Critical Thinking Assignment (Benefits Of Market Impacts)

Benefits of Market Impacts

The benefits related to social, environmental, and economic impacts are often categorized as either market or nonmarket impacts.

Market benefits include:

  • Increased sales quantities due to increased market demand
  • Increased prices due to quality and reputation
  • Reductions in costs due to increased efficiencies
  • Increased productivity
  • Reduced future costs related to environmental cleanup, internal control, and ethics breach

What are examples of this impact in the Kingdom of Saudi Arabia (middle east)? In a 3-4 page paper, provide as many examples are you can of the five benefits listed above.

Use University academic writing standards and APA style guidelines, citing references as appropriate. minimum 4 references.

It is strongly encouraged that you submit all assignments to the Turnitin Originality Check prior to submitting them

 

Read chapter 6 in Making Sustainability Work

 

chapter 5

Performance measurement, evaluation, and reward systems

In developing strategic responses, it is important for senior executives to understand the causal relationships between sustainability performance, and financial perform- ance, to understand the payoffs from social, environmental, and economic improve- ments, and to create a culture where employees understand and work toward corporate social, environmental, and economic goals. Corporate incentive and reward systems can be a critical tool to implement sustainability and align the interests of the corpora- tion, senior managers, and all employees. These systems are usually a part of a broader set of systems to evaluate the performance of the organization, its various units, and individuals. They will probably measure success in numerous areas, including both sustainability and financial performance. Systems that measure performance and encourage employees to pursue sustainability are necessary to improve social, envi- ronmental, and economic impacts, to communicate the value of sustainability to the organization, and to hold employees accountable for their contribution to the sustain- ability strategy. In this chapter we discuss some of the systems that encourage perform- ance and aid in performance measurement:

l Corporate, strategic business unit, functional, facility, and individual meas- urement and evaluations

l Compensation, incentive, and reward systems

l Internal waste taxes

l Emissions trading

l Strategic management systems (such as the balanced scorecard, shareholder value analysis, or other dashboards and performance measurement systems)

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122 making sustainability work 2

Performance measurement and evaluation systems One important tool for linking corporate objectives with results is the company’s per- formance measurement and evaluation system.1 Measurement is critically important because it links performance to the principles of sustainability and facilitates continu- ous improvement. Managers may use indicators to define goals and targets when they implement new programs to improve their sustainability performance; they can then compare these indicators to actual performance, along with various benchmarks, and measure success. Managers need to use feedback constantly to challenge their assump- tions about the viability of various decisions and their long-term implications for both the company and society. Appropriate measurement systems provide the proper tools for feedback and corrective actions. For example, in 2012, Colgate, a leading consumer products company with over 37,000 employees, began evaluating new products using a product sustainability scorecard to drive improvement across the product life-cycle. The scorecard rates products with 35 parameters across eight focus areas: responsi- ble sourcing; materials; energy and greenhouse gases; waste; water; ingredient profile; packaging; and social impact.2

For an organization intent on changing its corporate culture and achieving sustain- ability, performance measurement is extremely important. Best-practice companies achieve superior sustainability performance by sending a clear message that these issues are critical to company success. The challenge in performance measurement is that many systems in place are missing relevant and comprehensive measures of performance. Systems that extend beyond the financials to nonfinancials deliver maxi- mum value to shareholders, customers, and other stakeholders.

A measure for individual or business unit performance can be determined primarily by two factors: the corporation’s strategy and the action taken by a person or business unit that contributes to the success of the strategy. This can be centralized or decentral- ized. In a decentralized method, the corporation prescribes the performance measure for the individual or the business unit, and then they decide what the performance driv- ers are and how to manage them. In a centralized method, the corporation sets the per- formance measure by giving the individual or business unit the performance drivers and the weight each driver has in the determination of the performance measure.3 This becomes an important issue in both the formulation of strategy and the organizational design of decision-making discussed earlier. Corporate decisions on whether sustain- ability performance, strategy, and goals will be determined centrally or be delegated to the discretion of business unit or geographical unit managers will have an impact on performance and performance evaluations and on the incentive systems to be used.

Senior managers can use organizational performance indicators to evaluate whether the sustainability strategy is achieving stated objectives and contributing to overall cor- porate performance. A weak performance on the organizational metrics signals a need to examine the inputs and processes and determine whether they have been poorly specified or just poorly executed. It can also provide an opportunity to identify poten- tial benefits to organizational effectiveness and profitability from sustainability that may have been overlooked. This is an opportunity to examine how well sustainability

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5. performance measurement, evaluation, and reward systems 123

programs are contributing to corporate value and should unveil specific opportunities, directions for improvements, and standards of performance.

The social, environmental, and economic performance of the entire corporation, individuals, facilities, and business units is an integral part of performance meas- urement and evaluation systems. If sustainability performance is truly important to corporate leaders, evaluations should highlight that component. When performance measurement and evaluation systems are aligned with sustainability strategy, execu- tives gain a key source of information. That translates into increased performance and payoffs from sustainability investments. Thus, the sustainability performance of corpo- rations, business units, facilities, teams, managers, and all other employees should be measured and be part of the way they are evaluated for success.

The corporate-level measurement system sets the organization up for brainstorming complementary sets of measures down through the organization. Managers should cascade measures down through the hierarchy. By taking a cue from the family of measures developed by corporate executives, every unit of the organization should address sustainability measurement in a coordinated way. Business units, functional groups, facilities, teams, and even individuals obtain guidance from measures that dovetail with corporate strategy. When people’s efforts to execute strategy are aligned in this way, a company can expect to join leading organizations in enjoying the benefits of increased sustainability performance.

A prime challenge is to create a “performance logic” among all measures. From the bottom of the organization up, managers must ask: How does each variable measured contribute to a higher-level variable and, in turn, contribute to organizational results? From the top down: What variables drive the economic profit figure and, in turn, what variables drive those variables? The critical step is to configure the measurement sys- tem so that measures at corporate, functional, and team levels connect.

Devising the right performance measures It can be difficult to devise measures that send the right signals and prompt the right actions. Measures should have the following six objectives:

1. Make strategic objectives clear

2. Focus on core cross-functional processes

3. Focus on critical success variables

4. Act like early warning signals for problems ahead

5. Identify critical factors going awry

6. Link to rewards4

Managers should also include a mix of input, process, output, and outcome measures. Input includes the money and people used to implement a sustainability initiative; process includes any systems used to deliver an output; output includes intermediate results achieved; and outcomes are the final results that may include both sustainability and financial performance. Each element of the Corporate Sustainability Model from

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Chapter 1 (Fig. 1.4, page 29) should be converted into a performance indicator and measured.

Workable measures need to serve not just management but the people who actually execute the strategy, no matter what level of the organization they work in. Setting the top-level measures is only the beginning. Top managers must challenge business unit managers to create measures of their own, aligned with the top-level set.

Every team and operating unit needs a family of measures to motivate workers to act in concert with the strategy developed for the whole company. The idea is to cascade the measures down through the organization so they logically connect one to the next. Each group of employees should customize their own measures. Sometimes the meas- ures are the same as corporate measures, sometimes entirely different, but in any case they both come from a global strategy and serve local needs.

Performance measurement and evaluation systems fulfill at least three vital roles. The first role is to capture the logic behind a sustainability strategy and facilitate agree- ment about what is important, how day-to-day activities add value, and how each per- son contributes to the mission. Making the strategy explicit through a measurement system has at least three advantages:

l It allows discussion about the underlying assumptions, and provides agree- ment in the organization about the strategy

l It encourages communication of the strategy and its execution throughout the organization. Communication clarifies expectations and it becomes clear to staff why certain actions add value and others do not

l It tracks the evolution of the organization and the strategy. Sustainability efforts frequently span long periods of time; a performance evaluation and measurement system identifies if the organization is on the right track to achieve its sustainability objectives and whether the strategy is working

Volvo Car Group, a Swedish car manufacturer, has developed a sustainability scorecard to communicate strategy and measure performance. It also provides an overview of trends that are relevant to Volvo’s contribution to sustainable development (Table 5.1).5

The second use, and probably the most commonly thought-about function of meas- urement systems, is monitoring progress (in Volvo’s case exemplified with trend moni- toring). Organizations often develop performance measures to help them gauge the sustainability performance of strategic business units and company facilities. Regula- tory requirements and external stakeholders prompt some of these measures, such as toxic substance data, energy consumption, number of industrial accidents, employee safety, and workforce diversity. However, companies also recognize that it is impor- tant to develop measures that are aligned with the internal mission and objectives of the organization. Integrating measures of sustainability performance will ensure that statements of social responsibility articulated by the CEO and in corporate mission statements are implemented properly.

For example, Kingfisher, a leading home improvement retailer in Europe and Asia, has developed a performance evaluation system to measure its so-called Operating Companies’ progress against 50 targets. These cover Kingfisher’s Net Positive pri- orities (timber, energy, innovation, communities) and three other issues (employees,

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5. performance measurement, evaluation, and reward systems 125

suppliers & partners, environment). Kingfisher has developed a questionnaire to moni- tor Operating Companies progress against these targets. The nine Operating Compa- nies complete the questionnaire twice a year and average scores for each are published every six months on Kingfisher’s website (for January 2013 results, see Fig. 5.1). There are multiple targets for each Net Positive priority and the three other issues. The score for each issue is an average score, calculated from the individual scores for each rel- evant target. Since Kingfisher just started its ambitious Net Positive journey, results for January 2013 reflect relatively low scores in several areas.6

Table 5 .1 Volvo sustainability scorecard

Source: Volvo Car Group (2012) Sustainability Scorecard

A third role of measurement systems is to facilitate the ongoing discussion within an organization that will lead to better performance. Niagara Mohawk Power, a New York-based power company now part of National Grid, developed a comprehensive self-assessment program to focus the organization’s efforts on performance areas that would create value for the company’s stakeholders and that would help to sustain long- term improvements. Its three primary objectives were:

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126 making sustainability work 2

Figure 5 .1 Kingfisher’s monitoring of Operating Company performance

Source: Kingfisher (2013) Net Positive Report

l Responsiveness to customer needs

l Efficiency through cost management, improved operations, employee empow- erment, and safety

l Aggressive, responsible leadership in addressing environmental issues

The company also developed an environmental performance index that established targets and measurable improvements based on a baseline of performance. Improve- ments made toward meeting the three objectives determine how large a financial reward is available to company employees. Establishing solid benchmarks against which environmental performance can be measured encourages management and staff to improve compliance with environmental regulations. It also leads to a decrease in costly noncompliance issues and corrective actions. At Niagara Mohawk, three cat- egories of performance were measured: emissions/waste, compliance, and environ- mental enhancements.

