Two Solitudes – Measuring The Financial Impacts from Sustainability

In companies across Canada there are two camps when it comes to the social and environmental responsibilities of the firm. In the one camp there are zealots for sustainability. These individuals often advocate sustainability investments as essential to the firm’s long-term survival. They often have expertise in environmental management, community relations, with some even joining the organization from the nonprofit sector. Unfortunately, these advocates can be completely lacking in experience with financial management. Many students I’ve met with over the years have even chose this type of career path specifically because they are intimidated by the quantitative measures used in disciplines like accounting and finance. Too often, sustainability advocates lack the skill to communicate in the language of business. They don’t comprehend terms like cash flow, share price alpha, the difference between return on assets versus return on equity.

It’s the accountants and finance managers who speak this language that are found in the other camp. These people have a completely different view of sustainability, often worried that the financial impact of such initiatives cannot be measured. These people deplore anything that cannot be measured.

This chasm became acutely apparent when I recently presented a paper at a Corporate Social Responsibility event held by the Conference Board in Toronto. When a colleague asked the room of over 100 professionals how many of them were money managers, equity analysts, or work in a finance role within their organization, not one person in the room raised their hand. We were all speaking to ourselves, and speaking in a different language than the one spoken at the intersection of King and Bay Streets.

Sustainability advocates don’t do themselves any favours by shying away from financial metrics because it’s usually the number crunchers that are in charge of the investment decisions. And while the onus is on the part of sustainability champions to speak the language of business if they want to make change, people on both sides of the chasm are skeptical that the financial impacts from these “soft” initiatives can even be measured.

Based on the research track record, they can hardly be blamed for their skepticism. After 35 years of study, we really don’t know anything about the financial impacts from investments in sustainability. Although there is ample evidence to support a positive relationship between sustainability and financial performance, questions remain about the efficacy of investments in sustainability. The first problem concerns the size of the relationship. The correlation of .13 is considered small by both practical and statistical standards. More importantly, the causality of the relationship can be argued either way. Does sustainability lead to improved financial performance, or does improved financial performance give firms the ability to invest in sustainability? When the board asks for the ROI on an investment in sustainability, will you ask them to rely on a small average positive correlation over time? This amounts to the “trust me” argument, and it doesn’t work for sustainability any more that it works for any other investment made by the firm.

The majority of studies on the impact of sustainability on financial performance, whether from the academic or practitioner realms, rely on a single, broad measure such as a change in share price. But this doesn’t allow managers to track impacts of specific initiatives, and more importantly it doesn’t allow for leading indicators so managers can adjust their strategies on the fly. It only provides a broad form of “post mortem” without any specific learning. This is hardly a compelling argument for the board.

Enlightened managers track results from sustainability through measuring impacts across a range of stakeholders. For example, investments in a recycling program can have a positive impact far beyond the potential cost savings directly attributed to reduced waste. Price premiums with consumers are often associated with sustainable firms. Employees at sustainable firms tend to be more satisfied than those working at “regular” firms. Regulators look at the sustainable firm more favourably when they are asked to make a decision. Each of these potential impacts can be captured and contrasted against investments in sustainability. In turn, these impacts can be translated into the type of metrics that carry sway with decision-makers and the board – earnings per share, return on equity, etc. But without a series of metrics to measure the impact of one on the other, managers are left with nothing more than guesswork and personal bias.

The inclusion of more specific metrics will be especially critical as much of the “low hanging fruit” of sustainability becomes picked over. At the moment, many firms can make easy choices for sustainability. Replacing light bulbs costs $X and saves $Y. The go/no go decision is easily translated into the language of business. But as sustainability initiatives become less obviously profitable, and increasingly rely on the nuanced reactions of stakeholders such as employees, consumers, and regulators, the metrics must keep pace.

Failure to match the proper metrics for financial impact with sustainability initiatives will have one of two financial consequences for firms. The first is that firms may over-invest in sustainability, which can have harmful effects on asset utilization and profitability. The other is that firms under-invest in sustainability, which can not only lead to poorer financial performance when compared to rivals, it can also lead to stakeholder revolt and threats to the long term viability of the firm.

July 3, 2008
By John Peloza PhD, Research Fellow, CIBC Centre for Corporate Governance and Risk Management