The Profitability of Sustainable Companies: Towards a Rating System

By Luisa Nenci

Author: Luisa Nenci

A Green Economy (GE) is growing if economic prosperity goes hand-in-hand with sustainability – developing investments in green sectors and in greening brown sectors. Some investors are already screening companies through enhanced qualitative parameters. However, these practices usually lead investors to companies operating in a green sector (for example renewable energy projects) and not to “normal” companies in the process of implementing a green business model.

These latter companies may be adopting cleaner production processes as part of an integrated strategy to maximise profits by making more efficient use of inputs (such as energy, water, and raw materials), thereby minimising waste and pollution. This is different from a conventional pollution abatement which captures or converts waste during production and thus increases capital and operating expenditures.

Environmental gains – if included in the company’s evaluation procedure – will also produce financial benefits: cleaner production improves profitability, creditworthiness, and brand loyalty. Many cleaner production initiatives yield paybacks in 3 to 24 months because process re-engineering not only decreases pollution but manufacturing costs as well. Cleaner production initiatives also help companies comply with environmental regulations and obtain a competitive edge on international markets.

This study focuses primarily on how and why people – consumers, businesses, non-profit organisations, government agencies, and financial institutions – make decisions regarding the use of valuable resources taking into account imperfect data, risk, and uncertainty. Furthermore, it analyses this decision process and considers how it could be restructured so that people are encouraged to take decisions that result in a more favourable impact on both the environment and society.

“In a purely economic approach, businesses pollute because this is the most economical way to address practical issues considering current economic factors. The consequences of many decisions for the environment are difficult or even impossible to gauge.”

In a purely economic approach, businesses pollute because this is the most economical way to address practical issues considering current economic factors. The consequences of many decisions for the environment are difficult or even impossible to gauge. In the environmental field, identification and quantification risk involves managing variability and uncertainty. In this context of uncertainty, the second phase of the decision-making process determines how much risk is acceptably based on the identification of a certainty (confidence interval) assigned to future events.

Having information usually reduces the uncertainty of a decision. However, sometimes even with proper data, people behave in a manner that causes environmental degradation. This begs the question: Why?

There are various answers to this question. Ethics may be lacking: people pollute because they lack the moral and ethical fortitude to refrain from doing so. A sense of ethics, such as a concern for the well-being of future generations – are important in environmental economics.

Efficiency, risk treatment, and ethical considerations can guide private and social choices related to the environment because a win-win solution is created. While the former is primarily a guide to avoid wasteful use of resources, the latter refers to the adequate management of the consequences of human actions and has to do with ensuring fair treatment to all parties.

Social and Environmentally Responsible Business

The narrow and exclusive focus on short-term profits has led to counterproductive and negative consequences for both business and society. In order to support broad and shared value creation processes, a number of firms have been working with stakeholders – shareholders, employees, customers, suppliers, the surrounding community, etc. – implementing corporate social responsibility (CSR) policies.

Instead of focusing on a generic responsiveness toward society, a stakeholder management perspective turns, first, on the importance of locating and classifying stakeholders – who are typically defined as “any group or individual who can affect, or is affected by, the achievement of the organisation’s objectives,” and, second, to detect, scan, and respond to social demand in order to achieve legitimacy and increase acceptance and prestige which, in turn, support long-term value creation.

An extensive and in-depth review of about 250 empirical and theoretical contributions allowed the mapping of the principal mechanisms by which CSR efforts may contribute to improved corporate performance, leveraging stakeholder-related drivers.

A Theoretical Framework

Studies have proven that CSR policies universally carry a favourable rate of return. As a whole, and despite a generally positive attitude towards CSR, periodic reviews have challenged the validity of studies that link investment in CSR to an improved bottom-line, rekindling the debate on the business case for CSR.

Pavie and Filho (2008) state: “There is a positive correlation between corporate social and financial performance. This relation tends to be bidirectional and simultaneous and a firms’ reputation is an important moderator of this. The various measures of financial and social performance are behind this relation.”

Even though the real impact of the CSR efforts on corporate performance is still questionable, the general inconsistency of the results obtained has to be attributed to the complex relationship between social and economic performance. This is ruled by situational, company- and facility-specific elements that are difficult to detect by most analytical approaches.

The Social and Environmental Credit Rating (SECR) System

The innovative proposal of my research is the development of a SECR and ethical rating system for the evaluation of medium-risk companies. This system is to include parameters based on the principles of environmental economics. The inclusion of social and environmental responsibilities of a given business into the rating system will upgrade the evaluation, encouraging the adoption of eco-friendly choices through credit and investment rewards.

Because this rating system will focus on the profitability of CSR policies – such as transparency, social responsibility, and accountability standards that stretch to beyond the minimum legal requirements – which reduce overall corporate risk and allow companies to access less expensive credit lines.