In specific industries, industry leaders are exploring ways to evaluate, communicate, and share tools for measuring social, environmental, and economic performance of their products. Nike, for example, has been cooperating with the Sustainable Apparel Coalition (SAC), an industry-wide group of leading apparel and footwear brands, and with retailers, manufacturers, NGOs, academic experts and the US Environmental Pro- tection Agency, to reduce the environmental and social impacts of apparel and footwear

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5. performance measurement, evaluation, and reward systems 127

products around the world. Its core initiative is developing the Sustainable Apparel Index, a common, industry-wide tool for measuring the environmental and social per- formance of apparel products and the supply chains that produce them. Apparel retail- ers and brands can compare the performance of products and upstream supply chain partners, and those partners will have a single standard for measuring and reporting performance to their downstream customers. Eventually, this approach can provide a foundation for reporting to consumers on the sustainability of the products they purchase.7

Subjective measures Objective measures are the bread and butter of most performance measurement sys- tems. However, subjective measures of performance should be used to complement objective measures. There are numerous advantages to subjective evaluation. Manag- ers can:

l Include information not foreseen before the project started

l Observe the actions and decisions of the person evaluated

l Evaluate tasks that are hard to quantify and judge whether they are beneficial to the company

l Discount the effect of uncontrollable events

l Adjust the importance of different measures and observations with changing priorities for the sustainability project

l Use what they know about the person evaluated to better assess performance, because people interact in various issues and over time

However, subjective measures do have their limitations. They rely on the availabil- ity of information and the ability, knowledge, and effort of the person doing the evaluation. Subjective evaluation also relies on the evaluator having the right incen- tives to provide a fair evaluation and on his or her reputation, fairness, and ability to judge. A person without credibility will hardly lead to satisfactory evaluation. Subjec- tive evaluation can be the best performance measure when the person evaluating is competent, trustworthy, and committed—and the worst performance measure if any of these conditions are not met. A mix of objective and subjective measures for evaluation is the best approach. Over-reliance on either one distorts incentives and behavior.

Evaluating the CEO and senior executives One of the primary functions of the board, as discussed in Chapter 2, is oversight and evaluation of the CEO. Given recent concerns over excessive executive compensation, conducting a rigorous performance evaluation and explicitly linking it to compensa- tion can provide improved governance and accountability on the part of both CEOs and boards. The identification of the performance objectives should be a joint effort

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128 making sustainability work 2

between the board and the CEO, and should identify objectives and goals that reflect the CEO’s roles and responsibilities.

Dean Foods, one of leading food and beverage companies in the US, expressly charges board members with governing sustainability. The Audit Committee oversees corporate social responsibility policies, including those covering sustainability, ethics, compliance, and reputation, while the Compensation Committee evaluates executive officers on the basis of these factors, weighted 40%. The CEO is measured on the basis of instilling a culture of ethical behavior and social responsibility. The Chief Supply Chain Officer is measured on the basis of saving water, improving energy efficiency, and reducing waste output in the supply chain. As a result, Dean Foods has cut water use by 5.6% in 2010, and has reduced greenhouse gas emissions by 6% over the period 2008–2010.8

At National Australia Bank, one of the four largest financial institutions in Australia, individual senior executive performance is assessed against a number of key measures supporting the bank’s strategy and business objectives. Measures and targets are tai- lored to the individual’s role.9 Table 5.2 details some of the key measures used in 2012 to assess individual performance outcomes.

A particular challenge when constructing a performance evaluation system for the CEO is to develop a system that will adequately capture the inherent distinctions between corporate performance and the CEO’s performance. Performance evaluations and rewards should not result in rewarding poor performance or in overlooking supe- rior performance. For example, CEO performance can be marginal, even though the stock price is rising. Or the reverse may be true. It is the board’s responsibility, through the development of effective measurement and evaluation systems, to distinguish between the performance of the CEO and the performance of the corporation.10

Why performance measurement and evaluation is important Performance measurement and evaluation is an important tool in the implementa- tion of a sustainability strategy and aids in the alignment of strategy, structure, and other systems to achieve success. It is critical to set objectives and targets and meas- ure success against them. It is also critical to measure success of not only the results (outcomes) but also the inputs, processes, and outputs that lead to those outcomes. Explicitly identifying corporate goals and setting specific targets improves corporate sustainability performance and focuses attention on areas of concern and priority. These are some of the benefits a company can gain by including social, environmental, and economic indicators in its performance measurement evaluation at all levels and in all areas:

l Comparison of performance over time

l Highlighting of optimization potential

l Derivation and pursuit of social, environmental, and economic targets

l Evaluation of sustainability performance between firms (benchmarking)

l Communication tool for corporate reports

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129 Key Business Driver Measure(1) 2012 Achievements

Financial and risk management

Group cash earning ROE ROTAE Tier 1 ratio Risk appetite

l Group cash earning(2) of $5,433 million for 2012 year decreased by $27 million or 0.5% against 2011. Excluding the $250 million ($175 million post tax) uplift to the economic cycle adjustment, cash earnings increased by $148 million or 2.7%. This was largely driven by higher earnings in Wholesale Banking, Personal Banking and NZ Banking, partially offset by significantly lower earnings in UK Banking as a result of higher charges for bad and doubtful debts.

l Group cash ROE decreased by 100 basis points to 14.2% due to lower earnings, coupled with higher levels of capital being held as the Group continues its transition to Basel III.

l ROTAE was below budget. l The Tier 1 capital ratio has increased by 57 bps to 10.27%, consistent with the Group

objective of maintaining a strong capital position. l Maintained sound capital, funding and liquidity positions. l Adherence to risk appetite across the Group and strong risk culture.

Strategic projects and process quality

Technology and process transformation Cross sell

l Several key milestones achieved in the multi-year project, including launch of nabtrade. l Cross sell targets met.

Employees and culture

Employee engagement Diversity targets

l Strong gains in employee engagement, placing the Group above the financial services average.(3)

l On track to meet diversity targets (for more details see the Diversity section).

Customer and community

Customer satisfaction Corporate responsibility objectives

l Achieved the highest bank customer satisfaction score of the four major Australian banks since the customer satisfaction survey began.(4)

l Maintained or improved customer satisfaction across all Australian business segments.(5)

l Improved outcomes on majority of corporate responsibility measures (for more details see the Company’s 2012 Annual Review available at www.nabgroup.com)

(1) Refer to the Table of key terms for definitions of cash earnings, ROE and ROTAE and to the Glossary for a definition of Tier 1 ratio . (2) Refer to the Financial report for statutory net profit attributable to owners of the Company, and to Note 2 of the Financial report for a reconciliation between cash earnings and statutory net profit

attributable to owners of the company . (3) May 2012, measured though an annual employee survey conducted by external consultants (Hay Group) . (4) August 2012, Roy Morgan Research Customer Satisfaction Report . NAB compared with ANZ, CBA and WBC . (5) DBM Business Financial Services Monitor April 2009 to September 2012, six month rolling averages .

Table 5 .2 National Australia Bank links remuneration and performance

Source: National Australia Bank (2012) Report of the Directors

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l Feedback instrument for information and motivation of the workforce

l Technical support for certification programs

l Most importantly, providing the information to change managerial actions to improve performance

Despite their importance, many performance measurement systems are inadequate at most companies. They tend to rely on historical information and lack predictive power, failing to give managers the information they need to make decisions. And measures should not be an end in themselves.11 Instead, they should feed back into manage- ment systems to facilitate change and improvement in individuals, business units, and the organization as a whole. The challenge is to look past financial performance toward a more thorough integration of sustainability performance. A balanced family of measures can evolve into a powerful system for executing strategy. The measures help define the strategy, communicate it to the organization, and direct its implementa- tion, from the corporate level to the individual. They also help keep everyone’s efforts aligned, because they link strategy to budgets, resource allocation systems, and to pay programs. In the best cases, they route high-quality feedback through the organization so executives can make critical, mid-course adjustments in strategy.

Measures should communicate to employees the values of the company and how performance will be judged. A lack of communication and understanding of what is important to the organization, along with too much emphasis on short-term results, can lead to low levels of commitment and reduced performance.12 Shared understand- ing of what is important is critical to improving sustainability and financial perform- ance. Relating the measures to individual compensation might also be desirable, as an explicit system that directly affects individual pay provides strong incentives for employee performance. Examples of sustainability performance measures are pro- vided in Chapter 7.

Incentives and rewards The traditional accounting system often provides a disincentive to report potential hazards or violations of environmental laws, corporate goals, and corporate practices. Employees sometimes believe they will be penalized if they notify a manager of a poten- tial hazard because eliminating the hazard might cause the business unit to suffer a short-term financial loss. This expenditure typically is viewed as an expense rather than an asset, investment, or value creator and often has a negative impact on a manager’s overall rewards.

To confront this disincentive, many companies have programs that provide awards to employees for exemplary sustainability performance. In some cases awards are given to teams rather than individuals. They vary from cash gifts and various methods of acknowledging the achievement to banquets, plaques, and so on. Seiko, Japanese- based manufacturer of watches and precision and optical products, for example, has

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5. performance measurement, evaluation, and reward systems 131

established an environment prize in recognition of employees’ environmental contri- butions. It is a positive incentive for employees to go beyond their job responsibility and to become eligible for a cash award of US$500 to US$5,000. Awards can be useful but only in connection with a more comprehensive program of performance evaluation that includes other motivations for improved sustainability performance among divi- sions, their managers, and their support staff.

Some companies have tied individual performance reviews and compensation explicitly to social, environmental, and economic performance including performance on climate change. They have established sustainability performance as a critical vari- able for compensation in incentive systems. For example, Alcoa, a leading producer of aluminum, champions pay for performance to achieve specific sustainability objectives to ensure the integration of sustainability into core business strategies. During 2012, 20% of the variable compensation was tied to achieving significant aspects of Alcoa sustainability targets. Across the entire workforce, the targets focused on safety and CO2 emission reductions through process improvements and improved energy effi- ciency. Management-level employees had an additional target to improve the diversity of Alcoa workforce. Specifically, these sustainability targets and their share of the vari- able compensation plan at the corporate level were: CO2 5%; safety 5%; and diversity 10%. The 2012 achievement payouts at the corporate level were 9.1%, 2.5%, and 16.3% for CO2, safety, and diversity targets, respectively.

13

At Henkel, individual target agreements with employees also include sustainability criteria, such as reducing energy and water consumption or accident rates, if these fall within the sphere of influence of the employee concerned and have a clear bearing on business performance.14

Many other corporations across the globe from Intel, XcelEnergy, a utility supplier of electric power and natural gas service, National Grid, an international electricity and gas company and one of the largest investor-owned energy companies in the world, Suncor Energy, a Canadian integrated energy company, to ING, a Dutch insurance conglomerate, are making executive compensation decisions based on how well the company’s business units perform in relation to its sustainability goals.

The weight given to social, environmental, and economic targets also helps to signal the importance of their impact to the employee and to the organization. At UK-based Anglo American, one of the world’s largest diversified mining and natural resource groups, 10% of performance-related compensation at the executive level is tied to safety, while at the operational level it increases to 25%.15 This communicates that safety is highly valued at the company and that it benefits both the employees and the company to perform well in this area.

XcelEnergy has a significant stake in environmental preservation and marks its com- mitment to sustainability at the highest level by applying specific quantitative metrics to incentive rewards. One-third of the CEO’s annual bonus is tied to environmental performance, as measured by renewable energy, emission reduction, energy efficiency, and clean technology.16

Another way to involve individual employees in improving social, environmental, and economic performance is to give them a stake in the performance of the com- pany. One such company is UPS where approximately 40% of employees own shares in the company and own about 40% of the outstanding shares.17 Additionally, stock

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is rewarded to the management team based on the company’s performance on key goals, including sustainability. UPS believes that a stock- and profit-sharing plan is one way to align employee interests with company goals. However, it is important that the employees understand how and why positive performance in sustainability increases shareholder value. Otherwise, this strategy may not achieve its intended goals.

