NET PRESENT SUSTAINABLE VALUE | Major Sustainability

FINANCE & SUSTAINABILITY

Sustainability in Basic
Investment Models

To bring structure and rigor to sustainable investing, ESG (environment, social and governance) factors are incorporated into basic investment and valuation models. According to Principles for Responsible Investing (PRI)’s guidance on integration of ESG into fundamental investment models the incorporation of ESG factors is increasing as data becomes more available and reliable.

Fundamentally, in sustainable finance, ESG factors are integrated into:

- financial forecasting models to accurately reflect ESG impacts on revenue, operating and capital costs, asset book value and thus net present value (NPV)
- company valuation models affecting dividend discount models and discounted cash flow (DCF)

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How ESG factors relate to elements of financial models (Source: WWF)

Forecasting, Sustainability and Net Present Sustainable Value

Valuation from a sustainability perspective includes many factors not traditionally considered. The “10 Principles of Sustainable Value Analysis from HDR provides a good general overview. However, these factors must be measured and quantified via specific valuation models like Net Present Value.

Net Present Value (NPV) is a common method of evaluating and comparing potential projects. Sustainable finance which considers environmental, social and governance (ESG) factors can improve upon the NPV model to increase accuracy and allow for better comparisons between investments.

The traditional NPV method calculates the value of an investment today by discounting forecasted future cash flows so they can be understood in today’s dollars.

Case: How ESG affects valuations and NPV (Source: PRI)

- Criticism about labor standards, especially poor wages and overtime, has been surfacing at a company’s suppliers and sub-contractors in Southeast Asia
- Capital investments to improve standards are assumed to increase sales by increasing productivity, decreasing turnover and increasing sales thus impacting future cash flow projections
- The protection of workers enhances brand strength, risk management and as a result financial managers decrease the discount rate by 50 basis points

Beyond the Basics: Emerging Financial Models for Combat Poverty and Climate Change

In addition to integrating ESG into traditional financial models, a whole new set of emerging financial models is pushing the boundaries for how capital and debt markets can advance sustainability.

World Wildlife Fund (WWF) provides an example of how ESG issues affect financial models of infrastructure assets.

Payment for Ecosystem Services (PES), explained in the short video on the left, is just one of many emerging types of financial tools that make use of traditional models to protect natural systems and provide sustainable livelihoods–including paying people to not chop down trees so they can soak up carbon (NY Times).

Another example is the Global Footprint Network’s Net Present Value Plus (NPV+). NPV+ considers all costs and benefits to be “cash flows,” even if there was no actual exchange of monetary value. For example, purchasing land for conservation brings about environmental benefits that would not be calculated as cash flows in a traditional NPV calculation. NPV+ would include the full ecosystem benefits of that investment as cash flows.