Does sustainability really create value for shareholders?

* This article was written with Astrid de Reuver

Sustainability has become an increasingly important part of business practice – the UN Global Compact comprises more than 4,700 businesses committed to adopting sustainable and socially responsible policies, and to reporting on their implementation. In addition, the investment community has increasingly concerned itself with environmental, social and governance (ESG) factors - approximately 11% of assets under professional management in the U.S. – nearly one out of every nine dollars – are now linked to socially responsible investment (SRI) .

Although businesses are becoming more sophisticated at addressing sustainability issues, most social and environmental initiatives are still being made on an ad hoc basis due to the lack of tools or standards that allow corporations to measure their economic return. The current tools available to us fail to quantify the additional economic value that sustainability generates for the business. A recent survey conducted by McKinsey & Company revealed that a full quarter of CFO’s don’t know what effect, if any, sustainability has on shareholder value. The remaining percentage disagree by how much.

For the last few years, we have developed a model to support businesses in understanding their Economic Return on Social and Environmental Investment (EROSEI).

Our experience has shown that companies can create sustainable value by investing in one or more of the following areas:

1) Sustainable innovation: A clear example of this is GE’ “ecomagination” initiative. This commits the organisation to more than doubling its research investment in cleaner technologies to $1.5 billion and doubling its current annual revenues from “ecomagination” products and services to $25 billion by 2010. According to a 2008 Forbes Magazine GE’s “ecomagination” was growing at 20% per annum and had provided 5¢ of additional value per shareholder.

2) Brand Social Equity: We define this as the value of consumer preference for a brand’s social, environmental and ethical attributes in their purchasing decision. Currently, 62% of the world’s business is intangible – a significant proportion of which is comprised of brand value – and 60% of any company’s valuation is determined by its long-run or sustainable returns. According to recent trends, the social value of a company or brand is becoming a more important determinant of brand choice.

3) Mission culture: Most companies invest in creating a culture that enables respect and collaboration. However, this is no longer enough. A company must be able to inspire their staff and must convince them that its mission is worthwhile. A strong example is Patagonia whose mission is to “build the best product, cause no unnecessary harm, use business to inspire and implement solutions to the environmental crisis”. While industry-wide employee turnover is 20%, Patagonia’s turnover is 4.5%.

4) Character-based governance: In “Good to Great”, Jim Collins argues brilliantly that successful businesses are characterised by leaders that have both personal humility and professional will. According to Collins “these are not rock-star leaders whose companies go into decline when they move on. They are diligent and hard working - more bite than bark. Celebrity leaders often work for a time, but appear to be damaging in the long run, because they don’t create sustained results”. At the time of the study companies with character-based governance had 6.9 times greater average returns than the market.

5) Risk and opportunity management: Walkers Crisps turned a risk - climate change - into an opportunity. Using Life Cycle Analysis, Walkers Crisps identified cost savings of £1.2m p.a. while being able to reduce 28,000 tonnes of CO2 p.a.

6) Shared value engagement: Many issues related to sustainability are too complex for one organisation to address individually. That’s why a business must be willing to work with multiple stakeholders and share the benefits. There are now numerous initiatives where competitors are sharing information in order to address topics such as climate change (i.e. transportation issues) or supply chains (i.e. social auditing). Companies must also proactively engage stakeholders in order to remain credible.

Building on SAM’s financial valuation model , the sustainability initiatives within these areas can then simply be integrated into a traditional valuation approach. The question is how might companies manage sustainability trends and challenges in their respective sectors – factors that ultimately play a key role in a company’s costs of external financing, return on invested capital, sales growth and sustainable competitive advantage.

In order to test our case for using financial modelling skills that every CFO will turn to when making important investment decisions, we built a basic discounted cash flow (DCF) model and used a midsize UK-listed company as a case study (for more detail see end of article). Keeping ‘base case ’ assumptions constant, we then evaluated the impact specific ESG initiatives could have on the market value of the business. For this summarised article we consider four possible scenarios:

1) Eco-efficiencies: the company is committed to absolute energy reductions of 10% by 2020

2) Cost of debt: although this is an area continuously up for debate (see end of article for more detail), we believe there is opportunity to influence the cost of debt and equity through proactive engagement and dialogue with both debt and equity holders. For the purpose of the model, we have only assumed a lower cost of debt (through more active engagement of the senior debt holders) and kept this at a maximum of 30 basis points at the most (i.e. 0.3%) – this will then impact the WACC (weighted average cost of capital).

