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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The Relationship between Sustainability Performance and Financial Performance
1. The Relationship between Sustainability Performance and Financial Performance Dr. Olaf Weber Export Development Canada Chair in Environmental Finance, SEED, University of Waterloo
2. Content Introduction EBITDA and Sustainability Performance Credit Risk and Sustainability Performance SRI Funds and Sustainability Performance Conclusions
3. Two Possible “Cause and Effect” Relations between Sustainability Performance and Financial Performance Financial performance influences sustainability performance investing in community relations and charity Sustainability performance influences financial performance energy-efficiency measures to reduce energy costs 3
4. Research Results on the Relationship between SD and Financial Performance 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. 4
5. Three Kinds of Relations Positive Good Sustainability performance creates successful business Negative Good Sustainability performance creates less successful business environmental initiatives are applied poorly Neutral SD performance and corporate success are independent 5
6. Why a Positive Effect of SD Performance on Business? Access to Markets/Regulatory Approvals Customer Attraction/Retention Address Media/Activist Pressures Discounted Loan Rates Reduced Insurance Premiums Operational Efficiency Due Diligence Regarding Partnerships/Acquisitions Legal Due Diligence/Assurance Employee Satisfaction/Retention/Productivity Industry Self-Regulation Facilitate Divestitures SRI Funds (Retail/Institutional) 6
7. Why a Negative Effect of Sustainability Performance on Business? higher costs end of pipe environmental technology lower benefits environmentally friendly products are not accepted by consumers because of high prices Sustainability performance has been poorly applied investing in the wrong fields (offsets vs. technology) 7
8. Why a Neutral Effect of Sustainability Performance on Business? The influence of Sustainability performance is too small compared to other influences Sustainability performance is not perceived by the market 8
9. Negative and Positive Effect for Portfolios:Portfolio Theory vs. Socially Responsible Investment (SRI) What happens if non-sustainable companies are excluded from the investible universe? Positive effect: non-sustainable companies are destined to mediocre financial performance Negative effect: constraining the investible universe is destined to mediocrity Does sustainability correlate with financial performance? 9 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.
10. Sustainability Performance and EBITDA Margin Earnings Before Interest, Taxes, Depreciation and Amortisation margin (EBITDA) EBITDA margin is EBITDA divided by total revenue It measures the extent to which the cash operating expenses use up revenue 10
11. The Influence of Sustainability Performance onEBITDA Margin Study based on ASSET4 / Thomson Reuters ESG data More than 100 companies Sustainability drivers Sustainability outcomes 11 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.
12. Sustainability Drivers and Outcomes Drivers Based on reporting Strategies and operations to manage sustainability performance Outcome Based on quantitative measures Positive impact on the environment or the society A company may have a state of the art environmental management system, but very high CO2 emissions 12
23. i.e. community supportEnvironmental drivers Materials Energy Water Biodiversity Emissions Products and services Compliance and expenditures Environmental outcomes i.e. CO2 emissions 13
32. Conclusions (EBITDA) There is a positive relation between sustainability performance and EBITDA margin Generally the positive relation between sustainability outcomes and EBITDA margin is stronger than between sustainability drivers and EBITDA margin The sustainability result counts 22
34. Credit Risks and Sustainability Credit Risks Credit risk is the uncertainty about the future outcome of loans Compliance with the credit agreement Default (non-compliance with the credit agreement as defined by Basle II) Sustainability Credit Risk Uncertainty about the future outcome of loans emerging from environmental, economic and social sustainability risks 24
35. Ability to repay ? Ability to repay? • • Collateral value ? Collateral value? • • Reputation risk ? Reputation risk? • • Core Questions Does a commercial debtor’s sustainability performance affect its credit risk rating? Does adding criteria aimed at assessing a debtor’s sustainability performance provide added value to traditionalfinancial rating criteria? 25
36. Sustainability Risks in Credit Business Security risks of sites used as collateral that are contaminated Contamination of a site affects the collateral value Reputation risk Banks can attract a bad reputations because of bad reputation of a debtor Influences on the ability to repay the loan Debtors can be obliged to invest in environmental technologies because of regulations Changes in environmental attitudes of consumers or industries influence the business performance of a debtor 26
38. Results ? Economic (sustainability) criteria ? Environmental (sustainability) criteria ? Social (sustainability) criteria Traditional criteria ? Default / non-defaultclassification by thecredit manager 28
39. Predicting Credit Risk by Traditional Rating and Sustainability Indicators Traditional rating (logistic regression) Correct predictions = 81.1% AUROC = .91 Traditional and sustainability rating (logistic regression) Credit Risk = 5.10*trad.+2.14*econ. sust.+1.10*soc. sust.-1.44*env.sust.-21.87 Correct predictions = 85.7% AUROC = .94 29
40. Are Banks Integrating SD/Environmental Indicators into the Risk Management Process? 30
41. Conclusions (Credit Risk) Ability to repay ? Management ? • • Ability to repay Collateral value ? ? • • Future earnings Reputation risk ? ? • • 31 Debtors may improve their credit ratings by improving their sustainability performance Banks may improve their credit risk prediction by integrating sustainability indicators into the risk management process
42. The Performance of SRI Funds in Times of Turmoil Is there a significant difference in the financial return between a portfolio of SRI funds and a conventional index during times of turmoil? 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?
43. Database 151 SRI Equity Funds December 2001 to June 2009 Sustainability rating Monthly returns MSCI World as benchmark 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.
47. Conclusions SRI Funds SRI Funds are able to outperform conventional benchmarks General market impacts influence SRI funds as well Sustainability rating alone does not guarantee outperformance The combination between sustainability rating and financial rating creates outperformance
48. The use of sustainability criteria in company analyses, credit risk evaluations and asset management may create financial benefits Cause-effect studies are needed From correlative studies to filtering out those that are able to combine sustainability and financial performance 38 Conclusions
49. Thank you! Dr. Olaf Weber Associate Professor, Export Development Canada Chair in Environmental Finance School for Environment, Enterprise and Development University of Waterloo oweber@uwaterloo.ca
Editor's Notes
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.