges. Ethiopia, Africa’s second most populous country and one of the world’s fastest-growing developing countries, is grappling with reported problems of pollution, climate change, deforestation and degradation of natural resources (Dumont, 2019). Economic growth indicators include the growth rates of various GDP components and their contributions to growth. Growth rates represent the most active sectors of the economy, while GDP component contributions highlight the components that are most important to GDP growth. However, the smaller components of GDP are often the ones with the fastest growth. In this section, the study examined economic growth from the perspective of contributions of GDP components to real GDP. Figure 4 shows the trends of the various components of GDP. GDP growth is obviously driven by consumption and investment, with government spending coming third. There was a persistent imbalance between imports and exports during the study period, and the imbalance has worsened in later years.

The trend analysis found that the Ethiopian economy grew steadily over the study period, helping to reduce poverty from 44% in 2000 to 21% in 2018 (Dercon & Krishnan, 2000; World Bank, 2018). Growth is largely determined by two factors: first, the components of consumer spending and second, the amount of gross capital creation, especially since 2003. Previously, cross capital formation was the third largest contributor to GDP during this period. Household consumption expenditure is the main driver of GDP growth, with rates ranging from 63% in 2011 to 80% in 2002. Household consumption expenditure has a decisive influence on the well-being of the population. In the vast majority of developing countries it makes up the lion’s share of gross domestic product (Bonsu & Muzindutsi, 2017; Keho, 2019). Ethiopia’s average consumption spending is marginally less than Kenya’s when directly compared (Bachewe & Minten, 2019). Kenya’s average private consumption expenditure contributed 79.1% to the country’s GDP. This value peaked at 87.6% in 1995 and fell to 68.2% in 1985 (Gisore, 2020). This suggests that Kenya’s economy is much more likely to create jobs than Ethiopia’s economy. Consumer spending on final goods and services increases economic employment opportunities (Ganong & Noel, 2019). Every economy benefits from the production of goods and services that create jobs. Some jobs are created in industries that produce goods to satisfy consumer demand (final products), while others are created in industries that provide inputs to the production of final products. Until 2003, government spending was also the second largest contributor to GDP. However, measured in terms of gross fixed capital formation (GFC), investment surpassed consumption as the second largest contributor to GDP in subsequent years, accounting for at least 6% and at most 9% of GDP. However, capital formation is of undeniable importance in the process of economic growth and development and is considered a potential engine of growth (Szlaska, 2022). The share of capital formation is the lowest in the country. Capital formation determines national productive capacity, which in turn drives economic growth. A lack of capital accumulation has been identified as the greatest obstacle to long-term economic growth (Onyinye et al., 2017; Purba et al., 2019). Although capital accumulation is often seen as a way for developing countries to increase their long-term development rate, the level of Ethiopia’s capital formation, which stood at 29.4% in 2020, is very low compared to Nigeria. However, gross capital formation in Nigeria fluctuated significantly (Chancel et al., 2019). Net exports (exports minus imports) fell significantly during the study period as the country’s import volume far exceeded its export volume. Exports contribute positively to the country’s total sales and range between 1% and 5%. However, imports have a negative impact on GDP growth and have risen steadily from their low of 7% in 2000 to 20% in 2014. The imbalance of trade is the most significant component of Ethiopia’s huge current account deficit. The trade deficit has widened due to stagnant exports and increased imports (Gebreyesus & Kebede, 2017; Yeshineh, 2018). Ethiopia, like other countries in sub-Saharan Africa, has had a fairly significant trade deficit since the 1960s. Only eight countries in sub-Saharan Africa have a trade surplus, most of which are resource-rich countries such as Equatorial Guinea, Gabon, Angola and Nigeria (Coulibaly et al., 2019).

