Capital Markets

The Quest for an Environmental Metric

Gazing at weather systems, a ground-breaking scientist spawned an ecological accounting standard that Wall Street might one day embrace.
Marie LeoneDecember 15, 2005

In the Gulf of Mexico, near Crystal River, Florida, manatees swim in the shadow of a huge coal-fed power plant owned by Progress Energy Corp. These enormous “sea cows,” which can weigh up to 3,000 pounds each, hate the cold, and they consistently herd where the plant discharges millions of gallons of warm water daily into the Gulf and its estuaries. Experts say manatees are quite content to frolic in the tepid water.

To be sure, these endangered sea mammals seem happy about the effect of the power plant on their home. But measuring the total impact of coal-fired facility on the environment and local economy is more complicated. Indeed, identifying a metric that quantifies the symbiotic relationships between a power plant and manatees might be a bit too esoteric an undertaking for busy finance executives. Yet many corporate managers have been on the lookout for ways to measure such intangible gains and losses for a while now.

Their goal, in most cases, has been to measure “sustainability,” a catch-all term used to describe the way companies manage profits, people, and the environment to keep the business viable over the long term. But factoring environmental and social variables into the next five-year plan is new territory for most companies, not to mention documenting sustainability efforts.

Nevertheless, companies in the United States and around the world are increasingly issuing sustainability reports that highlight answers to such questions as whether cuts in air emissions add or detract from profits or if their worker-safety programs increase productivity.

The story of the Crystal River plant is an interesting footnote to sustainability reporting — and not only because the manatees treat the effluent it produces as a haven. Nearly two decades ago, the plant owners used an unorthodox metric to assess the facility’s impact on nearby estuaries. Called “emergy,” which is shorthand for “embodied energy,” the metric provides managers with a way to quantify variables once considered too qualitative to measure accurately.

Today, as the nascent practice of sustainability reporting becomes more popular, and managers search for a standard set of guidelines, emergy may be poised for a comeback. “Sustainability reports are all over the map with their metrics, and include a significant amount of qualitative statements,” notes Jason Makansi, research director for Pearl Street Capital, a hedge fund. Like many others, he’s trolling for more quantitative data.

Who Wants to Know?

Hedge funds aren’t the only investors searching for better ways to measure business risk linked to environmental and social issues. Managers of socially responsible investing (SRI) funds are also keen to find new and improved metrics. Further, the influence of such funds — which screen for sustainability criteria — is growing annually. In 2004, SRIs accounted for $2.6 trillion of assets under management, or 11.3 percent of the total managed assets market.

More tellingly, asset managers that don’t solely cater to the SRI crowd have also been keeping tabs on the way corporations approach these issues. Witness Citigroup Asset Management (CAM), which was acquired by Legg Mason on December 1. The company manages more than $430 billion of assets, of which about $1 billion is rigorously screened for sustainability criteria.

Further, CAM operates a social-research department that evaluates portfolio companies for risks related to environmental and social issues. The intent is to identify potential negative earnings effects posed by such things as product and environmental liability, employee lawsuits, and failed responses to emerging societal issues that affect business.

While social-research director Mary Jane McQuillen stresses that economic value is CAM’s top criteria, her charge is to focus, for example, on worker-safety initiatives and benefit programs to gauge whether a company can retain top talent. She might also study environmental lawsuits for their potential drag on a company’s earnings.

In some cases, McQuillen grills CFOs to make sure they’re reading emerging issues — like health matters, for example — that help shape their industries. For instance, when McQuillen recently questioned the finance chief of a large consumer food-products company, the executive “eloquently” addressed the market risk associated with consumption of the company’s products as it related to the rise in obesity and Type-2 diabetes in the general public. The CFO also discoursed on how the human body processes sugars and starches and the nutritional makeup of the company’s products.

Talk of gastronomical enzymes is a far cry from what most CFOs typically discuss with asset managers. But the fact that such discussions exist may be a sign that that business is ready to revisit the unconventional world of emergy analysis.

Dial “M” for Emergy

The basics of that analysis emerged in the mid-1980s. At the time, Florida Power Corp. (since merged into Progress Energy) was slapped with an environmental lawsuit that claimed that the hot water being discharged from its Crystal River plant was spoiling the Gulf’s ecosystem. The utility called in Howard Odum, the University of Florida professor who had earlier developed the emergy metric, to assess whether building a cooling tower to process the hot water was environmentally sound.

Odum’s analysis was set up to compare the emergy used to build a cooling tower with the emergy value of losses to the ecosystem caused by releasing the effluent straight into the offshore waters. Emergy is a calculation of the energy previously used to create just about everything — from natural resources like coal or oil, to a finished product like a dining-room chair. In general, the emergy value corresponds to how many solar-energy units are used to create a product.

Essentially, Odum’s analysis could thus provide an apples-to-apples comparison to help managers at Florida Power determine their next move. The professor found that the hot discharge had a temporarily negative effect on the surrounding waterways, disrupting plant life and sending fish scattering. The reason was that the heat was at first concentrated in one area.

But the ill effects dissipated quickly as the hot water swiftly circulated throughout the Gulf and its estuaries. The added flow and warmth increased the current, which enabled more fish to spawn and more sea grass to grow. Odum concluded that the power plant was giving back more emergy than it was taking from the environment.