Performance goals and incentives can also be used for subcontractors. Nike’s sub- contractors must comply with employment standards set by Nike. These standards are enforced by Nike inspectors and subcontractors who continually violate Nike’s require- ments risk the penalty of losing their contracts, even if they are in compliance with local laws and practices.18 So the subcontractors have a financial incentive to follow Nike policies. By instituting this policy and regularly monitoring performance, Nike reinforces sustainability performance as a core component of its strategy and encour- ages subcontractors to also value sustainability performance.

The problem with many incentive systems is that they reward the wrong behavior and provide disincentives for the right behavior. Incentive systems can also fail because they are overused. Putting too much emphasis on pay-for-performance without con- sidering the risks involved and pressures created may lead managers to shy away from taking risks. An additional challenge with incentive systems is their potentially nega- tive effect on intrinsic motivation—people’s internal drive to do something because they love doing it. Sometimes the most important reward for performance is the act of doing the job itself, and improving sustainability performance can provide significant personal rewards for many employees. Lastly, the level of risk taking that a company encourages is an important issue to consider in addition to measuring and rewarding. Risk-taking behavior is necessary for successful sustainability strategies but can be dys- functionally reduced if failure is punished economically.

Using an environmental multiplier to drive performance

BFI (Browning-Ferris Industries), a North American waste management company, part of Allied Waste Industries, decided in the 1990s that it needed to make a fundamental change to its corporate culture in order to meet its environmental objectives. The core corporate and district-level objectives related to both business and community needs. The company developed a set of AC (awareness compliance) tools for each of its three major lines of business: landfill operations; solid waste; and medical waste. The AC tools included a detailed training manual that described the objectives, explained the problems, and outlined the role of all employees in achieving corporate environmental compliance and responsibility, and training videos and other tools to help all employees understand and meet the performance goals.

In addition to providing the AC tools, the company changed its incentive program to tie environmental performance directly to employee compensation. Under this system, one-third of compensation became at-risk pay, whereby the incentive pay earned would be based on the employee’s score in meeting environmental goals. The table below illustrates the multiplier scale used by BFI to convert environmental performance to incentive pay. An employee who scored 95 points would receive 100% of the incentive pay, and an employee who only scored 75% would only receive 50% of the incentive compensation. Employees

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who scored lower than 70 points would not receive any incentive compensation. This incentive pay system applied to employees at the level of district manager; however, district managers themselves used incentives to motivate their subordinates to achieve district-level environmental goals.

Points earned District environmental multiplier 95–100 1.00 90–94 0.90 85–89 0.80 80–84 0.75 75–79 0.50 70–74 0.25 Below 70 0.00

BFI believed this emphasis on environmental compliance boosted the company’s image and, ultimately, its financial performance. This system worked partly because all employees understood that environmental compliance was non- negotiable and a critical success variable for both their own and the company’s performance.

Source: Epstein (1996) Measuring Corporate Environmental Performance

Internal waste taxes An internal waste tax is a practical application of activity-based costing at organizational level. It introduces more direct accountability by making each business unit responsi- ble for the waste it produces. This could also be developed and applied to other social, environmental, and economic costs. With an internal waste tax, waste treatment costs and fines are charged back to product lines creating the waste. This reduces the inter- nal subsidies created when environmentally efficient divisions are allocated similar monetary amounts for environmental costs as divisions that cause more waste-related costs. In fact, internal subsidies need not exist, as all business units are responsible and accountable for their own costs.

An example of the link between full cost accounting and performance evaluation is Dow Chemical’s waste tax. In the 1990s, Dow Chemical built a waste landfill at its Michigan division that was then expected to last until 2007. After development, the company began charging each plant a fee according to the actual waste it brought to the landfill. Plants discovered that it was more economical to introduce process improve- ments to reduce the quantity of waste. This Dow internal waste tax has reduced solid waste significantly. The Michigan landfill is now estimated to last until 2034.

Some companies have argued that a waste tax works better in highly centralized organizations than in less centralized ones. There is concern that in decentralized organizations a central tax imposed on business units may not fit in with the corpo- rate culture and will meet with resistance. Decentralized organizations often allow managers to make their own trade-offs of business and environmental improvements where necessary rather than dictating local actions. But, even in decentralized organi- zations, corporate managers often do provide incentives such as penalties or additional resources to motivate excellence in sustainability performance.

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Another innovative example of managing environmental performance through a waste-tax mechanism is the company-wide emissions trading program launched by BP in 2000. The company set as a corporate objective the reduction of its GHG (green- house gas) emissions such as CO2 and methane, contributors to global warming. BP- Amoco operating units were given internal targets for allowable emissions, and units reducing emissions to levels below the targets could sell the emissions credits to other BP-Amoco units that had not made deep enough cuts, improving both its environmen- tal and its financial performance.19

Internal taxes force the business units that cause negative social, environmental, and economic impacts to be financially accountable for the waste they generate. This accountability motivates managers to evaluate their processes and products for oppor- tunities to minimize the social, environmental, and economic impacts that are creating the additional costs.

Emissions trading A very different incentive for performance is developing rapidly with emissions trad- ing programs. They provide powerful inducements for corporations to reduce emis- sions, and it seems likely that these incentives and the financial impact will continue to increase. As emissions trading practices become more established, they are likely to have a more important effect on the evaluation of both corporate financial and corporate sustainability performance. The effect is also likely to cascade through organizations, influencing the evaluations and the rewards of CEOs, senior corporate managers, and managers throughout the organization as pressure to reduce the financial cost of emis- sions intensifies. This may be an important emerging development in using perform- ance evaluation and rewards to drive improved corporate financial and sustainability performance simultaneously.

The Kyoto Protocol requires nations to cut their GHG emissions and countries divide the burden among their industries. Companies who do not meet the standard can buy credits from companies who cut their emissions by more than what is required. The EU set up its carbon trading system in 2005, and trade in GHG permits doubled to more than US$26 billion.20

There are several options for companies to consider when developing strategies on how to use their emissions credits:

l Emission offsets. Companies may increase the level of a pollutant if they also do something that is good for the environment, such as planting trees

l Bubble policy. Companies may increase pollution at one source as long as they reduce pollution at another source

l Banking. Companies store emissions allowances for later use or lease them to another firm21

Launching its trading platform in 2003, CCX (Chicago Climate Exchange) was the world’s first, and North America’s largest, legally binding rules-based GHG emis- sions allowance trading system, as well as the world’s only global system for emis- sions trading based on all six GHGs. CCX members made a voluntary but legally binding commitment to meet annual reduction targets for GHG emissions. Those

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5. performance measurement, evaluation, and reward systems 135

who reduced below the targets had surplus allowances to sell or bank; those who emitted above the targets complied by purchasing CCX CFI (Carbon Financial Instru- ment) contracts.22

Strategic performance measurement systems Numerous approaches can be used to organize, identify, measure, and report sustain- ability performance for improved managerial decision-making. The balanced scorecard and shareholder value analysis are two approaches currently used by many manag- ers to help implement corporate strategy. Both of these systems can also be used to help managers implement social and environmental strategies, drive organizational change, and evaluate and improve performance.

The balanced scorecard The balanced scorecard is a strategic management system that links performance measurement to strategy using a multidimensional set of financial and nonfinancial performance metrics. The term “balanced scorecard” refers to the framework first described by Kaplan and Norton in 1992 and further expanded upon in numerous other books and articles.23

The traditional model contains four dimensions or perspectives that relate to the strategy and core values of the company. These dimensions are financial, customer, internal business processes, and organizational learning and growth. In practice, many managers use the term “balanced scorecard” to refer to any set of financial and non- financial measures that link performance indicators to corporate objectives. The four perspectives in the balanced scorecard represent four key components of creating and sustaining corporate value:

l The financial perspective focuses on the shareholders’ interests and shows the link between strategic objectives and financial impacts

l The customer perspective focuses on measures that reflect how the company is creating customer value through its strategy and actions

l The internal business processes perspective contains measures that indicate how well a company performs on key internal dimensions

l The learning and growth perspective stresses measures of how well the com- pany is preparing to meet the challenges of the future through leveraging its organizational and human assets

Many companies include sustainability key success factors and key performance indicators in each of the four dimensions of the balanced scorecard, choosing per- haps one or two key measures in each dimension. The choice of where to include sustainability indicators on the balanced scorecard depends on the challenges facing the organization. Figure 5.2 shows an example of a sustainability-focused scorecard.

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This example broadens the customer dimension to include other stakeholders of the organization, better reflecting a sustainability focus.

Percent of sales revenues from “green” products Recycling revenues Energy costs Fines and penalties for pollution

Financial dimension

Sustainability awards Funds donated for community support Number of community complaints Employee satisfaction

Stakeholder dimension

Percent of suppliers certified Volume of hazardous waste Packaging volume Number of community complaints Cost of minority business purchases Number of product recalls

Internal business process dimension Diversity of workforce and

management Number of volunteer hours Cost of employee benefits Percent of employees trained re sustainability

Learning and growth dimension

Figure 5 .2 Balanced scorecard for sustainability

Source: Epstein and Wisner (2006) “Actions and Measures to Improve Sustainability”

Companies that have identified sustainability as a key corporate value or strategy may choose to expand the balanced scorecard by creating a fifth perspective. This dimension would include social, environmental, and economic performance indicators that link with the other four perspectives, and would serve to highlight the importance of social, environmental, and economic responsibility as a corporate objective.

The weight given to this fifth perspective would depend on the relative priorities of the organization, and the measures included would depend on the drivers of perform- ance that managers of the company have identified. These are some of the reasons why companies establish a separate balanced scorecard perspective for sustainability:

l Social, environmental, and economic responsibility is seen as core to the strategy of the organization, creating competitive advantage (through factors such as corporate image, reputation, and product differentiation), as opposed to being seen as a means to improve operational efficiency

l The fifth perspective becomes a tool to focus managers’ attention on social, environmental, and economic responsibility as a core corporate value. It com- municates management’s strong concern about these issues and objectives

l When a company has high-profile or high-impact sustainability issues, a fifth perspective helps to highlight the importance of these issues. Companies in industries that have had problems (chemicals, oil, and apparel, for example)

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5. performance measurement, evaluation, and reward systems 137

may be more likely to focus internal attention on sustainability resources and company strategy

l When the resource allocation to social, environmental, and economic respon- sibilities is relatively large, companies may want to highlight the link between the use of those resources and company strategy24

Sustainability strategies reflected in the corporate balanced scorecard should be cas- caded down to the SBUs (strategic business units) of the organization and ultimately to the support functions, including EH&S. While the corporate-level scorecard clarifies corporate values and beliefs and identifies actions that create corporate synergies, the scorecards for SBUs can be customized to reflect the market and operational chal- lenges faced by each SBU.

For example, Unilever, the multinational consumer products company, has a corpo- rate goal of minimizing its “environmental imprint.” Each Unilever SBU links to this corporate goal but in ways that are relevant to the SBU. For example, some Unilever SBUs are challenged by the availability and quality of water, and focus their measures on reducing water use and effluents. Reducing packaging waste is a priority for other SBUs, especially those operating in northern Europe and North America. These SBUs focus on bottle weight reductions, developing concentrated product formulations that require less space, and developing a line of refillable products.

