The notion of using resource conservation, plant safety, labor, or other environmental and social issues in a company’s valuation and financial reporting has always been a tough sell for CFOs.
Just utter the word “sustainability,” and a finance chief’s eyes are likely to glaze over. The gains and losses of the next quarter are likely to be more compelling than the question of whether a company’s plants will have access to cheap energy over the next 20 years, for example.
But that indifference is slowly — and irreversibly — starting to change, thinks Tim Koller, a leader of McKinsey & Co.’s corporate finance practice. Prompted by increasing questions from pension funds, endowments, and other long-term investors, CFOs will have to possess a detailed, quantifiable understanding of how long-term sustainability factors will affect their company’s future cash flows and earnings.
“If the forces in the world that relate to sustainability are going to be material to a business, it’s management’s job to take a longer view and figure out what to do about them. Because eventually, these things will affect cash flows,” Koller said in an interview on the consulting firm’s website.
But then the question becomes: How can a CFO draw a line between a factor like the future availability of water and his or her company’s value today?
In a conversation earlier this week, Koller, an expert in corporate valuation, agreed that it was hard, but doable. He also says that the best way for CFOs to do such analysis is to zero in on how sustainability might affect their particular companies, rather than using a more generalized approach. Edited excerpts of that conversation follow.
How should CFOs evaluate the effects of sustainability factors on their companies’ cash flow?
In order for CFOs to judge their companies’ sustainability, they have to first determine what elements are material or critical to their particular business. If there were 20 things a company had to focus on, then they wouldn’t get anything done.
And all companies are not the same. If you are an oil and gas extracting company or a mining company, then clearly the things you need to focus on include the environmental impact of what you’re doing, the importance of safety. Another factor would be the long-term outlook for the minerals or oil and gas you’re taking out of the ground in terms of how long-lived the sources will be, what the demand will be going forward, and the question of whether the product be replaced by something else.
That’s going to be very different than it is for a consumer products company, which often use a lot of water, for example, to make food products or beverages or detergent. So water quality and water access are important issues for them in terms of sustainability. Also if you’re the CFO of a food and beverage company you have to be worried about trends in consumer behavior and issues that consumers are interested in, like obesity.
So it’s most important for CFO’s to narrow in on the small number of sustainability issues that are most critical to their company’s success. Then, it’s really a matter of putting together or figuring out the linkage between the sustainability issue and how it ultimately drives your profits and cash flows.
Can you dive a little deeper into how CFOs can determine that linkage?
It’s best to do that through specific examples. In the oil and gas extraction business, for instance, if I have some oil reserves that I can extract in the next couple of years, I’m pretty confident that there’s going to be a market for them. If I have some reserves that I’m never going to get around to producing in forty or fifty years, then maybe I want to place less emphasis on those, because it’s not clear what the demand will be that far out, given the shift to electric vehicles and other sources of energy. In the case of a food or beverage company, it’s a matter of supply sources, what’s happening in the environment that may affect the raw materials and water that I need. What will I do to make sure I have continued continued access at a reasonable cost to the raw materials that I need to produce my products.
Health and safety is another issue. In the chemical and mining industries, they’re important for their own sake. But also, if I’m not safe and accidents happen, they can shut down my plants and affect my reputation. CFOs of these companies need to think through what is the cost of not being safe and try to quantify that. It’s a pretty big cost, and in some cases it may make sense to go even beyond what government standards are.
Speaking of government standards, President Trump just signed an executive order that aims to revive the coal industry and roll back many of the environmental initiatives of the Obama administration. How could a CFO incorporate a move like that into his or her company’s valuation?
If I’m a CFO, I need to be aware that the regulations change, but I also need to be thinking about the long-term trends. First of all, nobody knows what the impact of the new regulations will be. Gas is already supplanting coal and in some cases it’s cheaper. So even with less regulation on coal, some people will be reluctant to build new coal-fired plants, and that will reduce the demand for coal overtime. When you’re figuring out such effects, you can’t swing your strategies that quickly.
If you’re in coal mining and you’re making decisions about whether to invest in a new coal mine, clearly you have to look at the long-term trends. There’s no crystal ball, it’s a risk assessment, and the longer-range the impact is, the longer there is uncertainty about what’s going to happen. it doesn’t mean you shouldn’t take risks, it just means that you should understand the risks you are taking and make sure the payoff is big enough to justify those risks.
Do you see CFOs becoming more interested in incorporating sustainability into their financial reporting?
Many more investors are talking about it and large investment houses are developing funds, so it’s going to be part of the language that they are going to be faced with. They’re not going to have a lot of choice, because they’re going to be asked a lot of questions. It’s hard to generalize. Some companies are far ahead on these issues perhaps because they believe it’s important to their customers and and therefore they want to be perceived a certain way. Some companies are saying our customers don’t know or don’t care, so we can be slower at it. Clearly there’s a trend in that direction, and it’s certainly not reversible.