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Environmental Shareholder Value

10 Cost of capital

10.1 Environment risks
10.2 Management of environmental risks
10.3 Access to special funds

Cost of capital or WACC (Weighted Average Cost of Capital) equals the return the company's investors and lenders expect on their investments. As described in the section on Economic Profit, a company increases value for its investors if it creates a profit that is higher than WACC and thus reduces the Shareholder Value if the profit lies below WACC. The required rate of return of investors and lenders will depend on the company's risk profile. The greater the risk, the greater the required rate of return.

This makes the company's management style and risk management important parameters in relation to Shareholder Value. These are also parameters that are central to the concept Corporate Governance (the relationship with Corporate Governance is described in further detail in chapter 14).

10.1 Environment risks

In the Nørby Committee's report on Corporate Governance in Denmark, the environment is mentioned as an important factor companies ought to include in their risk management:

"Risk management also focuses on procedures for damage control, the formation of contracts, safety at work, environmental issues and safeguarding physical values." (The Nørby Committee, 2001, p. 62)

Environment risks may include:

  • Environmental incidents where costs are incurred for subsequent remediation or measures to reduce the extent of pollution.
  • Ban on the use of specific chemicals or materials. A company could risk that a chemical is being phased out and that it will thus have to convert its production.
  • The company's product is banned or looses its market due to environmental conditions. For example, the future CO2 allowances could reduce the demand for fossil fuels. This could also apply to consumer boycotts of special products like genetically modified foods.
  • Introduction of legislation on extended product liability through which the company becomes obliged to take back products after use for recycling.

If the company does not always keep up-to-date with future legislation and expectations from society, it thus runs a risk of losing its production or customer base.

10.2 Management of environmental risks

Many risks are, of course, sector specific, but there may be great differences as to how different companies in the same sector manage risks. A clear example of this is shown in the CERES report "Corporate Governance and Climate Change" (2003). The report analyses how 20 of the world's companies have decided to approach the greenhouse effect in their business strategies and governance practices. All companies in the report are within the oil and auto industries. Two industries where the production and products lead to large emissions of greenhouse gases.

The analysis is made on the basis of a "Climate Change Governance List", identifying 14 specific actions that companies are taking to implement governance responses to climate change.

Climate Change Governance List

Board level

  1. Assign a committee of directors with direct oversight responsibility for environmental affairs.
  2. Conduct a formal board-level review of climate change and monitor company response strategies.

Management level:

  1. Place the chief environmental officer in a position to report directly to the chief executive officer or the CEO's executive committee.
  2. Make attainment of greenhouse gas targets an explicit factor in employee compensation.
  3. Have the CEO issue a clear and proactive statement about the company's climate change response and greenhouse gas control strategy.

Reporting

  1. Include a statement on material risks and opportunities posed by climate change in the company's securities filings.
  2. Issue a sustainability report based on the Global Reporting Initiative or comparable "triple bottom line" format, which includes a discussion of climate change and a listing of the company's greenhouse gas emissions and trends.

Emissions data

  1. Calculate and register greenhouse gas emissions savings or offsets from company projects.
  2. Conduct a system-wide inventory of the company's emissions and report the results directly to shareholders.
  3. Establish an emissions baseline (dating back at least 10 years) by which to gauge the company's emissions trends.
  4. Make projections of future emissions and set firm, company-wide targets to manage and control them.
  5. Hire a third party auditor to certify there are no material misstatements of the company's emissions data.

Other actions

  1. Participate in an external voluntary greenhouse gas emissions trading program.
  2. Purchase and/or develop renewable energy sources.

The analysis assesses the extent to which each of the 20 companies has conducted the 14 actions. The result of the study showed that there were great differences within the sector. The Europe-based oil companies had implemented all 14 actions, while their American competitors had only followed four or five. The auto companies ranged between five and ten actions, so there were also certain differences in this area, but the picture was not as clear geographically.

As the example illustrates, there is no difference in the potential risk the companies are subject to, but there are great differences in the way risks are managed and thus what the risk becomes for the individual company.

The actions mentioned in the 14 points are also included in the Nørby Committee report which recommends "that the board ensures that there are appropriate systems for risk management in place and, moreover, ensures that such systems meet the requirements of the company at any time. (...) The risk management system must define the risk and describe how this risk is eliminated, controlled or hedged on a continuous basis." (The Nørby Committee, 2001, p. 62)

It is, of course, also important to tell investors that the company is managing its environmental conditions. More and more companies include environmental information in their financial reporting.

10.3 Access to special funds

Besides the fact that investors generally assess the risk of a given investment, good environmental management also gives access to special ethical funds that emphasise that the companies in which they invest are among the most environment-friendly companies or meet a specific code.

 

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Version 1.0 April 2005, © Danish Environmental Protection Agency