Sustainable Development
Sust. Dev. (2015)
Published online in Wiley Online Library
(wileyonlinelibrary.com) DOI: 10.1002/sd.1594
Rodrigo Zeidan1* and Heiko Spitzeck2
1Fundação Dom Cabral and NYU Shanghai
2Fundação Dom Cabral
ABSTRACT
In this paper we present the Sustainability Delta model as an improvement over existing
environmental, social and governance (ESG) methodologies used in firm valuation. Starting
from the question of how banks should integrate sustainability criteria into their valuation
methods, we find that ESG methodologies currently do not consider the potential to generate
higher future revenues due to sustainable innovations, and also lack consideration of
different scenarios such as higher standards in legislation or consumer demand. To address
these shortcomings the Sustainability Delta model is developed. Simulation results on the
sugar manufacturing industry in Brazil demonstrate that by using the Sustainability Delta
we estimate an improved firm value of 1.24%. The Sustainability Delta would allow for a
more accurate valuation of firms as well as for the more effective allocation of capital for
investors, which should bring market pressure to improve sustainability practices and thus
contribute to sustainable development. Copyright © 2015 John Wiley & Sons, Ltd and ERP
Environment
INTRODUCTION
We know remarkably little of how investors incorporate sustainability issues into their portfolio
strategies. One growing approach is considering environmental, social and governance (ESG) risks
in the valuation of companies in different industries (Cormier and Magnan, 2007; Lydenberg, 2013;
Mengze and Wei, 2015; Park and Ravenel, 2013). Different cases such as BP’s Deep Water Horizon
(Kling et al., 2012; Noussia, 2011) or conflict minerals (Low, 2012) demonstrate that investors face the risk of significant
losses due to social and environmental mismanagement. However, most ESG criteria focus on currently
known issues such as employee health and safety, pollution and adherence to governance standards, and thus inherently
take a risk perspective (Lydenberg, 2013). Some companies, however, are beginning to take an opportunity
perspective to ESG issues, e.g. Unilever (Bell, 2013; Simanis and Hart, 2009). Unilever’s strategy is based on the
assumption that addressing ESG issues proactively will have a positive effect on future cash flows, and thus firm
value. In order to prepare for the future such companies use scenarios in order to detect latent ESG issues that
might become more relevant over time.
Similarly, there is a growing discussion in the literature taking ESG issues as leverage for value creation. First, a
new literature on shared value (Porter and Kramer, 2011; Prahalad and Hart, 2002; Spitzeck and Chapman, 2012;
Spitzeck et al., 2013) argues that business strategies should consider society as well as shareholders, as this enhances
their long-term competitiveness. Second, there is a growing stream of literature around sustainable innovation, with
the aim of creating new platforms of growth and future revenue for companies (Nidumolu et al., 2009). Third, there
is new evidence emerging that sustainable strategies lead to better financial performance in the long run (Eccles and
Serafeim, 2013; Eccles et al., 2013). Fourth, there is an increased awareness that financial markets have a particularly
important role to play regarding sustainability issues (Richardson, 2009; Scholtens, 2006; Scholtens, 2009; Soana,
2011; Weber, 2014).
These discussions, however, have not reached the finance literature (with some notable exceptions mentioned
above) and in particular research in the field of valuation. In order to contribute to the growing literature on sustainable
finance we address the following research questions.
Does considering ESG scenarios and opportunities in valuation methods lead to a significant difference in firm
value?
How should investors integrate future scenarios and ESG opportunities into valuation methods?
We explore the possibility that investors can improve portfolio allocation by evaluating firm valuation including
sustainability opportunities (and risks). If so, increased market competition for information on firms’ sustainability
issues could lead to market pressure for improved performance.
The structure of the paper is as follows. The following section presents a discussion of the literature on the relation
between ESG, sustainability and firm value in general. In the next section we focus on existing ESG methodology
and firm valuation in particular. In the fourth section we develop the Sustainability Delta model and in the fifth
present an application of the methodology for the case of a medium-sized sugar refinery in Brazil. The simulation
shows that the Sustainability Delta is 1.24%, which means that in this case enterprise value increases by 1.24% from
the base scenario once the firms moves to a sustainable business scenario. In the conclusion, we reiterate the main
findings and outline avenues for future research.
