Climate change and sustainability have become pivotal factors in companies’ long-term business, and it has become imperative to embed sustainability in business strategies and investment justifications. As a natural consequence new business models have emerged, new societal and environmental KPIs have been introduced and valuation criteria have been redefined.
Over the last years investors have increased investments in companies that have focus of sustainability in their portfolios as reported by e.g. BlackRock1. It is evident that sustainability embedded in business models and products has the potential to enhance economic growth, return on assets, return on equity, internal rate on return and lead to superior stock market performance.
New energy economy bolstered with technology
Notably, the societal demand to reduce CO2 and greenhouse gasses (GHG) have started an energy transition that will fundamentally change the energy mixture, energy distribution and energy economies towards decentralized, transaction-based and highly interconnected networks of utilities, consumer and ‘prosumers’. This new energy economy will be enabled by means of digitalization, block chain transaction technologies and computer-aided decision-making control and optimization systems. A successful transition towards a low-carbon and sustainable economy requires global coordination and collaboration at all scales between country governments, companies, educational institutions, society etc.
Sustainable investing is no longer a nice-to-have; it is an absolute need-to-have to ensure access to capital and social – and often governmental/regulatory – license to operate. Companies are increasingly defining and communicating its sustainability strategy, vision, roadmap and various low-CO2 initiatives. In addition, governments in countries world-wide are putting sustainability at the top of the political agenda and are launching initiatives on electrification of private and public transportation, transitioning to renewables, research in Hydrogen batteries and carbon capture and storage (CCS). In Europe alone, there are according to Rystad Energy around 10 large CCS projects being planned, likely to be operational by 2030 and located around the North Sea in Norway, UK, Denmark and Netherlands2.
Sustainability Drives Financial Performance
Researchers at Harvard University has shown that companies having sustainability embedded into their business strategy outperforms companies lacking the same3. Comparing 90 companies deemed “High sustainability companies” and 90 “Low sustainability companies” over 18 y period (1993-2010) revealed that the former outperformed the latter measured on different key economic indicators representing proxies for economic growth and financial leverage:
- Stock market performance: +46.8% ($1 invested in 1993 was on average $22.6 vs $15.4 in 2010) corresponding to +4.8% overperformance annually on a risk-adjusted basis.
- Return on Assets (ROA): +61.4% ($1 invested in assets in 1993 would on average have generated $7.1 vs $4.4 cumulated returns in 2010)
- Return on Equity (ROE): +23.3% ($1 invested in book value of equity in 1993 would on average have generated $31.7 vs $25.7 cumulated returns in 2010)
Another study reported that the global average internal rate on return (IRR) of energy efficiency initiatives has been 23%4. So clearly; investing in sustainable solutions, energy efficiency and low-carbon initiatives not only protects and preserve natural resources and the climate. It also drives superior financial performance.
Demands and Expectations from Shareholders
Investors are increasingly divesting in fossil fuels and investments in oil and gas related businesses are declining, while investments in sustainability are increasing. As a recent example, the private equity company HitecVison has announced that it will spend 30b NOK over the next two years on renewables5. This is partly due to the impact of sustainability on economic growth (e.g. ROE), asset values (e.g. ROA), rates on return (e.g. IRR) and financial markets as described above – and because of societal expectations. It is also likely that portfolios with more sustainability elements can reduce long-term risk exposure to investment portfolios, enhance returns and improve portfolio resiliency. BlackRock has even proposed a new investment model that include environmental, social, and governance (ESG)-optimized index exposures instead of traditional market index exposures to ensure higher returns to investors6. Moreover, initiatives to put sustainability as a central element in investment portfolio such as divesting in businesses with high sustainability-related risk (e.g. coal), thorough screening of fossil fuel investments and investing in sustainability and low-carbon companies have been accelerated to give more balanced portfolios.
Investors and financial institutions are now demanding that companies can show clear ESG policies, governance and that environmental and societal KPIs are openly reported and disclosed. It is simply a requirement to access of capital as either equity or debt.
In addition to shareholders, other non-shareholding stakeholders, including customers, employees, suppliers etc. are also demanding a sustainability focus and disclosure to assess consistency between what is said and what is done.
First step here is to have a balanced sustainable business strategy that include and balances financial and non-financial KPIs.
Environmental and Financial KPIs are Interdependent
As mentioned earlier many companies have put significant emphasis on sustainability in their communications. It is clearly acknowledged that sustainability is intimately linked to the social license to operate, to reputation and to access to human (people), financial and natural (assets) capital.
Sustainability embedded in the business strategy, models and ways of working have the potential to benefit companies in many ways. Beside the potential to increase profits and revenues and lead to superior financial growth and financial leverage measures (as described above), the recent Covid19 situation has shown that sustainability can enhance business resilience. Indeed, many companies with high focus on sustainability has increased in stock value since the outbreak of Covid19. A Harvard Business Review study also showed that during the Great Recession of 2008, US companies committed to sustainability had above average performance in financial markets (average of $650 million in incremental market capitalization) and showed less declines7.
