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End the drought; invest in sustainability and make it rain


Economic development relies on strong investment, not just by those who provide capital to companies but by the companies themselves. Corporate investment enables innovation and enhanced productivity, helping companies to offer new and improved products and services while meeting the challenge of scale.

 

However, according to a recent UBS report, companies’ capital (CAPEX) and research and development (R&D) expenditures have been decreasing significantly over the past several years. Meanwhile, an increasing portion of corporate earnings is being distributed to shareholders as dividends or share repurchases. In other words, investors are getting returns today, but as UBS points out, they may be coming at a long-term cost.

 

The paper, titled “The Investment Drought,” partially attributes this corporate behavior to short-termism among institutional investors who focus on “near-term free cash flow metrics and quarterly earnings targets.” For example, excessive desire to meet next quarter’s earnings projections may prevent CEOs from taking on investment projects with positive net present value (NPV). The report cites a McKinsey survey which found that 55 percent of 400 CFOs would rather meet earnings estimates than take on an investment benefiting their company over the long-term.

 

The report identifies changes to tax systems and compensation structures as some of the solutions to incentivize more long-term investing by companies and investors. However, even in the absence of more bureaucratic incentives, other external factors have already increased the relevance of far-sighted investment thinking. Sustainability issues can have direct impacts on companies’ cash flows, earnings, and financial position through dwindling natural resources, physical impacts caused by damaged ecosystems, and increasing societal and regulatory pressure. By managing these factors, companies can mitigate risks and capitalize on opportunities while investors, by considering these factors in investment decision making, are likely to have a more holistic view of a company’s performance.

 

SASB rigorously investigates the possible channels of financial impact for sustainability issues, and it is difficult to find an industry where CAPEX and R&D would not be affected by environmental, social, or governance factors. Climate change alone may impact a broad range of industries in a variety of ways. For example, in energy-intensive industries such as Chemicals, Containers & Packaging, or Iron & Steel Production, the cost of purchased electricity is likely to have a material impact on operating expenses. Companies in the Oil & Gas (O&G) industries emit significant amounts of direct greenhouse gases (GHG), regulations around which are becoming more stringent, creating regulatory compliance costs and risks. Industries that operate substantial fleets, such as Road, Rail, and Marine Transportation and Airlines are likely to be exposed to fluctuations in fuel prices. Moreover, the climate change issue is found to impact companies in the Automobiles, Auto Parts, Industrial Machinery, Appliance Manufacturing, and other industries, where customers are increasingly demanding products that have lower life-cycle environmental externalities, i.e. more fuel-, energy-, and water-efficient. In light of these impacts and regulatory efforts aimed at climate change mitigation, CAPEX and R&D are likely to be an increasing priority for these companies’ executives.

 

In fact, SASB’s Industry Research Briefs have identified many cases where sustainability factors have already begun to impact companies’ CAPEX or R&D expenditures. For example, Airline companies increasingly invest in fleet renewal and retrofit to meet stricter GHG emissions regulations as well as to improve their operational performance in the context of volatile fuel prices. One Containers & Packaging company was able to avoid $500,000 of environmental fees a year by implementing an advanced water treatment system; the system also creates methane gas that is later resold, resulting in total savings in excess of $1 million a year. At the same time, CAPEX on energy-related projects helped Iron & Steel Production companies to reduce cost of production by 4 to 14 percent, improving their margins. Moreover, in markets with regulatory efforts to internalize carbon prices or where vehicle emission standards are becoming more stringent, consumer preferences are likely to experience a shift, increasing demand for fuel-efficient or alternative-fuel vehicles. Therefore, automobile manufacturers that invest in R&D to meet regulatory requirements and evolving consumer demands are likely to improve their revenue and market share.

 

When assessing investment projects for NPV or internal rate of return, companies need to take into account the rapidly changing environment in which they operate, including the evolving sustainability issues likely to have material impacts. As the probability and magnitude of such impacts increase, value added from CAPEX and R&D investment is also likely to rise. A failure to identify, measure, and manage industry-specific sustainability issues may exacerbate the existing risks associated with short-termism. On the other hand, those companies that recognize risks and opportunities early are likely to be better positioned for long-term sustainable growth, benefitting both the companies and their investors.