What We Know (and Don’t) about the Impact of Sustainability on Firm Value
Environmental sustainability in project and firm appraisals is increasingly important, having a long tradition in the
sustainable development literature (Harou et al., 1994; Vinten, 1994; White, 1996). In the early 2000s, researchers
analyzed the relationship between financial and sustainability performance (Amato and Amato, 2012; Mãnescu,
2011; Margolis and Walsh, 2003; Orlitzky and Schmidt, 2003; Paine, 2003; Vogel, 2005). Their main conclusion
was that sustainability does not harm and, in the best-case scenarios, improves financial performance.
However, we know that mismanaging sustainability can lead to a loss of firm value, as high profile cases such as
the BP oil spill (US$30 billion of market value wiped out in a matter of weeks) demonstrate (Kling et al., 2012;
Noussia, 2011), and that most financial reports do not incorporate environmental information (Nilsson et al., 2008).
Today, there is little doubt that some companies, especially large ones, are moving towards incorporating sustainability
into their corporate strategy (Grayson et al., 2014; Porter and Kramer, 2011). There is also emerging evidence
that companies integrating sustainability into their strategies, governance structure and practices outperform their
counterparts over the long term, in terms of both stock market and accounting performance (Eccles and Serafeim,
2013; Eccles et al., 2013). We also know that there is a relationship between corporate social responsibility (CSR)
practices and economic performance (Ameer and Othman, 2012; Callan and Thomas, 2009), and, more importantly,
that corporate eco-efficiency (Guenster et al., 2011) and sustainability practices (Lourenço et al., 2014;
Quisenberry, 2012) generate value.
We can see then that there should be a relation between a company’s sustainability practices and firm value.
Research presents a strong case for a risk perspective towards social and environmental issues, as mismanaging
sustainability can be a cause for a decline in firm value. There is also an emerging case for an opportunity perspective,
in the sense that addressing sustainability proactively can enhance firm value in the future.
Sustainable Firm Valuation Methodologies
The Relevance of Sustainability to Valuation
Sustainable firm valuation methodologies are concerned with the impact of sustainability issues on a firm’s
economic performance, not on its overall impact to society. A simple discount cash model demonstrates direct or
indirect evidence that sustainability can impact a firm’s value. Let us assume that a firm’s value is the present value,
based on its weighted average cost of capital, of its future cash flow.
Figure 1 guides us in the estimating a firm’s value based on discount cash flows. The main idea is that the value
of a company is equal to the present value of future cash flows, discounted by financing costs of the firm, represented
by the weighted average cost of capital (WACC). Cash flows are determined by operating profits, as in net
operating profits less adjusted taxes (NOPAT), less investments needs, the result of the variation in working capital
and capital expenditures (Capex). We know that sustainability issues have a major impact on operating income, both
positive, in terms of turnover, and negative, in terms of increased operating costs, although best practices can result
in improved environmental performance and reduced costs (Chegut et al., 2011; Christmann, 2000; Quisenberry,
2012). We also know that investments in sustainable practices are larger in the short run, increasing capital expenditures
by greener companies (Jarvis and Sovacool, 2011; Laurence, 2011; Wagner, 2010). The result is that we have a
dynamic relationship between operating performance and capital expenditures in the long run – smart investments
will generate improved performance, even though there are periods of smaller cash flows related to increased
investments.