A cascaded set of balanced scorecard measures that reflects the strategy to reduce packaging waste could be expressed as follows:

Corporate l Percentage decrease in environmental impact

Geographic unit l Percentage reduction in packaging waste

Business unit l Number of product reformulations (concentrated)

l Percentage of refillable products

Manufacturing unit l Percentage decrease in packaging

l Container weight reduction

EH&S department l Percentage of life-cycle analyses on product lines

l Number of product designs with integrated environmental concerns

l Tons of waste

Balanced scorecards for support functions, including sustainability, community affairs, and EH&S, should align with the strategies and objectives of the corporation and the SBUs, thereby reinforcing performance alignment. Many companies are now extend- ing their sustainability oversight activities to their suppliers as issues such as child labor practices and environmental responsibility pass through the supply chain. A number of support functions could link their scorecard measures to this objective; for example:

l EH&S – Number of supplier audits – Percentage of suppliers with environmental certifications

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l Purchasing – Percentage of materials purchased from ISO 14000-certified suppliers

l Human resources – Number of audits of contract labor firms – Number of suppliers complying with corporate codes of conduct

A complete balanced scorecard for sustainability, EH&S, and other departments would probably contain performance measures in each of the four scorecard perspectives, reflecting each department’s role in supporting corporate objectives and strategy. Thus, successfully cascaded balanced scorecards provide clear linkages between the strategies and performance metrics at the various levels in the organization and provide guidance to employees throughout the organization as to how they can contribute to overall cor- porate financial and sustainability performance.25

Implementing a balanced scorecard causes managers to integrate financial meas- ures with other key performance indicators around customer, internal business proc- esses, organizational learning and growth, and perhaps sustainability perspectives. It increases social, environmental, and economic accountability by explicitly including performance metrics related to sustainability goals, and by recognizing their intercon- nection with a multidimensional set of corporate objectives. Companies using the bal- anced scorecard can position themselves to generate the profitability, and demonstrate the accountability, demanded by customers, shareholders, employees, and the com- munities around them.

Shareholder value analysis Increasing shareholder value is a key objective of most companies, and managers have begun to recognize that shareholder value is improved by creating value for employees, customers, suppliers, the community, and other stakeholders. Many companies have expanded their method of measuring shareholder value creation by using measures that reflect economic value created by an organization.

Perhaps the best-known metric of shareholder value analysis is economic value added. This financial metric of economic profit takes into account the cost of the capital and assets involved in creating profits. The traditional measurement of net profit does not take into account the cost of capital provided by shareholders and is also distorted by applying GAAP (generally accepted accounting principles) that govern corporate financial reporting. Shareholder value calculations include the costs of equity capital and also adjust for GAAP-related distortions.

As illustrated in the simplified equation in Figure 5.3, shareholder value is created by sustainability initiatives that generate profits, minus the capital charge for the utiliza- tion of assets. Profit is generated from growth initiatives that increase revenues, such as product innovation and market development, and/or efficiency achievements that reduce costs: for example, waste reduction. The capital cost of assets is a function of the amount of resources used and the risk involved when using such resources.26

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5. performance measurement, evaluation, and reward systems 139

Figure 5 .3 Shareholder value creation

Source: Fiksel (2003) “Revealing the Value of Sustainable Development”

Like the balanced scorecard, shareholder value analysis is a system that can be imple- mented throughout the organization, not just at senior levels, with the expectation that all employees will be directed toward creating shareholder value. It can also be used to measure and report performance in the capital markets, for capital investment projects, and in the evaluation and compensation of performance.

DuPont uses a metric called “shareholder value added per pound of production” or SVA/lb. SVA is defined as the shareholder value created above the cost of capital. A company increases SVA by adding material, knowledge, or both. SVA/lb emphasizes the addition of knowledge, rather than material. DuPont has used this metric to evalu- ate its business units and set goals to increase its SVA/lb based on those evaluations.27

Using shareholder value analysis

Georgia-Pacific, the large forest products company, used shareholder value analysis to align the company’s goals of creating shareholder value and environmental responsibility. The EH&S department at Georgia-Pacific, as well as individual environmental projects, has been evaluated using shareholder value analysis. Included in each environmental project evaluation is an assessment of the project’s impact on revenues, operating costs, such as consulting fees, fines and administrative costs, and capital costs. Using shareholder value analysis, Georgia-Pacific has been able to identify environmental investments that create financial and shareholder value for the company. For example:

l A project to use boiler fly ash generated at the plants reduced landfill and transportation costs, generating a shareholder value analysis of US$800,000

l An aerator optimization project reduced energy usage, generating an shareholder value analysis of US$102,000

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l By re-engineering the process for complex environmental permitting, the cycle time for new permits and construction projects was reduced, as well as external consulting fees, generating increased shareholder value of US$2.1 million28

Shareholder value analysis provides an incentive for sustainability managers to pur- sue investment opportunities to create shareholder value. It also helps to communi- cate the potential value of sustainability initiatives to managers who must justify the allocation of scarce resources. By better identifying and including broader and longer- term social, environmental, and economic impacts that affect corporate profitability into a single performance measure such as shareholder value analysis, executives can improve the likelihood that an organization’s sustainability objectives will be pursued.

Summary Performance measurement systems communicate management priorities by signaling throughout an organization the expected outcomes that management has determined to be important. “What gets measured gets managed” is an adage that represents the signaling capability of performance measures. Also, the actual performance outcomes provide feedback to management about the efficacy of the strategy.

The performance of all employees, teams, facilities, and business units should include a sustainability performance component where appropriate. By defining spe- cific social, environmental, and economic work goals for the individual and meas- uring progress toward these targets an organization is signaling that sustainability performance is an important driver of corporate value. Incentives are often necessary to motivate employees to integrate social, environmental, and economic impacts into their decisions. Sustainability performance can often be improved if it is integrated into the performance evaluation system for all employees, teams, and business units. Empowering and rewarding managers and production workers can improve social, environmental, and economic planning and compliance activities. Better alignment of corporate and sustainability strategies with company-wide performance measures and rewards can improve sustainability and financial and operational processes and performance.

Taken together, the impact of management commitment and leadership, organiza- tional structure and rules, systems, communication, performance measurement, and the incentive structure all are key factors in establishing the culture of the organization toward sustainability initiatives. It is through effectively establishing and managing these strategic management systems that an organization establishes a culture of sus- tainability and can most effectively move toward its strategic sustainability goals.

The next chapter gives an overview of the approaches that can be used to effectively measure social, environmental, and economic impacts of products, services, processes, and other corporate activities.

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chapter 6

The foundations for measuring social, environmental, and economic impacts

Measuring the payoffs of sustainability initiatives is challenging even without specifi- cally identifying the appropriate inputs, processes, outputs, and outcomes. However, to know if sustainability strategies are succeeding, measurement of these elements is critical. In addition, surveys indicate a growing market in impact investments that are made into companies, nonprofit organizations, and funds with the intention to generate measurable social, environmental, and economic impact alongside a financial return.1 Although it is difficult to precisely measure sustainability performance, social science, economic, and financial analysis techniques that provide reasonable estimates for social, environmental, and economic performance do exist. These measures pro- vide substantial and valuable information that enables managers to more accurately evaluate the trade-offs made in day-to-day management decisions.

In this chapter we look at the conceptual foundations for measuring social, environ- mental, and economic impacts and risks before discussing the practical applications of these approaches in Chapter 7.

The costs and benefits of a sustainability strategy are cross-dimensional through- out an organization, not firmly lodged in any one functional area. Furthermore, many economic benefits of sustainability initiatives are often seen as intangible and there- fore difficult to measure. Measuring hazardous waste generated is relatively straight- forward, measuring employee satisfaction is harder, and measuring the impact of a company on society is even more difficult. And converting these impacts into monetary terms provides additional challenges. However, for each of these, we know the number is not zero and they each represent an output that relates to the success of a sustainabil- ity strategy. Sustainability benefits are also often longer-term in nature, making them more challenging to relate to current organizational performance.

Organizations also have to consider the differing and multiple objectives of stake- holders. Some of these objectives relate to the social, environmental, and economic impacts of organizational actions. Where once managers might have made a routine capital-investment decision based on estimated cash flows including such traditional

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142 making sustainability work 2

items as capital outlay, cost of capital, and reduced expenses or additional sales, manag- ers now must consider the social, environmental, and economic impacts of the decision as well. While research suggests that organizations need to evaluate multiple, diverse stakeholder interests, be aware of social, environmental, and economic impacts, and integrate this into decision-making, there is little guidance on the underlying process. But, although sometimes managers think that sustainability is more difficult to meas- ure and integrate into investment decision-making models, there is a solid academic foundation for measurement.

Collecting these data differs from obtaining traditional financial measures from a cost accounting system since organizations must first identify multiple stakeholders and understand their objectives. Furthermore, relevant measures might rely on meth- ods more typically used in sociology, social psychology, and economics, and which are only now being applied to management decision-making. Companies should first identify the potential impacts to their stakeholders. Examples of these not-so-obvious impacts are often defined as externalities and include changes in landscape due to a construction project or the effects on biodiversity. Externalities need to be incorporated into management decision-making. Although usually viewed as negative impacts, externalities can provide benefits to stakeholders. For example, a tree forest planted by a lumber company is a scenic landscape until it is harvested.

DB (Deutsche Bank), a leading German bank and one of the world’s “greenest” banks, recently introduced its Global Impact Tracking to assess all global and regional flagship projects (with minimum investment of €25,000). This enables DB to evaluate whether its investments as a corporate citizen are efficiently and effectively aligned with its stra- tegic goal of building social capital in its key areas of activity: education; social invest- ments; art; and music. Figure 6.1 shows DB’s three-step impact measurement process (input–output–impact). In Step 3, DB measures the impact of its various corporate citi- zen projects on beneficiaries, project partners, society, the company, and employees.

Figure 6 .1 Deutsche Bank Global Impact Tracking

Source: Deutsche Bank (2012) Corporate Responsibility Report

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6. the foundations for measuring social, environmental, and economic impacts 143

A separate exhibit (Fig. 6.2) presents an example of a matrix with measurements of awareness and relevance of DB’s support of corporate citizenship (CC) projects as perceived by cultural professionals in Germany, UK, and the US.2

Figure 6 .2 Deutsche Bank is assessing corporate citizenship projects

Source: Deutsche Bank (2012) Corporate Responsibility Report

Measuring environmental impacts at PUMA—PUMA’s E P&L

PUMA, one of the world’s leading sport lifestyle companies, has developed an important approach to value and report the environmental externalities caused by the corporation and its entire supply chain. Called E P&L (Environmental Profit and Loss), it measures and values both reductions in ecosystem capacity and increases in environmental impacts which occur as a result of PUMA’s operational and supply chain activities. PUMA published the first E P&L in November 2011, assessing the cost of its environmental impacts at €145 million. The E P&L covers water use, GHG (greenhouse gas) emissions, air pollution, land use, and waste.

