0. Tools for Valuing Business Sustainability
Prepared for:
The Research Network for Business Sustainability
By:
Dr. John Peloza, Simon Fraser University
and
Mr. Ron Yachnin, Yachnin & Associates

1. Research Question
Identify the business tools with which managers can value the business case for sustainability. In which contexts have these tools been applied? What are the collective results?

2. Motivation Move beyond the rhetoric Hard measures for the CFO
The argument that it makes sense is no longer good enough. How does it work at my firm? How does it work in my industry? How I know when I am doing too much? Discussion of the inverted U-shape relationship between sustainability and FP is useful here (I.e., “smart zone”).

3. Systematic Review Criteria for Inclusion
Quantitative calculation of business value or process for calculating it
Time
Academic – all time periods
Practitioner – 2001+
Further detail of the search and coding process is available in the academic report.

4. Results

5. Sustainability Initiative
Stages of Metrics
Sustainability Initiative
Environmental
Social
The starting point should include a discussion of how sustainability is measured. This varies widely as highlighted in the academic report. Many studies used measures that could not be classified as either social or environmental, but rather as broad measures (e.g., DJSI which covers a wide range of issues on both fronts).

6. Results How sustainability is measured matters:
Environmental sustainability = 65% positive correlation to financial performance
Social sustainability = 55% positive

7. Sustainability Metrics
How sustainability is measured matters:
Environmental sustainability = 65% positive
Social sustainability = 55% positive
Some are outright negative:
South Africa (75% negative)
Mutual fund screens (45% negative)

8. Sustainability Initiative End State Outcome Metrics
Stages of Metrics
Sustainability Initiative
Environmental
Social
End State Outcome Metrics

9. End State Outcome Metrics
Included in 91% of all observations
Most common:
Share price (78)
ROA (26)
ROE (23)
End state metrics are presented first in order to build the mediation process later in the presentation. These metrics are also by far the most common so introducing others first doesn’t allow the presenter to talk about the complete literature at the outset which can be limiting.

10. Results
Accounting measures more positive (causality?)

11. Stages of Metrics Sustainability Initiative Environmental Social
Intermediate Outcome Metrics
End State Outcome Metrics
Market (e.g., share price)
Accounting (e.g., ROA)

12. Intermediate Outcome Metrics
Relatively rare (included in 16% of studies)
Only 9% included both an intermediate and end state measure
Most common:
Changes in cost (13)
Cash flow (12)

13. Stages of Metrics Sustainability Initiative Environmental Social
Mediating Metrics
Intermediate Outcome Metrics
Cost changes, revenue increases, cash flow
End State Outcome Metrics
Market (e.g., share price)
Accounting (e.g., ROA)

14. Mediating Metrics Extremely rare (used in 8% of all studies)
Only 3 included consideration of mediation, intermediate and end state metrics
Epstein and Roy (2001)
sdEffect (2006)
JP Morgan (2006)

15. Mediating Metrics Extremely rare (8% of studies)
When mediation is considered:
Employee related
Cultural innovation
Input/output
Reputation related
Most mediation is considered at the conceptual level (versus empirical)

16. Mediating Metrics
Very little sector specific work, more than half coming from practitioners

17. Mediating Metrics Is access to data an issue?
Mediation is examined extensively in the academic literature but rarely with financial outcomes attached
Internal measures such as cash flow are used more extensively in the practitioner literature (11 out of 31, versus 1 out of 129 in academic)

18. Practitioner Tools Some examples
Three examples have been chosen to highlight how the measurement concepts are used in practice.

19. 3 Examples SAM and World Resources Institute Citigroup
Changing Drivers. The Impact of Climate Change on Competitiveness and Value Creation in the Automotive Industry, 2003
Citigroup
Towards Sustainable Mining. Riding With the Cowboys or Hanging with the Sheriff, 2006
Yachnin & Associates, Sustainable Investment Group Ltd. and Corporate Knights Inc.
Translating Sustainable Development into Financial Valuation Measures, 2006

20. SAM and World Resources Institute
Changing Drivers. The Impact of Climate Change on Competitiveness and Value Creation in the Automotive Industry, 2003

21. Authors (Organizational)
SAM Sustainable Asset Management
“A Zurich based independent asset management company specializing in sustainability-driven investments”
Key player in Dow Jones Sustainability Indexes
World Resources Institute
“A Washington, DC based environmental research and policy organization”
SAM/WRI

22. Purpose
“to help investors make better informed decisions regarding automotive company stocks in light of emerging ‘carbon constraints’ – policy measures designed to mitigate climate change by limiting emissions of carbon dioxide (CO2) and other greenhouse gases”
“Carbon constraints could affect some of the industry’s traditional value drivers (e.g. costs and innovative capacity) and alter competitive balance”
SAM/WRI

23. Focus 10 leading automobile original equipment manufacturers (OEMs)
BMW, Daimler Chrysler (DC), Ford, GM, Honda, Nissan, PSA Peugeot Citroen, Renault, Toyota and VW Group (US, EU, JP)
SAM/WRI