Finally, there is mixed but compelling evidence that more sustainable companies can reduce the cost of capital of
non-financial firms. Goss and Roberts (2011) show that the modest premiums associated with CSR suggest that
banks do not regard CSR as either significantly value enhancing or risk reducing. Correspondingly, banks’ own
CSR performance is relatively low (Weber et al., 2014). However, Nandy and Lodh (2012) find that eco-friendly firms
obtain more favorable loan contracts than less sustainable firms, and there is also evidence that banks value CSR
practices (Dhaliwal et al., 2011; El Ghoul et al., 2011), even though the effect is not the same for all kinds of firm
– high quality borrowers can get loans with lower costs regardless of their sustainability performance. Similar
results have been observed in the insurance industry (Phelan et al., 2011; Scholtens, 2011). There are two trends
regarding the relationship between sustainability and cost of capital – banks should value strategic sustainability
over pure CSR policies (Zeidan et al., 2014), and as markets mature there should be a stronger relationship between
those characteristics.
The overall evidence is that sustainability issues can impact a firm’s valuation by changes in future operating
income and the cost of capital. The main challenge is bringing materiality to these issues so one can measure the
change in valuation related to sustainability in business practices (Eccles et al., 2012) and shared value (Porter
and Kramer, 2011).
The main concern in relating sustainability issues to valuation methods is that neither one is well defined. The
impact, in terms of risks and opportunities, of sustainability issues on the value of a firm is a multi-dimensional
issue, and therefore there is more than one kind of valuation method. An ideal model that would incorporate sustainability
into valuation models should have the following desired characteristics:
• to be able to bring materiality to sustainability issues;
• to be relatable to issues in the chosen valuation method;
• to be amenable to the creation of different simulation scenarios.
The first issue is one of the main hurdles in incorporating sustainability issues into financial modeling. First,
sustainability reporting standards need to improve sector-specific materiality (Eccles et al., 2012), because the usual
way of reporting does not readily allow the creation of financial information based on the self-reported sustainability
initiatives (Reverte, 2012). Many firms already use AA1000 certification or develop a materiality matrix, but have
difficulties explaining how relevant materiality issues impact on financial performance. In a recent Accenture
CEO survey, only 38% of interviewed CEOs ’believe they can accurately quantify the value of their sustainability
initiatives’ (Accenture, 2013, p. 15).
Given this background, we need a working model of how investors determine the value of a firm. There are three
main categories of valuation techniques (Damodaran, 2012): comparable analysis (such as multiples, precedent
analysis, SOTP), liquidation models (asset-based, and fair-based values) and discount cash flow methods. The first
requires information on company peers and adjust value for company-specific information.
Liquidation models assume the company is going to be liquidated and therefore management decisions and
outside expectations do not impact the future of the company.
Discounted cash flow methods look at future cash flows, assuming a company is only as valuable as its capacity to
generate value to shareholders in the future. It is the most common valuation method and the one we argue that is
best suited to incorporate sustainability issues.
In practice, there is evidence that some measure of valuation models already incorporate ESG (environmental,
social and corporate governance factors) in discounted cash flow methods based on data from the GRI (Global
Reporting Initiative) reports generated by listed companies (Kocmanova and Simberova, 2012). The GRI is an important
measure of compliance with social and environmental regulation and standards by large public companies.
For instance, the MSCI Sustainability Indexes include companies with high ESG ratings relative to their sector peers
– the methodology is based on the highest ESG-rated companies making up 50% of the adjusted market capitalization
in each sector of the underlying index, subject to the limitation that only companies with an ESG rating of ’B’ or
above are eligible for inclusion. Kiernan (2007) argues that ESG is particularly important for ultimate owners who
want to create long term value for their companies.
Another advantage of the ESG methodology is that, if done well, it includes an internal view and values strategic
decisions by the management team. This differentiation is important, because as Székely and Knirsch (2005) argue,
most sustainable development initiatives have been developed in response to outside pressure and in isolation from
business activity and are therefore not yet directly linked to business strategy. The same point has been made by
Milne and Gray (2013), who argue that GRI reporting is an insufficient condition for organizations contributing
to sustainability. They also argue that, paradoxically, such focus may reinforce business as usual (BAU) and greater
levels of un-sustainability, as reporting indicators are not used to alter management decisions. If companies and
banks only focus on improved reporting, without using such standards on decision-making, it may indeed reinforce
BAU behavior. We take a different view, but concede that merely focusing on publicly available data, sometimes
generated for compliance only purposes, may present problems in addressing relevant impacts to a firm’s future
cash flow based on sustainability issues.
