Integrated Investing

2.5. Deficit analysis

The introduction of the conventional investment decision-making processes in companies revealed the differentiation between the phase of the investment appraisal and the phase of the actual investment decision. On the basis of this differentiation the focus of this thesis is on the most common investment appraisal methods as this phase represents the foundation for the actual investment decision.

Hence, the goal of the investment appraisal is to sketch a realistic picture of the expected profitability, cash flows or risk over the lifetime of the investment object so that the decision-maker can compare this to competing investment objects. The introduction of the most common investment appraisal methods revealed that each method investigates another aspect of the investment object. While the payback period focuses on the point of time till amortisation, the ROI sets the averaged relation between invested capital and expected profits. In addition, the comparison of costs or benefits represents basic financial assessments. Cost/benefit comparison, payback period and the ROI represent static investment appraisal methods and thus do not recognise the time value of money. However, their advantage can be seen in a simple and quick calculation that is easy to comprehend also to non-financial professionals.

With regard to the dynamic investment appraisal methods, the NPV records the point of time of cash inflows and cash outflows and transfers them via a discounting factor to the present value. In analogy, the CV transfers the cash flows of an investment to the end point of the investment object’s lifetime. Therefore, NPV and CV represent the value of the investment object that is added to the company’s value. In addition, the IRR provides the discounting factor leading to a zero NPV, which provides the decision-maker an impression about the sensitivity of the investment object. Hence, the IRR sets the relation of the investment and the future discounted cash flows and thus represents an indicator for the efficiency and quality of an investment.

Since no investment appraisal method is able to assess all relevant aspects, a set of indicators is needed for a comprehensive investment decision. While the investment appraisal is able to generate quantitative figures, the decision-maker also takes qualitative factors into consideration. The UVA represents a popular method to compose such a set. Nevertheless, the allocation of weightings to the corresponding sub-goals as well as the judgement of the utility values depend on subjective weightings and are in the focus of criticism.

In addition to the most common investment appraisal methods, modifications of conventional investment appraisal methods are discussed to assess their ability to integrate environmental impacts. The EPP and EROI represent environmental analogies to the payback period and ROI. Nonetheless, EPP and EROI differentiate with extending the boundary of assessment by taking into consideration the environmental aspects occurring in the production phase of the investment object. The problem, which practitioners are confronted with, is the lack of environmental data of this production phase.

Another problem is the absence of an environmental impact assessment within EPP and EROI. In addition, both methods are only able to assess one environmental aspect at a time. Therefore, a comprehensive environmental impact assessment cannot be conducted on the basis of EPP and EROI.

The third environmental investment appraisal method is the ENPV which mainly focuses on the opportunity to adjust the discount factor with the intention to influence the investment behaviour of the decision-maker. Nevertheless, finding an appropriate level of this environmental discount rate is a controversially discussed issue in literature. Hence, the common criticism notes that adjusting the discount factor overwhelms the ability of the discount rate which is originally intended to represent a trade-off between investing now or later. Furthermore, the management accounting professionals do not intend to answer macroeconomic questions or the ethics of inter-generational equity.

Evidence for the low popularity in applying modified investment appraisal method is represented by a study of Schaltegger et al. (2011a) revealing that only 9.7 percent of the surveyed companies apply environmental investment appraisal methods.

Besides discussing the investment process within companies, conventional investment appraisal methods and their modifications, the state of current academic knowledge regarding environmental impact assessment in companies is highlighted. The environmental management department aims for continuous improvement of the environmental performance of the company.

This continuous improvement involves the collection, monitoring and analysis of environmental data which is also referred to as environmental management accounting. In contrast to this, authors see the field of environmental management accounting as a subsystem or extension of conventional management accounting (compare Baumast, 2009). While this involves collaboration between environmental management and management accounting, a survey reveals a lack of such collaboration. Possible reasons can be found in missing communication as well as the inability of resolving conflicting goals.

Besides organisational issues, the data quality regarding the measurement of relevant environmental aspects, which build the basis for a subsequent impact assessment, remains an issue which needs to be solved by the installation of additional measurement technology. Hence, integrated environmental information systems provide an overview about environmental aspects but lack detailed insights on equipment level. In context of investment decisions, this lack concludes the problem of executing validity checks. In addition, different perspectives of financial and environmental management accounting professionals have impact on the scope of measurement. While financial management accounting is concerned with cost-related resource and emission flow, the environmental management accounting is interested in a wider scope due to compliance checks of given threshold values.

Finally, the instruments of assessing the environmental impacts are still under development. The immaturity of environmental impact assessment methods is expressed in their inability of offering reproducible and comparable results on the one hand and an increased complexity leading to high effort and a lack of comprehension at practitioners on the other hand.

