As talks on climate change shift from debate to consensus, sustainability and green initiatives are taking leading roles in some of the biggest corporations around the world. In Harvard Business Review’s April 2014 issue, Kurt Kuehn, CFO of UPS, discusses how sustainability initiatives expose some of the shortfalls of traditional capital budgeting tools, and how big businesses are developing workaround solutions.

Elizer Varias

 

As talks on climate change shift from debate to consensus, sustainability and green initiatives are taking leading roles in some of the biggest corporations around the world. In Harvard Business Review’s April 2014 issue, Kurt Kuehn, CFO of UPS, discusses how sustainability initiatives expose some of the shortfalls of traditional capital budgeting tools, and how big businesses are developing workaround solutions. In particular, discounted cash flow (DCF) valuation is unable to: 1) capture fully the value externalities (positive for sustainable initiatives, negative for high-emission, high-energy projects); 2) endorse projects with longer payback periods (typical for sustainability projects); and 3) accurately assess the required rate of return from these investments, either through lack of internal metrics or comparable data. If we are to bring sustainability to the mainstream, we need tools to evaluate the financial viability of these projects and appropriate them into capital budgeting norms.

HBR’s latest edition also highlights some of the ways companies are dealing with green valuation:

Lowering the hurdle rate for green investments

Companies such as Ikea and 3M favor green projects by assigning lower discount factors for them. In essence, this makes it easier for sustainable projects to hit positive NPVs and thus get approved. And from a theoretical standpoint, it makes sense as well – sustainability projects are likely to have a lower risk profile than the company’s core business vis-à-vis the overall market.

It does, however, beg the question: just how much lower than the corporate benchmark rate do we go? A lower hurdle is good in principle, but difficult to substantiate in practice, precisely because there aren’t a lot of comparables in the market. Over time, as more data on sustainability comes into play, we may be able to address the return issue. In the meantime, though, this is something companies need to grapple with.

Dedicating CAPEX to green projects

Johnson & Johnson kept in simple by earmarking $40 million a year solely for sustainability. By budgeting green projects separately from the core businesses, they are allowed to stand on their own merit, without financial pressure from profitable segments. Doing so gives green investments a platform to compete with like investments.

However, what do we do when faced with two competing initiatives, fighting for the same financial resources? Without a fungible discount rate, we would not know which project to choose. Not all projects are created equal, and given budgetary constraints, how then do we choose?

Creating efficiency portfolios

GE is taking a different route – that of efficiency portfolios. By bundling green projects into a portfolio, it hopes to be able to use its internal hurdle rate to approve these investments. It argues that by combining quick payoff projects with long-dated ones, together they achieve cash flows necessary to get them approved. In short, stronger projects in effect subsidize weaker projects from a financial standpoint, but are perhaps more impactful environmentally.

In principle, this sounds promising, as green projects create a profitability ecosystem, a self-funding mechanism. However, this approach violates a basic tenet of project analysis – the concept of incremental cash flows. Unless these projects are essential to each other’s viability, by creating value synergies, they do not have any business being evaluated as an entity. Doing so is simply window-dressing for bad projects.

Shadow pricing of intangibles

Still for some companies, they turned to shadow pricing to address issues on pollutants and carbon emissions. By assigning monetary values to negative externalities, they are penalizing the use of these and facilitating the inclusion of sustainable alternatives. But as what any economist will tell you, pricing externalities are easier said than done. Moreover, it involves a degree of value judgment, and therefore room for manipulation, especially in cases with overwhelming financial attractiveness.

At the heart of the issue lies a data problem. Until we reach such a point that the market provides substantial feedback on pricing and returns for green investments, finance needs to take a proactive approach in putting this into place, by:

• Creating return benchmarks for companies with a green mindset to form comparables bases for future investments
• Consensus pricing on intangibles that will standardize the financial impact of pollution, logging, carbon emissions as well as green initiatives
• Establishing environmental risk premium frameworks, akin to credit rating agencies for default risk, for assessing environmental spreads on projects

Strategically, we appreciate the value that sustainability brings to the company, by making us less reliable on scarce resources. Now, we need to back up these claims with hard numbers that can convince shareholders of their worth.