Figure 6.3 sets out in monetary terms the changes in human welfare which result from PUMA’s environmental impacts. The impact on climate change, for example, was measured by tons of GHG emissions and these were monetized through an estimate of the so-called SCC (social cost of carbon) to PUMA’s 2010 operational and supply chain emissions. Estimates of the SCC look to value the damage resulting from current and future climate change (e.g., reduced crop yields, damage to infrastructure, or increased incidents of extreme weather) attributable to each ton of CO2 equivalent (CO2e), released in a given year. PUMA’s global estimate of the 2010 SCC is €66 per ton of CO2e.

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Figure 6 .3 PUMA’s E P&L

Source: PUMA (2011) PUMA’s Environmental Profit and Loss Account for the Year Ended 31 December 2010

l PUMA operations include offices, shops, warehouses, business travel, logistics, and IT

l Tier 1 Suppliers include shoe, apparel, and accessory manufacturing

l Tier 2 Suppliers include outsole and insole production, textile embroidery and cutting, and adhesive and paint production

l Tier 3 Suppliers include leather tanning, petroleum refining, and cotton weaving and dyeing

l Tier 4 Suppliers include cattle rearing, rubber plantations, cotton farming, petroleum production, and other material productionCo

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6. the foundations for measuring social, environmental, and economic impacts 145

PUMA has identified that most of its environmental impact occurs far down its supply chain, mainly in Asia, where the impacts were assessed at €96 million. The greatest environmental cost arises from production and use of raw materials, for example the methane produced during cattle farming, and the water consumed during the subsequent transformation of cattle hides into leather. PUMA is considering including social impacts in sustainability arising from decent/fair wages, security and stability, standard of living, empowerment, and community cohesion in future reports (PUMA’s Environmental, Social, and Economic P&L).

Various approaches have been used to identify and measure the sustainability impacts of a company’s products, services, and activities. These approaches provide an important conceptual foundation for measuring sustainability. They include meth- ods such as cost of control and shadow pricing, damage costing, market price and appraisal, hedonic pricing, travel costing, and contingent valuation. Managers need guidance in applying these techniques to identify metrics that facilitate the implemen- tation of sustainability and an informed decision-making process. Measuring these impacts, monetizing them, and including them in management decisions permits improved analyses of benefits and costs and better decisions for both the social benefit of stakeholders and the long-term profitability of the firm.

The concept of value The benefits related to social, environmental, and economic impacts are often catego- rized as either market or nonmarket impacts. Market benefits include:

l Increased sales quantities due to increased market demand

l Increased prices due to quality and reputation

l Reductions in costs due to increased efficiencies

l Increased productivity

l Reduced future costs related to environmental clean-up, internal control and ethics breaches, and employee and customer problems related to lack of social sensitivity

Examples of nonmarket benefits include:

l Increased recreational benefits from cleaning up waterways (boating, swim- ming, and fishing)

l Enjoyment of greater species diversity

l Increased life-span and quality of life

To measure these impacts, we need to understand how stakeholders place value on social, environmental, and economic assets. The concept of value is based on the Co

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preferences that people have for the services and products they use. Preferences are in theory substitutable—one service or product can be exchanged for another if individu- als perceive that they are no better or worse off than before. The trade-offs made by individuals indicate the value placed on social, environmental, and economic goods and services.3

The value given to goods and services can include:

l Use values – Consumptive value: for food or recreation – Nonconsumptive value: observing, photography

l Nonuse values – Option value: personal opportunity to use the resource in the future – Existence value: importance of the resource to others in the present and

in the future

Use value is defined as the economic value associated with human use of a resource. Use value may be further categorized as having either consumptive value (logging of forests or use of water for drinking or farming) or nonconsumptive value (recreational use such as bird watching or photographing which leaves the resource unchanged). If a resource such as a river is used more often and more effectively because it is clean, then a nonmarket use value has been created. When a company takes actions that improve the environment and create a water resource that is more suitable for swim- ming, drinking, boating, or washing, and is of no cost to users of the resource, it pro- vides a value in use that can be measured and included in resource decisions.

Nonuse value refers to any values not directly associated with human uses of natural resources and includes two types: option value and existence value.

Option value. If the future benefits that a resource might yield are uncertain and the depletion of the resource would be irreversible, one might value preserving the option to use the resource in the future. For example, the pharmaceutical industry relies on plants and animals for potentially curing diseases. As the industry gains more infor- mation about a particular species, it may begin to place value on having the option to use the species in the future. The magnitude of the uncertainty and the extent to which people are risk-averse determine the magnitude of the option value.4

Existence value. Also called conservation or intrinsic value, existence value is inde- pendent of people’s present use of the resource. These values arise from a sense of environmental stewardship related to a responsibility to preserve natural resources for future generations. Even if a resource does not have any clear value in use in the present (use value) or in the future (option value), people may wish to preserve the resource because they believe it has a right to exist and should be protected.5

Therefore, the total value of a resource is the sum of the three components:

Total value = use value + option value + existence value

In many cases, the distinction between these values is unclear because individuals can sometimes derive both use and nonuse values from a resource. For example, a per- son’s interest in preserving a wilderness area may be motivated by the anticipation of

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6. the foundations for measuring social, environmental, and economic impacts 147

hunting and the pleasure of conserving it for future generations. Additionally, placing a value on the continued maintenance of a species could be considered an existence value or a use value because the user obtains some value from knowing the resource exists and there may be a clear and present benefit to the user.

So, how can managers measure these values and incorporate them into organiza- tional decisions to reduce social, environmental, and economic impacts and also to improve long-term profitability? How can they include these measurements in reports to various stakeholders to improve their ability to monitor and evaluate the perform- ance of the firm on various dimensions including past, current, and future financial, environmental, economic, and social performance? How can managers include these measurements in decision-making and evaluate the importance of various social, envi- ronmental, and economic impacts (both costs and benefits) in various operational and capital investment decisions?

One step is to express the use and nonuse values in terms of individuals’ WTP (willingness to pay) for the resource or WTA (willingness to accept) compensation in exchange for the resource. Then managers can use the economists’ approach of con- sumer surplus to estimate what constituents are gaining from the resources available:

l Willingness to pay. One way to measure consumer benefit from social, envi- ronmental, and economic improvements is to compare what they are willing to pay for them with actual price for these services. Thus, if a social, environ- mental, or economic benefit is provided at no charge, the stakeholder benefit can be measured by the amount that they would be willing to pay for it. Aggre- gated, this provides an estimate of the total benefits provided

l Willingness to accept. An alternative approach is to examine the amount of money stakeholders would be willing to accept that would make them indif- ferent to degradation in the environment, the society, or in ethical values or practices

l Consumer surplus. Consumer surplus is the basic approach that economists often use to measure consumer benefits. It is the difference between what one is willing to pay and what one actually must pay to acquire a service or product. Thus, when stakeholders are provided with a benefit (for example, a reduction of pollution in the environment) at no cost or at a cost that is less than they would be willing to pay, they receive a consumer surplus

Though both WTP and WTA have been found to be good approximations of social, environmental, or economic impacts, studies have determined that the results are somewhat higher in WTA analyses as stakeholders state how much they need to be compensated for the damage from social, environmental, or economic declines from the status quo. By using the status quo as their reference point, stakeholders require higher compensation to allow social, environmental, or economic degradation than they are willing to pay for making improvements. However, WTP questions can often result in higher estimates of values on commodities (for example, a quality improve- ment on a TV) and could capture an attitude that is not appropriate for economic trans- lation to a stated preference in terms of a WTP; that is, the theory that underlies WTP, economic consumer theory, may not always be appropriate.6 But, although the method

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may not be entirely precise, it does provide an effective approach to measuring stake- holder reactions and a relevant quantifiable measure of corporate social, environmen- tal, and economic impacts and performance.

Both WTA and WTP measures are based on the assumption of substitutability of goods and services, but WTP is constrained by the individual’s income and tends to lower its value of social and environmental goods and services. WTA has no upper limit on what a person might ask as compensation for giving up the right to use public services, and so the goods or services tend to be overvalued.7 It is important to assess this ambiguity when designing surveys to measure social, environmental, and eco- nomic values. Because WTP is constrained by the realistic limitations of an individual’s income level, but WTA is not subject to any such constraint, the US Department of the Interior and the US EPA (Environmental Protection Agency) have both endorsed the use of WTP, instead of WTA, to achieve conservative estimates in costing studies of environmental damage. A recent study again proved that consumers are in fact willing to pay more for ethically produced goods and will demand a substantial discount from companies that produce goods in an unethical manner.8

In Chapter 4 we discussed the costing systems (ABC, LCC, and FCA) used to ana- lyze and integrate social, environmental, and economic costs that would otherwise go unaccounted for. Understanding the magnitude of internal costs through application of these types of costing system is important. But to fully evaluate the impact of social, environmental, and economic costs on its operations, a company must also evaluate external costs, especially for potentially large liabilities or for impacts that are likely candidates for future regulation. External costs present another level of complexity in that, unlike conventional internal costs, they are not transaction-based and often can- not be directly observed in the marketplace. Once monetized, the cost estimates can be integrated into the costing systems for improved decision-making. Using concepts such as WTP, WTA, or consumer surplus can aid managers in placing value on how their products and services affect company stakeholders. By internalizing these exter- nal costs (externalities) managers have a better understanding of the long-term sustain- ability and financial impacts of their actions.

Methodologies for measuring social, environmental, and economic impacts A variety of techniques have been developed to collect data on WTP or WTA. The first type is categorized as revealed preference methodology. Revealed preference meth- ods use estimation of actual behavior to determine the value people place on social, environmental, and economic products and services. When expenditures vary with the level of sustainability impacts posed by the product, then the value of the impact can be estimated. The value can be estimated using various methods including the travel cost method and hedonic pricing (discussed later in this chapter). The second type is known as stated preference methodology. In this approach, people respond to

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6. the foundations for measuring social, environmental, and economic impacts 149

hypothetical questions rather than observations of real-world alternatives. It is used to evaluate potential social, environmental, and economic policies or when nonuse values are involved. The primary approach used for stated preference is contingent valuation. Table 6.1 summarizes several of the approaches.

Description Advantages Disadvantages

Cost of control and shadow pricing

l Cost avoiding damage before it occurs

l Avoid difficult-to- determine actual costs

l Simplicity of calculations

l Shadow pricing assumes legislators accurately value costs of damage

Damage costing l Actual costs of damage

l Recognizes external damages

l Difficult to assess monetary effects

Market price and appraisal

l Resources are traded in existing markets

l Uses LCA l Requires existence of a competitive market

Contingent valuation

l Hypothetical questionnaire

l Assesses passive use values

l Helps identify impacts

l Lacks precision

Hedonic pricing l Property value of wages as proxy of costs

l Values an entire range of impacts simultaneously

l Precision is often challenged

Travel cost l Cost of travel to recreation sites

l Data are available l Difficult to measure hypothetical alternatives

Table 6 .1 Methodologies for measuring sustainability impacts

While none of the methods described represents a perfect proxy for the cost of social, environmental, and economic damage, each gives a sense, at the very minimum, of the general magnitude of the cost. Each approach to monetizing external costs pro- vides information about market and nonmarket values that is important for effective decision-making.

Cost of control and damage costing Many companies have considered two major approaches to monetizing social, envi- ronmental, and economic externalities: the cost-of-control approach and the damage- costing approach. The cost-of-control approach is defined as the cost of reducing or avoiding damage before it occurs. Damage costing focuses on attempting to assess actual cost incurred from social, environmental, and economic damage.

