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Tools for Valuing Business Sustainability

Prepared for:The Research Network for Business Sustainability

By:Dr. John Peloza, Simon Fraser Universityand Mr. Ron Yachnin, Yachnin & Associates

www.sustainabilityresearch.org

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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?

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Motivation

• Move beyond the rhetoric

• Hard measures for the CFO

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Systematic Review

• Criteria for Inclusion

– Quantitative calculation of business value or process for calculating it

• Time

– Academic – all time periods

– Practitioner – 2001+

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Results

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Stages of Metrics

Sustainability Initiative•Environmental

•Social

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Results

• How sustainability is measured matters:

– Environmental sustainability = 65% positive correlation to financial performance

– Social sustainability = 55% positive

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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)

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Stages of Metrics

Sustainability Initiative•Environmental

•Social

End State Outcome Metrics

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End State Outcome Metrics

• Included in 91% of all observations• Most common:

– Share price (78)– ROA (26)– ROE (23)

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Results

• Accounting measures more positive (causality?)

01020304050607080

Market Accounting

PositiveNegativeNeutral

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Stages of Metrics

Sustainability Initiative•Environmental

•Social

End State Outcome Metrics•Market (e.g., share price)•Accounting (e.g., ROA)

Intermediate Outcome Metrics

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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)

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Stages of Metrics

Sustainability Initiative•Environmental

•Social

End State Outcome Metrics•Market (e.g., share price)•Accounting (e.g., ROA)

Intermediate Outcome Metrics

•Cost changes, revenue increases, cash flow

Mediating Metrics

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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)

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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)

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Mediating Metrics

• Very little sector specific work, more than half coming from practitioners

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44

3

3 Chemicals

Utilities

Forestry

Food Processing

Mining

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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)

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Practitioner Tools

Some examples

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3 Examples

• SAM and World Resources Institute– 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

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SAM and World Resources Institute

Changing Drivers. The Impact of Climate Change on Competitiveness and Value

Creation in the Automotive Industry, 2003

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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”

SA

M/W

RI

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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” SA

M/W

RI

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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)

• 2003-2015

SA

M/W

RI

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Approach – 3 Steps

1. Quantify the risks associated with emerging carbon constraints in a measure of “Value Exposure”

2. Quantify the related opportunities in a measure of “Management Quality”

3. Aggregate cost estimates and management scores and express them as discounted EBIT forecasts (Earnings Before Interest and Taxes)

SA

M/W

RI

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Step 1Value 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) S

AM

/WR

I

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Step 2Mgmt. 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)

SA

M/W

RI

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Step 3Results + 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

SA

M/W

RI

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SA

M/W

RI

e.g. Honda – lowest value exposure because of high fleet efficiency

e.g. Toyota – highest management quality because of strong position in technologies

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Step 3Results + 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

SA

M/W

RI

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Step 3Results + 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

SA

M/W

RI

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Step 3Results + 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

SA

M/W

RI

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SA

M/W

RI

Upper limit = MQA alone, Lower limit = VEA alone, Point = combined impact of both assessments

Range from +8% for Toyota to -10% for FordS

igni

fican

t up

side

eff

ect

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Citigroup Global Markets

Towards Sustainable Mining. Riding With the Cowboys or Hanging with

the Sheriff, 2006

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Author

• Citigroup– 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

Cit

igro

up

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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

Cit

igro

up

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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”

Cit

igro

up

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Focus

• 17 large mining and metals companies– 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

Cit

igro

up

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Approach – 4 Steps

1. Sets out the five factors of SD Citigroup considers have the potential to add or destroy value for mining and metals companies globally

2. Develops a Sustainable Mining Index to identify those companies best positioned to create (or destroy) value based on their sustainability profile

3. Calculates alternative risk-adjusted discount rates based on a company’s integration of sustainability-related risk/valuation impacts

4. Makes investment recommendations in favour of specific companies (and in disfavour of others) based on this analysis

Cit

igro

up

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Step 1 – Five Factors of SD

Cit

igro

up

See handout

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Cit

igro

up

Step 2 – Mining Index

See handout

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

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Step 3- Risk Adjusted Discount Rates

Cit

igro

up

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

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Step 4Investment 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 Cit

igro

up

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The sdEffect

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

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Authors

• Yachnin & Associates– Ottawa/Toronto based management

consulting company

• Sustainable Investment Group Ltd.– Toronto based consulting company

• Corporate Knights– Toronto based media organization

sdE

ffec

t

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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

sdE

ffec

t

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Focus

• Five Canadian mining companies – Alcan– INCO– Noranda/Falconbridge– Placer Dome – Teck Cominco

• 2006

sdE

ffec

t

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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)

sdE

ffec

t

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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

sdE

ffec

t

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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

sdE

ffec

t

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Conclusions

• Measure where impacts are expected

Environmental sustainability

Social sustainability

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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

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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.

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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?