The Relationship between Sustainability Performance and Financial Performance

Dr. Olaf Weber

Export Development Canada Chair in Environmental Finance, SEED, University of Waterloo

Content

• Introduction• EBITDA and Sustainability Performance• Credit Risk and Sustainability

Performance• SRI Funds and Sustainability Performance• Conclusions

Two Possible “Cause and Effect” Relations between Sustainability

Performance and Financial Performance

1. Financial performance influences sustainability performance– investing in community relations and charity

2. Sustainability performance influences financial performance– energy-efficiency measures to reduce energy

costs

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Research Results on the Relationship between SD and Financial Performance

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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.

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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

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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)

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Why a Negative Effect of Sustainability Performance on

Business?1. higher costs

• end of pipe environmental technology

2. lower benefits• environmentally friendly products are not accepted by

consumers because of high prices

3. Sustainability performance has been poorly applied• investing in the wrong fields (offsets vs. technology)

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• The influence of Sustainability performance is too small compared to other influences

• Sustainability performance is not perceived by the market

Why a Neutral Effect of Sustainability Performance on Business?

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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?

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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.

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

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The Influence of Sustainability Performance onEBITDA Margin

1. Study based on ASSET4 / Thomson Reuters ESG data

2. More than 100 companies

3. Sustainability drivers

4. Sustainability outcomes

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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.

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

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Indicators Analysed

• Environmental drivers– Materials– Energy– Water– Biodiversity– Emissions– Products and services– Compliance and expenditures

• Environmental outcomes– i.e. CO2 emissions

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• Social drivers– Employment– Labour-management relations– Health and safety– Training and education– Diversity and opportunity– Human rights– Society– Product responsibility

• Social outcomes– i.e. community support

ModelYear 1 Year 1 Year 1-3

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Environmental Outcomes by Sector

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Environmental Drivers and EBITDA per Sector

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Environmental Outcomes and EBITDA per Sector

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Multiple Regression Models for Drivers and Outcomes

• There is a positive influence of the outcomes on EBITDA margin

199.*006.*004.*017. outcomeoutcomeoutcomema soencgEBITDA

318.*033.*024.*022. driversdriversdriversma cgsoenEBITDA

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The Relationship between Sustainability Performance and

Financial Indicators

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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

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Default Risk…

Integrating Sustainability Indicators into Credit Risk

Management

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

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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?

• Ability to repay ?

• Collateral value ?

• Reputation risk ?

• Ability to repay?

• Collateral value?

• Reputation risk?

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Sustainability Risks in Credit Business

1. Security risks of sites used as collateral that are contaminated– Contamination of a site affects the collateral value

2. Reputation risk– Banks can attract a bad reputations because of bad

reputation of a debtor3. 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

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Credit Rating CriteriaTraditional criteria

(Cronbach’s alpha =.91) Economical Sustainability Criteria

(Cronbach’s alpha =.83) Environmental Sustainability Criteria

(Cronbach’s alpha =.76) Social Sustainability Criteria

(Cronbach’s alpha =.75) Reputation Legal capacity to borrow Competency of management Follow-up regulation Relations to the lender Potential for development Attainment of budget Dividend policy Sector Region Product and market Competition Clients Suppliers Volume of orders Future margin Agency report Credit limit Account turnover Outstanding interest and amortization Auditing company Management systems Trustee Personal securities Physical securities Liquidity ratio Return on equity Cash flow ratio Debt ratio Free Cash Flow Equity-to-fixed-assets ratio Self-financing ratio Risk of change in interest rates

Net debt service Sustained growth Quality of growth Sector development Integration of environmental aspect in economic decision making Robustness against crises Personal resources Community relations Risk of accidents Job creation Adequate firm size Eco efficiency Information and communication Material productivity Spatial relation Commuter mobility Car fleet Energy efficiency Technical update of power plants and machines Amount of waste Waste management Toxic waste Contaminated sites Technology management Material substitution Longevity Recycling capacity Redemption of used products Miniaturization of products Ecological product design Contracting

Costs of environmental measures Emissions Environmental friendly construction Consideration of nature and landscape Soil erosion Sealing of soil Sewage emission Sewage quality Air emission Noise emission Resource protection Material use Ratio of renewable resources Use of non-renewable energy sources Use of renewable energy Use of water (amount)

Wage policy Health policy Social security of the employees Workers’ participation Conservation of workplaces Flexible working conditions and working hours

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Results

Traditional criteria

Default / non-defaultclassification by thecredit manager

?

Economic (sustainability) criteria ?

Environmental (sustainability) criteria?

Social (sustainability) criteria

?

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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

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Are Banks Integrating SD/Environmental Indicators into the

Risk Management Process?

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Conclusions (Credit Risk)

• Ability to repay?• Collateral value?• Reputation risk?

• Management ?• ?• ?

Ability to repayFuture earnings

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• 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

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?

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.

Results: Returns between 2001 and 2009

Returns in Bull Phase

Returns in Bear Phase

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

• 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

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Conclusions

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