Sustainability provides a rich investment opportunity for any organization – business, NGO or public agency. However, conventional approaches to comparing investment options may under-represent the value of sustainability efforts, and therefore lead to underinvestment, missed value creation opportunity and increased risk. By expanding outdated notions and definitions of the “returns” from investment options, CFOs, business leaders and managers of public or non-profit organizations can make more prudent and strategic decisions regarding sustainability opportunities.
The standard measure for the risk-adjusted opportunity of an investment is a simple equation: the benefit or “gain” of the investment divided by the initial cost – referred to as “return on investment.” Put $100 into a project, get $140 back, divide the gain ($40) by the initial investment, and voila – a 40 percent ROI.
While expected ROI is widely used by investors, our focus here is on investment decisions made by CFOs and business managers inside organizations about where to allocate their internal resources to achieve their goals.
From Conventional ROI to SROI
To illustrate the problem with the standard ROI analysis, consider the following example: You’re deciding whether to invest in an energy upgrade project that includes switching out inefficient incandescent lights with more energy efficient T-5 fluorescent lamps, replacing some overhead lighting with task lighting at workstations, and adding natural ventilation and daylighting to the space to save air conditioning and lighting costs. Suppose the initial or “first cost” of the upgrade is $100,000, and you get $15,000 annual energy savings: a 15 percent ROI. If that payback seems low or there is a competing use for those funds that would have an 18 percent ROI, the energy upgrade wouldn’t be worth the investment. But is that really the whole picture?
The problem with the standard ROI analysis is that it overlooks some of the potential benefits of the sustainability investment, and therefore undervalues the possible outcome. The first question in doing a Sustainability ROI analysis is, “Did we really look at all the financial costs and benefits of the project?” The first place to look for additional financial benefits is in the area of Life Cycle Cost Analysis, or LCCA. Did your analysis take into account the fact that the new T5 lights last for 5 years, yet the incandescent lamps they were replacing only last for a year? Did it measure the dollars spent paying maintenance staff to climb a ladder and replace each incandescent bulb each year? Did the analysis uncover the fact that the T5’s produce considerably less heat than the incandescents? In a building where you run air conditioning for 68 percent of the year, the cooler T5’s save you money again.
There are also external costs that you don’t bear directly in your energy bill, at least for now. Suppose some mix of your electrical supply comes from coal power – even here in Portland, Oregon, where most of our energy comes from hydro and a fair amount from wind, coal still comprises 40 percent of the energy mix. There is a societal cost to coal – the impacts of pollution from the mining and transportation of the fuel, and the impacts of climate change associated with its combustion. Although those impacts may not show up on your electric bill today, they may well in the future, when the U.S. catches up to the rest of the developed world and starts regulating carbon or adding carbon tax to fuel costs. Suddenly this energy upgrade is also a risk mitigation strategy – lowering your exposure to rising energy prices or carbon taxes.
And then there is what we call the Human Benefit. Numerous surveys document the fact that people prefer, and workers perform better, in spaces where they have control over their environment – like operable windows and task lighting. Additional studies show that student test scores go up, retail sales improve, worker performance goes up and absenteeism goes down when you increase daylighting in work spaces. So now we’re starting to see a more robust picture – additional, measurable financial benefits, reduced risk, and perhaps some more difficult to measure, but still important, financial benefits. Reduced absenteeism and improved performance have real and significant financial value, even if they are difficult to measure.
Broaden Your Investment and Your Return
Now suppose that in addition to the energy upgrades, you consider investing a little more. You replace your old carpet with a newer product that doesn’t offgas toxic fumes and contribute to ‘sick building syndrome’, and add a “green housekeeping” program that replaces your cleaning products with GreenSeal certified alternatives (available from all major cleaning supply vendors, nowadays). Now, perhaps, you could even credibly talk about having a “sustainability program,” an integrated approach to activities designed to save money, reduce risk, and protect the health of your staff, customers, and the planet. Is that something you would talk about in your branding, in your PR and marketing? Would it matter to employees, investors, and the communities in which you operate?
You are now moving from conventional Financial Return on Investment to what we refer to as Sustainability Return on Investment – what is the sum total of all the benefits of the strategy you are considering? How does that total compare to the total of all the benefits of the alternative strategies? The SROI model actually represents the true impacts of your decisions with much greater precision. And even if some of those factors – say, the risk of carbon tax – may seem negligible in financial impact, just recognizing that they are part of the equation may help inform the discussion and lead to a more robust evaluation of the tradeoffs.
A quick comparison of conventional ROI and Sustainability ROI reveals these fundamental differences:
As this table illustrates, an SROI evaluation leads to a much broader and deeper analysis than conventional ROI, and thus provides decision makers with a more accurate and robust picture of the real risks and benefits presented in alternative investment decisions. While the model I chose involved an energy efficiency upgrade decision, the exact same logic applies equally well in any cost-benefit or ROI evaluation, whether on a product strategy, business opportunity, merger or acquisition analysis, or valuation decision. Conventional methods of looking at cost and benefit tend to skew the outcome by excluding real benefits from the equation if they cannot be easily monetized, or ignoring real costs and risks that may not be directly attached the project, but do show up as a result of the project. A good SROI analysis closes those gaps and allows for a better-informed decision, and therefore, a better outcome.