Sustainability and Return on Investment (Without the Spin)

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.