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SPECIAL FEATURE: Building sustainability into investment decisions

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“Capital investments made by organisations result in the commitment of significant resources to projects expected (in most cases) to enhance the value of the organisation and/or provide shared community benefits over time.”

An Australian study reveals trends in incorporating sustainability impacts when making capital investment decisions

The past decade has seen the emergence of significant interest in the way in which financial markets respond to environmental and social factors. Part of this trend has emerged out of the socially responsible investment movement, designed to offer investors the capacity to both positively and negatively screen their portfolios based on the responsibility characteristics of particular companies and their products. Impetus was added by the global financial crisis and responses to climate change.

As such, there is now a relatively high level of understanding on the availability of resources enabling the channelling of financial capital based on environmental and social risk and opportunity. The other significant flow of capital occurs within companies themselves, predominately through their capital investment strategies. Here our level of understanding is less developed. It is thus important to explore the extent to which established methods of capital investment appraisal are being adapted, or supplemented, to aid management in their decision-making across a widening range of financial and non-financial performance factors.

Capital investments made by organisations result in the commitment of significant resources to projects expected (in most cases) to enhance the value of the organisation and/or provide shared community benefits over time. Capital investment decisions are usually long-term and require significant resources. As yet minimal research exists to demonstrate how sustainability-related impacts are included in everyday capital investment appraisal. Indirect sustainability investment is where the sustainability impacts of routine capital budgeting projects are understood as ‘indirect’ to the proposal, but can be isolated in analysis. These are contrasted with direct sustainability investments when there is a deliberate choice to invest in sustainability assets. Certified Practising Accountants (CPA) of Australia has been able to explore indirect sustainability investment practice from the perspective of management decision-making and the use of associated tools.

Similarly, we do not know to what extent traditional or alternative sustainability-focused models are currently being used by companies. Little is known about the extent to which professional boundaries are drawn when sustainability-related expertise is required.

Most studies reveal the popularity of particular techniques and tools developed over decades. These show that corporations prioritise discounted cash flow techniques, such as net present value (NPV) and internal rate of return (IRR). Good practice guidance suggests discounted cash flow (DCF) analysis is the more appropriate tool from which to evaluate an organisation’s capital expenditures. More sophisticated capital budgeting techniques being used include real options, the Monte Carlo simulation, decision trees, and sensitivity analyses. When cash flow projections or risk profiling is challenging, it is argued that ‘real options’ theory may offer flexibility over DCF techniques alone.

With the view to developing a fuller understanding, CPA Australia, in collaboration with the International Federation of Accountants and HRH The Prince of Wales’ Accounting for Sustainability Project, undertook a survey of current practice in 2012. The study forms the platform for further investigation, by way of case studies, both in Australia and internationally.

A sample was selected to reflect organisations where sustainability-related issues are more likely to be present. As a result, two databases were combined to generate the sample. These were the Australian Stock Exchange top 300 companies (ASX300) and the National Greenhouse and Energy Reporting (NGER) register, which includes organisations that meet threshold levels of emissions as required by the Australian government. The project had 139 respondents commence the survey and complete at least portions of it, representing a 23% response rate. Some 69 respondents completed the majority of the survey (a response rate of 11.5%). Most respondent organisations were either private companies (40%); publicly listed (33%) companies or government entities (14%). The more dominant industry classifications were manufacturing and automotive (22%), transportation (20%) and mining (14%).

As with other studies, CPA Australia’s study notes the use of multiple methods for capital appraisal. The most widely used method (76.8% of respondents in this study) is net present value, which is shown to be the preferred tool in similar studies. This study shows less use of internal rate of return (55%), accounting rate of return (58%), payback (58%) and sensitivity analysis (43.4%). The second most used method for capital appraisal is cost–benefit analysis (61% of respondents), which interestingly has not featured prominently in previous studies. Other contemporary methods also used in the appraisal process are life cycle costing (29%), real options (24.6%), decision trees (17.4%) and economic value added (EVA) (17.4%). The least used methods are Monte Carlo simulation (8.6%) and marginal abatement curves (1%).

For each appraisal tool, respondents were further asked to identify its use in a range of investment decisions. For strategic and operational/replacement investment decisions, respondents adopt a multifaceted approach, not only using capital appraisal tools that rely on quantitative data but also incorporating qualitative analysis through the use of cost–benefit analysis, life cycle costing and sensitivity analysis.

Turning to some of the more specific sustainability related findings:

In building an understanding of the role of sustainability in decision-making, respondents were asked whether systems flag when sustainability-related data are required. Only 16% of respondents agreed that they used screening techniques to flag requirements for sustainability-related data collection. Similarly, there were mixed views on whether the financial effects of sustainability initiatives were specifically tracked (32% agreed, 33% disagreed). It appears that the major hurdles to the inclusion of sustainability-related impacts in capital appraisal are measurement difficulties, coupled with the lack of available data, cost of external expertise, and the cost of data collection.

Respondent comments also suggest that organisations are in the early stages of sustainability-related data collection and are currently building up the necessary resources and skills. One possible explanation for not including sustainability-related impacts in capital investment appraisal is that sustainability-related issues may be viewed more as a corporate-wide issue rather than specific to individual projects. This is partly supported by the 45% of respondents who report that they treat sustainability-related issues as corporate-wide rather than individual project overheads.

The decision type seems to have some influence over the use of different appraisal tools. Some differences occur in the prominence of using appraisal tools, whether the decision is more strategic or related to operational/replacement, occupational health and safety (OH&S) or to some other regulation. The decision type also seems to influence the extent of the use of qualitative data – and the mix between quantitative and qualitative data – in capital investment appraisal. Key sustainability-related items that are included in capital investment appraisal include OH&S compliance, employee health and well-being effects, the impact on brand and reputation, and clean-up and remediation costs.

Some final insights into the changing role of professional accountants, in Australia and, we believe by implication, internationally. Accounting staff seem to hold a more traditional view of accounting than we might otherwise expect, yet play a relatively minor role in initiating sustainability-related factors for consideration. They have a slightly greater role in verifying sustainability data and are slightly less involved than others in dealing with qualitative data.

John Purcell is Policy Advisor in Capital Corporate Regulation, CPA Australia