24. Approach – 3 Steps
Quantify the risks associated with emerging carbon constraints in a measure of “Value Exposure”
Quantify the related opportunities in a measure of “Management Quality”
Aggregate cost estimates and management scores and express them as discounted EBIT forecasts (Earnings Before Interest and Taxes)
SAM/WRI

25. Step 1 Value Exposure Assessment
Ask
“What costs do OEMs face in meeting higher fuel economy standards in 2015, given their initial sales levels + vehicle mix?”
Recognize
The costs incurred by each OEM will vary depending on its product portfolio and the current sales-weighted average fuel economy of its fleet, and on the costs of achieving CO2 reductions for different vehicle types
Calculate/Model
The lowest-cost combination of technologies each OEM must add to its existing fleet to meet new standards (measure: additional costs per vehicle) (Key factors: 2002 sales/fuel economy + access to incremental technologies, diesel + hybrid technology)
SAM/WRI

26. Step 2 Mgmt. Quality Assessment
Ask
“Which OEMs have the strongest potential to capitalize on their investments in lower-carbon technologies and so benefit from carbon constraints?”
Recognize
OEM’s ability to capitalize on carbon constraints depends on a wide range of management attributes regarding lower-carbon technologies – not just technological development capabilities
Calculate/Model
Management quality using modified competence model developed by SAM Research (measure: SAM score 1-100) (key factor: positioning relative to ability to capitalize on various carbon technologies)
SAM/WRI

27. Step 3 Results + Implications for Valuation
Aggregate
Risks and upside strategy opportunities
Differentiate
among companies in terms of their positioning
Assess
implications for valuation by expressing in terms of discounted EBIT forecasts
SAM/WRI

28. e.g. Honda – lowest value exposure because of high fleet efficiency
e.g. Toyota – highest management quality because of strong position in technologies
SAM/WRI

29. Step 3 Results + Implications for Valuation
EBIT a foundation for valuation estimates in the auto sector
Changes in an OEM’s EBIT offer useful insights into possible changes for overall return on invested capital and thus shareholder value
Converting cost estimates and management quality scores into EBIT figures sets results in context of business performance/financial position
SAM/WRI

30. Step 3 Results + Implications for Valuation
Translation – Value Exposure
Carbon related costs ($) will increase the costs of goods sold and so reduce EBIT
VE costs integrated into baseline EBIT forecasts
Changes the rankings of companies relative to cost only rankings
e.g. BMW improves markedly – highest costs to meet carbon constraints, luxury brand has higher than average price margins and better ability to tolerate cost increases
ensures that the EBIT implications of its value exposure are less damaging than the cost-only figures would suggest
SAM/WRI

31. Step 3 Results + Implications for Valuation
Translation – Management Quality Assessment
Extensively studied but difficult to integrate into valuation models – permeates balance sheet
Possible impacts on a number of financial variables, including increases in EBIT margin, ROIC and sales – magnitude difficult to measure
To integrate MQA scores assumes OEM with the strongest management quality (i.e., Toyota) would see its projected EBIT margin increase by 20 percent, while the OEM with the weakest management quality (i.e., PSA) would see no increase
SAM/WRI

32. Significant upside effect
Upper limit = MQA alone, Lower limit = VEA alone, Point = combined impact of both assessments
Significant upside effect
The challenge for investors is to determine how the risks and
opportunities from carbon constraints will affect earnings,
return on invested capital and ultimately, shareholder value.
Consequently, we translate the results of the Value Exposure
and Management Quality assessments into changes in forecasted
EBIT (Earnings before Interest and Taxes) for the period
2003 through 2015.
❙ Converting our cost estimates and management quality scores
into EBIT figures sets our results in the context of existing and
projected business performance. The results shown in Figure B
reflect the range of possible effects on estimated EBIT, in terms
of percentage changes from business-as-usual EBIT forecasts.
The upper limits reflect the results from the Management
Quality Assessment alone, which captures the opportunity for
OEMs, while the lower limits are results from the Value
Exposure Assessment alone, which reflect risks. The points indicate
the combined impact of both assessments on EBIT. Toyota
appears best positioned, while Ford has the weakest result.
Range from +8% for Toyota to -10% for Ford
SAM/WRI

33. Citigroup Global Markets
Towards Sustainable Mining. Riding With the Cowboys or Hanging with the Sheriff, 2006

34. Author Citigroup Global Markets/Mining Group
A major New York headquartered financial services company
Among the largest companies in the world
Currently operates as Citi
Global Markets/Mining Group
Brokerage and investment analysis in the mining sector
Citigroup

35. Purpose For the mining sector:
To show that “the ‘five factors’ that make up sustainable development (SD) will affect long-term shareholder value and that those companies which are reacting most effectively to these challenges are likely to outperform”
To make investment recommendations based on sustainability-oriented analysis
Citigroup

