The Relationship between Sustainability Performance and Financial Performance


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At the Canadian Responsible Investment Conference, June 20, 2011, Dr. Olaf Weber gave a presentation on the relationship between sustainable development performance and financial performance, including EBITDA margin, credit risks, option pricing and rules of thumb valuation.

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  • This presentation was delivered by Dr. Olaf Weber at the Canadian Responsible Investment Conference in Victoria, British Columbia on June 20, 2011.
  • This slide deck is targeted towards portfolio managers with institutional investors, ESG and securities analysts, and high net-worth advisors. It is part of a ‘tech-intensive’ session on ESG Valuation and Risk Management.
  • So far we talked about a relation. However, we did not discuss the direction of the relation. Thus there are mainly two directionsFinancial performance influences environmental performance and environmental performance influences financial performanceFinancial performance influences environmental performance means that for example Investing in community relations and charity is only done if the company was successful and thus can afford the costs for investing in the community, charity or environmental issues.Environmental performance influences financial performance, means that it pay to be green. Examples are energy-efficiency measures to reduce energy costsThus a Win-win-situation is creating a positive impact on the companies success and on the environment.
  • Let us have a look on some research results. Margolis and Walsh analysed a high number of studies on the relation between environmental and financial performance. They came to the conclusion that a majority of these studies reported about a positive relation between environmental and financial performance.A small number reported about a negative relation, meaning that high environmental performance creates costs or diminishes returns.About 20 studies reported a small relation and about 15 reported mixed results that could not confess a positive or a negative relation.Thus let us explore these results, find arguments for them and try to explain why there is such a variance.
  • Generally there are three kinds of relations between environmental and financial performanceA Positive relation means: Good environmental performance creates successful business. It does pay to be green. Maybe because it reduces costs or attracts more clients.A Negative relation means that good environmental performance creates less successful business. It costs to be green. Maybe because investments in environmental issues are not rewarded by the market or the clientsA Neutral relation means that environmental performance and corporate success are independent.
  • The Relationship between Sustainability Performance and Financial Performance

    1. 1. The Relationship between Sustainability Performance and Financial Performance<br />Dr. Olaf Weber<br />Export Development Canada Chair in Environmental Finance, SEED, University of Waterloo<br />
    2. 2. Content<br />Introduction<br />EBITDA and Sustainability Performance<br />Credit Risk and Sustainability Performance<br />SRI Funds and Sustainability Performance<br />Conclusions<br />
    3. 3. Two Possible “Cause and Effect” Relations between Sustainability Performance and Financial Performance<br />Financial performance influences sustainability performance<br /> investing in community relations and charity<br />Sustainability performance influences financial performance<br />energy-efficiency measures to reduce energy costs<br />3<br />
    4. 4. Research Results on the Relationship between SD and Financial Performance<br />MARGOLIS, J. D. & WALSH, J. P. (2001) People and Profits? The Search for a Link Between a Company´s Social and Financial Performance, Mahwah NJ, London, Lawrence Earlbaum Associates, Publishers.<br />4<br />
    5. 5. Three Kinds of Relations<br />Positive<br />Good Sustainability performance creates successful business<br />Negative<br />Good Sustainability performance creates less successful business<br />environmental initiatives are applied poorly<br />Neutral<br />SD performance and corporate success are independent<br />5<br />
