Resource Efficiency = Shareholder Value
Resource efficiency is a natural and progressive economic phenomenon and a fundamental characteristic of our industrial economy. It is the practical and continuous innovation that comes from a combination of necessity and ingenuity. It is a catalyst that hastens the transition to a more sustainable model of economic prosperity in an environment of resource constraint.
For a business, resource efficiency is an economic imperative to counter rising input costs, widen margins and drive profitability. It is also a compelling measure for determining a company’s ability to cope with the challenges of decreasing resource supply and increasing price volatility. And it is a valuation metric that distinguishes businesses that are able to create more from less.
Linear versus Circular
Early economic theorists modelled our industrial economy in a vacuum. Inputs and impacts were of little or no consideration. They were not negligent and it’s not overly surprising considering the abundance of inputs and perceived lack of impact during the hay day of industrialization. Throughout the period of rapid industrial growth, both policy and action reflected a mentality of plenty. Fuels were cheap and disposal was frankly, irrelevant. But as Bob Dylan tells us, the times, they are a changing.
Ours is a linear economy, based on the cultivation or extraction of raw material and the subsequent manufacture of material into goods. We distribute these goods to markets and consume with abandon. We apply energy and labour at each stage, creating waste and refuse along the way, ultimately discarding residual waste and unused goods. It is an unsustainable Take Make Dispose model.
Our system is focused on maximizing production in order to meet the demands of consumption in a rapidly growing economy. Materials used, energy consumed and waste created are necessities and by-products of the productive goal. It is an inefficient process that fails to maximize the benefits of the multitude of resources and energy required to keep the system operating.
To be clear, the sky is not falling. We are not suddenly running out of resources. Even rare earth minerals are more common than their title suggests. But the issues at play are daunting and they are in our near future. There are 7 billion people on the planet. We will add another billion or so before 2030. It is estimated that there will be 3 billion additional middle class consumers by then. At that point, according to a McKinsey report in November 2011, demand for key natural resources will have increased by more than 50%. That’s a reality which is less than two decades away.
Considering the efforts that have gone into generating the current level of supply over the past 150 years, the requirement to fulfil an additional 50% to meet demand is absolutely enormous.
Newer economic theorists believe that the realities of resource constraint require us to re-think the whole of the linear economy and move to a more circular one, one that promotes a closed loop philosophy where waste is all but eliminated, resources are conserved and growth becomes vastly more sustainable. It may sound idealistic, but necessity is pushing more firmly and more quickly in that direction.
The fact is that there are many real life examples of successful closed loop or near closed loop processes in action already. Nike, for example, crumbles old sports shoes to make sports courts and running tracks; simple, genius. Desso in Holland has developed carpet tiles that are fully closed loop, 100% recyclable into new carpet tiles; a near zero waste, perpetual use of resources model in action.
Some circular economy advocates hold that the transition to circular must be fast tracked. In fact, even efficiency gains merely represent continuous improvements to an unsustainable linear process rather than part of a new way of thinking; a sort of bandage to system that needs to be rebuilt. Even recycling is simply prolonging the linear wasteful process rather than planning waste out from the onset.
But practical reality precludes these efforts from fulfilling the requirements in the near term as we transition to a more resource aware society. The politics of compromise across industries and geographies will ensure that the transition is slower than hoped. That is not to say that the process will not happen; only that it will inevitably be evolutionary as larger corporations embrace and incorporate circular thinking.
In the meantime, investment in sustainability will continue to include the linear ideas of recycling and increasing efficiencies, particularly with respect to resources. In fact, it is the seemingly new found awareness of resource constraint that is driving the move from linear to circular. The economics of the transition are making it happen, and they are far more powerful than the emotive desire to save the planet. Resource efficiency is a significant contributor to the transition from our linear habits to circular sustainability.
Many believe that the popular sustainability acronyms (ESG, SRI and the like) that pervade the investment community are new. While environmental, social, responsible, ethical and governance in whichever combination you choose may be new concepts to some of the investment community, policy makers and business leaders have been keenly aware of their implications for decades, if not more.
