Sustainability is not just a fashionable word
Sustainability is one of the most frequently used buzzwords today. Everyone, from heads of state to ecommerce players, seem to want to hop onto the sustainability bandwagon. As it often happens, when the word gets thrown around more frequently, the meaning gets diluted.
What do I mean by sustainability?
How sustainable a business is, quite literally translates to how long it can continue in the current form when you factor in all costs. “All” being the key word. Ideally it should encompass ecological, financial and social costs. In fact, over a long enough horizon they are all interlinked. This is becoming evident today.
The things we assumed to be zero-cost inputs are becoming increasingly scarce, thus, completely compromising the business model and challenging its viability. Once these are factored in, it becomes increasingly clear that sustainability is not a tradeoff or a compromise. In fact, it makes a lot of business sense as it not only has a positive impact on the world, but also on the topline. Here’s how.
How long will the party last?
In October last year, Pacific Gas and Electric (PG&E) cut off power supply for 8,00,000 Californian homes to avoid causing wildfires by overheated transmission lines. Two weeks later it did it again for 1,79,000 homes. Between 2017 and 2019, these overheated lines sparked 17 major wildlife incidents. As their stock price slid into a 52 week low, they went on to announce that they would need ten years until they upgraded their power infrastructure.
Why did they have to wait this long? Because ten years ago, wildfires were not that big a risk.
Keeping shareholders happy meant not investing potential dividend-dollars, into a supposedly unnecessary upgrade. You see, ten years ago, upgrading this infrastructure was regarded as dividend dollars being used up for tree hugging initiatives. When you adopt the perspective of immediate shareholder value, money is rarely invested into long term thinking or in other words sustainable thinking. Dividends are front loaded and investment into business sustainability are put on the back burner until absolutely necessary. When it does become absolutely necessary, money has already been distributed or spent and most firms resort to raising debt. This is so unnecessary! This is not a one off case. This is happening across the world, every day to a varying extent. The situation is so prevalent now, that quite a few institutional investors are urging firms to take a look at long term risks to their businesses and even investing a few years of bottomline towards avoiding it. It makes a lot of sense to avoid a sudden death.
Since 2011, PG&E has given close to 8$ as dividend per share. In april 2019, they announced a $28B plan to invest into their power and gas infrastructure. In the meanwhile, by oct 2019, over 90% of its market capital was eroded due to falling stock price pushing it to the brink of bankruptcy.
Cost of Commons – Nothing is free forever.
In 1833, William LLoyd wrote a pamphlet where he coined the term “commons”. He was referring to an english village grazing their cattle. When there is enough abundance, and the cattle numbers are small, the grassland, or the common, seems to be infinite. So every villager can now assume that the grassland ecosystem will rejuvenate on its own with no extra effort or cost. As a result, every villager is intrinsically ‘incentivised’ to add another cow to his herd simply because he gets the incremental benefit of the cow without really bearing the incremental cost of the grassland. If every villager continues to do this, at some point, the grassland starts degrading or in other words, the cost of the grassland stops being zero. It takes effort to maintain it and as a result, the villagers now need to account for the effort/cost of ‘cultivating’ the grassland – the cost of the commons. However, the rest of the village, which was used to buying the milk, may not be willing to pay for this added cost that seems to have emerged all of a sudden. Thus completely disrupting the viability of cattle rearing.
This is one of the most important aspects of being sustainable – include the cost of the commons. Never assume they are free. This, not only is a better way of pricing something, but also helps us to look at our value addition in a holistic sense. The implications of not doing so are catastrophic and are visible all over the world. The same extends to farming. Excessive use of synthetic fertilisers has rendered farm yields to consistently drop with the US reporting an average farm yield of -9% in 2016. Suddenly one of mankind’s most basic industries has been rendered unviable and steeply dependent on state subsidies. This analogy has repeated itself over and over again across the spectrum. Take fishing, for example, and the depleting offshore fish pools across europe. In fact, now most of the fish in a European plate is caught in Africa, filletted and canned in China and then shipped all the way to Europe. It is cheaper to do that now than to revive the fish populations artificially via breeding locally. Imagine that!!
Today, 20 Indian cities are on the brink of day zero (day when there’s no drinkable groundwater left) and might see it anytime in the coming year. This includes Bangalore, the silicon valley of India. 5 decades of exploitative unsustainable development that assumed that water is always available underground has led to this. Now the Karnataka govt has spent close to 7Billion USD on major and minor irrigation projects since 2016 alone.
William Lloyd’s grassland was never free, we just assumed it was.
When the going gets tough, the sustainable get going
An interesting offshoot of the increasing cost of commons is that companies that had factored this in have actually performed better over the last two decades. In a report on sustainable investing published by Deutsche bank in 2012, some remarkable observations were made that underlined the importance of being sustainable. The report elaborated how companies that ranked high in Environmental, Social and Governance (ESG) metrics outperformed the market. Infact, they even observed that a value weighted portfolio of 1$ invested in high ESG companies in 1993, would have been 22$ by 2010 compared to 15$ of low ESG companies.