3) Packaging reduction: annual cost savings due to a single 50% cardboard usage reduction for in-store display for one of the brand’s of the company

4) Revenue uplift from cause related marketing (CRM): a strong CRM campaign that will drive an increase in sales of 5% for the brand in year 1 with subsequent trickle down effect of 1.7% for the years 2-4 yrs (the business is 30% of sales of the total company)

Based on our model (and the assumptions made), the market value created through these four initiatives would be £204m (on a total market value of £12.5 bn). Two conclusions can be drawn from this:

Sustainability does pay: The model demonstrates that ESG initiatives can create additional value to shareholders. Although the market value created in our model is a small percentage of the total, the initiatives we considered were not pushing the boundaries of strategic innovation where we believe significantly more value can be created. In addition, we took a very conservative approach in our assumptions.

Better decision-making: Historically, companies have many ways to value the return of economic investment in their business. For ESG factors this has proven to be much more difficult. Although there are many assumptions underlying our model, and there is still a long way to go to refining those assumptions more accurately, this case study shows that CFOs can simply use the traditional financial tools to optimise investment decisions for ESG initiatives. In our EROSEI model, for example, we learned that revenue-generating initiatives created more value than the cost saving measures. This will, of course, differ depending on the industry, so the model can support decision making in this area by directing investment towards the most value-generating opportunities.

Note:

DCF: To attempt to quantify the possible shareholder value a company can expect to create through investing in ‘sustainability’ risks and opportunities, we use the very mainstream method, the discounted cash fow (DCF) model, to analyse the potential for value creation. As a case study, we use a midsize UK-listed company of which reasonable coverage is available. We then use the assumptions about the business’ future projections provided in a Morgan Stanley Report, extrapolated for 10 years explicitly and assuming a FCF growth rate of 0% after that into perpetuity.

Lowering the cost of debt: Although this is an area where the theory would suggest it is impossible to lower the cost of capital through improved engagement and governance, we believe better communication and engagement of senior debt holders can increase their confidence in the capability of management to manage the risks for the business in the long term. Therefore, the business could willingly demand a lower risk premium for their debt. For example, investors will be more willing to invest in a company that is prepared to address any business discontinuity that can result from climate change.

Can businesses really improve the quality of life of the poor?

In a 2002 article, C.K. Prahalad and Stuart L. Hart argued that businesses could sell to the poor and help them improve their lives by “producing and distributing products and services in culturally sensitive, environmentally sustainable, and economically profitable ways” .

The authors believed that doing businesses with the world’s 4 billion poorest people living on less than US$2 per day (two-thirds of the world’s population) would require innovations in technology and business models.

Four years later, in his paper “Fortune at the Bottom of the Pyramid: A Mirage How the Private Sector can Help Alleviate Poverty”, Aneel Karnani challenged Prahalad’s and Hart’s thinking. Karmani pointed out that some of their argument was based on flawed empirical evidence and that some of the case studies referenced in the article were not actually benefitting the poor. Karmani argued that the emphasis should not be in selling to the poor bur rather enabling them as producers or employees. He concludes, “the only way to alleviate poverty is to raise the real income of the poor”.

Despite some of its flaws, Prahalad’s and Hart’s Bottom of the Pyramid (BoP) thinking - or Inclusive Businesses as some organisations might call it - has been adopted by many businesses around the world and is being promoted by institutions such as The World Business Council for Sustainable Development, The Word Resources Institute, The World Bank, and The United Nations.

As with any management approach, no one size fits all and for this reason the purpose of this paper is not to discuss the failings of BoP but rather to examine case studies that have improved the living conditions of the poor and identify the factors that have enabled their success.