Figure 7 shows the proportion of GDP accounted for by human labor, human capital and environmental capital over the sample period. The estimated average shares of labour, human capital, and environmental capital in GDP for the study years were 48%, 20%, and 32%, respectively (See Table 2). The proportion of labour and environmental capital decreased over the study period, but man-made capital increased. It is worth noting that the country’s recent rapid growth over the last decade has resulted in the share of human-made capital in GDP output being higher than that of environmental capital. The recent increase in the share of man-made capital is associated with the rise of the service sector as well as the industrial sector as the most important sector. Over the last decade, the relatively rapid expansion of banking and financial intermediation, transportation, information and communications, and real estate has contributed to a tremendous increase in the number of human-made capital investment products entering the economy.

The average share of labour in GDP is 48% over the study period, but it also shows a declining trend. The assessment of the growth model shows that labour has a significant impact on Ethiopia’s economic growth. This result is consistent with theory and is supported by the labour’s significant contribution to GDP growth (Autor et al., 2017, 2020). Labour is by far the most important factor in producing GDP in Ethiopia. The basis of the economy is actually agriculture and services sector, both of which require large numbers of workers. Agriculture and service sectors have low capitalization and high labour intensification, which helps justify the effect of labour on production (Oqubay, 2018; Shikur, 2020). Therefore, measures such as human capital investment need to be taken in Ethiopia to improve the skills of the workforce by facilitating their access to education and healthcare. There is increasing evidence that the labour share has been declining for some time, as this study also shows (Bridgman, 2018; Dorn et al., 2017; Guerriero, 2019). Declining labour shares are often associated with serious negative consequences such as income inequality because capital is more concentrated than labour resources (Bengtsson & Waldenström, 2018; Moreira, 2022). When the negative impact of the declining labour share on private consumption is not offset by investment, governments resort to borrowing and net exports to maintain aggregate demand. This could exacerbate economic uncertainty and global inequalities.

On average, around 32% of GDP is produced by environmental capital, although this share has been declining over the study period. This finding is quite lower than that obtained in Ghana (Anaman & Agyei-Sasu, 2014). This might be due to Ghana’s natural resource endowment being substantially bigger than Ethiopia’s. The share of environmental capital in the economy may decline due to factors such as economic growth, dependence on agriculture and depletion of stocks. Agriculture, which relies heavily on land, water and forests, contributes the largest share to the economy. As the economy grows, the share of agriculture falls while industry and services increase, leading to a decline in environmental capital and rise in the share human made capital. Another potential reason could be stock depletion, i.e. the failure to restore supplies of natural resources. Ethiopia faces serious environmental problems such as climate change, land degradation, overgrazing, flooding, deforestation, and indoor air and water pollution, all of which contribute to the decline in environmental capital stock (Wassie, 2020).

People over-exploit natural resources such as forests and fish stocks and emit waste and pollution to supplement their income, and most of the time there are no alternative activities (Touza et al., 2021). For ecological sustainability, natural capital must be preserved as a source of economic inputs and absorber of the waste of economic outputs (Costanza, 2020). Resource utilization rates must be maintained within the regeneration rates at the ‘source location’(Kjaer et al., 2019). Industrial wastewater pollutants should be disposed of at the landfill site to ensure that they do not exceed the ability of the environment to absorb them without harm (Ezimah, 2021; Ola, 2019). Recent attempts to estimate the social costs of environmental degradation highlight the setbacks in valuing environmental capital. Economic analysis can help individuals understand how natural and man-made capital come together to produce valuable goods and services (Ricke et al., 2018; Spierling et al., 2018). The consumption of environmental capital, of which oil, forest and water are the most important in the process of industrial production, increases the added value of the economy (Ushakov et al., 2019). Most growing economies achieve high growth by depleting natural resources, leading to environmental degradation (Balsalobre-Lorente et al., 2018). Environmental capital is also the predominant source of income in most developed countries (Saidi & Hammami, 2017).

A comparison between GDP and sustainable GDP confirmed that environmental damage can account for up to 15% of GDP, leading to an overestimation of GDP. This suggests that there is a possibility that GDP has been grossly overestimated because conventional estimates do not fully account for environmental damage. While GDP is undoubtedly the most widely used measure of economic success, GDP adjusted for environmental degradation is definitely better. To restore the flow of goods and services into the environment, additional spending is required. These include restoring rivers, rehabilitating land unsuitable for urban or rural development and planting trees. Due to the ideal size of the state, these investments must come from the private sector. Zhang (2019) showed that environmental investments can enhance a firm’s market value by increasing the valuation coefficient, thereby enhancing profit continuity without affecting capital expenditure. The gap between actual GDP and sustainable GDP widened between 2003 and 2011. This indicates a declining share of environmental capital, and as natural capital declines, the productive base of the economy may also decline, thereby lowering the standard of living for coming generations (Kurniawan et al., 2021).

