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Module 6: Finance

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Investments and Corporate Performance

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Finance

Investments and Corporate Performance

Capital Investments

Prior to the acceptance of sustainable projects, socially responsible organizations have to evaluate the feasibility and sustainability of capital investments.
Common financial methods historically employed in capital budgeting decisions include return on investment, payback period, unit cost of service, cost-benefit ratio, internal rate of return, and net present value. However, these methods are not always the best choices in sustainable finance since these methods do not explicitly account for cash flows associated with social, environmental, and economic impacts. These methods tend to externalize rather than internalize sustainable costs imposed on the society.

Sustainability Valuation

Valuation determines a company’s worth. Sustainability valuation shows how sustainability adds value to the business. Currently, no existing methodology is considered adequate for sustainability valuation. This has led to much debate surrounding the best way to measure sustainability valuation within the firm.
A McKinsey & Company survey shows that executives believe that improvements in social, environmental, and governance performance create value; however, they do not agree on how much or how to measure it. [1] Naturally, respondents agree that it would be helpful if companies reporting on sustainability performance would quantify financial impact, measure business opportunities as well as risks, and be transparent about methodology. [2]

Research
Research has shown that nonfinancial measures are the leading indicators of a firm’s future financial performance. [3]
Additionally, research shows that firms listed on the Dow Jones Sustainability Index consistently outperform firms not listed on the Index. Thus, determining appropriate sustainability valuation metrics is particularly critical in this time of increasing emphasis on sustainability.

Valuation Metrics

Given the importance of sustainability valuation but the lack of standardized approaches, several efforts have been made to identify or develop appropriate valuation metrics. In a recent effort to valuate sustainability performance, qualitative reports of progress were analyzed and converted to five common financial metrics: ratio analysis, discounted cash flow analysis, rules of thumb valuation, economic value- added analysis, and option pricing.[4] Other traditional financial approaches used include cost-benefit ratios and net present value.
Yet it is commonly agreed that existing financial metrics are insufficient to capture the real value of sustainability. As a result, a number of new approaches and methods have been proposed. Click the button to see some of the approaches.

Approaches
• Deliberative monetary valuation
• Social multicriteria evaluation,
• Three-stage multicriteria analysis,
• Multicriteria mapping,
• Deliberative mapping,
• Stakeholder decision/dialogue analysis. [5]
Financial Valuation Tool
Yet another approach, the Financial Valuation Tool for Sustainability Investments, [6] has been developed specifically for the extractive industries (mining, gas and oil exploration, etc.) and could serve as an example for other industries.
Until appropriate methods are developed and widely adopted, businesses are left to use common financial metrics.

Capital Budgeting Investment

Capital budgeting decisions allow companies to use financial metrics to compare and prioritize investments in sustainability projects. Return on investment, payback period, and unit cost of service can be utilized in cases that have explicit costs and revenues related to sustainable investment.
The use of basic capital budgeting tools, such as internal rate of return, net present value, and cost-benefit ratio, will require some adjustments and cautious use in order to accommodate sustainability analysis.
Total cost accounting and life cycle costing analysis are excellent tools for a comprehensive analysis of sustainability-related investments. Once capital budgeting projects are analyzed, selected, and prioritized, there may exist various outside financing options for sustainability-related projects.


Socially Responsible Investments

Socially responsible investing (SRI) refers to the evaluation of investment options in light of its social, economical, and environmental impacts on the globe in the future. This is an ethical investment strategy that focuses on maximizing both an investor’s financial return and an investment’s sustainability impact. Green investing refers to the investment in securities that focus solely on financing to environmentally conscious businesses.
SRI is estimated to be a $2.7 trillion industry in the United States. [7] The Interfaith Center of Corporate Responsibility represents the largest association of faith-based institutions making socially responsible investments.

Common screens or criteria used to eliminate companies for SRI investments are animal testing, product and worker safety, industry focus (such as gambling, mining, or weapons systems), and product focus (such as alcohol or tobacco). The proliferation of SRI products and services, such as mutual funds, equity indexes, and investments in individual stocks and bonds, is a reflection of the growing trend in SRI.



The European nonprofit Ethical Investment Research Service also provides a source of research on the social, environmental, and economic performance of various companies as does the Investor Responsibility Research Center and the Sustainable Investment Research International network.



The Social Investment Forum (SIF) and other SRI publications provide good sources of information about social investing. SIF is a national nonprofit trade association that provides programs and resources to its members to assist them with integrating social, economic, environmental, and governance factors into their investment decisions.

Mutual Funds

As a $200 billion business, SRI-focused mutual funds perform competitively with non-SRI funds over time despite concerns for the higher risk levels.[8] Some of the largest families of socially responsible mutual funds are managed by AHA, Calvert, Domini, MMA Praxis, Parnassus, and Pax World.