In the US, the Superfund Amendment and Reauthorization Act of 1987 (SARA) created the Toxic Release Inventory. It is referred to as the “right to know” legislation for its requirement to audit and report on all toxic environmental releases. It followed several pieces of legislation in the US but was the first that required companies to publicly disclose environmental data. That was 25 years ago.
Increasing volumes of emissions data flowed from companies following the SARA legislation. And from this process, companies gradually began to voluntarily release more and more information through corporate sustainability reports.
The first global business to voluntarily release detailed corporate sustainability data in the form we know today was The Body Shop in 1995. By the millennium, there were 44 firms that voluntarily disclosed sustainability data according to the guidelines of the Global Reporting Initiative (GRI). Today, there are nearly 2,000 and that number is growing steadily.
There are a variety of reasons that companies choose to produce these reports, but at their core they are intended to be vessels of transparency and accountability. Essentially, they are meant to improve internal processes, engage stakeholders and persuade investors. It also happens that responsibility plays well with the public, so the public relations benefits of transparency and engagement is an additional factor.
As investors, what does this data tell us? Well, for starters it provides insight into an organization, insight that is deeper than the actual data itself. The voluntary disclosure of material environmental information requires a significant investment in time and effort at all levels of an organization, increasingly up to the board of directors.
In order to produce data for disclosure, companies must measure the inputs and impacts of their operations in a very detailed manner. It follows that company’s which measure data, by default monitor the data and they tend manage it in greater and greater detail as they become more fully aware of its impact on the business.
At worst, disclosing sustainability data is an indication of better corporate governance. At best, it indicates a forward thinking continuously improving organization that is better prepared for a more resource constrained future.
The Model of Resource Efficiency
Even better, environmental and sustainability information can be used to create valuation metrics which demonstrate the link between resource efficiency and shareholder value.
There are more than 700 environmental effluents disclosed in sustainability reports every year. Clearly, all organizations are different, even within the same industry. And most do not use or report on the bulk of the more esoteric effluents.
However, nearly every company in the world will consume or create some measure of three basic factors; water, energy and waste. It is not surprising therefore, that details on these factors are the most widely reported. What may be surprising is that the disclosed information on these factors reveals a great deal about a company.
By collecting, standardising and analysing observed amounts of energy and water used by a company as well as the total amounts of waste it creates, an investor is able to determine the relative amount of each factor required to generate a unit of revenue. This provides interesting insight into the management and potentially to the risk management of a company.
Quantitatively combining these factors into a single metric creates a stable, provocative tool for assessing both value and risk in a public business. The ability to create more from less is clearly an ideal toward which many companies strive. The ability to measure this concept using material, disclosed, audited data without traditional financial metrics is unique in the investment community.
Companies that are more resource efficient across every sector of the economy tend to display greater operating margins and better asset yields than their peers. It is intuitive that they would, given the premise that resource efficient companies produce more from less. They also tend to show greater return on assets and greater return on equity.
It is important that that this determination is objective and auditable down to a granular level. There is no subjectivity involved, no intervention, no grading system. And importantly, there are no traditional financial metrics involved. The Model is a pure methodology for comparing the ability to generate a unit of revenue per unit of resource across industry peers. The results are eye catching and will become a norm by which companies are compared and valued.
Bringing together the most resource efficient large public companies from each sector across the global economy creates a basket of highly liquid, blue chip names. Systematically updating the basket on a monthly basis to take account of continuous data, the portfolio of companies outperforms global benchmarks by an average of more than 5% per year over the past 8 years; which is the time span over which disclosed data has been available to make a determination.
The investment characteristics that these companies display are not unique to resource efficiency, but it is not possible to replicate a resource efficient basket using traditional financial metrics. In other words, you could not create a similar portfolio by screening all companies in a pool for high operating margins, asset yields, return on equity, return on assets and the like.