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150 making sustainability work 2

Cost of control The cost-of-control approach is a measure of the cost of reducing or avoiding social, environmental, and economic damage before it occurs to place value on the damage itself. For example, a facility could assign a value to soil contamination from a leaking underground storage tank by estimating the cost of the equipment needed to prevent the leak, or the cost of implementing a process redesign that would eliminate the need for such tanks. The cost-of-control approach avoids difficult-to-determine actual costs of environmental damage by replacing them with more easily estimated costs of install- ing, operating, and maintaining environmental control technologies.

Advocates of cost of control contend that control costs are an acceptable substitute for damage costs. In certain situations, cost of control can represent the most realistic estimate of that dollar value which will eventually be internalized by the organization. The use of child labor in some parts of the world has led to product boycotts, ruined company reputation, and multi-million-dollar lawsuits. When considering the use of child labor by itself, contractors, or licensees, a company might assess the costs of using part-time workers, overtime, or exclusively adult workers to control or avoid the cost of any negative social impacts. Cost of control can also be seen as the cost to miti- gate risk. The mitigation could be accomplished through insurance or various actions to control or avoid the cost.9

A variation of cost of control, shadow pricing, deduces the cost of avoidance from existing regulations. Shadow pricing implies society’s willingness to pay for sustain- ability performance from the cost of specific measures that have been required under regulations. In other words, the basis for valuation under this approach is the cost of complying with regulations. Like the cost-of-control approach, shadow pricing uses the cost of controlling sustainability impacts to monetize social, environmental, and economic damage. This approach regards existing and proposed social, environmental, and economic regulations as estimates of the value that society implicitly places on specific sustainability impacts and extrapolates the cost of future impacts of the same type from this implied willingness to pay for avoidance.

The most significant advantage of cost of control and shadow pricing lies in the sim- plicity of the calculations. Cost information about control technologies is readily avail- able, and a given control strategy can usually be linked to a quantifiable reduction in the sustainability impact being controlled. However, the most significant weakness of this approach is that the resulting value may bear little relation to the true cost to society of the impacts being avoided. Ideally, the cost of the social, environmental, or economic damage itself should be quantified, and the cost of the control technology should be used to evaluate the cost-effectiveness of investment in preventing that damage.

In addition, these approaches do not account for national or regional differences or site-specific characteristics associated with various options. This information can be critical in determining the extent of damage. For example, the cost of control for two similar power generation stations would be the same even if one were located close to an urban center with high population density and the other situated in a rural area.

Damage costing In contrast to cost of control, which uses the remediation cost of a sustainability impact as a basis for decision-making, damage costing attempts to assess the actual economic Co

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6. the foundations for measuring social, environmental, and economic impacts 151

cost of the social, environmental, or economic damage. The loss of value attributable to the damage is estimated by the public’s willingness to pay to avoid the damage. This willingness to pay can be extrapolated from market-based data on the commodity or impact in question (as in the market price, hedonic pricing, and travel cost methods discussed below) or can be observed through a survey that replicates the commodity in the form of a valuation scenario (contingent valuation).

Because damage costing focuses on site-specific impacts and provides a realistic esti- mate of external damages, it is able to assign an economic value to nonmarket com- modities. The downside of damage-costing approaches, and the reason that so few companies use them today, is that they are complicated and require substantial data. Collecting adequate data to perform the analyses could require significant time and financial resources. Because proper design and execution of a contingent valuation or other damage-costing exercise is critical to its usefulness as a valuation tool, organiza- tions commonly turn to third parties for research and advice. This can translate into a substantial expense. A company attempting to estimate a potentially large social, environmental, or economic liability would need the expertise of professional survey designers and trained interviewers to produce accurate results. Sometimes, though, approximations can be developed simply and quickly and aid in better understanding the scope of the impacts and improve decisions. And, in many instances, large or com- plex projects do warrant the resource expenditure to do a complete analysis.

The basic principles of damage costing have broader applicability for an organiza- tion. The estimation of passive-use values or other external costs through solicitation of consumers’ willingness to pay can be applied informally in the preliminary phases of internal decision-making. Damage costing can be helpful even in the absence of a formal study. Conducting focus groups or brainstorming with employees or commu- nity constituencies to estimate order of magnitude, if not a specific value, can clarify a company’s vision of its environmental priorities.

The approach has often been applied specifically for cost–benefit analysis of health, safety, and environmental policy and for assessing damages in civil cases. One of its main applications, however, has been in health valuation, defined as the cost of illness approach. Valuing the cost of illness requires the identification of direct and indirect costs associated with illness, injury, or death. Direct costs include the resources used to diagnose, treat, rehabilitate, or support ill or injured persons affected by adverse social, environmental, or economic conditions. Valuing these costs is done by identifying the relevant categories of healthcare costs such as hospital care, physician services, nurs- ing, and home healthcare, estimating utilization rates by persons with the same condi- tion, and multiplying by cost estimates of each category.

Indirect costs, often calculated separately, relate to forgone earnings from morbidity and mortality. Morbidity may affect earnings through increased absenteeism, reduc- tion in the amount of time a person works, or impairment of a person’s ability to per- form specific activities. Mortality losses are estimated from the value of statistical life derived from the willingness to pay to reduce fatal risks.10 For example, a firm that has operations in South Africa could be faced with a growing number of employees who are becoming symptomatic and dying of Aids. The company realizes that it will bear a large overhead cost due to absenteeism, high turnover, and the need to consistently train new skilled personnel for the jobs that are being left open because of Aids-related deaths. Using a damage-costing approach, the company could estimate the earnings

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lost by doing nothing to mitigate the situation or it can estimate the costs of undertak- ing a variety of programs such as workplace education, condom distribution at work sites, HIV testing at facilities, or medical treatment for workers and families (see the De Beers example in Chapter 4, page 112).11

In the 1990s, Ontario Hydro, at that time Ontario’s hydroelectric power company, used the damage-costing approach, rather than the cost-of-control-approach, to identify, quantify, and, where possible, monetize the external impacts of its activities. Its reason- ing for using damage costing was that the approach considers specific environmental and health data, uses modeling techniques that take into account how emissions and effluents are transported, dispersed, or chemically transformed in the environment; and then considers who or what (for example, people or fish) are affected by these emissions. The company could then apply economic valuation techniques to translate physical impacts into monetary terms.

Although the company realized that there was a degree of uncertainty associated with the quantification and monetization of externalities, it concluded that uncertainty was pervasive in many areas of business and the measurement of environmental exter- nalities must be placed in that context. Using the damage-costing approach, Ontario Hydro attempted to assess the actual costs from environmental damage. Although cal- culation may be difficult, this approach can provide a realistic estimate of external dam- ages, including human health problems, animal herd losses, and crop damage from toxic air and water emissions.

Market price and appraisal Adverse social, environmental, and economic impacts identified during a life-cycle assessment can often be linked with the damage, depletion, or loss of resources that do have market values. Air pollution from an electric power plant may cause acid rain, which leads to crop losses in the region. The market-pricing approach directly measures the market value of resources damaged or lost as a result of social, environmental, and economic impacts. For example, the utility could assess the cost of air pollution using the market value of the resulting crop losses. In evaluating human health impacts, the cost of medical treatment can serve as a useful proxy.

The market-pricing approach is useful because it expresses social, environmental, and economic damages in terms of concrete, tangible losses of economic value. Clearly, virtually all corporate activities and decisions translate into a variety of associated ulti- mate impacts, and ultimate impacts can usually be traced to a range of sources. How- ever, developing and implementing a model such as the one discussed in this book can be helpful in understanding the impacts of corporate activities and the subsequent effects on stakeholders and company profits. Such an analysis can be used to estimate both acute and chronic social, environmental, and economic risks. The market-pricing approach can broaden the evaluation of long-run losses, making these values present in short-term decision-making as well.

The market-price method requires resources or services to be actually traded in a rea- sonably competitive market through voluntary exchanges between buyers and sellers. The value of the service is directly revealed through the market process. Where such exchanges do not exist, a professional appraiser’s knowledge of markets may be used instead of directly observed values. This method also needs a market to exist to provide the appraiser with knowledge of market outcomes.

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6. the foundations for measuring social, environmental, and economic impacts 153

Hedonic pricing Most social, environmental, and economic impacts cannot be expressed strictly in terms of damage to private goods. Therefore, valuation of more general indicators of social, environmental, and economic quality must supplement market price assess- ments. Hedonic pricing is one method of valuing consumers’ willingness to pay for superior social, environmental, and economic quality. This technique applies informa- tion derived from surrogate markets for private goods, traded in a competitive market, which may bear some relationship to a public social, environmental, or economic good.

The most commonly used surrogate markets for social, environmental, and eco- nomic quality are real estate and labor markets. Hedonic pricing has been used to estimate the impact of environmental deterioration by examining the decline in real- estate values after a contaminant has been discovered. The method can also be applied to decreases in real-estate values based on an airport expansion that changes a flight pattern or changes in government policy affecting the desirability of living in a particu- lar neighborhood. A company facility and its impact on the community will probably also affect real-estate values as residents desire to be close to or distant from the facil- ity depending on its level of pollution or its appearance. Additionally, a company can also affect real-estate values through its investment in other areas in the community such as schools, community centers, and various community programs. The hedonic- pricing method assumes that consumption of housing depends on the characteristics of the house, neighborhood characteristics such as parks and crime rates, and location- specific social and environmental impacts.12

Hedonic pricing also uses labor markets to determine salary scales and premiums for riskier jobs. Labor costs can reflect environmental differences: holding all else con- stant, workers in positions requiring exposure to environmental hazard would demand a risk premium. This is, in effect, a proxy for willingness to accept environmental risk. Thus, companies can use information from these markets to place a monetary value on environmental quality.

The main advantage of hedonic pricing is that it allows the entire range of impacts associated with an activity, as reflected in overall environmental quality observed by homeowners or wage-earners, to be valued simultaneously. Hedonic pricing applies statistical modeling techniques to identify differences in property values or wage rates specifically attributable to environmental quality, separating out other attributes that influence the decision to purchase property or accept a job in a given region.

Travel-cost method The use of recreational sites can also lend insight into the value the public places on social, environmental, and economic quality. TCM (travel-cost method) uses observed expenditures and behavior to develop an indirect measure of the economic value of nonmarket goods. In particular, travel to recreational areas can indicate the value of maintaining those areas. TCM most commonly serves as a tool to evaluate alterna- tive management plans for recreational areas. The difference in travel costs between two management alternatives illuminates the potential gain or loss in economic value associated with changing from one practice to another. Travel costs typically include both direct travel expenses and some measure of the opportunity cost of scarce time, although a variety of methods have been applied to approximate opportunity costs. Co

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Using the cost per visit and the number of visits in a given time period, a demand func- tion is estimated.13

In addition to its direct use by recreational planners, TCM can be a valuable tool for business decision-makers faced with potential impacts on nearby recreational sites in two ways. First, facility managers can use TCM and hypothetical TCM to monetize their direct impacts on recreational sites in the region. Deterioration of surface water or air quality as a result of industrial pollution may manifest itself as a decrease in the use of nearby recreational facilities, and the value of this loss use can be used as a proxy for the damage done.