This deficit analysis intends to assess the underlying reasons for the lack of application of environmental investment appraisal methods in practice. One main reason can be found in the weaknesses of EPP, EROI and ENPV resulting in a low degree of practical applicability. Besides organisational issues focusing on the collaboration between environmental management and management accounting professionals, the immaturity of environmental impact assessment methods can be regarded as main reason as well.

Therefore, it is necessary to develop a method that is able to overcome the weaknesses and problems identified in this deficit analysis. This integrated investment method needs to comprise an environmental impact assessment, which implies that all relevant environmental aspects are previously identified and measured. In addition, the method must represent a low degree of complexity to ensure that also non-professionals are able to comprehend the underlying rationale of the investment appraisal. This is especially important when regarding the cross-functional collaboration of environmental management accounting issues. Furthermore, the method needs to generate reproducible results which also provide the basis for comparison. Finally, the results need to be traceable and expressed in monetary terms to increase acceptance and thus successful practical applicability.

3. Method development

The current state of academic knowledge reveals in its concluding deficit analysis that the available environmental investment appraisal methods show a low popularity due to their lack of practical applicability. This chapter intends to identify and discuss additional methods that can serve as a basis for developing a new environmental investment method.

However, before discussing these additional methods, the basis for such a discussion needs to be determined. This basis is represented by a set of requirements according to which the methods are assessed. The set of requirements is composed by the results of the deficit analysis of the previous chapter on the one hand and the literature on environmental performance measurement on the other hand. Besides defining these requirements, the assessment criteria need to be determined as well to ensure a standardised evaluation procedure.

Therefore, this chapter is structured into three parts. The first part reveals the definition of requirements and the corresponding evaluation parameters. The second part introduces additional approaches which can function as a basis for further method development. These approaches are clustered into three groups – environmental cost accounting methods, flow-based cost accounting methods and additional methods of integrating environmental impacts. The second part also represents the evaluation of the approaches on basis of the previously defined requirements. Finally, the third part discusses the implications of the method screening and evaluation for the development of the new integrated investing method, before the interim results of this chapter are summarised and discussed in subchapter 3.4.

3.1. Determination of requirements

The discussion of environmental management accounting in the previous chapter revealed requirements with regard to measuring and monitoring all relevant environmental aspects. Hence, the physical flows of an investment object need to be predicted and their relevance needs to be assessed to compose an environmental inventory of all relevant environmental aspects associated with the investment object.

Furthermore, the continuous improvement of environmental performance in the context of environmental management requires an environmental impact assessment of the previously identified and quantified relevant environmental aspects. The results of this environmental impact assessment need to be reproducible and comparable to competing investment objects.

In addition, the deficit analysis revealed the problem that existing methods of assessing the environmental impacts are too complex and thus require a high timely effort on the one hand and lead to a limited degree of comprehensibility on the other hand. Hence, the requirement of comprehensibility is added to the set.

Besides the results of the deficit analysis, the academic literature on environmental performance measurement reveals additional requirements. Recker (2013) claims that validity and reliability are important attributes when assessing the scientific quality of methods. While reliability ensures that the application of the methods lead to the same reproducible results, validity ensures that the method serves the intended aim (ibid.)

Figure 14 shows the necessity for meeting both requirements by visualising the reliability and validity of fictitious measurement data.

Figure 14: Visualisation of different levels of reliability and validity of measurement results

Source: Recker, 2013:69

Prammer (2009) lists requirements concerning the application of environmental assessment methods in business practice. Besides a solid scientific basis, the methods need to be comprehensible and practicable to reach general acceptance (ibid.). In addition, Günther (2008) claims that the method needs to be applied within appropriate timely effort, which leads to increased practical applicability.

Another important requirement is the transparency of a method. Transparent methods enable decision-makers to understand the origin of the underlying data as well as the calculations and rationales behind the methods. This in turn increases the method’s credibility. (Schwegler et al., 2011)

In addition to comprehensibility and transparency of the method, the requirement of monetary evaluation aims at increasing the method’s practical applicability. In this context, it is important to differentiate monetary evaluation from monetarisation. While monetarisation intends to assign a monetary value to an environmental impact, the term ʻmonetary evaluationʼ aims to express the result of a method in monetary values (FEM, 2003). The expression of the results in monetary values intends to increase the acceptance of the management since it represents a “language that business managers understand” (IFAC, 2005:41).

For a structured discussion in the course of this chapter, the requirements originating from the deficit analysis and the current academic literature are clustered into two groups. While one group represents requirements aiming at a sufficient degree of scientific quality, the other group of requirements aims for a successful practical application of the method.