On the other hand, Odum found, construction and ongoing maintenance of a cooling tower would eat up more emergy than the straight water- discharge method. The higher emergy value meant that a cooling tower would take more away from the local environs than it would give back.

But explaining the conclusion in court was futile because the emergy concept was too new and complex. Florida Power eventually settled out of court and built the cooling tower. Over the next two decades, emergy analyses were used to support several other environmental court challenges. But in each case the companies settled, eventually relegating the metric to academia.

In 2001, before he could see the United Nations and the U.S. Environmental Protection Agency apply emergy analysis to major policy initiatives, Odum died. Currently, however, the UN is working on a soil erosion project in North African countries, while the EPA just completed an emergy analysis of the state of West Virginia’s economic and natural resources.

Screaming Economists

Indeed, it’s hard to glimpse how blasphemous the concept seemed to economic traditionalists. Emergy lectures “used to send economists screaming from the room,” quips Mark Brown, an associate professor of environmental-engineering sciences at the University of Florida who considers Odum his mentor. “Emergy questioned their core beliefs,” asserts Brown in explaining why so many economists were bothered by the concept.

The uneasiness had philosophical roots. Emergy analysis relies on a donor system of valuation, rather than the traditionally accepted receiver system. Donor systems assign value based on how much energy, time, and material have been invested in a product or service, while a receiver system determines value by assessing what buyers are willing to pay for a product or service.

Receiver systems work well in a classic supply-and-demand marketplace, where price sets value. But when more comprehensive factors, such as the depletion and remediation of natural resources, are considered, a donor system like emergy is the better yardstick, contends Brown.

The emergy concept has been kicking around since the 1950s. Odum, then an Air Force meteorologist, observed how solar energy directly affected weather patterns. He also studied such indirect effects of the the sun’s rays on such phenomena as tidal power and deep geological heat. His observations triggered a life-long pursuit of ways to compare different types of energy on a common basis.

That common denominator, according to Odum, is solar energy, the most basic energy component he could measure. Seen that way, emergy is Odum’s blueprint for breaking down the world into basic, measurable energy components called solar emjoules. A joule is a unit of energy that is available now. An emjoule (“energy-embodied joule”) represents an amount of energy invested in producing a specific product or providing a service.

Odum noted that emergy exists in a natural hierarchy that starts with solar energy and cascades down, capturing the energy-transformation processes it takes to produce a finished product — including all the environmental effects along the way. For instance, an emergy analysis of an oak table would comprise the emjoules picked up in growing the oak; cutting it down; shipping it to a mill; producing the boards; sending the lumber to a furniture factory; manufacturing and finishing the table; and shipping it to a retail outlet.

Leading Indicator

Over the last two decades, while the merits of emergy were being debated in court and at academic seminars, managers, investors, and activists were busy trying to quantify environmental and social issues in other ways. One prominent set of metrics to emerge from those attempts is the “sustainability reporting guidelines,” developed in 1997 by the Global Reporting Initiative (GRI), a non-profit group based in Amsterdam.

To date, more than 700 companies worldwide — including Airbus, Dell, Fuji Film, GlaxoSmithKline, General Motors, Microsoft, and Nike — use the GRI guidelines, which track such factors as corporate energy usage, pollution emissions, child labor statistics, and health and safety records. In practice, the guidelines are broader than emergy’s environmental focus.

Nevertheless, some experts don’t think GRI goes far enough. Mark McElroy, a one-time management consultant with KPMG and what was then Price Waterhouse, and currently executive director of the non-profit Center for Sustainable Innovation in West Windsor, Vermont, says that while GRI measures behavior, it fails to calculate supply constraints.

More specifically, McElroy describes sustainability as a quotient, in which the numerator represents the behavior affecting the sustainability (reducing air emissions or water consumption, for example) and the denominator represents the amount of natural resources involved (clean air and water). If a metric only focuses on the numerator, as GRI does, the measure of sustainability is skewed, according to McElroy.

For instance, GRI guidelines suggest that companies report water consumption per year (a numerator). But unless water consumption is compared to how much water is available (the denominator), argues McElroy, the metric does not measure how long the supply will last. As a result, the company could register an improvement in water use year over year, yet be operating at an unsustainable rate if consumption outpaces the available water supply.

McElroy uses another set of metrics — dubbed the environmental and social footprints — to measure sustainability. His idea is to include the denominator in all calculations so improvement or failure of a goal can be measured within the proper context.

Although he’s not familiar with emergy, McElroy acknowledges that corporations do need an alternative to GRI. That alternative should offer a common measurement unit for environmental and social issues and takes stock of fluctuations in the supply of natural resources.

For his part, Odum was apparently on the right track by commercially launching his metric in the power-generation business. According to Pearl Street’s Makansi, executives in the power generation industry are always looking for ways to increase the value of plant assets “by adding positives and subtracting negatives.”

To that end, Makansi developed his own proprietary methodology called E-Equity to measure the value of a power plant asset while assessing its impact on the environment, national security, community development, and other external factors. Familiar with the emergy metric, he points out that it’s more robust than his tool in terms of measuring environmental effects.

Although Makansi believes that emergy analysis is still more academic than commercial, he expects business leaders to eventually develop the methodology, or one like it, into an environmental accounting standard. “There is no standard to simultaneously measure the economic, social, and environmental impact of technologies or corporations, but emergy is a starting point.”

4 Powerful Communication Strategies for Your Next Board Meeting