I was extremely surprised by the clarity of the findings in that study. As investment philosophies have evolved over time, more and more institutional players are now giving a lot of weightage to companies that place importance on ESG – factors that were traditionally considered non-financial, qualitative in nature and not readily quantifiable in monetary terms including changing policy and regulatory environments.
What’s even more interesting is that quite a few studies have observed that high ESG firms have a significantly lower cost of capital in terms of debt. In other words, the market recognizes them as being lower risk and rewards them accordingly. This may be a conscious reward or just based on the resulting outperformance, but what matters most is that this alone should make sustainability a high priority to any CFO in the world.
Goodness has a value
If a firm is following principles of ESG, then it makes a terrific story. The interesting thing is that it’s not just the markets that recognize this, but consumers too. There are innumerable examples of brands that have weaved their story around the environmental and ethical values behind their products. Take Patagonia for example. In 2013, in the run up to Christmas, when Europe and the US were at their consumerist best, the adventure gear company famously did the “don’t buy this jacket” campaign where they asked people to not buy their gear unless they really needed it. This was the first time a firm was asking folks to think hard if they really need their products. Although it sounded very counter-intuitive at the time, it established the values behind the brand and more importantly a strong community of super loyal customers who really appreciated the anti-consumerism sentiment they portrayed. This cohort of loyalists swear by this brand and this in turn created a lot of value centred around the “goodness” of it.
The concept of conscience buys is becoming increasingly prominent as consumers around the world are getting more educated about sustainability issues that are staring us all in the face. Being sustainable is not just a differentiator anymore but an entire identity by itself. Goodness has a value and most consumers don’t mind paying it.
The difficulty of being good
Having said that goodness has a value, I have to admit, it is not always easy to quantify it. Simply because we honestly do not know the complex systems that go into making an ecosystem in its entirety. Even amongst the factors we understand, we are quite far from actually arriving at a monetary value. For eg, shade grown coffee using fig and other evergreen trees in the western ghats is definitely a lot more sustainable than using silver oak as the shade layer. The figs hold the soil together, prevent erosion thus preventing landslides etc. But can we assign a value to a possible landslide? Maybe not accurately. But today, reasonable assumptions can be made and sensible approximations arrived at. Using this, one can include the cost of the commons in one’s business model itself.
Several frameworks exist today, to value the natural capital as an estimate. inVEST from Stanford university is one of the more popular ones. Infact, this has been used by the Government of India to assign a monetary value to the tiger reserves in the country. However, even these frameworks are estimates at best. It is almost impossible to assign a single value to being good and that’s what makes it difficult. Infact a recent study revealed that from among a 1000 companies that were sampled, 90% wanted to be more sustainable, 60% of them had a strategy for it, and only 25% were able to incorporate it into their business model to a reasonable extent. In my opinion, It is this difficulty that makes it interesting as well. It gives companies a chance to get really innovative both in terms of developing new technologies as well as new methodologies of measuring their impact. This is a great opportunity to create a differentiator for your products and be a pioneer.
I just work better when I am happy
Recruiting and retention of employees is a major focus area in any business. Recent research indicates that sustainable business practices are a major factor for the younger workforce when it comes to deciding their place of work. Beyond the paycheque and the work challenges, everyone likes to believe that they are making the world a better place. A recent global survey by HP showed that 40% of the workforce felt that sustainable practices are mandatory and about 46% admitted that they would look to change jobs if their current workforce moved towards unsustainable practices. For India in particular, the former number was at 73%.
Employee retention is not just an issue for the HR department. Operating units feel the pain in terms of product quality, productivity and customer service. With most big companies, it costs 6 to 9 months of pay to train a new employee. HR costs are only the tip of the iceberg. Bigger problems arise when the new guy is assigned to a team. Until the assignment happens, someone in the existing team would be shouldering those responsibilities. When the new hire comes in, someone has to train him, thus reducing his own productivity. Especially in sales, the effect is very direct on the topline. Nevermind the strain of a new dynamic coming into a closely knit team. These are very qualitative concerns that may not boil down to an exact monetary value, but will definitely have a huge impact on the firm’s topline. If it can be avoided, and being sustainable takes you a fair distance on that front, do we need another reason to adopt sustainability as a core principle?
Swimming downstream is never exhausting
At the end of the day, being sustainable largely implies aligning the firm along the natural order of things. In other words, the firm is choosing to swim along the current. It often boils down to reducing wastages, getting more efficient, eliminating redundancies and avoiding unnecessary vanity pitfalls. In the long term, we need to understand that being sustainable goes way beyond adding a touch of green to our usual practices but rather to think of the system as a finite whole and to understand our impact. In the process, we also acknowledge that this impact will have an effect on the viability of the business itself over a long enough horizon. As studies have repeatedly shown, it is not a question of whether a firm wants to adopt sustainable practices or not, but rather the understanding that, by definition, it’s in the best interest of the firm and all its stakeholders to do so.