Investors are paying increased attention to risks and opportunities arising from sustainability related issues, particularly the effects of climate change and related ‘net-zero’ commitments made by many companies. Some sustainability risks directly affect financial statements, but you need to look further when considering inputs for equity valuation.
Risk affects different aspects of equity valuation. It is well known that risk factors affect the discount rate, but the impact on other valuation inputs may get less attention. We explain how sustainability risks and opportunities should be included in your analysis.
Many investors pay close attention to sustainability related risks and opportunities . For some, the ESG1ESG (Environmental, Social and Governance) is a component of sustainability risks and opportunities, but the two terms are not the same. Screening on ESG criteria is narrower than considering wider sustainability risks and opportunities in individual stock selection.
credentials of companies are important, and stocks may be screened on this basis. This may be motivated by ethical considerations, an attempt to make a positive impact on society through investment selection, and/or because of a belief that companies that perform well on selected ESG criteria will also outperform as investments.
We are sceptical of the assertion by some investors that ESG based screening can result in superior investment returns. In our view this is a market efficiency question, and we are not convinced that the market systematically values sustainability risks and opportunities any better or worse than other valuation factors. However, ESG constraints that restrict the investible universe could reduce diversification benefits and affect the risk/return efficiency of portfolios. This may only be significant if investible sectors are severely constrained; nevertheless, investors should be aware of a possible negative diversification effect when considering any perceived benefits of ESG based screening.
Even if sustainability and ESG factors are not directly part of your investment screening, the related risks and opportunities may still be relevant when considering the overall risk profile and value of an investment. Sustainability related risks and opportunities should therefore matter to all investors.
Sustainability risks may affect both the cash flow and discount rate components of DCF valuations
The sustainability factor that deservedly receives the most attention is climate change and related changes in consumer behaviour, regulation and business practices. For example, many companies are planning or implementing a transition to ‘net-zero’ which may impact the expected amount, and also the variability, of future cash flows. What is less clear is how these risks should be included in equity valuation. In a DCF model, does sustainability risk impact forecast cash flows, the discount rate, or both?
Before considering valuation inputs it is important to understand to what extent sustainability risks are reflected in financial statements. For example, whether a company currently reports a liability for its net-zero commitments will affect future reported performance and may affect what is included in the enterprise to equity bridge.
Financial reporting implications of sustainability and net zero
The financial statement effects of sustainability issues may be more limited than you might expect given the potential impact of climate change on many businesses. Financial statements deal with assets and liabilities present at the balance sheet date and with changes of these amounts during the reporting period. However, many sustainability effects concern future changes to a business and the future disposal and acquisition of fixed assets. These future effects are only likely to partly or indirectly affect the current financial statements.
Here are some of the situations where sustainability risks could affect financial statements and why we think the impact is likely to be limited in practice.
Fixed asset useful life and residual value
Climate change may result in assets being retired and replaced sooner than originally anticipated and, as a result, impact their residual value at the end of that life. Under IFRS, companies must already constantly update estimates of useful life and residual value to calculate depreciation, and changes should be disclosed and explained. However, remember that these depreciation changes are prospective and there is no immediate catch-up adjustment – unless the asset is deemed ‘impaired’.
Fixed asset impairments
If the future cash flows attributable to a fixed asset have declined sufficiently the asset may have to be immediately written-down and an expense recognised. These cash flow effects would include the potentially higher and earlier cost of asset replacements due to climate change. However, the use of value-in-use under IFRS (and the non-discounting approach under US GAAP), together with the fact that most tangible and intangible fixed assets are tested for impairment as part of a wider business unit, means that a reduction in economic value often does not show up as an accounting impairment.2For more about measuring the impairments of fixed assets, the problem of ‘shielding’ and why economic losses may not result in accounting write-downs, see our article ‘Goodwill impairments may not identify impaired goodwill’.
Decommissioning liabilities
Companies are required to recognise a liability for the present value of the estimated costs to decommission facilities at the end of their useful life. Such liabilities are very common in the energy, utilities and extractive industries. Climate change may affect the timing of such decommissioning. This in turn will change the amount of that liability and the associated depreciation expense.3Depreciation changes because any remeasurement of a decommissioning liability is adjusted against the related fixed asset carrying value rather than being immediately recognised as an expense. However, some decommissioning liabilities may be omitted from the balance sheet due to the difficulty of measuring them – as can be seen in the extract from the financial statements of BP shown below.