Second, the money spent on travel to recreational sites can be an indicator of poor social, environmental, or economic quality in the region from which people are traveling. The opportunity cost of this travel—money that would have been spent within the region if social, environmental, or economic conditions did not motivate people to leave the area—represents a loss of economic value to the region. For exam- ple, a company might use TCM, in conjunction with other valuation methodologies, to estimate the economic impact of a spike in crime rates or pollution from fossil-fueled power stations, evidenced as increased travel away from the affected region.

While TCM permits valuation of an existing scenario, using current management practices and travel frequencies, decision-makers frequently need to compare current practices with a hypothetical alternative. Traditional TCM alone does not provide a structure for evaluating how individuals will value a recreational site with a decline or improvement in environmental quality, or under management options that have never been implemented. Others propose use of a hybrid methodology that blends traditional TCM techniques with contingent valuation. This approach, called the hypothetical travel-cost method, uses traditional TCM to estimate current demand for recreation opportunities delivered by a given site. In this approach, respondents are asked about actual trips taken to the site and to substitute sites, actual expen- ditures per trip, and hypothetical questions about what the respondent would have done if they had not taken the trip in question. These questions about decisions under actual conditions are asked prior to questions about hypothetical behavior, remind- ing respondents about their actual behavior. Respondents are then given hypothetical scenarios and asked how many trips they would make under those circumstances. In contrast to typical contingent-valuation methods, price and payment vehicle are not explicitly stated.

TCM has several limitations. First, it provides an estimate of WTP for the entire site, but people may value only specific features within the site. If the analysis were completed to enhance or add a particular feature, TCM would not serve the purpose unless the survey specifically addressed preferences within the site. Another limita- tion is that the method is limited to evaluating sites to which people from different zones have significantly different costs. It could not be used to evaluate a site where people attending have easy access because there would probably be little variation. TCM also relates the total cost of traveling as WTP to attend the site, but the persons traveling could have multiple destinations and in such case only a fraction of the travel costs should be attributed to the site. The estimation of opportunity costs is also a difficult task but needs to be factored in if visitors face radically different costs for their time.

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6. the foundations for measuring social, environmental, and economic impacts 155

Contingent valuation The cost-of-control method, the market-price method, hedonic pricing, and travel costing all rely on existing market values. However, in determining the full range of costs associated with social, environmental, and economic impacts or improvements, some costs evade extrapolation from market transactions. At the same time, limiting the analysis to market-driven values has the potential to severely underestimate some environmental, economic, and social costs. While the value of national parks and wil- derness areas might in part be inferred from annual collections in visitors’ fees and other expenses related to visiting these sites, the existence of such areas has inher- ent value even to those who do not visit them. Likewise, pressure to protect spawning grounds for threatened fish species may derive largely from populations other than commercial or recreational fishermen, the direct users of the resource. For some com- modities, “passive use” value or “existence” value—the benefit perceived by people who do not directly use the commodity—is large and can have a significant impact on decision-making.

CV (contingent valuation) is a method that has been used since the 1960s to estimate passive use values and can be used in conjunction with the other methods described above.14 CV assesses WTP for a defined benefit or WTA payment for a defined loss, by presenting consumers with a hypothetical market in which they have the opportunity to buy or sell the goods or services in question. Though there are questions about the precision of CV estimates, the method has been used extensively in valuing social, environmental, and economic impacts and can be used effectively to improve manage- ment decision-making.15

CV studies take the form of a questionnaire describing a hypothetical “valuation scenario” and moving through a series of WTP or WTA questions. CV studies are often presented as a referendum upon which participants in the study will vote on what they are willing to pay or accept. CV obtains the estimate of the benefits of a public good, which can then be used in a cost–benefit analysis.

Despite its usefulness in assessing passive use values, there are some potential chal- lenges and limitations with the CV process:

l Inconsistency with rational choice. Some CV studies have found that WTP does not increase with the magnitude of the benefits

l Uncertainty of responses. Because a CV study typically ask participants to consider only one valuation scenario at a time, critics have claimed that indi- viduals give WTP responses that are unrealistically large, considering the multitude of environmental commodities from which a consumer must typi- cally choose at any given time

l Absence of a meaningful budget constraint. Individuals may respond without considering how much disposable income they have available to allocate

l Information provision and acceptance. Some CV studies have not provided respondents with adequate information to make informed valuation choices. Even if substantial information is provided, its usefulness is limited by respondents’ ability to process and use the information in formulating their responses16

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Nonetheless, CV studies, when properly designed, tested, and executed, constitute an important tool for gaining insight into passive use values. Managers have found that, even though CV usually lacks precision, it is very useful for determining the impacts of a product, service, or activity on the community and other stakeholders. Furthermore, the first step of the identification of the impacts provides useful information and the CV will at least provide a sense of both the direction of the number of the impacts (are they positive or negative and do the costs exceed the benefits?) and the scope of the numbers. This usually provides sufficiently precise information for the decision and usually more precision than most other methods. In fact, in most cases, companies have not been including any of these measurements in their management decisions. Though the measures are imprecise, the analysis is critical for improved managerial decisions. Currently, companies tend to ignore these significant impacts in their capital investment decision-making (and thus implicitly consider that these impacts have no value). Decisions are improved with more rigorous measurements and reporting of the risks including the impacts on both sustainability and financial performance even when included as range of estimates instead of point estimates.

Evaluating impacts of natural gas drilling

Sublette County, Wyoming, contains one of the largest natural gas reserves in the US. Six main energy companies operate in Sublette County: Anschutz Exploration, EnCana Corporation, Questar, Shell, Stone Petroleum, and Ultra Petroleum. The rapid expansion of gas production and development has triggered tremendous environmental concerns. Development, due in part to natural gas drilling, threatens the migration corridor of pronghorn antelope, elk, and mule deer. The population of the sage grouse, which makes use of this habitat during summer months, has declined by 90% over the past century owing to the loss and degradation of sagebrush habitats.

Residents are concerned about protecting the environment for future generations but also realize the value in having gas production in the area. To partially alleviate concerns, there is a winter moratorium on drilling natural gas wells. During this annual moratorium (November 15 to April 30), energy companies operating on public lands cannot drill any new wells. In addition to the moratorium, there are restrictions on the spacing of wells in an attempt to preserve the habitat for big game animals and sage grouse.

So how can the energy companies balance development with the need to be environmentally responsible? It is important that these companies analyze and evaluate the effect of their strategies and systems on both sustainability and financial performance. The sustainability performance impacts financial performance most prominently through stakeholder reactions. It is therefore critical to identify the likely stakeholder reactions and acknowledge how the stakeholders make necessary trade-offs. An estimation of willingness to pay to offset the development of the environment is an important part of understanding stakeholder reactions. To elicit data on stakeholder reactions, a contingent valuation study was conducted with a broad range of stakeholders including homeowners, ranchers, hunters, conservationists, environmentalists,

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6. the foundations for measuring social, environmental, and economic impacts 157

local businesses, and government. Details of the survey used, survey methods, and measurements will be discussed further in Chapter 7.17

Methodologies for measuring sustainability and political risks Social, environmental, economic, and political issues pose risks to companies that must be measured and managed. Bob Dudley, the CEO of BP, wrote in his letter to stakehold- ers: “Following the Deepwater Horizon incident, our employees have worked systemat- ically to enhance safety and risk management. And we have turned the insights gained into new oil spill response plans and technologies, which we are adopting within BP and sharing with others. As someone who has worked in the oil and gas industry for more than 30 years, I know that risk can never be entirely eliminated. But it can be managed effectively, and in increasingly sophisticated ways.”18

In fact, risks should be monetized for inclusion in ROI calculations, and to improve resource allocation and investment decisions. Product take-back and producer responsibil- ity (requirements that companies accept responsibility for final disposal of their products such as computer goods, cartridges, and appliances) is increasingly common throughout the world. Similarly, site clean-up has become mandated in many locations, and compa- nies are now recognizing that they did not consider these sustainability and political risks when making costing decisions. This has led to underestimating total product cost. Better forecasting of potential changes in the social, natural, economic, and political environ- ment can lead to improved decision-making on process, product, and capital investment.

Not only do managers need to know the impact that their products, processes, and services have, they also need methods to measure the risks they undertake when mak- ing decisions. Contingent liabilities can constitute a substantial risk, even if the associ- ated probability is very small, and it should be emphasized that scenarios of very low probability should not be ignored. Social, environmental, economic, and political risks are typically low-probability, high-cost events—often with long time horizons. This makes the analysis of these risks quite critical. In the case of a nuclear power plant, the risk of meltdown, however improbable, is so potentially disastrous that it merits con- siderable precaution. Social, environmental, economic, and political assessments that omit measurements and discussions of risk can create future legitimacy and credibility problems for the company.19

Volkswagen quantitatively and qualitatively evaluates all risks against eight criteria, and assigns ratings. The results of the risk evaluation process are reported to the board of management, and the process itself is reviewed annually. This wide-ranging evalua- tion is at the heart of Volkswagen’s climate protection strategy which takes into account several factors: firstly, regulatory aspects, in particular EU penalties for failing to meet fleet-average emission targets; secondly, market-related requirements, resulting in par- ticular from increased public awareness of climate issues; and, thirdly, physical aspects, such as potential supply-chain or production disruption. Water shortages pose a signifi- cant risk to Volkswagen’s operations, particularly in light of the company’s plans for new production facilities in Asia, Africa, and Central and South America.20C

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158 making sustainability work 2

An organized methodology for quantifying uncertainty in risk assessment and NPVs (net present values) should comprise technical evaluations, programmatic interpreta- tions, and mathematical computations, with the joint goal of measuring the degree of confidence with which the estimate is held. Every estimate of risk is in actuality the sum of estimates of risk levels of a large number of contributing factors, each of which is itself uncertain to some extent. In fact, the simple act of conducting such an analysis often calls attention to possible risks that previously had been unnoticed.

To measure risk, management must first identify the potential liabilities. The scheme in Figure 6.4 classifies risk into four broad categories—strategic, operational, report- ing, and compliance:

l Strategic risks relate to an organization’s choice of strategies to achieve its objectives

l Operational risks relate to (1) threats from ineffective or inefficient business processes for acquiring, financing, transforming, and marketing goods and services, and (2) threats of loss of company assets, including its reputation

l Reporting risks relate to reliability, accuracy, and timeliness of information systems, and to reliability or completeness of information for either internal or external decision-making

l Compliance risks address the inadequate communication of (1) laws and reg- ulations, (2) internal behavior codes and contract requirements, and (3) infor- mation about failure of management, employees, or trading partners to comply with applicable laws, regulations, contracts, and expected behaviors21

Risks

Strategic risks Operational risks Reporting risks Compliance risks

Economic risks Industry risks

Strategic transaction risks

Social risks

Technological risks Political risks Organizational risks

Environmental risks

Business continuity risks

Financial risks

Innovation risks

Commercial risks Project risks

Human resource risks

Health & safety risks

Property risks

Reputation risks

Information risks

Reporting risks

Legal and regulatory risks

Control risks Professional risks

Figure 6 .4 Risk classification

Source: Epstein and Rejc (2005) Identifying, Measuring, and Managing Organizational Risks for Improved Performance

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6. the foundations for measuring social, environmental, and economic impacts 159

This classification is used in Chapter 7 as a guide to specifically identify, measure, and manage social, environmental, economic, and political risks. These contingent or probabilistic costs can then be evaluated in terms of their expected value—the cost of the impact, weighted by the probability of its occurrence. Using a decision tree to struc- ture the various potential outcomes of different management options, managers can use expected-value calculations to provide a realistic monetary value for use in decision- making. Several methods of valuing contingent liabilities are available.

