The concepts of sustainable development seem to apply easily to certain disciplines; for example, in supply chain management, the issues will focus on transport (energy consumed, pollution); in marketing, the questions will revolve around consumption and obsolescence (fast fashion, circular economy). But what about the role of finance in sustainable development? Is it an oxymoron to say “sustainable finance”?
To answer this question, we can look at how today’s finance approaches investment projects, and how concepts of sustainability can be brought to the table.
Understanding the traditional approach to investment
In the field of corporate investment projects, we use decision models derived from economics, such as the calculation of the net present value (NPV) of a project. This model consists of making a cash flow forecast (sales minus expenses) for each year of the project and then applying the time value of money with a discount rate – because one euro in one year is not worth one euro in 10 years’ time. But such a model as the NPV formula – which is widely used in corporate finance divisions when it comes to assessing investment projects – will face several problems when we want to incorporate sustainability issues. And the other classical models (IRR, Payback) are no better since they suffer from the same drawbacks.
First, these models are based on a single objective, which is trying to increase shareholder value. In those conditions, if a project enriches the shareholder, but degrades environmental, social or governance conditions (ESG criteria), it will be considered profitable, even though it is not “sustainable”. Secondly, these models do not consider all the data or consequences. Indeed, project forecasts only consider the revenues and expenses that the project will bring to the company, and they ignore all the consequences outside of the firm (those consequences being called externalities). Pollution, environmental degradation or unemployment are therefore not counted in the forecast because they are negative externalities that have no (or very little) impact on the company’s accounts. Consequently, a project that brings a profitable result to the company will be adopted, even if it is very polluting, socially disastrous or dramatic in terms of the environment. At worst, the company will have written down a provision for a possible lawsuit or a potential fine, but those recorded amounts will be nowhere near the real cost imposed to the external world by the launching of this project.
How concepts of sustainability can be brought to the table
One of the solutions to make finance more sustainable is to include the cost of externalities in company forecasts. Although not currently done, it is not impossible to do. For example, a company can decide to bill the project’s estimated pollution directly to the investment expenses. Indeed, the expected annual pollution can be estimated in the form of CO² emissions, and then valued as an annual expense of the project, which will therefore reduce the estimated cash flows for each year. To value the CO² emissions, the company can use the current market price per tonne of CO² – even if it is very low – or it can set its own internal value per tonne of CO² and then apply this price to all its projects that generate pollution. If this is done, then a polluting project will be de facto less profitable than a non-polluting project. That will not only be more representative of the economic reality but also more in line with sustainable development goals (SDGs). This reflection can be extended to a variety of external indicators: the average health of populations, the degradation of natural resources or social issues within the company. Of course, this requires an additional investment in collecting those external elements, and an effort to evaluate the financial cost for those items, but:
The simplest estimation model will always be better than not taking these factors into account at all.
The great advantage of this approach is that there is no need to change the model, it is just a matter of changing its underlying parameters. Indeed, investment decision models such as NPV are well established in the financial departments of companies, and they are commonly used because of their great conceptual soundness. So, it is better to adapt a widely used model, rather than trying to impose a new standard.
Accepting the current limits of our financial models
On the other hand, some parameters of the NPV model cannot be changed as easily: whereas we can easily contemplate to include new information in the estimation of projected cash flows, the adaptation of the discount rate presents greater difficulties when it comes to integrating sustainable development issues. Indeed, this rate is supposed to represent the level of risk of the investment project under consideration: in finance, to each level of risk corresponds a level of required profitability.
But when it comes to integrating sustainability issues in the discount rate of investment projects, things become tricky. For sure, we can always add a risk premium for the projects that do not comply in terms of sustainability, but the crucial question is to correctly estimate this risk premium. Should a project that degrades natural resources have a discount rate increased by +1%, +3% or +7%? To answer this question, it is necessary to be able to quantify environmental risk premia, statistically speaking, which is currently difficult to do. Indeed, all classical models in finance are based on the concept of a perfectly diversified portfolio, in which the risks of certain companies are offset by different risks in other sectors. To achieve this overall balance, opposites are needed: virtuous companies versus “vice” companies (tobacco, gambling, weapons), cyclical companies versus stable companies, and environmentally destructive companies versus socially responsible companies.
Today, some investors are indeed ready to consider investment projects on three distinct axes: risk, profitability, and sustainability – but other investors will still continue to apply a simple risk/return ratio instead. They will look for the most profitable company, whatever its environmental score.
It is, therefore, better, for the time being, to leave the discount rate alone and to focus mostly on including sustainability costs in projected cash flows. This is a first (easy?) step for sustainability to tiptoe into financial models.
Feature photo credit: Thanit – stock.adobe.com.
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