Therefore, we argue, with a caveat, that the ESG is a good way to bring materiality to sustainability issues, because
it measures how companies are affected by, and responsive to, sustainability issues based on the GRI questionnaire.
Some researchers see it as far from perfect (Eccles et al., 2012), but it is the best standard that is readily and publicly
available, and Hanson (2013) shows that the world’s best ’business value investors’ have long incorporated ESG considerations
into their investment decision-making.
Summarizing the findings in the literature we recognize two major limitations of the ESG methodology: (1) it is
focused mainly on risks and does not consider opportunities, and (2) it does not consider future scenarios.
ESG Valuation – Predominantly a Risk-Calculation
Itaú Asset Management (2013) provides one interesting example of using ESG for firm valuation. The bank uses the
ESG methodology to change the valuation of construction companies in Brazil in 2013. They measure the sustainability
risks of the operations of six listed companies and potential impacts in their future cash flows. Four of the six
companies present measurable sustainability risks, and the change in valuation of these companies ranges from US
$2.7 million to US$421 million. Table 1 shows the companies, their market value, as measured by regular DCF
methods, and the sustainability risks, as measured by the ESG methodology.
We can see from Table 1 that the ESG impact on market capitalization is small (less than 1%) for all companies
but one: MRV. For this company the sustainability impact reaches over US$400 million, and 17% of market value.
This prediction was found to be reasonably accurate when MRV was found using slave labor in 2013 and accordingly
was fined and excluded from government contracts for a while. This is evidence that incorporating sustainability
risks can have a significant impact on firm value. The ESG methodology used by Itaú Asset Management is based
on the characteristics shown in Figure 2.
In Phase 1 data is collected on the industry and its specific financial, social and environmental issues (e.g. relationship
with communities in the mining industry, product toxicity in toys, or child labor in the apparel industry). Also,
firm performance of players in the industry is observed. In Phase 2 impacts of social and environmental management
on financial variables (revenue, costs, Capex etc.) are quantified in order to determine in Phase 3 how far discounts
need to be applied to specific firms.
The method used by Itaú follows a typical valuation methodology, but incorporating ESG factors. Likewise, Herzel
et al. (2012) use sustainability as a constraint in optimal portfolio decisions. In the Sustainability Delta model, we aim
to complement the ESG methodology with the possibility of positive cash flows. The idea is that more sustainable
companies should generate a market premium, and not only a zero discount in their market valuation.
ESG Valuation – and If the Scenario Changes?
Environmental, social and governance issues usually represent currently known sustainability risks. In the same
way, benchmarking exercises might help companies to identify current best practices and apply them to their
own operations.
However, the relevance of some issues might increase or decrease in the future. Take the availability of water as
an example. Some regions will be more affected by droughts in the future and water-intensive businesses might
become economically unviable. Additionally, new issues regarding innovation or climate change risks might emerge
in the future, which are not relevant for a firm’s cash flow at present. Therefore, researchers are starting to use
scenario planning to predict future ESG impacts (Bügl et al., 2012; Gössling and Scott, 2012; Parkinson et al.,
2012), mostly from an industry perspective as suggested by Eccles et al. (2012).
If scenario planning techniques help model the future of industries they might also increase the accuracy of
valuation as a better fit between sustainability risks and opportunities – the relationship between firm strategy
and future cash flows should be particularly sensitive to sustainability risks and opportunities. Looking at how
sustainability issues evolve over time is then paramount to adjust regular discount cash flow methods of firm
valuation.
The Sustainability Delta – Integrating Opportunities and Scenarios
The discussion on existing ESG methodology has shown that current approaches to sustainable firm valuation do
not consider positive future cash flows or future scenarios. We present the Sustainability Delta as well as a simulation
to demonstrate its impact on firm value.