Sustainability has other benefits that positively impacts the business:
- Sustainability drives innovation as it forces people to think differently and out of the box. When status quo is no longer an option, creativity takes over. From creativity and new ways of thinking new solutions to improve operational efficiency and cutting costs come which have direct positive impact on profit, net working capital (NWC) and productivity as well as other financial and operational key indicators.
- Sustainability forces a shift from short-term to long-term thinking and from traditional discounted cashflow analysis to more holistic valuation approaches (see below) which put emphasis on long-term business resiliency.
- Sustainability fosters collaboration. The recent Covid19 situation has also revealed that crises and fundamental societal transitions facilitate collaboration and partnerships. Businesses can no longer be seen as isolated micro-entities primarily aiming to improve own cashflows and balance sheets. Businesses are linked in a network of dependencies with shared boundary conditions and with a purpose of achieving an overarching shared goal which foster collaboration.
- Finally, sustainability has a psychosocial impact – both on employees and customers. The impact can manifest itself in talent recruitment and retention, employee satisfaction and loyalty and employee motivation and productivity. Similarly, people today buy into a purpose and a narrative of something good that transcends cash flows leading to improved revenue streams from sales and re-sales.
Sustainability has Changed Investment Valuation and Justification
With these changes, the valuation of companies and business investments justifications have become more complex. Where discounted cashflows analysis, DuPont framework analytics, assessment of historic and projected EBITDA, Monte Carlo-based scenario analytics etc. have been ways to evaluate and justify investments, an increased focus is now put on intangible assets and value. Researchers at Harvard University have recently developed a method to monetize and quantify the impact hereof8. ESG metrics are examples of intangibles that affect financial performance and should be taken into account when investing and making strategic decisions. This relates to climate risks, natural resources scarcity, CO2/GHG emissions, societal risks and opportunities, social license to operate etc.
Sustainability has impact on risk management and cost of capital: What if the societal and governmental pressure increases further to reduce CO2/GHG emissions? What if an aggressive CO2 taxation is put on emissions and oil production? What if assets become subeconomic and potentially stranded? What if the supply chain changes dramatically due to climate change? What are the implications on climate on demographics and geopolitics in a business context? – These factors have to be factored in when justifying investments.
One reason why investing in sustainability has not been favored historically is – at least partly – because of the nature of cashflow discounting-based investment justification analytics, where net present value (NPV), IRR and discounted profitability index (DPI) are evaluated. In discounted cashflow analysis, cashflows are discounted back to a present date using a discount rate to calculate time value of money. Late cashflows are discounted more aggressively than early cashflows and consequently investments with short-term profits will be favored, whereas it would be the opposite for long-term profits. Sustainability investments will often be associated with high early and thus only modestly discounted capital expenditures (CapEx), while revenues, savings, cost reductions or other impact will either be somewhat intangible from an economics point of view or come late and be discounted over many years and hence contribute little to the NPV.
The discount rate will depend on the business context uncertainty and stability, risks perceived and interest rate and is thus intimately linked to the weighted average cost of capital (WACC). While impact of sustainability is often intangible in nature, the resilience-improving and risk mitigating effects as described above can effectively reduce the WACC (compared to low-sustainability investment strategies) from its ability to de-risk projects, enhance access to capital and reduce sustainability-related risks.
Companies will have to create sustainable portfolios that are resilient to uncertainties and fluctuations and profitable. Resiliency can be taken into account by artificially imposing carbon taxation ($/kg CO2 emitted), by using a sustainability discount factor contribution linked to this specific uncertainty or by including capital, operational or asset abandonment expenditures linked to sustainability efforts or themes. Obviously, incentives, tax deductions etc. should be included as well. By proactively implementing sustainability into investment analytics and business strategies, business resiliency is ensured and impacts from new regulations or Black Swan events can be mitigated or dampened.
In my following article I will discuss ways to create a sustainable business. Watch this space for more such insight pieces that you can put into practical use.
Martin V Bennetzen
Martin is director and part of the Energy, Utility and Chemicals core team in Capgemini Norway. Martin has a background with oil and gas operations, petroleum economics, big data analytics and digitalization and has earned his PhD degree from University of Southern Denmark. Martin has worked in an oil operator company in the Qatar and Denmark and an oil service company in Norway prior to going into consultancy as has experience from day2day production optimization, master development planning and economic investment evaluation and technical/commercial due diligence. Martin is leveraging his background from oil and gas in his work on technical and economic aspects of sustainability and energy transition including renewable energy, carbon capture and storage, electrification and digitalization.
Martin has been awarded “Top 100 Business Talent” in Denmark in 2016 by the Danish Newspaper ‘Berlingske Business’ and received the EliteResearch Award from the Danish Ministry of Science, Technology and Innovation in 2010.