The main function of the rating system is to constitute a tool that efficiently provides a concise indication and summary of the comprehensive scrutiny conducted by independent analysts. The ethical rating will imply a methodologically impartial assessment based on the recognition of shared principles by companies. This rating represents a condensed and easily understandable judgement.

A well-designed set of indicators will measure key interactions between social, environmental, and economic criteria of different companies across selected sectors. Three principal groups of indicators relevant to the Green Economy (GE) concept can be considered:

• Define an exclusion list of sectors in which investors do not want to take positions;
• Define the social and environmental impacts and benefits of individual sectors;
• Define key sectors for GE investment.

Key sectors of the green economy include energy, building, transport, manufacturing, tourism, waste management, as well as critical ecosystem and resource-based sectors of agriculture, forests, fisheries, and water management.

The rating thus created will fill in the existing gap between the evaluation of micro projects – which normally have a low level of risk – and the full environmental impact assessment study required for large companies and big projects. Moreover, companies and projects with a medium environmental risk level are generally small and medium enterprises (SMEs).

Table 1: Relationship between CSR and Corporate Financial Performance (CFP). [k: number of correlation coefficients] – click to enlarge

The Framework

The framework, described above, will be implemented in order to set up a rating system that is based on an ethical review that investigates aspects related to social and environmental economic activities. This rating system will be closely complementary to a traditional evaluation because it can’t be the sole reference parameter for investors.

Taking into consideration the Sustainable Values ABIS (Academy of Business in Society, 2009) Research Project findings and recommendations:

“The role of the ratings agencies has not been considered and they have not been involved. However, a number of commentators have emphasised that they could and should be incorporating ESG risks into their assessments. We have not explored the dialogue and relationships inside companies between the CR/Sustainability function and the investor relations function, and within the investment community between ESG analysts and financial analysts and how this can be improved. The Value Creation Framework represents an important breakthrough, but the next step would be to show the interactions between improvements to the individual drivers of non-financial performance with one another.”

This strategy will be theoretically tested to assess a specific hypothesis: implementing an ethical rating system will promote investments in sustainable companies because socially and environmentally responsible businesses usually perform better.

The implementation of the concept of sustainability involves the assessment of the impact of corporate activities on society and the environment. That impact will be evaluated and included into the ethical rating via the selection of measurable parameters whose relevance will be tested through the analysis of real cases concerning companies that surpass median sectorial outcomes.

The implementation of the SECR has been developed from an original sample of 22,877 Spanish companies which are categorised according to their functional dimension, sector of economic activity, and geographically location. A theoretical model was developed with the idea that if banks can differentiate projects based on environmental risks, this may help companies show their achievements in sustainability.

“The role of the ratings agencies has not been considered and they have not been involved. However, a number of commentators have emphasised that they could and should be incorporating ESG risks into their assessments.”

For example, two sectors – construction and consumer – of the sample have been distributed on a matrix according to their financial credit merit (CM). The environmental impact which characterises their sectors were identified as green credit merit (GCM). Results show that if projects are funded with a rating of at least 50%, the bank will grant loans to at least 173 projects (≈ 7%) which are financially viable but may not be environmentally-friendly.

When a comparison is made between CM and green energy credit (GCMen) or waste (GCMw) where a specific environmental parameter is taken into account, results increase to funding 416 projects (≈ 17%) with a clear negative impact on energy (GCMen) and circa 10% with a clear impact on waste (GCMw).

Therefore, this (preliminary) analysis suggests that the GCM can significantly affect credit rating because it may include specific warnings about possible compensation of profitability and environmental quality. The increased sensitivity to the specific indexes GCMen and GCMw is due to fact that an improved definition of the environmental impact of projects helps in their evaluation and in better remediation techniques. The strong correlation between standard credit score and the more generic GCM is determined from the fact that if a bank decides to use an environmental credit rating, a first evaluation screening will involve a company’s green reputation or lack thereof.

Conclusions

Bridging the gap between current investment flows and what is needed to achieve sustainable growth is achievable. By defining the benefits created by investing in a green company, it is easy to conclude that the incremental costs of green growth is negligible compared to the costs of inaction.
However, there are important barriers to overcome, such as institutional inertia, the disadvantage of being the first, and a natural resistance to change.

A strong political and business vision is needed to undertake the transformation. More competitive solution are required because these reduce business risk by replacing environmental and social risk with the long-term management of physical and human resources. Improved management reduces the risk of fines for pollution or dumping, or to lose talented or experienced employees due to a contrary public opinion. Companies will gain competitiveness in terms of both financial budget and the financial management of cash flows.

The goal of green finance is to mobilise the largest possible green capital, sharing environmental and social objectives with the public. Mobilising private capital towards green investments will boost performance by increasing corporate competitiveness. Multiplying green public investments creates a win-win-win solution: economic growth receives a boost, environmental impact is reduced, and social equity is assured.