These characteristics are the effect and not the cause of the resource efficient portfolio. In fact, a Brinson performance attribution of MoRE World against MSCI World shows that stock selection has had by far the greatest overall impact on portfolio return.
While Brinson analysis is arguably not conclusive it is indicative, particularly when a factor is so statistically dominant. In the case of the model of resource efficiency, Brinson clearly indicates that over multiple periods, the resource efficiency selection metric is responsible for the bulk of shareholder returns.
To many in the sustainable investment field, this is an astonishing revelation. This represents verifiable, statistical evidence that the market, directly or indirectly, values companies that are more efficient at converting their resources to goods. And what’s more, the market has priced this concept for many years. Resource efficiency, in fact does lead to shareholder value.
The methodology is unique and original. This type of analysis has not been done before because the relative newness of large scale environmental disclosure. Additionally, most traditional financial analysts have been aware of environmental disclosures and recognize their materiality but find it very difficult to add tons of water or kilojoules of energy into a traditional balance sheet.
As a result they tweak their valuations in some way to compensate. And in doing so, they completely miss the point. There is an incredible depth of insight to be gained by understanding the resource efficiency of an organization and its impact on shareholder value.
The model of resource efficiency is a bottom up process that identifies companies by their ability to create more from less. It does not identify the specific reasons for resource efficiency. It simply identifies businesses that have achieved resource efficiency, generally over a period of years.
Each company’s path to resource efficiency is unique. Some achieve greater resource intensity through technology, some through process and some through products. Identifying the underlying reasons for higher levels of resource efficiency in public companies can be insightful, but the common thread is an economic imperative.
Boeing is a good example of effective, innovative resource efficiency. They are one of the most resource efficient aerospace organizations in the world. Like many efficient businesses, there is no single reason for high overall relative resource efficiency. Boeing undertakes significant efforts across many fronts. One effort does however stand out.
In 1994 Boeing began work on a sophisticated flywheel device that efficiently stores and distributes electric energy on a large scale. They are not the only provider but they have become very good at this technology. It effectively creates an efficient, stable and secure supply of electricity even when the generation is not necessarily stable.
As a division, Boeing Energy has sold their products to utility companies for more than a decade. Recently, they teamed up with Siemens to deliver storage and distribution together with smart grid technology to the US Department of Defence.
As such, Boeing Energy is a significant contributor to top line financials for the company. But it is also a significant contributor to the reduction of costs across the organization. Not only have they built a leading energy and storage distribution technology, the company uses their own technology internally to harness, store and distribute their multiple legacy energy sources together with their many forward thinking renewable energy sources across the organization.
As a result, they are extraordinarily energy efficient both in absolute terms and with respect to their industry peers. They have built a clean tech solution for clients, created wealth from them and have utilized their power to reduce costs internally.
More interestingly for the investment community, this is an example of detail that tends to escape the scrutiny of many sell side analysts. You will be hard pressed to find the implementation of flywheel energy storage and distribution as a key to reducing costs at Boeing in many brokers report on the company.
This is an example of capitalized clean tech at its best; an implemented technology, process or product that results in more efficient use of resources and less waste. These kinds of initiatives are the real source of resource efficiency. They are a hallmark of sustainable companies; businesses that are able to make more from less.
As our linear economy advances further, companies like Boeing will continue to shine. Their forward thinking nature prepares them better for the volatility of price and supply that is faced today and will inevitably increase.
Unfortunately, the transition from linear to circular will be a long process despite the dangers of resource constraint and climate change. The politics of compromise will almost guarantee this. Too many large corporations, governments and influential people have too much invested in the current system. Change will surely come, but will not do so at the speed that many would prefer.
But as the transition proceeds to a more sustainable circular leaning economy, companies that use less resource in the creation of value will display the resource efficient characteristics of higher operating margins and better asset yields. Linear, circular or somewhere in between, they will fare well within the parameters of the Model of Resource Efficiency. And the markets are very likely to continue to price them accordingly.