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Environmental Productivity Analysis Is Essential

Successful investors are always looking for incremental information advantages in their quests to generate superior returns for their clients. In our world, where natural resources are increasingly constrained, a company’s environmental productivity (EP) is an essential piece of data that all investors should consider.

Our World’s Finite Natural Resources

Economic forecasts point to at least a tripling of the demands on our natural resources by 2050, absent any change in our economy’s natural resource impact intensity. Simple supply/demand models suggest that this will lead to higher and more volatile pricing for the use of and impact on our planet’s natural systems. Additionally, these costs—which have historically been viewed as “externalities” for companies—are increasingly being pushed onto all companies’ income statements and balance sheets by regulatory and investor pressure. Hence, companies need to evolve their operations to assure success in this world of increasing constraints on natural resources.

Considering EP as a Factor

The use of EP helps provide better risk-adjusted returns for investments, while also playing a role in positively impacting our natural capital resources. Importantly, the broader the adoption of using this data and EP analysis, the greater the pressure on our economic system to be more environmentally prudent and conscious of natural resource need and use. Wide adoption of EP in business and investing will change our economic system and its use of natural resources, so in this way, investing with EP is an “impact investment” approach at its core; it’s simply a better way to evaluate investment opportunities.

Higher Returns

Increasingly, research demonstrates that companies with higher environmental awareness provide higher returns for their shareholders.

  • Research on sustainability as a driver of financial outperformance used 200 sources of research on ESG and found 80 percent of the studies showed a positive investment return from companies with diligent sustainability practices. A Harvard Business School study showed that when companies invested in “material” sustainability projects—identified via industry-specific classifications of material sustainability areas—those firms with “good” ratings on material sustainability issues outperformed the same industry firms with “poor” performance investing in material sustainability issues.

At a corporate level, environmentally efficient projects demonstrate prudent preparation for long-term profitability.

For active investors, finding informational advantages that generate improved returns is a constant endeavor. With the growth of passive investment products (for example, index funds and exchange traded funds), it’s never been more important. For fiduciaries, being able to better assess their investment managers’ and funds’ (active or passive) abilities to find opportunities and manage risks is an ongoing challenge. The tracking of environmental data (along with other ESG factors) can provide a more detailed picture of companies and assets not yet found in mainstream reporting or in brokerage house research.

Emissions Data

Energy efficiency and assessing greenhouse gas (GHG) emissions start with using a company’s disclosed data on GHG emissions—Scope 1 and 2 (and Scope 3, when possible). In addition to their contribution to a warming and increasingly unstable planetary weather system, GHG emissions can reflect inefficiencies in energy use and create risks and opportunities as regulations and markets increasingly move toward global efforts to combat the negative impacts caused by climate change.

Already, it’s estimated that nearly 70 percent of all new electric capacity added in the next 25 years will be from renewables.

  • New York-based utility Con Edison estimates it will save roughly $1 billion by deploying a mix of renewables (for example, solar and fuel cells) and efficiency measures instead of building out conventional energy infrastructure to accommodate growing demand in New York City.
  • Hilton Worldwide’s environmental management efforts, which have reduced energy use by 14.5 percent and carbon output by 20.9 percent (compared to 2009 levels), have saved the hotel chain $550 million since 2009.

Water Access and Use Data

Fresh water is only 2.5 percent of the earth’s supply, 70 percent of which is inaccessible. Limited or no access to water—what was once a distant concept to businesses—has now become reality for many and a near-term challenge globally.

Competition for water can disrupt operations, damage reputations and constrain growth. In 2015, 405 global companies reported detrimental water challenges that totaled more than $2.5 billion (from CDP’s 2015 annual water survey). Droughts in the United States in 2011 halved the production of cotton, causing cotton prices to spike. Gap Inc.’s share price fell 17 percent after cutting its full-year profit forecast by 22 percent due to the scarcity of cotton.

Also in 2011, higher-than-average rainfall aligned with other factors to cause Thailand’s worst floods in 50 years. Almost 40 percent of the world’s hard disk drive (HDD) production and manufacturing facilities were located in Thailand’s Chao Phraya River valley, a known floodplain. The severe floods caused massive evacuations, factory shutdowns and supply chain disruptions for all industrial processes located in the valley:

  • HDD shipments fell 30 percent below demand orders.
  • The world’s biggest HDD maker, Western Digital Corp., was forced to close its Thai factories, where it made 60 percent of its HDDs. Its operations and ability to meet customer demand were seriously impacted. Shares dropped 7 percent in one day.
  • The global shortage of HDDs added $5 to $10 to the cost of each hard drive, as reported by Lenovo Group Ltd., the world’s second biggest maker of PCs.
  • Toyota, Honda, Nissan and Ford all had to close their Thai plants, and the shortages of parts slowed manufacturing around the world. Honda faced costly repairs to its flood-damaged factory; it was forced to delay model releases, and it reported negative earnings that quarter. In 2011, Honda’s stock was down 28 percent. Toyota reported an 18.5 percent net income drop, a 4.8 percent decline in revenue and a 32.4 percent fall of operating profit. Toyota’s stock was down 22 percent following the negative earnings report.

Conversely, the information technology company Cognizant was prepared and able to implement continuity plans by shifting operations to another location when floods closed all 11 offices in the city of Chennai, India in December 2015. There was no impact on its operations as a result, nor on its stock price.

Materials and Waste Data

Collecting data on material use and waste production is a fairly simple means to assess the financial advantages of a company’s material-use efficiency. Material extraction and waste generation have historically undergirded global economic growth and are both increasing as global consumption continues to grow.

Risks and opportunities manifest in operational, reputational, regulatory and strategic marketing realms for companies regarding material use and waste production. The collection of a company’s physical waste is typically an obvious and quantifiable company expense; hauling away less waste makes an immediate reduction on company cost. Content used can make a material difference, too.

  • In 2013, only 7.2 percent of Pepsico’s waste was sent to a landfill, allowing the company to avoid $3 million in landfill disposal costs.
  • In March 2015, a 60 Minutes report exposed unlawfully high levels of formaldehyde in laminate flooring from Lumber Liquidators. The company was subject to investigations and fines, and its stock fell over 80 percent from its 2015 peak. Had the company properly assessed the intensity and content of its material inputs, perhaps the damage could have been avoided.

Inclusion of EP

In a world with a rapidly increasing population and a growing middle class, the pressure on our finite natural resources necessitates that the corporate sector adapt to a more efficient use of natural capital for long-term profitability. Environmental data allow for quantitatively driven analysis that complements other financial and performance indicators. The EP analysis is an essential investing tool for successful portfolio construction in the 21st century.

 

This is an adapted and abbreviated version of the authors' original article in the September issue of Trusts & Estates.

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