Long-term provisions
It is possible that the future costs associated with adapting a business in response to climate change could be reported as a provision, in the same way that other reorganisation costs could be reported as a liability. However, IFRS Standards (and US GAAP) have strict criteria for recognising a liability in the balance sheet, the most important of which is that a contractual or constructive commitment to the expenditure must exist at the balance sheet date. If the expense can be avoided, for example by discontinuing that business activity, then no liability exists.4The IASB has recently clarified when provisions for the costs associated with climate change should be recognised as a liability – here is a useful explanation by KPMG. Some climate lobby groups believe that provisions for the future costs related to climate change should be more commonly recognised in the balance sheet. However, doing so would be contrary to the conceptual framework for financial reporting and result in the recognition of provisions that do not meet the definition of a liability. It would also open financial statements to greater management discretion and opportunities for ‘big-bath’ provisioning and income smoothing, which we do not think is in the interest of investors. Committing to net-zero does not by itself create an accounting liability and immediate expense.
Disaggregation in financial statements
The recently issued IFRS 18 has introduced new principles regarding the extent and basis for aggregating and disaggregating items in financial statements. The key focus is whether items have different or similar characteristics, one of which could be the exposure to sustainability risks. Companies must provide disaggregated analysis of assets and other financial statement items that have a different exposure to those risks. At least that is our interpretation of what IFRS 18 requires, we suspect compliance with this ‘principle’ may fall short of investor expectations.
Financial statements should already incorporate the impact of climate change
Although sustainability risks are not specifically mentioned in existing accounting standards, the above effects are fully covered, and companies should already be considering these risks when preparing their financials. Nevertheless, the IASB has recently issued proposals to emphasise and clarify the financial reporting effects of ‘Climate related and other uncertainties in financial statements’ by adding additional illustrative examples to several standards. The examples mainly focus on the additional disclosures that may be needed to fully understand the financial statement effects.
Here are links to the exposure draft and to some related educational material published by the IASB. The educational material includes a more comprehensive explanation of the different financial statement effects of climate change, some of which we summarise above.
Investor focus on sustainability has already resulted in increased disclosure and comment by many companies in their financial statements, which we welcome. Here are some examples:
BHP explanation of climate uncertainties in impairment testing
BHP 2023 annual report
BHP explains how climate is factored into their impairment assessments, although notice how they emphasise the large degree of uncertainty in these forecasts. We are also interested to see that climate is not included as a specific risk factor in their cost of capital used for impairment testing (see below for our perspective on this).
BP accounting policy and estimates for decommissioning provisions
BP 2023 annual report
In the case of BP, the company seems to acknowledge that the timing of decommissioning expenditure will be affected by the response to climate change. However, the company has not “materially brought forward” the assumed timing, and therefore not changed its decommissioning liability. They argue the “future active management … of the portfolio” means no change is necessary – something we don’t fully understand.
Furthermore, BP says it makes no provision for the future cost of decommissioning refineries because the closure date is so uncertain – IAS 37 says that a provision is only required if a “reliable estimate can be made of the amount of the obligation”.5IAS 37 paragraph 14. However, this is a contentious area in financial reporting, particularly the interpretation of the word ‘reliable’. The fact that not all decommissioning costs are recognised as a liability by BP serves to illustrate the challenges faced by investors in this area.
While the economic effects of climate change may not be fully recognised in financial statements, the impacts we explain above are nevertheless important for investors. For example, a change in asset useful life and the earlier replacement of assets is likely to impact the forecasts for future capital expenditure. The risk disclosures, and potential additional disaggregation related to differences in risk, will also be useful valuation model inputs.
However, the financial statement effects are unlikely to be sufficient by themselves for investors to build a comprehensive view of the future cash flow and risk implications of sustainability and climate change, which is why we welcome recent developments in sustainability reporting. More on this later, first let us consider how risk, including sustainability risk and opportunities, should impact equity valuation.
Sustainability (and other) risks in equity valuation
It is well understood that the discount rate applied in discounted cash flow valuation6Although our focus for this article is DCF valuation, the same considerations apply to valuation multiples: a higher level of risk means a lower valuation multiple. should reflect the riskiness of the investment. Higher risk means a higher discount rate and lower value.
Climate change, sustainability and net zero commitments affect each component of risk in equity valuation
However, risk does not just impact discount rates. It is also important to consider risk factors when forecasting future cash flows. Forecasts of ‘most likely’ cash flows may not necessarily fully reflect these risks, and forecasts of the ‘success scenario’ cash flows most certainly do not.