The Sustainability Delta presented in Figure 3 considers a variant of ESG opportunities, which have the potential
to increase present firm value at t1. Additionally, considering scenarios might improve the accuracy of the valuation
if management decisions help to reduce future risks and increase the chances to exploit opportunities (upper
Sustainability Delta at t2). If, to the contrary, management does not integrate sustainability issues into its strategic
considerations, we might find firm value compromised by higher risks and lower chances to exploit opportunities in
the future (lower Sustainability Delta at t2).
The main issue for the ESG methodology or the present Sustainability Delta is one of materiality – relating
sustainability issues to future cash flows. The ESG methodology tries to solve this by ranking the possible impact
of ESG factors on firm value. Our present methodology is complementary to the ESG approach – it requires the
creation of primary data for it to be successful, and ranks the relevant factors to impact future cash flow. The data
requirements are specific to companies and industries and relate to variables in a cash flow statement. For instance,
prices can be affected by price premiums based on sustainable goods and services, and the quality of such goods can
affect the quantity of goods and services sold. The result is that long-term revenue is affected by investments in
more sustainable goods and services. This is the main strategy behind the new sustainability push by companies
such as Unilever. Other variables are affected by sustainability issues in different ways. The cost of capital is based
on reputation and the eco-premium perceived by financial institutions, while capital expenditures may be higher in
the short run and lower in the long run for companies that are first entrants in promoting sustainable means of
production.
We assume the following to develop the Sustainability Delta:
• weak form of the efficient market hypothesis;
• risk neutrality;
• homogeneous beliefs (Ohlson, 1995).
We want to arrive at a measurable outcome that is independent of investors’ preferences for sustainability. By
having homogeneous preferences and risk neutrality, we can try to objectively measure the impact of sustainability
on a firm’s cash flow. The weak form of the efficient market hypothesis is necessary to guarantee that market
valuations do not incorporate all information into a firm’s future cash flow.
The methodology of the Sustainability Delta goes from general principles to firm-level analysis, as in Figure 4.
The first stage establishes the variables that are relevant to a specific firm, going from general variables regarding
six sustainability dimensions to the specific ones that impact a firm’s future cash flow. The qualitative analysis is
composed of a life-cycle analysis of the products, identifying the main social and environmental impacts as well
as their financial impact. Additionally, six sustainability dimensions are evaluated: economic growth (EG), environmental
protection (EP), social progress (SP), socio-economic development (SD), eco-efficiency (EE) and socioenvironmental
development (SD). Equipped with this data the most relevant value drivers can be identified. In a
second step the impacts of the value drivers on future cash flows are evaluated, including revenue and costs. In the final
valuation stage the sustainability delta is calculated in terms of ROIC (return on invested capital) and WACC, considering
different possible scenarios, with associated probabilities to allow us to simulate different valuation results.
It distances itself from the ESG methodology because it has the same focus on opportunities as it has on risks.
Hence, it analyzes the probability of increased revenue by new products or services, decreasing costs by targeted
sustainable practices, and increased social capital by renegotiation of the social contract between the company
and its stakeholders. Building sustainable goodwill can increase revenue and decrease costs, from litigation and
provisions to improved market share (Lourenço et al., 2014).
Another difference is the focus on the time dimension. We analyze the evolving role of sustainability on cash
flows through different sustainability paths. Impacts on cash flows depend on investments and decisions towards
more sustainable means of productions and final goods and services. We analyze such a path through three phases:
business as usual (BAU), sustainable business (SB) and future sustainable business (FSB), as in the work of Zeidan
et al. (2014).
We argue that classifying companies among their peers in such a way allows us to create a model that would
enable a researcher to value future cash flows.
Since we are dealing with cash flows, it is paramount to understand the path of a company regarding sustainability
issues. Take long-term costs, for instance. Assuming a company is investing in innovation and sustainable
means of production, costs should be lower in the long run, and thus operating income should be higher. If
companies already comply with best practices, their costs should not rise in the near future, impacting the cash flow,
as in figure 4. Significant fines for labor practices and environmental issues that could be prevented happen
constantly and show how some companies are far away from embodying the best practices of many industries.
