Presentation on theme: "Research Question Identify the business tools with which managers can value the business case for sustainability. In which contexts have these tools been."— Presentation transcript:
0 Tools for Valuing Business Sustainability Prepared for:The Research Network for Business SustainabilityBy:Dr. John Peloza, Simon Fraser UniversityandMr. Ron Yachnin, Yachnin & Associates
1 Research QuestionIdentify 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 itTimeAcademic – all time periodsPractitioner – 2001+Further detail of the search and coding process is available in the academic report.
5 Sustainability Initiative Stages of MetricsSustainability InitiativeEnvironmentalSocialThe 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 performanceSocial sustainability = 55% positive
7 Sustainability Metrics How sustainability is measured matters:Environmental sustainability = 65% positiveSocial sustainability = 55% positiveSome are outright negative:South Africa (75% negative)Mutual fund screens (45% negative)
8 Sustainability Initiative End State Outcome Metrics Stages of MetricsSustainability InitiativeEnvironmentalSocialEnd State Outcome Metrics
9 End State Outcome Metrics Included in 91% of all observationsMost 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 ResultsAccounting measures more positive (causality?)
11 Stages of Metrics Sustainability Initiative Environmental Social Intermediate Outcome MetricsEnd State Outcome MetricsMarket (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 measureMost common:Changes in cost (13)Cash flow (12)
13 Stages of Metrics Sustainability Initiative Environmental Social Mediating MetricsIntermediate Outcome MetricsCost changes, revenue increases, cash flowEnd State Outcome MetricsMarket (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 metricsEpstein and Roy (2001)sdEffect (2006)JP Morgan (2006)
15 Mediating Metrics Extremely rare (8% of studies) When mediation is considered:Employee relatedCultural innovationInput/outputReputation relatedMost mediation is considered at the conceptual level (versus empirical)
16 Mediating MetricsVery 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 attachedInternal 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, 2003CitigroupTowards Sustainable Mining. Riding With the Cowboys or Hanging with the Sheriff, 2006Yachnin & 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 IndexesWorld 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 StepsQuantify 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?”RecognizeThe 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 typesCalculate/ModelThe 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?”RecognizeOEM’s ability to capitalize on carbon constraints depends on a wide range of management attributes regarding lower-carbon technologies – not just technological development capabilitiesCalculate/ModelManagement 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 AggregateRisks and upside strategy opportunitiesDifferentiateamong companies in terms of their positioningAssessimplications for valuation by expressing in terms of discounted EBIT forecastsSAM/WRI
28 e.g. Honda – lowest value exposure because of high fleet efficiency e.g. Toyota – highest management quality because of strong position in technologiesSAM/WRI
29 Step 3 Results + Implications for Valuation EBIT a foundation for valuation estimates in the auto sectorChanges in an OEM’s EBIT offer useful insights into possible changes for overall return on invested capital and thus shareholder valueConverting cost estimates and management quality scores into EBIT figures sets results in context of business performance/financial positionSAM/WRI
30 Step 3 Results + Implications for Valuation Translation – Value ExposureCarbon related costs ($) will increase the costs of goods sold and so reduce EBITVE costs integrated into baseline EBIT forecastsChanges the rankings of companies relative to cost only rankingse.g. BMW improves markedly – highest costs to meet carbon constraints, luxury brand has higher than average price margins and better ability to tolerate cost increasesensures that the EBIT implications of its value exposure are less damaging than the cost-only figures would suggestSAM/WRI
31 Step 3 Results + Implications for Valuation Translation – Management Quality AssessmentExtensively studied but difficult to integrate into valuation models – permeates balance sheetPossible impacts on a number of financial variables, including increases in EBIT margin, ROIC and sales – magnitude difficult to measureTo 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 increaseSAM/WRI
32 Significant upside effect Upper limit = MQA alone, Lower limit = VEA alone, Point = combined impact of both assessmentsSignificant upside effectThe challenge for investors is to determine how the risks andopportunities from carbon constraints will affect earnings,return on invested capital and ultimately, shareholder value.Consequently, we translate the results of the Value Exposureand Management Quality assessments into changes in forecastedEBIT (Earnings before Interest and Taxes) for the period2003 through 2015.❙ Converting our cost estimates and management quality scoresinto EBIT figures sets our results in the context of existing andprojected business performance. The results shown in Figure Breflect the range of possible effects on estimated EBIT, in termsof percentage changes from business-as-usual EBIT forecasts.The upper limits reflect the results from the ManagementQuality Assessment alone, which captures the opportunity forOEMs, while the lower limits are results from the ValueExposure Assessment alone, which reflect risks. The points indicatethe combined impact of both assessments on EBIT. Toyotaappears best positioned, while Ford has the weakest result.Range from +8% for Toyota to -10% for FordSAM/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 companyAmong the largest companies in the worldCurrently operates as CitiGlobal Markets/Mining GroupBrokerage and investment analysis in the mining sectorCitigroup
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 analysisCitigroup
36 PurposeSustainable development in the mining sector presents companies with a number of choicesSeek 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
38 Approach – 4 StepsSets out the five factors of SD Citigroup considers have the potential to add or destroy value for mining and metals companies globallyDevelops a Sustainable Mining Index to identify those companies best positioned to create (or destroy) value based on their sustainability profileCalculates alternative risk-adjusted discount rates based on a company’s integration of sustainability-related risk/valuation impactsMakes investment recommendations in favour of specific companies (and in disfavour of others) based on this analysisCitigroup
39 Step 1 – Five Factors of SD See handoutCitigroup
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 GovernanceSee handoutStep 2 – Mining IndexCitigroup
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 indexesScenario analysis based on mining index builds in additional company-specific factorsCitigroup
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 downsideOn 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 KazakhmysCitigroup
43 The sdEffectThe sdEffectTM – Translating Sustainable Development into Financial Valuation Measures, 2006
44 Authors Yachnin & Associates Sustainable Investment Group Ltd. Ottawa/Toronto based management consulting companySustainable Investment Group Ltd.Toronto based consulting companyCorporate KnightsToronto based media organizationsdEffect
45 PurposeTo 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 externalitiescan be measured, reported, compared, communicated, and… invested in in the same way as other business elementssdEffect
46 Focus Five Canadian mining companies 2006 Alcan INCO Noranda/FalconbridgePlacer DomeTeck Cominco2006sdEffect
47 Approach SD measures from sustainability reports Five valuation techniquesRatio AnalysisDiscounted Cash Flow (DCF) AnalysisEconomic Value-Added (EVA) AnalysisRules of ThumbOption Pricing10 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 areaCost savings = $2.4 million per yearDCF value = $31 millionEquivalent to $0.16 per share valueP/CF value = $0.06-$0.08 per shareLots of M&A activity in sectorCVRD“Material”“What’s at stake”At the time/moment in time/staticAvoidedRiskCostTaxsdEffect
49 e.g. Placer Dome Community Involvement Programs Community involvement and investment allow fast-tracking of expansions and permitting of new projectsLarge projected fast-tracked by 1-yearDCF value of early start = $337 millionEquivalent to $0.81 per share value5.5% equity value liftBarricksdEffect
50 Conclusions Measure where impacts are expected Environmental sustainabilityEnvironmental 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 ConclusionsResearch only recently considering company/firm and initiative level measuresUseful to take us beyond the generic business case argumentMediation measures required for causality and comparison between initiatives
52 ConclusionsWhat do we really know about the business case?Causality not addressedAre 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.