Sustainability and Return on Investment (Without the Spin)

Let me cut to the chase and say that the ROI for sustainability can be good, but almost never as good as some other investments companies can make.

Reading any of the Internet green blogs and newsletters will lead you to immediately conclude that sustainability is good for business. I am in total agreement. Where it gets sticky is when you hear about all the money saved or earned through sustainability efforts (especially environmental efforts such as energy savings). This also is a true statement.

The problem is when we take it too far and start boasting about return on investment (ROI). The issue of ROI on sustainability measures is quite complicated and not a simple matter. In most cases, the ROI of a new factory, new product, new production line, advertising and most other business investments will be much better than the ROI for sustainability on a purely financial basis. Investments for sustainability usually are made for strategic reasons and not for purely financial reasons, regardless of the spin that you read.

As a first caveat, ROI implies a capital investment. There is a huge array of sustainability projects that require no capital and either can save money or increase sales (or both). The recycling of waste is a simple example. One can go from paying for waste removal to actually selling waste — which means it is no longer a waste, to be technically correct — as just one simple example. The point is that this discussion does not include projects without capital investment.

My second caveat is that selling a product that builds sustainability (like wind turbines) is excluded. In this case, ROI clearly is a major issue, just as it is for most new product introductions requiring capital. Fee-constrained electric utilities offer just one example where ROI is a major consideration for the development of renewable energy (unless mandated by government).

My final caveat is that this discussion is limited to a very pragmatic view on capital investment based on my personal experiences, and does not include all potential or possible financial analyses that can be used.

ROI AND CAPITAL

ROI on capital is a standard business metric that has been around a very long time. In the vast majority of companies, investment is a function of earnings (a certain portion of earnings are plowed back into the company). While it is true that companies can and do borrow (through loans, bonds, stock, etc.) to make investments, no company will be able to borrow if it cannot justify the loan based on earnings (or cash flow). Investment monies are extremely difficult to get in most companies today (and in the past) due to the global economic slowdown and low rates of return.

Most investments are judged based on their payback (another metric for ROI). Said another way, how long will it take for the investment to pay for itself? This also is called the “hurdle rate” (minimum payback period or minimum return that is acceptable). In very good times, the payback period can be up to 5 years (depending on the company). Most companies today are using a hurdle rate or payback of 3 years or less, with many companies now using just 1 year. Companies in economic distress are using even more strict criteria.

What happens when there is a fixed pot of money for investment and everyone and every project competes based on payback or ROI? Few sustainability projects can compete head-on based solely on ROI. For example, a common and very good energy reduction measure is to replace older lighting with the newest versions of high efficiency lighting. The typical payback for these projects is between 2 and 4 years. A new high speed packaging line could have a payback of less than a year. Do you simply use ROI as the decision point?

Let me use green buildings as another example. Studies have shown that investing in a green building costs on average about 10 percent to 15 percent more. Savings on operational costs versus the capital invested for even the best of buildings is just a few percent a year. It typically takes at least 7 years (and sometimes up to 20) to recoup the extra investment of capital. Does this mean you should not build green buildings?

The decision for investment is not made solely on ROI. You can counter my point by saying the operational costs are reduced, thereby vastly helping the bottom line. Simple logic, but not the way companies are governed. Capital is treated completely differently than operational costs and the two issues rarely are considered at the same time.

All companies have programs to reduce operational costs without the expenditure of capital. The main function of capital is to grow the business, not principally to reduce operational costs (even though you may think this is a “Dilbert” statement). If this were not true, you would replace all electrical motors in a factory with newer, higher efficiency ones as just one example.

For the sake of simplicity, we will not consider depreciation of capital assets in this discussion. However, if you were to make too many investments, cash flow would go negative since depreciation normally occurs over many years and is cumulative (for a longer term than investment). Said another way, there is a balance to earnings and depreciation that also can limit investments.

INVESTMENT DECISIONS

Investment decisions are made based on a number of factors. There are investments that are mandated by law, such as those related to safety and health and the environment. Usually there are several options available to meet compliance with a new or existing requirement. The options go through the normal financial analysis, but the investment is made because it is required. These investments do, however, drain the pool of monies available for other non-mandated improvements requiring capital.

There also are investments made for strategic reasons, and I submit that most of the sustainability investments are made in this category. They may not have as good an ROI as other competing projects, but they are considered strategic and critical to the long-term success of the business. For example, a company might want to enhance its image and decides to invest in green energy production. Green energy investments normally are at least 10 percent more expensive than buying energy off the grid.

This is not to say that green energy always will be more expensive and not have a “good” ROI. There are countries where power is quite expensive (and unreliable) and solar hot water heating (as an example) can have a very good payback of under 2 years. Solar photovoltaics, on the other hand, can have very long pay backs with our current technology. Unless subsidized by governments or other means (such as the sale of renewable energy credits), such projects would never compete with other uses of capital.

Yet, we still read every day about someone installing a new photovoltaic panel, a decision obviously not based solely on ROI. Let me give you a current example: An environmental newsletter recently carried an article on the Ford Motor Co.'s plans to power a small car manufacturing plant using solar power (Environmental Leader internet newsletter, Aug. 13, 2010). Reading carefully, you will find the purchase and installation of the solar equipment at Ford is underwritten by $3 million from Detroit Edison and a $2 million grant from the Michigan Public Service Commission. This is a great sustainability and green energy project, but would Ford have done this without the subsidy? The issue here simply is that stating sustainability projects are driven by their great ROIs is spin.

SAVING MONEY AND THE BOTTOM LINE

Environmental projects are much easier to quantify than social projects such as diversity programs, fair trade, fair payments, community involvement and supply chain set-asides for their impact on the bottom line. Reducing water use can reduce wastewater treatment volumes and lower costs for water and the treatment of the wastes. Reducing packaging in your supplies and your products also reduces costs as well as waste and adds to the bottom line. Improving energy efficiency reduces energy costs and adds to the bottom line.

All of these obvious examples have great corporate social responsibility and sustainability advantages as well as saving the company money. They rarely are undertaken solely based on cost savings. Companies undertake these projects because it is in the nature of business to search for efficiency and cost savings as well as discover ways to meet their societal obligations. Companies that sell directly to the public have the additional incentive of building their brand images and typically are the leaders in these efforts.

Helping to justify a sustainability project based on cost savings and a good ROI definitely is the way to go. Let's just not spin the story to say that it is an amazing, newfound way to significantly beef up the bottom line. To be successful, you need a great product, great marketing and great customer satisfaction, regardless of how sustainable your business is.


Zack Mansdorf, Ph.D., CIH, CSP, QEP, is a consultant in sustainability and EHS. He is a former senior vice president, L'Oreal, and a past president of AIHA. He can be reached at [email protected].

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