Most decisions in companies are made with some data and metrics to back them. Financial indicators are regarded as unbiased facts that tell the objective truth. Metrics like Discounted Cash Flows (DCF) and Net Present Value guide the direction of investments and the direction of our business.
Unfortunately, these metrics are not objective. Nor are they unbiased. Metrics often end up favoring unsustainable investments over sustainable ones. They fail to accurately value positive cash flows or savings generated by sustainable alternatives in the long run.
Financial metrics are like a flashlight in the dark
Chris Corps provides an example of the bias of metrics in Elkingtons & Hartigan’s 2008 book The Power of Unreasonable People. When asked to evaluate the financial estimates of a sewage treatment plant proposal, Corps notes that:
“– projection was that a sustainable approach could be as much as C$1.6 billion better than a traditional sewage approach. [As calculated by the client originally]. The discounted cash flow devalued the future cost savings and value benefits, which will grow substantially over the cash flow horizon, to 2065. One hundred dollars in 2065 is only worth $6.60 in the year of calculation”
In effect the use of discounted cash flows discounts the future value and the longer life cycle of sustainable approaches.
Time value of planet
Anyone who has some background in finance knows that the bias above is due to the time value of money. One euro is more valuable today than it is tomorrow. This applies regardless weather the euro is spent or saved.
The aim of this article is not to challenge time value of money or specific metrics. The aim is to show that strictly monetary metrics might over or undervalue sustainability related aspects. Accounting for time value in itself is often called for and necessary.
Below is an very bare-bones example of an investment with two scenarios. The scenario is most applicable to investments such as infrastructure where lifespans vary significantly and require notable real investments such as natural resources or energy.
Scenario A – An investment with a life-span of 20 years with a price of 10 000 €. The investment needs to be renewed at the end of its lifespan in year 2040.
Scenario B – A similar investment with a life-span of 40 years and thus a higher investment cost of 13 000 €. This investment does not have to be renewed during the 40 year period.
From a sustainability standpoint it is clear that is it more resource efficient to purchase only one investment in a usage cycle: Scenario B. The discounted cash flows however favor scenario A.
The re-investment in 2040 is 10 000 € which does not carry notable financial relevance since the Net Present Value is only ≈ 2 580 € (yearly interest of 7 %). From a sustainability standpoint however the resources needed are twice fold and the environmental cost does not diminish in relevance the time value of money does.
Environmental cost does not diminish in relevance as the time value of money does.
We cannot know the regulation or other sustainability related costs in 2040, thus it is also possible that the reinvestment in 20 years might hold additional sustainability costs or brand related challenges.
The presented metric show clearly that scenario A is cheaper. It is however safe to say that it fails to provide a holistic view of the situation and to account for both the environmental as well as the potential financial savings of Scenario B.
As one of the most rudimentary parts of the financial system it is not practical to question the relevance and the role of time value itself. It however is necessary to acknowledge its implications on sustainability and how it might guide us into the wrong direction in some occasions.
A flashlight is only as useful as the person deciding where to point it
Financial metrics are usually calculated by CFO’s or somebody on the same team. There are two crucial moments in the process that can lead to more sustainable use of metrics.
The choice of metrics. Choosing complementing metrics alongside financials that account for ESG factors. Another option is choosing more holistic financial metrics that include the monetary value to ESG factors in one way or another.
Acknowledging the shortcomings of the used metrics. The most popular metrics are used widely and frequently in decision processes. Decision makers have come accustomed to NPV, payback-rate et cetera and know to expect them. Thus it might not be practical to omit them altogether but to more clearly acknowledge that they only show a small portion of the truth and carry uncertainties and blind spots.
The most important aspect when assessing investments is understanding and critically questioning where those numbers come from and how have they been processes. Current metrics are not bad or faulty, but they do have an array of characteristics that should be accounted for.
You only need a flashlight when it’s dark
The flow of capital and investments determines the success of sustainability efforts. The best sustainability innovation will never realize or even have the required incentives to innovate it in the first place unless financial motives are strong enough. Thus the critical evaluation of the metrics that dictate investments is crucial.
Most metrics account for the time value of money, which they should do. One Euro, Dollar or Yen is worth less in 20 years, but the same does not apply for one ton of CO2 or for natural resources to provide investments. It is even likely that the CO2 ton and natural resources are worth more in 20 years.
Reassessing the use of metrics and putting in the hours to understand their wider implications will guarantee concrete financial advantages and long-term savings.
Make sure your CFO has the needed knowledge the point the flashlight in the right direction, not only to the direction that it always has been pointed at. It is not only the planet you could be saving, it might be your business along with it.