The following table represents a summary of the requirements, which are defined in detail in the following subchapters:

Table 3: Summary of requirements as a basis for the method screening and evaluation

Source: Own representation

3.1.1. Requirements ensuring scientific quality

Environmental inventory

The targeted integration of environmental impacts bases on the method’s ability to measure and quantify environmental aspects. Therefore, the environmental inventory requirement assesses whether all relevant environmental aspects are directly measured and quantified.

However, before assessing the methods in this chapter, three key elements, which are part of this requirement, need to be defined to ensure a uniform understanding of the requirement itself. These three key elements comprise:

- environmental aspect

- relevance

- scope of measurement and quantification

The International Organization for Standardization (ISO) provides a definition of environmental aspects in its norm addressing environmental management systems. According to the ISO (2009:11), an environmental aspect is an “element of an organization’s […] activities or products or services that can interact with the environment”. While this definition emphasises the interaction between the operations of a company with the environment, the ISO (2009) recommends the establishment of an input-output model as a basis for further measurement and quantification. The suggested inputs and outputs cover:

“- emissions to air,

- releases to water,

- releases to land,

- use of raw materials and natural resources,

- use of energy,

- energy emitted e.g. heat, radiation, vibration,

- waste and by-products” (ISO, 2009:26f.).

While conforming with the ISO regarding the recommended input-output model, the European Commission (2009) adds in its published regulation on the European Eco-Management and Audit Scheme (EMAS) additional environmental aspects.

These additional aspects include:

“- use and contamination of land […]

- use of additives and auxiliaries as well as semi-manufactured goods [...]

- transport issues […]

- risks of environmental accidents and impacts arising, or likely to arise, as consequences of incidents, accidents and potential emergency situations.” (European Commission, 2009:22)

The assessment of both standards on environmental management systems reveals an extensive list of possible environmental aspects. However, which environmental aspects need to be considered depends on the one hand on the investment object and on the other hand on the relevance of the environmental aspect. Hence, it needs to be defined when an environmental aspect can be regarded as relevant.

Concerning the definition of relevance, the ISO (2009:11) states that “a significant environmental aspect has or can have a significant environmental impact”. While this definition connects environmental aspects with their impacts on the environment, it is not helpful in determining the relevance of environmental aspects.

Although the European Commission (2009:22) also describes this connection, further assistance in assessing the significance of environmental aspects is provided:

“- size, number, frequency and reversibility of the aspect or impact - existence and requirements of relevant environmental legislation - importance to the stakeholders and employees of the organisation”

In conclusion, the relevance of an environmental aspect can be determined on the basis of several parameters such as physical quantities, environmental legislation or outcomes of stakeholder dialogues. In the context of this thesis, the relevance is determined according to the quantities of environmental aspects. Moreover, the proportion of the total measured and quantified environmental aspects is important when determining the relevance of environmental aspects.

In addition, the scope of measurement and quantification needs to be determined. In the context of this thesis, the scope is set on direct environmental aspects which can be measured on the company’s site (gate-to-gate). Furthermore, the scope is set on the environmental aspects resulting from the operation of the analysed investment object and not on the environmental aspects resulting from its establishment or disposal.

Finally, the evaluation question regarding the environmental inventory requirement can be formulated as follows:

Are all relevant environmental aspects directly measured and quantified?

The following table summarises the evaluation parameters of the environmental inventory requirement with their corresponding definitions:

Table 4: Definition of evaluation parameters of the environmental inventory requirement

Source: Own representation

Environmental impact assessment

After the basis of the method’s ability to measure and quantify environmental aspects is assessed, the concluding step is the environmental impact assessment. This step is important since the sole relevance of the environmental aspect does not provide any conclusion about the severity or damage to the environment. Hence, this requirement evaluates whether the analysed method is able to assess and to integrate the environmental impacts of the relevant environmental aspects.

However, before analysing the methods on the basis of this requirement, two parts need to be determined beforehand. First, the term ‘environmental impact assessment’ needs to be defined. Secondly, the differentiation between direct and indirect environmental impact assessment needs to be clarified. Finally, a definition of environmental impact assessment in the context of this thesis is derived.

The ISO (2009:11) defines an environmental impact as “any change to the environment […], whether adverse or beneficial, wholly or partially resulting from an organization’s […] environmental aspect”. While the definition of environmental aspects concentrates on the interaction between a company’s operations and the environment, this definition highlights the consequences of such interaction to the environment. In this context, Prammer (2009) determines three major categories of environmental impacts:

- change of resource inventory

- change of material composition of the natural environment

- change of ecosystem and landscape

In addition, Prammer (2009) differentiates between direct and indirect environmental impacts. While direct environmental impacts cause changes to the environment by operations of the company itself, indirect environmental impacts are caused by suppliers or clients.