Amanco

Amanco is a Latin American leader in the production and marketing of integrated solutions for the construction, infrastructure and irrigation industries.

In 2003, the President of Grupo Nueva (Amanco’s holding company at the time), Julio Moura, proposed that 10% of the firm’s turnover should originate from the low-income market segment, and for this to increase to 15% by 2010. Not only was this morally right but also important if the company wanted to grow its customer base .

In 2003, a competition was organised, in which employees were encouraged to come up with a business plan aimed at the low-income segment. The projects had to be innovative and economically sustainable.

The result was the design of a drip irrigation system that would meet the needs of small-scale farmers in Guatemala and that would use water more efficiently. This was particularly important for this country as in Guatemala 87% of the poor population depend on agriculture as the main source of employment .

AMANCO then partnered up with Guatemala’s Ministry of Food, Agriculture and Livestock, who agreed to finance the installation of the drip irrigation systems and provide technical assistance and training programmes .

According to Ethical Corporation Magazine, after only one year of the project’s implementation “participating farmers have cut labour costs by an average of a third and have seen their water use halve during irrigation. Improvements in production (up by over a fifth) and quality have translated into long-term contracts with foreign buyers and, in turn, increases in the standard of living. Farmers’ incomes have doubled to about $1,950 a year, enabling them to integrate into the formal economy and to pay for their children’s schooling” .

For its part, AMANCO estimated that for Latin America as a whole, by 2015 annual sales could total 14,000 irrigation systems with a total value of US$28 million. Not bad considering that the irrigation systems’ estimated gross margin is estimated to be around 31% .

Danone

In 2005, Professor Muhammad Yunus, the founder of Grameen Bank met with Franck Riboud, the chief executive officer of Groupe Danone. Yunus proposed to form a joint venture between Grameen and Danone with the objective of supplying nutritious food to poor children of Bangladesh and alleviate poverty through the implementation of a unique community based business model.

Accordingly, the two men entered into an agreement to form a company called Grameen Danone Foods. Today, Grameen Danone Foods produces a special yogurt called Shaktidoi from pure full cream milk that contains protein, vitamins, iron, calcium, zinc and other micronutrients to fulfil the nutritional requirements of children of Bangladesh and contribute in improving their health. The price of each 80 gram cup of yogurt is about €0.05; an affordable price even for the poor.

Grameen Danone Foods is helping to reduce poverty by creating business and employment opportunities for local people since raw materials including milk needed for production, are sourced locally. The companies that make up Grameen Danone Foods have agreed not to take out any of the profits out of the company. Instead they invest these for creation of new opportunities for the welfare and development of people. For this reason the venture is referred to as 'social business enterprise'.

The whole of the production and distribution system of Grameen Danone Foods has been constructed with the clear objective of creating as many jobs as possible within the local community. Use of machinery is kept to a minimum in its factory plant in order to promote the use of labour which should mean that the plant will be able to employ 50 full-time workers within four years.

Grameen Danone Foods also relies on developing micro-farms which supply the raw materials (milk, sugar, date molasses) used to produce Shaktidoi. Local farmers also benefit from micro-credits offered by the Grameen Bank to start up or expand their businesses, while Danone provides its expertise to help farmers improve the quality of their production. Lastly, Grameen Danone Foods has created an original distribution system based on the so-called "Grameen Ladies" who, supplied by small wholesalers, make sales door-to-door. This activity should provide income to more than 1,600 persons within a radius of 30 km around the plant .

Mi Farmacita Nacional

Mi Farmacita Nacional is a for-profit, Mexican owned pharmacy franchise with a social imperative. The company’s mission statement is "to bring medicines and special services to the regions of most necessity in the Mexican Republic and to provide health, well-being, communication and accessible prices to the majority of homes."

Mi Farmacita was established in Tijuana, Mexico, in 2003, and employs a classic franchise business structure. As of March 2007, Mi Farmacita had established 57 franchises in over 15 Mexican states.

