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.