In the context of this thesis, the emphasis is set on direct environmental impacts, which is also in line with the gate-to-gate scope of the environmental inventory requirement. Moreover, the emphasis is set on the severity of the change to the environment and not on the type of environmental impact category and its detailed consequences. This emphasis is set in order to enable integration in investment decisions since a detailed description of the consequences would result in limited comparability of investment objects within the investment appraisal.

Finally, the question regarding the environmental impact assessment requirement can be formulated as follows:

Is the method able to assess the environmental impacts of the relevant environmental aspects?

The following table summarises the evaluation parameters of the environmental inventory requirement with their corresponding definitions:

Table 5: Definition of evaluation parameters of the environmental impact assessment requirement

Source: Own representation

Validity

The validity requirement assesses whether the methods analysed in this chapter serve the intended purpose. Hence, it needs to be verified that investment decisions based on the integrated investment method lead to an improved financial and environmental performance of the company. Finally, the investment decisions should support the company in achieving the strategic environmental and financial goals. In this context, the terms ‘financial performance’ and ‘environmental performance’ need to be determined.

With regard to financial performance, the definition focuses on the financial and commercial efficiency of the company and on its ability to add value to the total value of the company (Günther et al., 2006). Hence, the literature on performance measurement lists several indicators and ratios to measure this efficiency. As a representative of a broad consensus Gladen (2011) lists among others indicators such as sales turnover, costs per product, profitability or liquidity. With regard to investment appraisals, the methods introduced in the previous chapter refer, amongst others to PBP, ROI, NPV, CV, IRR, etc. (Poggensee, 2011).

Concerning the definition of ‘environmental performance’ of a company, Günther et al. (2006) discuss eight different definitions provided in literature. As a result, the authors analyse two main perspectives. On the one hand, definitions of environmental performance concentrate on the activities of a company such as activities of the environmental management department. On the other hand, definitions concentrate on the total amount of environmental aspects of a company and their impacts on the environment. (ibid.)

The ISO (2000) established an international standard on environmental performance evaluation. Within this standard, environmental performance is defined as the result of “an organization’s management of its environmental aspects” (ISO, 2000:5). In close relation to the standard concerning environmental management systems, the environmental performance evaluation is described PDCA cycle aiming at a continuous improvement. This aspect is also addressed by Günther et al. (2006), who declare the reduction of environmental aspects of a company from one year to another as ‘environmental profit’.

In the context of this thesis, financial performance is defined as economic and commercial efficiency of a company. The determination of environmental performance is in line with the definition of financial performance. Hence, environmental performance is defined as the reduction of environmental impacts. In both cases, it is assumed that strategic financial and environmental company goals exist so that investment decisions can be taken with the aim to achieve these goals.

Therefore, the validity requirement intends to assess whether there is a correlation between the investment decision and the strategic environmental and financial goals of the company. This is the case, for instance, if the method assesses the financial and environmental efficiency of the investment object and if investment decisions aim to increase this efficiency.

In conclusion, the main question for the validity requirement can be formulated as follows:

Does the decision based on the integrated investment method lead to an improved financial and environmental performance of the company?

The following table summarises the evaluation parameters of the validity requirement with their corresponding definitions:

Table 6: Definition of evaluation parameters of the validity requirement

Source: Own representation

Reliability

The final requirement ensuring scientific quality assesses the reliability of the discussed methods in this thesis. Hence, the requirement analyses whether the method leads to the same results after repeating the calculations under the same circumstances and with the same assumptions (Recker, 2013).

Hence, the consistency of the results depends on the reproducibility of the method’s application. In conclusion, the method should reveal the same result if:

a) one person repeats the calculation of the method after some period of time or

b) two different persons conduct the method’s calculation independently (ibid.).

Transferred to this thesis, the reliability requirement assesses whether the investment decisions based on the method’s results are the same, whether one person repeatedly conducts the calculation after some period of time, or whether two independent persons conduct the method’s calculation separately.

In this thesis, the decision-maker is assumed to take investment decisions rationally. Furthermore, the reliability can be increased by a detailed description of applying the analysed methods and their underlying calculation. With such a detailed description, uncertainty in application is decreased as well as room for subjective judgement and interpretation leading to lower variation of results.

Thus, the question regarding the reliability requirement can be formulated as follows:

Does the method lead to the same result when repeating its underlying calculations?

The following table summarises the evaluation parameters of the reliability requirement with their corresponding definitions:

Table 7: Definition of evaluation parameters of the reliability requirement

Source: Own representation