Our analysis is based on a sustainability path as in Figure 5. We try to determine the sustainability factors related
to costs, revenues and other variables as they evolve over time.
Discount cash flow methods rely on operating income as the main variable to be discounted to the present, and a
decrease in costs leads to higher valuation. The main issue is how to measure such cost savings on future cash
flows. Here we are explicitly concerned with the sustainability impacts on firms’ future cash flows by establishing
a probability that the variables related to a firm’s valuation are related to sustainability events. Given a selected
industry, the process involves the following.
• Value drivers: product life-cycle analysis, value chain, legislation and public policy, industry self-regulation, and
innovation.
• Defining variables related to individual firms, in each of six sustainability dimensions: economic growth (EG),
environmental protection (EP), social progress (SP), socio-economic development (SD), eco-efficiency (EE) and
socio-environmental development (SD).
• Developing paths for the average firm: business as usual (BAU), sustainable business (SB) and future sustainable
business (FSB).
• Determining the relationship between the selected variables over time and the components of firms’ valuation.
• Combining the information on the steps above to obtain the percent of coverage on each variable and measurable
impacts on cash flow and WACC.
• Calculating the Sustainability Delta.
• Establishing scenarios for simulations of the results.
The Sustainability Delta is supposed to combine qualitative and quantitative methodologies. In this respect it
relates well to regular discount cash flow methods, which rely on qualitative assumptions about the behavior of
future cash flows. If used well it should fit nicely in the line of arguments developed by Eccles et al. (2012) and Cerin
and Scholtens (2011) regarding the ability to bring materiality to sustainability issues. The end result is a matrix of
coverage and impact that affects the valuation of a company, as represented in Table 2, which shows a typical
simplified cash flow statement used in valuation methods.
Take for instance addressable market share. The first question one should ask is whether sustainability plays a
role in addressable markets. For companies such as the cosmetic companies The Body Shop or Natura, sustainability
is related to all its addressable market, hence the coverage of the addressable market affected by sustainability
issues would be 100%. In another case, take a construction company in a poor country. For such a company most
of the addressable market is related to local infrastructure projects, which are hardly affected by sustainability opportunities,
given that there is no demand for sustainability-specific projects in government purchases in most poor
countries. Moreover, there is no eco-premium in this market – local governments, for instance, are not willing to
pay higher prices for projects that take sustainability into account. Companies may be forced to change their projects
to comply with environmental law, but their customers are not, in general, willing to purchase projects at higher
prices given its sustainability characteristics. This may change in the future, and the probability that the addressable
construction market is affected by sustainability issues is close to 0% in the BAU scenario, but increases in the path
to SB and FSB practices.
In contrast, if we analyze another industry that has been the target of sustainable finance initiatives, the sugar
industry in Brazil, we can establish positive probabilities to the addressable market in relation to the path from
BAU to FSB. Sustainable farmed sugar has a very small penetration in the world market in 2013, less than 1%,
but its relevance is expected to increase over time (Potts et al., 2014). It also commands an eco-premium, with prices,
as of 2013, 20% above that of regular refined sugar. Companies rated higher in terms of sustainable production
could improve their margins and sales, hence commanding higher valuation. The same change in valuation is
due to the production process and cost management. Take water challenge, one of the most important issues in
agriculture as we move towards a future sustainable business. It is not an issue for every firm (it affects farmers
more than manufacturers), but it can become a major issue in some areas in Brazil. Depending on the area its probability
of impact on costs range from 5% to 20% of variable costs. Companies that are rated higher in the path from
BAU to FSB in relation to water management increase their valuation by lowering future variable costs. However,
companies that want to pursue sustainability strategies have, at first, to increase their capital expenditures, which
can reduce their value. Addressing a comprehensive Sustainability Delta involves then assumptions about the
necessary investments and future cash flows generated by sustainability strategies.
We argue that the main advantage of the Sustainability Delta methodology is that it provides a seamless integration
with regular discount cash flow methods. We need assumptions, qualitative information and measurable
impacts to determine changes in the variables that comprise a firm’s future cash flow.