Selection of companies for these funds are generally screened based on governance, ethics, diversity and women, indigenous people’s rights, transparency, equitable and affordable access to water, climate change, stakeholder engagement, weaponry, nuclear power, and other factors.

SRI Indexes

The risk of investing in SRI indexes is lower than investing in individual socially responsible investments. The proliferation of SRI indexes is a reflection of the growing trend for sustainable investment.

Australian Sam Sustainability Index (AuSSI). The AuSSI was launched in Australia in 2005. The AuSSI represents sustainability leaders in 21 industry clusters.

Opportunities for the Majority (OM) Index. The OM Index represents publicly traded firms operating in base of the pyramid markets in Latin America and the Caribbean.


FTSE4Good Index. The FTSE4Good Index Series measures the performance of companies that meet FTSE’s globally recognized corporate responsibility standards on their environmental record, development of positive relationships with their stakeholders, and support for universal human rights. Member companies are primarily from the United Kingdom, United States, and Japan.


Dow Jones Sustainability Indexes (DJSI). The DJSI are comprised of global, European, Eurozone, North American, and U.S. benchmarks. Launched in 1999, DJSI are the first global index tracking the financial performance of leading sustainability companies. The companies are screened based on environmental attributes (climate change strategies, energy consumption), social attributes (human resources development, knowledge management, stakeholder relations), and economic attributes (corporate governance, risk management) in 57 industry sectors.

Green Investment
Green investing refers to the investment in organizations that are committed to environmentally conscious business practices, such as the conservation of natural resources, the production and discovery of alternative energy sources, and the implementation of clean air and water projects.
Despite the fact that investing in green companies is riskier than other investment vehicles due to the life cycle of the companies, 64% of respondents identified the environment as the most desirable investment opportunity.[9] Green bonds, carbon trading, and renewable energy credits (REC) are notable examples of green investments.

Green Bonds, or Qualified Green Building and Sustainable Design Project Bonds, are tax-exempt bonds issued by federal or municipal qualified agencies to businesses to provide financing for green design, green buildings, investment in other projects intended to mitigate climate change, as well as for the development of brownfield sites (underdeveloped or abandoned areas often containing trace amounts of industrial pollution).

Measuring Corporate Performance
As we discuss capital investments and socially responsible investments, it is appropriate that we discuss how to measure corporate performance. Whereas businesses have traditionally assessed corporate performance through financial measures, there is growing emphasis to adopt a long-range and broader perspective that includes nonfinancial measures.
There is much support for adopting more comprehensive strategic corporate performance measurement systems. Research has shown that nonfinancial measures are often the leading indicators that drive lagging financial performance. [10] Furthermore, nonfinancial indicators can provide a link between current activities and future financial performance of the firm. [11] Indeed, a triple bottom line orientation requires the inclusion of nonfinancial indicators of company performance.

Balanced Scorecard
The balanced scorecard [12] is the most popular performance measurement system currently used that incorporates both financial and nonfinancial measures in evaluating overall firm performance.
The most recent biennial survey of management tool usage among corporations worldwide shows that 66% of respondents report their company uses the balanced scorecard. [13] The balanced scorecard provides a comprehensive measure of corporate performance.

Balanced Scorecard Categories
The balanced scorecard is comprised of four categories of indicators in the areas of innovation, learning and growth, internal business processes, customer value, and financial performance.
Organizations select unique indicators within each area that are directly linked to the organization’s strategic goals. Indicators often selected include employee training and corporate culture attitudes, internal business processes, customer requirement conformance and satisfaction, and risk assessment and cost-benefit data.
As a management system, it helps identify measures to be taken by providing feedback concerning external outcomes related to internal processes. This allows for the alignment of daily business activities with long-term organizational goals and performance.

Research
There has been an effort by some researchers to show how the balanced scorecard can be used for the sustainability-focused organization. [14] Balanced scorecards that incorporate sustainability considerations are referred to as Sustainability Balanced Scorecards.

Bibliography
[1] “McKinsey global survey results: Valuing corporate social responsibility.” McKinsey & Company. (2009). http://www.commdev.org/files/2393_file_McKQ_Valuing_Corporate_Social_Responsibility.pdf
[2] “McKinsey global survey results: Valuing corporate social responsibility.” McKinsey & Company. (2009). http://www.commdev.org/files/2393_file_McKQ_Valuing_Corporate_Social_Responsibility.pdf
[3] “Nonfinancial performance measures and strategy execution.” , Frigo, M. (2002). Strategic Finance, 84(2), 6–9.