Sustainability assessment models and systems

24th June 2007

While environmental issues continue to rise up the corporate agenda, so does the importance of adopting financial analysis techniques for assessing sustainability issues. Models or framework are needed that enable valuations of corporate sustainability to be systematically and accurately made, and that also measure the impact of sustainability on a company's financial performance. Nicky Leahy, FSN senior writer looks at some of the current options.

 

 

Environmental Systems Cycle

Management accountability systems can be designed to capture and measure sustainability data such as the company's main environmental impacts. Targets and appropriate actions can then be set for their reduction. Sustainability frameworks or models enable the incorporation of environmental performance measures into strategic management and operational monitoring. Such systems recognise that there may be no overall optimum solution to highly complex environmental and sustainability issues, but that it is possible to adopt a course of action that minimises the impacts to the environment, as well as to the company's economic performance.

Sustainability assessment modelling was developed in the UK by BP, in association with the University of Aberdeen , as a full cost accounting approach to make previously external environmental costs more central to corporate decision making.

BP's environmental impact data incorporated in the model was drawn from specific project activities, such as volumes of water used, waste produced, hours worked. It was then aligned to financial performance estimates. Costs of environmental damage caused by BP's economic activities were categorised and included damage and operational cost estimates from output of emissions and from wastes created.

Analytical Frameworks for Financial Evaluation of Environmental Impacts

A more inclusive and up to date analytical framework for translating sustainability objectives and environmental impacts into financial valuation measures has been recently developed by Yachnin & Associates ( Yachnin & Associates, Sustainable Investment Group Ltd & Corporate Knights Inc. 2006).

This framework, entitled The sdEffect ™: translating sustainable development into financial valuation measures comprises seven key steps which are:

  1. identify the environmental metric to be analysed
  2. establish the scope of the metric, including
    • operations that are to be reviewed
    • factors which are material
    • what is the timeline?
    • what can be measured and quantified?
    • what must be estimated?
  3. gather data and quantify as many elements of the metric as possible
  4. consider valuation methodologies that are appropriate for the company's industry and apply these to the data
  5. convert the valuation impacts into per share impacts or another basis for communicating additive value in financial terms
  6. aggregate results for individual metrics to estimate the overall valuation impact of the environmental factors
  7. communicate findings with relevant audiences

A worked example of how this is translated is given below.

Table 2. environmental valuation information for solid waste diversion

Metric

Valuation Information

solid waste diversion

identify volume of waste reduction / diversion

 

identify type of waste reduction / diversion

 

identify average £ cost / unit of waste reduction / diversion savings

Solid Waste Diversion

Performance:

Non-hazardous solid waste is diverted from municipal landfill at the Sudbury location

Translation:

Cost savings on landfill fees = $2.4 million per year

Valuation:

Example A – Discounted Cash Flow (DCF) Valuation

i) estimate cost of capital

WACC=Rf + ß(Rm-Rf)

where;

WACC = weighted average cost of capital

Rf = risk free rate of return (10-year)

ß = stock beta

(Rm-Rf) = equity risk premium

therefore;

WACC = 4.2% + 1.3 (6.5%)

WACC = 12.7%

ii) estimate value of cash flow assuming 5% annual growth in usage or avoided fees

DCF = incremental cash flow/(WACC-growth)

= $2.4 million/(12.7%-5%)

Present value of savings = $31 million

iii) convert to per share valuation

shares outstanding = 189 million

per share incremental value = $0.16 per share

Example B – Price to Cash Flow Per Share ratio (P/CFPS)

Peer group P/CFPS multiple = 5.0 – 6.0 X

Cash flow per share = annual savings per share = $0.013

Value per share = $0.063 per share low

= $0.076 per share high

Result:

Waste diversion at INCO saves the company $2.4 million per year, which is equivalent to just over 1 cent earnings per share. These savings are worth $31 million in total shareholder value (using DCF), or between $0.06 and $0.16 per share in total value (using P/CFPS and DCF).

Yachnin & Associates, Sustainable Investment Group Ltd & Corporate Knights Inc. 2006

Table 2 above illustrates the translation of solid waste diversion to DCF, whereby at an estimated weighted average cost of capital of 12.7%, and an estimated value of cash flow assuming 5% annual growth in usage or avoided fees, this represents a present value of savings by waste diversion of approximately $31 million, and with 189 million shares outstanding, this converts to per share incremental value of this waste diversion of $0.16 per share.

Integrated Framework for Financial Analysis of Sustainability

Figure 2 below identifies six financial value drivers of sustainability; customer attraction, brand value and reputation, licence to operate, human and intellectual capital, innovation and risk profile which have been incorporated into a model of shareholder added value. This shows how the management of environmental matters can be linked to the company's ability to create value. From this cause and effect ratios can be developed.

 

From Rappaport A. 1986, Creating Shareholder Value, Free Press: New York

Supporting Metrics with Information Systems

After selecting and defining those environmental impacts to be measured, systems are required which enable the collection and aggregation of data. These should piggy back existing operational database systems such as those used to manage orders, co-ordinate inventory, calculate accounts payable and manage shipments.

Data warehouses, which collect information from all organisational sources and store it for analysis and reporting, are integral to the management of environmental performance. Data warehouses can be constructed which combine technical specification databases, marketing and distribution databases, recycling databases, financial databases.

Calculations can be made which quantify the dollar benefits of reduced weight, improved energy efficiency and reduced end of life costs. From these it is possible to calculate net present value investment evaluations and to understand the costs and benefits of design for environment options. Without such calculations, environmental design improvements often remain an after-thought that contributes no significant improvement to the bottom line.

Such calculations can be reported as illustrated below:

Table 3. Environmental Metrics

10 000 products sold in 2006

Product based environmental performance metrics

2006

2005

Financial Benefit or (cost) £ 000

Av product weight (Kg)

4.32

4.35

1 000

Av recycled content by mass

12%

11%

( 500)

Shipping per product (Kg / Km)

4350

4750

1 300

Av energy consumption (watts)

46.7

48.7

5 000

EOL costs accrual

3.48

4.50

5 300

Adapted from Muller A. et al "Product Based Environmental Performance Metrics", Carnegie Mellon University , 2000.

There are many different stages of maturity in how companies are responding to environmental or sustainability issues. This is reflected in the accountability systems that have been developed and are in use. All systems should enable companies to gather information across product life cycles, so as to define sustainability priorities, identify and implement practices, and develop decision making tools and processes to evaluate performance. Some business advantages are already clearly apparent, others methods to track and delineate the costs and benefits of managing or not anticipating business risks remain a serious challenge.

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