Sustainability Delta: an Application
We present the SD impact on the valuation of a sugar manufacturer. This case is based on real data (with some
approximations for simplicity) from a small sugar manufacturer in the Midwest in Brazil. Its valuation is based
on the following assumptions:
The company produces white sugar in Brazil. It has seven year contracts with farmers that supply sugar cane in
close vicinity. It is located in a frontier region in which the industry is expanding, with productivity that is lower than
in the main producing regions in the country, but growing at 1% a year.
The initial valuation period is 5 years, from 2015 to 2019. We assume that the values of 2019 are going to be
constant from then on, arriving at a terminal value equal to the present value of a perpetuity based on (NOPAT less
working capital and Capex) discounted by the WACC of the company.
Today the firm produces 400 000 pounds of sugar a year, and is expanding towards 700 000 tons in 5 years. Its
production is growing by roughly 15% a year. Sugar prices are estimated to be US$15 a pound in 2015 and should be
constant at US$16 a ton for the rest of the period.
Variable costs are US$10 per pound in 2015 and grow by 3% a year during the 2015–2019 period (accounted for
the growth in productivity). Fixed costs are US$800 000 in 2015 and grow at 10% a year. All values are inclusive of
taxes. Capital expenditures are US$500 000 in 2015 and grow by 10% a year from 2015 to 2019. Investments in
working capital are US$100 000 in 2015, and given a constant financial cycle of 40 days its values are, respectively,
US$151 111 in 2016, US$122 667 in 2017, US$141 067 in 2018 and US$162 227 in 2019.
Capital structure is composed of 40% of debt and 60% of equity, and assumed constant for the whole period.
Cost of capital is also assumed constant, 7% a year for debt (due to subsidized credit) and 14% a year for equity. Cost
of capital is also assumed constant over the whole period. Given all these assumptions, the final cash flow is found
in Table 3.
We arrive at an enterprise value of around US$9.6 million with the BAU scenario.
We apply the Sustainability Delta by focusing on two cases, for simplicity: impact on cost management and an
eco-premium on organic sugar. After looking at qualitative data, specifically the questionnaire based on the work
of Zeidan et al. (2014), we classify the company in the BAU category based on energy management and product
development. We do not, at this point, analyze the company in terms of sustainability risks. By looking at its classification
from the questionnaire, the company clearly faces some sustainability risks that would bring its valuation
down if we followed solely the ESG methodology. We base our analysis on the SB path, in which the best practices
for these two issues follow the example of companies that already use these practices.
The result of the analysis of the opportunities regarding energy management in the area, with data from the
industry and a typical SB firm, shows that best practices on energy management rely on bioenergy production from
sugarcane bagasse, a by-product of the production process. We estimate that the coverage rate is only 2% of total
fixed costs, a very conservative estimate. The measurable impact follows the typical cash flow profile of an investment
in bioenergy production for a small sugar producer.
• Capex of US$200 000 in the first year and US$100 000 in Years 2 and 3.
• Energy savings (the firm is not large enough to sell excess energy until Year 5, but this would require more investments
in connecting the company to the grid, which we disregard at this point) of US$15 000 beginning in Year 2.
• Subsidized credit for the investment, reducing the firm’s total cost of capital by 0.2% a year (we assume 70% debt
financing with subsidized loans by innovation programs from the Brazilian government –this is a generous assumption,
as bioenergy projects can find 100% debt financing at very low costs by some Brazilian agencies such
as Finep, BNDES and others).
As for organic sugar, the SB firm production ranges from 5 to 20% of the total sugar production for the local
market or exports. Our firm could, with its current infrastructure, easily produce up to 5000 tons of organic sugar
a year with minimal investments, a coverage rate of less than 1.5%. It could choose a larger production, but that
would involve distribution, marketing and investment risks. Assuming no costs for introducing the product or additional
marketing, a strong but realistic assumption given the distribution channels already in place, we assume the
following measurable impacts.
