As environmental strategy consultants we believe in leveraging market forces to solve our environmental crisis. If financial analysis integrated externalities -- such as pollution, contribution to climate change or biodiversity loss -- then company valuations would reflect their true impact on our economy, net of their impact on our environment.
Financial markets are slowly moving in this direction. More and more data providers, from niche player RiskMetrics to giants Bloomberg and Thomson Reuters, are reporting on environmental, social and governance issues from greenhouse gas emissions to human rights and everything in between. And with good reason -- ESG-based investments are expected to reach $26.5 trillion by 2015 (pdf).
One thing that strikes me though is how much emphasis there is on quantifying risks, and not evaluating growth opportunities.
There is a paradox here. In financial valuation, the rate of growth typically matters more than other dimensions. That’s why an Internet darling with greater growth potential and an unclear path to profitability may be valued higher than a company with solid, consistent dividends but limited upside. But conversely, when it comes to sustainability, analysts seem to place greater stock in managing risks than developing new markets.
Of course the cleantech sector is all about growth. But what about old-economy large industrial or chemical companies that get environmental innovation, and that position themselves to capitalize on the opportunities created by new energy challenges? Is Wall Street valuing the growth potential from their proactive sustainability strategies and differentiating between a leader and a slow follower? Do we think that the stock price of GE or Dow properly reflects their position at the forefront of this new growth opportunity?
Unfortunately, it’s easier to gather data on greenhouse gas emissions or employee diversity than develop metrics on how much a company’s products are geared to meet the needs of a resource-constrained world. But unless financial markets start valuing companies’ efforts to seize green growth opportunities, and not just their risk exposure, we will insufficiently value, and incent, decisions that will benefit our economy and our environment, and this will remain an example of market inefficiency.
Image CC licensed by Flickr user bifishadow.
I think that externalities
I think that externalities won’t be well integrated into financial markets until we price them or we expect them to be price in the future. So now that the markets are beginning of expect new regulations looking forward in the sustainability space, they are starting to price them. For instance, a regulation that either tax carbon emissions or cup them would price any environmental initiative of companies that directly impact their cash flows.
In the same note, as markets are starting to expect some new regulatory initiatives that might punish companies that are not being socially or environmentally responsible, the markets will increased the risk of those companies, making the more sustainable ones better off. Additionally, as the consumers get more eructated about sustainability, they would start valuing more sustainable products/services and companies.
Finally, sustainability is not like a new industry or trend, it is across the board and involves the human activity as a whole. As we start learning about its extend, reducing the regulatory uncertainty, the markets will be able to price it more fairly.
Risk/return? Sarah, I think
Risk/return?
Sarah, I think your last sentence is critically important. Innovations in sustainability are not currently rewarded by financial markets, regardless of the company's market position or size. The risk/return profile is not well-defined or understood by investors.
In my opinion, this issue is one of market maturity. Sustainability is not yet ingrained in the mainstream business community and as such, investors are still highly focused on risks, not returns. For instance, regulatory risk is one that most investors try to avoid because of the reliance on subsidies, but the emerging solar industry has seen over $7 billion of VC investment in the last five years. The VC market is inefficient compared to public markets and places high value on growth. In contrast, the more efficient public markets are much more comfortable with less risky dividend paying stocks with limited risk.