36. Purpose
Sustainable development in the mining sector presents companies with a number of choices
Seek out low-regulation, low-cost environments for their future development – “riding with the cowboys”
Develop a new business model that places a premium on environmental responsibility and social progress – “hanging with the sheriff”
Try to operate in the old way in the new world and go out of business – “going to jail”
Citigroup

37. Focus 17 large mining and metals companies 2006
Rio Tinto, BHP Billiton, Anglo-American, Alumina Ltd., Alcoa, Newcrest, Lonmin, Xstrata, AngloGold Ashanti, Impala Platinum, Anglo Platinum, Lihir Gold, Antofagasta, Vedanta, Norilisk Nickel, CVRD, Kazakhmys
2006
Citigroup

38. Approach – 4 Steps
Sets out the five factors of SD Citigroup considers have the potential to add or destroy value for mining and metals companies globally
Develops a Sustainable Mining Index to identify those companies best positioned to create (or destroy) value based on their sustainability profile
Calculates alternative risk-adjusted discount rates based on a company’s integration of sustainability-related risk/valuation impacts
Makes investment recommendations in favour of specific companies (and in disfavour of others) based on this analysis
Citigroup

39. Step 1 – Five Factors of SD
See handout
Citigroup

40. Most companies perform well on Commodity Exposure and Country-Specific-Exposure
The bulk of the variation is on company-specific Factors such as Mine Development, HSE in Operations and Sustainable Governance
See handout
Step 2 – Mining Index
Citigroup

41. Step 3- Risk Adjusted Discount Rates
Winners and best bets are large, diversified companies = valuation upside of 23% to 30%
Traditional valuation based largely on country-specific exposure and bond indexes
Scenario analysis based on mining index builds in additional company-specific factors
Citigroup

42. Step 4 Investment Recommendations
Citigroup sees largest upside to valuation occurring for the large diversified mining companies such as Anglo American, BHP Billiton, and Rio Tinto – 23%-30%
Generally platinum companies show valuation upside while gold companies show downside
On this basis Citigroup recommends buying stand out companies BHP Billiton, Anglo American, Alcoa Inc together with risk adjusted upside in Lonmin and Impala Platinum; and selling Kazakhmys
Citigroup

43. The sdEffect
The sdEffectTM – Translating Sustainable Development into Financial Valuation Measures, 2006

44. Authors Yachnin & Associates Sustainable Investment Group Ltd.
Ottawa/Toronto based management consulting company
Sustainable Investment Group Ltd.
Toronto based consulting company
Corporate Knights
Toronto based media organization
sdEffect

45. Purpose
To translate the impact of specific corporate sustainability initiatives into financial valuation measures so that additive value (+/-):
can be demonstrated in financial terms that are familiar to and easily used by all representatives of the financial/investment community; high level integration into workings of marketplace, address externalities
can be measured, reported, compared, communicated, and… invested in in the same way as other business elements
sdEffect

46. Focus Five Canadian mining companies 2006 Alcan INCO
Noranda/Falconbridge
Placer Dome
Teck Cominco
2006
sdEffect

47. Approach SD measures from sustainability reports
Five valuation techniques
Ratio Analysis
Discounted Cash Flow (DCF) Analysis
Economic Value-Added (EVA) Analysis
Rules of Thumb
Option Pricing
10 calculations (7 SD measures) of “The sdEffect” on overall company valuation + share price (3 environmental, 2 social, 2 economic)
sdEffect

48. e.g. INCO Solid Waste Diversion
Non-hazardous solid waste is diverted from municipal landfill to company-managed tailings disposal area
Cost savings = $2.4 million per year
DCF value = $31 million
Equivalent to $0.16 per share value
P/CF value = $0.06-$0.08 per share
Lots of M&A activity in sector
CVRD
“Material”
“What’s at stake”
At the time/moment in time/static
Avoided
Risk
Cost
Tax
sdEffect

49. e.g. Placer Dome Community Involvement Programs
Community involvement and investment allow fast-tracking of expansions and permitting of new projects
Large projected fast-tracked by 1-year
DCF value of early start = $337 million
Equivalent to $0.81 per share value
5.5% equity value lift
Barrick
sdEffect

50. Conclusions Measure where impacts are expected
Environmental sustainability
Environmental initiatives can often be profitable in an of themselves (e.g., reduced waste costs) while social initiatives often rely on some reputational benefit that may need to come at the expense of some other firms. Be inclusive about measuring all benefits and expected cost centres.
Social sustainability

51. Conclusions
Research only recently considering company/firm and initiative level measures
Useful to take us beyond the generic business case argument
Mediation measures required for causality and comparison between initiatives

52. Conclusions
What do we really know about the business case?
Causality not addressed
Are measures comparable?
Need to move beyond the generic business case to specific initiatives, structures and processes to examine business case at firm and initiative levels.

53. Where Do We Go From Here?
Increased use of mediation metrics, and inclusion of all 3 types within the same case study.
More company/firm initiative specific measures are needed - collaboration between practitioners and academics.
Matching access to data with measurement and modelling expertise.
Consistency among sustainability measures. ISO? Classification of effects?
Future research directions and gaps.