• Prices 20% higher than regular sugar.
• Sales in the local market, diversifying revenue streams (the company is mainly an exporter). Effect is not shown as
cash flow.
• Production begins in Year 2 and grows at the same rate as total production (which stays the same over the period).
Results are in Table 4. The Sustainability Delta is 1.24%, which means that in this case firm value (actually enterprise
value, as we do not consider the amount of debt, cash holdings and the value of the land) increases by
1.24% from the base scenario if the firm moves from BAU to the SB path regarding bioenergy and a small amount
of organic sugar production. We should note that, given the impact of terminal value on the valuation of the firm,
analyzing the FSB path is actually quite relevant to the present valuation of a firm. Companies that are moving towards
more sustainable means of production and looking to sell more sustainable goods and services should become
significantly more valuable as markets develop to incorporate it in their cash flows.
Conclusion
This paper aimed to answer the question whether considering ESG scenarios and opportunities in valuation
methods leads to a significant difference in firm value. The Sustainability Delta is presented as a new methodology
and used in a simulation to a small sugar manufacturer with some simple assumptions about its cash flow profile.
The result is a change of 1.24% in enterprise value. This simulation, in addition to insights from the literature
review, suggests that the integration of ESG scenarios and opportunities can lead to significant alterations in firm
value.
Theory on sustainable finance demonstrates that current ESG methodologies lack a consideration of opportunity
exploration to enhance future cash flows as well as a scenario building exercise. To contribute to theory, we therefore
propose the Sustainability Delta as an alternative valuation methodology. We provide evidence of materiality to
sustainability issues (Eccles et al., 2012) and show that sustainability reporting can generate useful information
for market agents, to mitigate the critique by Milne and Gray (2013).
There are three main limitations to the Sustainability Delta methodology:
• information requirements;
• the fact that it works better with single product companies;
• difficulty of assumptions regarding SB and FSB paths and its impacts on future cash flows.
Any valuation method suffers from the first two issues, but they are more relevant when trying to incorporate
sustainability into future cash flows. It is particularly difficult to estimate the needs for present day investments
and future savings and improved cash flows from sustainability issues. Ratings and indexes (Singh et al., 2007;
Zeidan et al., 2014) are a major step forward, but full cash flow estimations based on sustainability issues are still
in their infancy.
The third requirement is related to qualitative information on the future of the industry and the place of the
typical firm as a future sustainable business.
Future research could analyze in more detail how sustainability innovations enhance future cash flows by either
improving revenues, lowering operating costs or reducing costs of capital. In particular, it would be interesting to
implement the Sustainability Delta in a given portfolio and compare firm values with current standard valuations
over time. Ideally, financial modelling would show increased return for selected portfolios based on capital asset
pricing models that incorporate sustainability issues. These potential results should encourage the diffusion of
methodologies akin to the present Sustainability Delta.
Our research points to practical implications for several audiences. First, investors might be interested in testing
the Sustainability Delta methodology to allocate capital more efficiently, even in a scenario in which lack of
standards, regulations and uniform accounting schemes still poses a challenge to contemporary sustainability
finance and accounting (Ngwakwe, 2012). Second, environmental managers are encouraged to collaborate with their
colleagues from the financial departments to generate data on how activities such as life-cycle analysis, future
scenarios and the implementation of benchmarks impact future cash flows. Third, policy makers might want to
encourage companies to share more information about their sustainability investments and increase the accuracy
of sustainability reporting.
By presenting the Sustainability Delta we hope to encourage firms to invest in sustainability technologies and
innovations that prepare them for future market requirements as well as for investors who will profit from future
cash flows. If we can prove that investments into sustainability prepare firms for higher returns, lower risks and
longevity in the future, we can expect that businesses engage more seriously in sustainable development. Especially
if investors use their capital allocation to favor more sustainable management practices the consolidated impact on
sustainable development can be substantial.
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Keywords: sustainability; risk management; ESG; firm valuation; WACC; sustainable finance; scenarios; sustainability analytics, sustainability credit score system