    6. 6. Why a Positive Effect of SD Performance on Business?<br />Access to Markets/Regulatory Approvals<br />Customer Attraction/Retention<br />Address Media/Activist Pressures<br />Discounted Loan Rates<br />Reduced Insurance Premiums<br />Operational Efficiency<br />Due Diligence Regarding Partnerships/Acquisitions<br />Legal Due Diligence/Assurance<br />Employee Satisfaction/Retention/Productivity<br />Industry Self-Regulation<br />Facilitate Divestitures<br />SRI Funds (Retail/Institutional)<br />6<br />
    7. 7. Why a Negative Effect of Sustainability Performance on Business?<br />higher costs<br />end of pipe environmental technology<br />lower benefits<br />environmentally friendly products are not accepted by consumers because of high prices<br />Sustainability performance has been poorly applied<br />investing in the wrong fields (offsets vs. technology)<br />7<br />
    8. 8. Why a Neutral Effect of Sustainability Performance on Business?<br />The influence of Sustainability performance is too small compared to other influences<br />Sustainability performance is not perceived by the market<br />8<br />
    9. 9. Negative and Positive Effect for Portfolios:Portfolio Theory vs. Socially Responsible Investment (SRI)<br />What happens if non-sustainable companies are excluded from the investible universe?<br />Positive effect: non-sustainable companies are destined to mediocre financial performance<br />Negative effect: constraining the investible universe is destined to mediocrity<br />Does sustainability correlate with financial performance?<br />9<br />Milevsky, M., Aziz, A., Goss, A., Comeault, J., & Wheeler, D. (2006). Cleaning a Passive Index: How to Use Portfolio Optimization to Satisfy CSR Constraints. The Journal of Portfolio Management(Spring), 110-118. <br />
    10. 10. Sustainability Performance and EBITDA Margin<br />Earnings Before Interest, Taxes, Depreciation and Amortisation margin (EBITDA)<br />EBITDA margin is EBITDA divided by total revenue<br />It measures the extent to which the cash operating expenses use up revenue<br />10<br />
    11. 11. The Influence of Sustainability Performance onEBITDA Margin<br />Study based on ASSET4 / Thomson Reuters ESG data<br />More than 100 companies<br />Sustainability drivers<br />Sustainability outcomes<br />11<br />Weber, O., Koellner, T., Habegger, D., Steffensen, H., & Ohnemus, P. (2008). The relation between sustainability performance and financial performance of firms. Progress in Industrial Ecology, 5(3), 236-254. <br />
    12. 12. Sustainability Drivers and Outcomes<br />Drivers<br />Based on reporting<br />Strategies and operations to manage sustainability performance<br />Outcome<br />Based on quantitative measures<br />Positive impact on the environment or the society<br />A company may have a state of the art environmental management system, but very high CO2 emissions<br />12<br />
    13. 13. Indicators Analysed<br /><ul><li>Social drivers
    14. 14. Employment
    15. 15. Labour-management relations
    16. 16. Health and safety
    17. 17. Training and education
    18. 18. Diversity and opportunity
    19. 19. Human rights
    20. 20. Society
    21. 21. Product responsibility
    22. 22. Social outcomes
    23. 23. i.e. community support</li></ul>Environmental drivers<br />Materials<br />Energy<br />Water<br />Biodiversity<br />Emissions<br />Products and services<br />Compliance and expenditures<br />Environmental outcomes<br />i.e. CO2 emissions<br />13<br />
    24. 24. Model<br />Year 1<br />Year 1<br />Year 1-3<br />14<br />
    25. 25. Environmental Outcomes by Sector<br />15<br />
    26. 26. Environmental Drivers and EBITDA per Sector<br />16<br />
    27. 27. Environmental Outcomes and EBITDA per Sector<br />17<br />
    28. 28. Environmental Drivers and EBITDA<br />18<br />
    29. 29. Environmental Outcomesand EBITDA<br />19<br />
    30. 30. Multiple Regression Models for Drivers and Outcomes<br />There is a positive influence of the outcomes on EBITDA margin<br />20<br />
    31. 31. The Relationship between Sustainability Performance and Financial Indicators<br />21<br />
    32. 32. Conclusions (EBITDA)<br />There is a positive relation between sustainability performance and EBITDA margin<br />Generally the positive relation between sustainability outcomes and EBITDA margin is stronger than between sustainability drivers and EBITDA margin<br />The sustainability result counts<br />22<br />
    33. 33. 23<br />Default Risk…<br />Integrating Sustainability Indicators into Credit Risk Management<br />