Scenario-based methods A tool used by several companies to identify social, environmental, economic, and political issues and opportunities is scenario analysis. The approach is based on antici- pating stakeholders’ reactions to and concerns about sustainability in order to deter- mine the underlying issues. Those issues that could have an impact on the business are then grouped, and different scenarios are developed and forecasted. In companies with high levels of uncertainty, where change is imminent and diversity of opinion exists, scenario forecasting can be useful to clearly identify the various choices for decision- makers. Some have suggested that scenario forecasting aids in assessing and manag- ing risk, broadens corporate thinking, and makes managers focus on the long-term impacts of their decisions.

Royal Dutch Shell has a history of using scenarios to forecast alternative future events and identify potential challenges associated with current decisions. Shell’s glo- bal scenarios are prepared every three years by the Global Business Environment Unit. The scenarios are carried out in four phases:

1. Research. This phase addresses knowledge gaps and attempts to reframe thinking in order to identify new challenges for the company

2. Scenario building. Interviews are conducted with leaders and workshops are held to build scenarios to address the challenges identified during the first phase

3. Application. Participants take ideas back to their respective business units. Once finalized, scenarios are presented at workshops and used to test strategies

4. Dissemination. Copies are distributed to staff and presentations are made to staff in locations around the world

Shell has used this process to write scenarios on topics including de-integration of the international oil business, entry into inaccessible countries, and the inclusion of renewable energy sources in Shell’s portfolio.22

National Australia Bank uses tools such as stress testing, scenario planning and eco- nomic modeling to help the group, business lines and support functions to understand their resilience in the event of a significant event or shock, and to help monitor and prepare for future opportunities and threats.23

Risk mapping is also commonly used and plots the expected frequency, severity, and degree of exposure of various risks on a graph, with probable frequency on the hori- zontal axis and expected severity on the vertical axis.24 Calculations are made according to the following formula:

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Exposure = (event) × (hypothetical likelihood) × (hypothetical consequence)

The benefit of such modeling is that it permits measurement of various types of risk, and enables managers to visualize where to allocate resources for risk management. In addition, mapping is a valuable communication tool, providing a comprehensible visual review of exposures, though they are often not expressed in monetary terms. For this reason, mapping as currently practiced does not provide a link to the financial statement, or to the ROI calculation that is critical for comparisons between possible project options. With some modification, including assignment of monetary values to the hypothetical consequences, however, axis points on such a risk map could correlate to financial data and be integrated into ROI calculations.25 The integration of these risks into ROI calculations is discussed in Chapter 7.

Some companies may consider not only the scenarios of impacts produced by the corporation’s products and processes but also the effects that third parties have on sustainability. For example, when a company’s staff travels on business, the airline generates emissions of carbon and nitrogen oxides. These gases can be calculated from total air miles traveled by company executives and could then be monetized. From this information, companies could not only improve their environmental performance (gas emissions) but could also cut costs by avoiding travels when possible and using other sources of communication (tele- and videoconference, for example).26 For exam- ple, British company Vodafone, the world’s second largest mobile telecommunications company, reduced its carbon emissions from business travel by 24% in 2012/13. Busi- ness travel was limited to only the most essential trips as part of the group-wide cost reduction efforts, bringing accompanying carbon savings. At the same time, Vodafone has increased the use of its remote collaboration technologies by almost 30%, with employees using video conferencing for more than 75,000 hours a month. Vodafone’s flexible working programs in several markets have also helped to reduce energy use and emissions from offices and employee commuting.27

Companies should also think about scenarios involving contractors in the supply chain. As contractors engage in activities such as poor manufacturing practices or working conditions, other companies in the supply chain are often affected. Use of a scenario-based model would monetize the risk to the company in continuing a partner- ship with this supplier.

Fuzzy logic Fuzzy set theory is a branch of mathematics dealing with sets of information that do not have precise boundaries. To account for uncertainty, a “best” estimate is provided to establish the “most likely” dollar value that will be required to cover the foreseeable con- sequences and the most probable to occur of the uncertain consequences. Next, the most optimistic (best case) and pessimistic (worst case) monetary value limits are estimated.

To use fuzzy logic, identified possible magnitudes of future social, environmental, and economic liability independently are assigned a DOB (degree of belief ), between 0 and 1. These future liabilities might include various externalities such as water and air pollution of a residential area near a plant or internal disposal costs for chemicals used directly in the manufacturing process. DOBs are also assigned to possible interest-rate levels for each period. All possible combinations of circumstances that define the range of possible realizations of future financial liability are considered. NPV is calculated for C

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6. the foundations for measuring social, environmental, and economic impacts 161

each such realization, and a DOB is derived by combining the DOBs attached to each circumstance and associated with that NPV level. The fuzzy logic analysis results in a set of possible NPV levels, along with a DOB for each. One way to use the results of a fuzzy logic analysis is to rank the possible NPV levels according to DOB magnitudes. Though fuzzy logic has many limitations, it does provide an alternative approach to identifying and measuring future sustainability impacts.

Monte Carlo simulation For complex decision trees, Monte Carlo simulation can be used to calculate the prob- ability distributions of outcomes. First, the user expresses a given social, environmen- tal, or economic risk in terms of a probability distribution. That risk can increase or decrease depending on changes to social, environmental, or economic regulation or improved information. Once probability distributions are established for all inputs required for an NPV analysis, a computer program implementing the algebraic for- mula for NPV is written, except that when dollar value of future liabilities or interest rates is called for, it is replaced by random numbers drawn from appropriate probabil- ity distributions. More commonly, widely available software is used to run the Monte Carlo simulations.

The computer goes through the decision tree, drawing a sample from the relevant probability distributions at each point where an event occurs, and then applies simple logic to determine how to proceed through the tree. At each point in the tree where the computer must choose among alternatives, it will choose to minimize cost. If the decision tree has different possible events, the computer will model each event and the possible outcomes. This process is repeated until meaningful probability distributions can be established.

Many companies have applied Monte Carlo analysis to the problem of comparing the possible costs of alternative environmental remediation options. Using Monte Carlo random sampling from an option’s cost-probability distribution, the probability that one option will cost more than another can be estimated and the most likely costs of each operation can be compared. Probabilities (that is, confidence levels) can be assigned to a range of possible costs, leading to more credible and defendable comparisons.

Option pricing, option assessments, and option screenings Option pricing is a method for calculating the expected market value of an option. It models the time series interaction between investments and has been used most often in the financial markets (stock options). The value of a stock option is determined primarily by the volatility of the underlying stock. The same kind of methodology can be applied to social, environmental, and economic investment decisions. As social, environmental, and economic regulations and information change, so do options, processes, and products. The value of the strategic social, environmental, or option increases with the riskiness of the underlying cash flows.

Real options analysis provides a way to aid the framing of decisions for risk analysis. It is consistent with discounted cash flow approaches but also provides a recognition that plans often change as new information is obtained. Thus, when a static model may be inadequate, real options may be used for capital investment decisions to articu- late how small early expenditures may preserve options for future investments. The

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162 making sustainability work 2

calculation of the value of the investment is thus likely increased due to the value of preserving these options.

Option assessments and option screenings are designed to provide decision-makers with a full vision of alternative courses of action, their associated costs, and their relative attractiveness. This helps analyze the choices, options, and the value of retaining some of those options for future managerial decisions. The process consists of four steps:

1. Drawing a flow diagram

2. Identifying the major social, environmental, and economic issues

3. Defining the options

4. Selecting the most likely options for further investigation, based on cost-effec- tiveness, relevance for decision-makers, and sustainability impact

The EPA has proposed an option-rating weighted-sum method for screening and rank- ing pollution prevention options. The method involves three steps:

1. Important criteria in terms of program goals and constraints are determined and each is given a relative weight

2. Each option is rated on each criterion on a scale of 0–10

3. The rating of each option for a particular criterion is multiplied by the weight of the criterion

The option with the best overall rating is chosen and may be subject to further technical and economic analysis.28

Niagara Mohawk Power Company has used option screening to compare various externalities. It implemented a system to identify and measure the options related to both demand and supply sides of electric power usage. The company used option screening to determine the optimum mix of demand and supply strategies that provide electrical energy services at the lowest cost, within a set of various constraints. It used focus groups to determine the appropriate options and assign probabilities to the most likely scenarios.

Niagara Mohawk developed five separate tests of cost-effectiveness to use in the screening analysis. The results of these tests were used in the screening process to determine all relevant costs and benefits and to choose the best option. The objective was to optimize and balance economic, financial, environmental, energy and engineer- ing, and customer service objectives to determine the best resource plan considering trade-offs relative to numerous uncertainties, constraints, and policy objectives.

Summary The evaluation of the social, environmental, and economic impacts of an organiza- tion on society is important for management decisions. This evaluation is important to better meet the needs of the various stakeholders and usually benefits all of the Co

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6. the foundations for measuring social, environmental, and economic impacts 163

stakeholders. By more broadly examining the needs of all of the stakeholders, both sustainability benefits and long-term corporate profitability are often increased. The method of evaluation of the impact of an organization’s activities, products, services, and processes on society, environment, and economy is critical.

Although most managers understand the importance of measuring social, envi- ronmental, and economic impacts, it often remains difficult to implement. Through methods such as those described here, sustainability performance can be measured. Available data are gathered, assembled, and processed to provide the best available information, the likely outcomes, and the likely impacts of those outcomes. Although these methods often seem to lack precision, they can provide an estimate of how com- panies are performing. These methods provide guidance to managers when making difficult decisions when social, environmental, or economic interests and corporate interests are not aligned. They provide a solid academic foundation for developing measurements for sustainability performance.

The following chapter provides specific guidance on how to execute these methods and design measurements to use in improving resource allocation decisions for both operating and capital investments.

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chapter 7

Implementing a social, environmental, and economic impact measurement system

The identification and measurement of the costs and benefits from corporate sustain- ability activities is critical to the evaluation of projects within the company and the evaluation of the company and its components and members. As the previous chapter shows, there is a solid academic foundation for measuring sustainability performance. Significant improvements in the development of corporate performance measure- ment systems that include both financial and nonfinancial measures permit much- improved evaluation of social, environmental, and economic impacts. This is aided by vast improvements in corporate information technology capabilities that permit the collection, aggregation, and disaggregation of information for improved analysis, man- agement, and reporting.

In the last chapter we looked at methods such as hedonic pricing, market pricing, and contingent valuation. In this chapter we translate these concepts and approaches into systems and measures that can be effectively implemented. We look at:

l The drivers of sustainability performance

l Measuring reputation

l Measuring risk

l Measuring social, environmental, and economic impacts

Many social, environmental, and economic impacts may appear to have no market consequences and no financial effect, but many of the externalities are internalized in future periods and do affect the operations and profitability of the firm in the long term. Proper evaluation of the consequences of these long-term impacts when activities are

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