5. Conclusions

The aim of this study is to provide a long-term approach to measuring Ethiopia’s sustainable GDP. The findings revealed that labour is the largest (48%) factor of production contributing to Ethiopia’s GDP and human-created capital contributes 20%. In Ethiopia, labour is the most important factor used to generate GDP. The remaining 32% of the contribution goes to the environmental endowments. However, the share of natural resources contributes less and less to GDP over the study period. The population overuses natural resources and services (e.g. forests, fisheries, waste and pollution) to meet their income and in most cases no replacement measures have been taken. New investments are needed to restore the flow of services from lost ecosystems. This allows us to provide environmental services including river restoration, soil clean-up for urban or rural growth, and investment in tree planting, all of which have contributed to rebalancing Ethiopia’s GDP. To maintain the current flow of services from environmental foundations, various stakeholders should engage in activities such as pollution control, municipal waste treatment, maintaining the flow of surface and groundwater systems, and protecting natural resource reserves. Due to the optimal size of government, the private sector must provide these investments. Ethiopia’s natural resources declined from 31.2% in 2003 to 5.2% in 2018. The results suggest that current GDP estimates underestimate the true costs of environmental degradation and therefore GDP is likely grossly overstated. While GDP will most likely be the standard indicator of economic success, GDP adjusted for environmental capital depreciation is obviously a better measure. Traditional measures of national income such as GDP do not take crucial factors into account. This can lead to misperceptions of national well-being as well as the concealment of serious environmental problems. Institutions directly involved in calculating GDP had to shift to more accurate reporting of environmental data, thereby providing a basis for a more accurate estimate of actual national wealth.

5.1. Policy implications

Ethiopia’s goal is to transform its economy into a green, climate-resilient economy. The study therefore recommends the implementation of necessary steps to provide sufficient resources for the restoration and conservation of environmental resources as follows:

• Sustainable investment in environmental capital is critical to long-term economic success and requires the establishment of policies to promote environmental investment.

• Policymakers should pay attention to sufficient investments in environmental capital to keep the economy sustainable and compensate for existing degraded natural resources.

• Institutions involved in GDP calculations should improve their collection of environmental data to ensure a more sustainable measurement of national well-being.

• Promoting economic mechanisms such as tradable allowances and environmental taxes can help to reduce the depletion of natural resources.

5.2 Limitation and suggestion for future

Finding comprehensive data from a single source was one of the study’s constraints. In addition, it was difficult to examine long-term time series data because some variables had no information before 2000, while others had no information after 2018. Furthermore, due to lack of labour share records as well as other covariates prior to the year 2000, the study only examined 19 years of time series data. The method used also poses a problem since obtaining environmental capital data is difficult; thus, we approximated it using a constant return to scale assumption.

Future research should employ long-period time series data to validate the studies’ outcomes and use an econometrics model of forecasting, if possible. While more thorough environmental depreciation indicators would need further in-depth investigation, this study suggests that some proxy measures should be constructed using current studies and publicly available data, and that the GDP adjusted by such assessments may provide significant insights into sustainable development.

Author contribution

The author conceived the original study concept and design. He led the analysis of the collected data, prepared the first draft of the manuscript, and made extensive revisions to the manuscript. The author read and approved the final manuscript.

Disclosure statement

No potential conflict of interest was reported by the author.

Data availability statement

Data will be made available upon request to the corresponding author.

Additional information

Notes on contributors

Mohammed Adem

Mohammed Adem is an assistant professor of economics at Bahir Dar University in Ethiopia. His research interests include food security, poverty, impact assessment, resource and environmental economics, production economics, and technology adoption using econometric models.