    34. 34. Credit Risks and Sustainability Credit Risks<br />Credit risk is the uncertainty about the future outcome of loans<br />Compliance with the credit agreement<br />Default (non-compliance with the credit agreement as defined by Basle II)<br />Sustainability Credit Risk<br />Uncertainty about the future outcome of loans emerging from environmental, economic and social sustainability risks<br />24<br />
    35. 35. Ability to <br />repay<br />?<br />Ability to repay? <br />•<br />•<br />Collateral<br />value<br />?<br />Collateral value?<br />•<br />•<br />Reputation <br />risk<br />?<br />Reputation risk? <br />•<br />•<br />Core Questions<br />Does a commercial debtor’s sustainability performance affect its credit risk rating?<br />Does adding criteria aimed at assessing a debtor’s sustainability performance provide added value to traditionalfinancial rating criteria?<br />25<br />
    36. 36. Sustainability Risks in Credit Business<br />Security risks of sites used as collateral that are contaminated<br />Contamination of a site affects the collateral value <br />Reputation risk<br />Banks can attract a bad reputations because of bad reputation of a debtor<br />Influences on the ability to repay the loan<br />Debtors can be obliged to invest in environmental technologies because of regulations<br />Changes in environmental attitudes of consumers or industries influence the business performance of a debtor<br />26<br />
    37. 37. Credit Rating Criteria<br />27<br />
    38. 38. Results<br />?<br />Economic (sustainability) criteria<br />?<br />Environmental (sustainability) criteria<br />?<br />Social (sustainability) criteria<br />Traditional criteria<br />?<br />Default / non-defaultclassification by thecredit manager<br />28<br />
    39. 39. Predicting Credit Risk by Traditional Rating and Sustainability Indicators<br />Traditional rating (logistic regression)<br />Correct predictions = 81.1%<br />AUROC = .91<br />Traditional and sustainability rating (logistic regression)<br />Credit Risk = 5.10*trad.+2.14*econ. sust.+1.10*soc. sust.-1.44*env.sust.-21.87<br />Correct predictions = 85.7%<br />AUROC = .94<br />29<br />
    40. 40. Are Banks Integrating SD/Environmental Indicators into the Risk Management Process?<br />30<br />
    41. 41. Conclusions (Credit Risk)<br />Ability to <br />repay<br />?<br />Management <br />?<br />•<br />•<br />Ability to repay<br />Collateral<br />value<br />?<br />?<br />•<br />•<br />Future earnings<br />Reputation <br />risk<br />?<br />?<br />•<br />•<br />31<br />Debtors may improve their credit ratings by improving their sustainability performance<br />Banks may improve their credit risk prediction by integrating sustainability indicators into the risk management process<br />
    42. 42. The Performance of SRI Funds in Times of Turmoil<br />Is there a significant difference in the financial return between a portfolio of SRI funds and a conventional index during times of turmoil?<br />Is there a relation between financial and sustainability ratings based on the past performance of funds and the return of an SRI fund portfolio in times of turmoil?<br />
    43. 43. Database<br />151 SRI Equity Funds<br />December 2001 to June 2009<br />Sustainability rating<br />Monthly returns<br />MSCI World as benchmark<br />Source: Weber, O., Mansfeld, M., & Schirrmann, E. (2011). The Financial Performance of RI Funds After 2000. In W. Vandekerckhove, J. Leys, K. Alm, B. Scholtens, S. Signori & H. Schaefer (Eds.), Responsible Investment in Times of Turmoil (pp. 75-91). Berlin, Germany: Springer.<br />
    44. 44. Results: Returns between 2001 and 2009<br />
    45. 45. Returns in Bull Phase<br />
    46. 46. Returns in Bear Phase<br />
    47. 47. Conclusions SRI Funds<br />SRI Funds are able to outperform conventional benchmarks<br />General market impacts influence SRI funds as well<br />Sustainability rating alone does not guarantee outperformance<br />The combination between sustainability rating and financial rating creates outperformance<br />
    48. 48. The use of sustainability criteria in company analyses, credit risk evaluations and asset management may create financial benefits<br />Cause-effect studies are needed<br />From correlative studies to filtering out those that are able to combine sustainability and financial performance<br />38<br />Conclusions<br />
    49. 49. Thank you!<br />Dr. Olaf Weber<br />Associate Professor, Export Development Canada Chair in Environmental Finance<br />School for Environment, Enterprise and Development<br />University of Waterloo<br /><br />