Can finance be sustainable?
Until relatively recently, the dominant ideology of modern business was the doctrine of shareholder value – the idea that businesses existed to maximise the owner’s profit. Over the past two decades, however, a new idea has taken root: that managers must also consider how a business’s conduct affects its customers, employees, society, and the environment.
Story by Bennett Voyles
Sustainable finance is a new approach to financial decision-making that gives companies and investors a clearer idea of the social and economic costs of their investment. ‘More and more people are getting on to it. In fact, it’s catching on like wildfire,’ says Prof. Dirk Schoenmaker, professor of banking and finance at RSM, who recently published an e-book on the subject titled From risk to opportunity: a framework for sustainable finance.
Conceptually, the idea of sustainable finance made intuitive sense. But at first, observes Prof. Schoenmaker, managers and investors didn’t really have the tools to measure how well a company performed. People experimented with different paradigms, such as a triple bottom line, but these alternatives tended to add a level of complexity that didn’t always help managers make better decisions. It also positioned the environmental and social aspects as something extrinsic to the economic health of the business, which in the end always positioned sustainability as a cost rather than a source of opportunity, a bit like regulatory compliance.
Revisiting the time horizon
Schoenmaker argues that in the end, the problem of accounting for sustainability has less to do with the limitations of traditional accounting than the time horizon with which we evaluate investments. An irresponsible environmental practice, for example, may yield a company more profit in the short term but not in the long term, once the true costs are incorporated: in the short run, a company might make more money by dumping toxic sludge in the river, but not if you count the millions someone may have to spend to clean it up in 20 years or the cost of the sicknesses it may cause.
Under a sustainable financial approach, a company would incorporate those negative externalities up front, Prof. Schoenmaker says, including them in your calculation of net present value. This kind of “true price” analysis can give companies a better sense of the advantages of sustainable practices.
For instance, one 2014 analysis – of cut rose shipments from Kenya that sold for an average 70 cents per stem in Europe – found that making a number of sustainability-friendly changes such as transportation by ship, the use of solar-powered greenhouses, closed-loop hydroponics, and health and safety training for workers, would actually reduce the true cost per rose from 92 cents to 74 cents.
But sustainable finance is not just about risk reduction: it’s also a good way to find new opportunities. One case in point, he said, is to think about a traditional car company trying to decide whether to manufacture an electric vehicle. In traditional terms, an electric car might look like a long-shot bet best left to Elon Musk.
However, once you incorporate a rising price of carbon, Prof. Schoenmaker points out, it starts to look irresponsible for the company to not invest in electric vehicles. ‘At this point, if your car company has not the ability to make electric cars, I would be worried as a shareholder,’ he adds. Sustainable finance also tends to reduce volatility by reducing cost variability: the wind farm’s cost for wind, for example, doesn’t change over time.
Spreading the idea
Prof. Schoenmaker is teaching his students at RSM to use this new technique by asking them to make a standard cash flow analysis of a few companies, but then asking them to incorporate other environmental and social costs into their spreadsheets. ‘It’s not rocket science,’ he says.
One advantage young people have is that they already think this way, he says, so they can focus on mastering the tools they need to express this concept in financial form. Converting corporations, however, may be a longer process. First, because the multiple tiers in the modern supply chain make such accounting difficult. ‘You can only adopt this strategy if you know the value chain in full, and the entire value chain is committed to the effort,’ Prof. Schoenmaker says.
Second, Wall Street may also be a tough sell. Sustainable investing does not align well with passive index investing in which investors don’t know the companies they hold, he said. In addition, short-term trading keeps investors further disengaged from the long-term consequences of their investment.
Ultimately, however, Prof. Schoenmaker cautions, finance can only do so much. A lot will still depend on consumers, and our willingness to buy products whose true costs are reflected in their price.
Professor Dirk Schoenmaker
Dirk Schoenmaker is professor of banking and finance and academic director of the MSc Finance & Investments Advanced programme at RSM. Dirk is also senior fellow at the Brussels-based think tank Bruegel, member of the Advisory Scientific Committee of the European Systemic Risk Board at the ECB, and research fellow at the Centre for European Policy Research.
Download Professor Dirk Schoenmaker’s From Risk to Opportunity: A Framework for Sustainable Finance.