In Mexico, low-income communities often have no convenient access to quality, affordable medicines or doctors. This is due to inefficiencies in Mexico’s healthcare system. It is estimated that 52.9% of total health spending in Mexico is out‐of‐pocket, compared to 19.9% in the US and 25.9% in Colombia. An estimated “2 to 3 million households in Mexico spend more than a third of their income on healthcare each year‐‐an expenditure that can easily lead to or exacerbate poverty” .

Mi Farmacita tries to close this gap by selling certified generic medicines for common illness such as cold, flu, allergies and pain relief. The majority of Mi Farmacita medicines are sold at a price of over 50% less than the prices of comparable patented, name brand medicines . In addition, many franchises offer doctor consultations for only US$2, where customers may receive basic check‐ups and prescriptions.

Lessons

As demonstrated above, BoP initiatives can improve the quality of life of millions of people. However, there are certain conditions that need to be fulfilled in order for this to happen. These are:

• Job creation: Prahalad, Hart and Karmani all agree that in order to meet the needs of the poor, businesses need to develop new and innovative business models. In order for this to happen, the poor need to be empowered and be integrated into the firm’s added value chain. These could be in the form of producers, suppliers, employees, or distributors. For those that advocate that the poor should be seen as a market opportunity then this is even more relevant as distribution of products and services in remote areas would be difficult to achieve without them. More importantly, as with any other customer, the poor need to be consulted in order to understand what their real needs are.

• Productivity: Products or services designed for the poor should focus primarily on helping them increase their productivity and, thus, their disposable income.
• Lower prices: By definition BoP products and services need to offer lower prices than existing alternatives. Some argue that this will help the poor as they will be able to save a higher percentage of their disposable income. However, it is likely that if a non-essential item such as a flat screen TV is offered at a lower price, this will result in the poor spending their savings, as they will still need to purchase essential items such as food. This would be counterproductive since those savings should be used for productive means.

• Access: BoP initiatives should also provide access to basic services such as education and health. Seventy-three million children around the world are not attending primary school, and more than 500,000 women still die during pregnancy, childbirth or in the six weeks after deliver . These numbers, as well as the Mi Farmacita Nacional case study, suggest that businesses can have a roll in development, particularly in countries where the government does not have the resources to guarantee basic Human Rights.

To conclude, BoP initiatives do have the potential to improve the quality of life of many people around the world. These can be by generating new employment opportunities, enabling entrepreneurs, facilitating access to basic services, or lowering prices. Companies that look at the BoP as a market should make sure that by doing so they will be raising the disposable income of the poor. Otherwise they will be accused of profiteering at the expense of the poor.

Should we be optimistic?

I was recently asked by my colleagues to share some thoughts on optimism with the rest of our community. Optimism is one of our community values and plays an important role in our work.

It is this value that tells us that no matter the difficult times we will accomplish our objectives. Since we work everyday to solve complex issues such as climate change, poverty, inequality, etc., we must believe in this value. Otherwise, we might as well stop what we are doing and look for a more lucrative career.

But this is not the case. Optimists believe in success and share a passion for a better world. Where others see darkness, we see opportunity. While others might be concerned about an economic recession we see a renewed focus on human development. While other think money we think happiness. While others prefer continuity we embrace a period of enlightenment.

More importantly, optimists believe that this world is the best possible word. Consider just the following:

According to The Centre for Systemic Peace, today there are less wars between countries than 40 years ago.

Johns Hopkins University estimates that civic society (including volunteer contributions and the non-for-profit sector) accounts 5.0% of global GDP. Compare this to the 5.6% contribution by the financial services sector.

CourhSurfing, a site that allows people to offer strangers accommodation for free has become the most visited hospitality service on the Internet, averaging more than 30 million daily page views in July 2008. According to its creators, 99% of experiences turn out to be positive.

The happiest countries, according to The New Economic Foundation, are developing countries. Further research suggests that happiness can’t be bought.

The proportion of children under age five who are underweight has fallen in the last 10 years all around the world.

Total net enrolment has increased in primary education since 1991 in all regions of the world.

These facts give us hope. Hope in our future and hope in the goodness of human kind. When it comes to choosing between darkness or lighting a candle, which one will you choose?