Tools for Valuing Business Sustainability

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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
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?)

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Stages of Metrics

• Sustainability Initiative
• Environmental
• Social

• Intermediate Outcome Metrics

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

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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

• Mediating Metrics

• Intermediate Outcome Metrics
• Cost changes, revenue increases, cash flow

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

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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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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

SAM/WRI
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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
  industrys traditional value drivers (e.g. costs
  and innovative capacity) and alter competitive
  balance

SAM/WRI
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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

SAM/WRI
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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)

SAM/WRI
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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)

SAM/WRI
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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
• OEMs 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
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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

SAM/WRI
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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
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Step 3Results Implications for Valuation

• EBIT a foundation for valuation estimates in the
  auto sector
• Changes in an OEMs 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
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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

SAM/WRI
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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

SAM/WRI
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Upper limit MQA alone, Lower limit VEA alone,
Point combined impact of both assessments
Significant upside effect
Range from 8 for Toyota to -10 for Ford
SAM/WRI
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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

Citigroup
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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

Citigroup
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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

Citigroup
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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

Citigroup
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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 companys 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

Citigroup
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Step 1 Five Factors of SD
See handout
Citigroup
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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
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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
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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

Citigroup
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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

sdEffect
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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

sdEffect
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Focus

• Five Canadian mining companies
• Alcan
• INCO
• Noranda/Falconbridge
• Placer Dome
• Teck Cominco
• 2006

sdEffect
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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)

sdEffect
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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

sdEffect
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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

sdEffect
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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?