Working Report, 2/2005 – Environmental Shareholder Value

Environmental Shareholder Value

7 Fixed capital investments

7.1 Environmental investments
7.2 Investments in cleaner technology in connection with CO₂ emission allowance trading
7.3 Summary

Investments in fixed assets are investments in "assets that are intended for permanent ownership or use by the enterprise" (schedule 1, C. 2. of the Danish Act on Commercial Enterprises' Presentation of Financial Statements, etc.). For example, this may be real property, technology or patents.

Fixed capital investments are important for the company's free cash flow, because investments tie up money and thus, at first, reduce the free cash flow. At the same time, investments are obviously required for the company to carry out its activities and create earnings.

An investment may increase Shareholder Value when it entails greater income than the cost of capital of the investment. From a Shareholder Value point of view, the best investments are thus those that are less capital intensive but yield a high return (Schaltegger & Figge, 2000).

7.1 Environmental investments

Investments in fixed assets in the environmental area may be divided into the following groups:

Installations for the remediation of harmful impacts on the environment
Installations for pollution abatement
Cleaner technology

7.1.1 Installations for remediation of harmful impacts on the environment

Installations for the remediation of harmful impacts on the environment include investments in the establishment of remediation wells to prevent contamination from spreading to groundwater resources, etc. This type of investment is required by law and must be implemented in order for the company to be able to continue operations in the future. Such an investment does not result in any form of earnings or goodwill, since it merely remediates damage and does not create value. Shareholder Value is consequently reduced.

7.1.2 Installations for pollution abatement

Installations for pollution abatement include cleaning technologies or the so-called "end-of-pipe" solutions, such as water treatment plants, desulphurisation systems and filters. This type of investment is typically ordered by the authorities on the basis of regulations on the maximum volumes of specific substances the company is permitted to emit or discharge. In some cases however, companies decide independently to remediate beyond the legislative requirements. This is the case with eg. emissions of SO₂ which, from 2003, are subject to taxation in Denmark. By reducing its emissions, the company may thus reduce its taxes. Other companies choose to carry out further remediation in order to improve the company's and the product's environmental profile in connection with marketing.

Like investments in remediation of harmful impacts on the environment, investments made because of legislative requirements have a negative effect on Shareholder Value. However, investments that lead to tax savings may contribute to increasing Shareholder Value. Investments made with a view to green marketing will be dealt with in chapter 9 "Earnings: sales growth and operating profit margin".

7.1.3 Cleaner technology

Cleaner technology is a very broad concept encompassing the types of technology that improve the company's environmental performance by changing production processes. This could be through a reduction of resource consumption and emissions or by replacing an environmentally hazardous chemical product with one that is less hazardous. Cleaner technology may also include changes to product design so that the product can be taken back after use and recycled.

Like installations for pollution abatement, investments in cleaner technology may be caused by authority requirements, however they will often be made at the initiative of the management as part of production improvements and optimisation.

Resource consumption savings will be seen directly as a reduction in the company's operating costs. Likewise, the company may achieve savings by recycling parts of old products. Emission reductions may also result in financial benefits if the emissions are subject to taxation. Substitution of a hazardous chemical with another one that is less hazardous may also reduce operating costs, since there will often be a reduced need for personal protective equipment and safety procedures in connection with production. At the same time, the risk of accidents that could entail future costs for remediation of the impact is reduced.

However, the associated savings in time and resources are often forgotten in the assessment of the investment, because the expenses are hidden in different accounts in the company's management accounting system. This subject will be dealt with in further detail in chapter 8 "Working capital investements", since it is a general problem that the associated environmental costs cannot be identified clearly in the total operating costs.

7.2 Investments in cleaner technology in connection with CO₂ emission allowance trading

A very current example of how the environment could have a direct influence on Shareholder Value, is CO₂ trading which was placed on the agenda with the adoption of the EU Directive on greenhouse gas emission allowance trading in July 2003.

7.2.1 The EU Directive

The first stage of emission allowance trading will commence on 1 January 2005 and will first cover companies with plants over a certain production capacity within energy production, oil refining as well as the metal, mineral, glass, paper pulp and paper industries.

The companies subject to the directive will, at the beginning of each calendar year, be allocated a number of allowances in accordance with a national allocation plan. At the end of the year, the companies must surrender allowances corresponding to the amount of CO₂ they have emitted during the year. If a company does not have sufficient allowances to cover its emissions, it becomes subject to a penalty of EUR 40 per tonne CO₂ in 2005-2007 and EUR 100 per tonne CO₂ in 2008-2012.

The market price of CO₂ is very uncertain and depends on many circumstances.

7.2.2 Significance for Shareholder Value

The allowances can of course be compared to a tax, since the company must pay for CO₂ emissions exceeding its allowances. However, where the company can only save tax if it reduces its emissions, allowances can be sold if the company reduces emissions so much that it has excess allowances. A company that invests in reducing its CO₂ emissions will thus be able to increase earnings through sales so that the investment, simply speaking, pays for itself faster.

With a view to Shareholder Value, the company must consider the following questions:

Should the company try to reduce its own CO₂ emissions or should it buy allowances?
Is it decisive whether the price is DKK 50 or DKK 100 per tonne CO₂?

The answers depend on several things, including the options the company has to reduce emissions and how expensive they are compared to buying allowances as well as whether the company is growing rapidly at a national or international level and thus needs more allowances.

7.3 Summary

On the face of it, investments in environmental fixed assets will reduce the free cash flow by tying up funds. However, if there is a chance of saving environmental taxes or saving on operating costs, the investment will, in the long term, be able to improve earnings and thus Shareholder Value.

Therefore, we can distinguish between different types of environmental investment which differ significantly as to their impact on Shareholder Value. With regard to accounting only, there will be no difference, however, between an installation for remediation of harmful environmental impacts and one for cleaner technology since they are both fixed assets with a value-in-use for the company. However, with respect to investors it could be of significance to emphasise if an investment is a pure necessity for the continued operation of the company or if it also gives savings or earnings.