DCF valuation also requires the separate consideration of non-core assets and non-operating liabilities, and risk may play an important part in determining their contribution to overall value. In these cases, how risk is dealt with in financial statements, and particularly in measuring assets and liabilities in the balance sheet, becomes important.
Risk and forecast cash flows
Future profits and cash flows are uncertain and depend on multiple risk factors. Value in the future is determined by how those risk factors resolve, while value today depends on the range of potential outcomes, and the probability investors assign to each. Cash flows in a DCF analysis should therefore be probability-weighted expected values.
Consider possible negative outcomes and not just the success scenario
Of course, in practice, a detailed probability-weighted calculation may not be feasible, but it is important that any approach to valuation considers the potential for negative outcomes and is not just a forecast based on the successful implementation of management plans.
Furthermore, the most likely outcome may not fairly reflect the expected cash flows needed for a valuation. If the downside risks are greater than the upside opportunities, using the most likely scenario will overstate value. A negatively skewed distribution may well apply to many companies where a ‘black swan’ type negative event is possible. The fact that such events may be unlikely does not mean they should be ignored.7We discussed the concept of expected cash flows in our article ‘The most likely profit may not be the most relevant profit’ in which we considered the disruption to markets caused by Covid-19. We argued that the equity market reaction to Covid-19 reflected the (correct) focus on probability weighted expected outcomes, whereas consensus analyst profit forecasts seemed to us to reflect the most likely outcome; because the distribution of outcomes was skewed the two did not equate.
Discount rate premium as an alternative to adjusting cash flows
Conceivably, it is possible to use a ‘success’ profit and cash flow scenario and allow for all or some negative outcomes in the discount rate (in addition to allowing for risk in that rate). However, it is impossible to determine the discount rate adjustment without knowing the probability weighted cash flow (or an approximation thereof) in the first place.
Putting both the cash flow effect and required return risk premium in the discount rate is commonly applied in the bond markets8The yield to maturity of a bond is based on the assumed repayment of the contractual principal and interest cashflows, and represents the best possible outcome for investors. The expected return to bondholders will likely be lower than this contractual yield due to the potential for default and the reduced cash flows that will likely result. Valuing a bond by discounting contractual cash flows at a yield to maturity effectively allows for both the potential for reduced cash flows and the risk of variation in those cash flows., where the contractual cash flows, and their duration, are much more clearly defined, but we do not think this is a good approach to valuing equity investments.
Climate risks are no different from all other risk factors when it comes to forecasting cash flows. In our view, every effort should be made to identify the absolute expected cash flow effect of all risk factors, even if the estimated effect and related probabilities are highly subjective. Nevertheless, the alternative discount rate adjustment may be a simpler approach to apply in practice. In effect, an additional ‘margin for safety’ is added to your required rate of return.
However, be mindful of the absolute effect. Separately identifying the absolute value effect of a discount rate adjustment will help to ensure the outcome is as realistic as possible.
The following extract from the financials of ENI illustrates a discount rate adjustment being used as an alternative to fully probability weighted cash flows. The company describes an additional risk premium for the “risks of energy transition”, although unfortunately they do not specify its magnitude, or the absolute effect it has on the valuations used in their impairment testing.
ENI ‘energy transition risk’ discount rate adjustment
ENI 2023 financial statements – extract from note 15
Risk and the discount rate
How risk should be factored into cash flows used for valuation is clear – use expected values and consider all risks. How risk should be factored into discount rates is somewhat less intuitive due to the complication of diversification.
Holding multiple stocks does not affect expected cash flows; the cash flows of a portfolio are the aggregate of the cash flows of the individual components of that portfolio. However, the risk of a portfolio is affected by how many stocks are held and the inter-relationship or correlation between those stocks. Where stocks react to risk factors differently, their correlation will be less than perfect (R < 1.0) which means some part of individual stock risk tends to be cancelled out. A larger portfolio and lower correlation results in reduced relative risk for a portfolio.
It is generally accepted that investors are risk averse and consequently require a higher rate of return from more risky investments. A higher required return translates into a higher discount rate in DCF valuations, and a lower enterprise or equity valuation multiple. However, what is less clear is how risk should be measured and how risk can be translated into a required return.
CAPM is the most common method for deriving a risk adjusted discount rate
The best known, and it seems the most widely used, method to identify a risk-adjusted discount rate is the Capital Asset Pricing Model (CAPM). The model gives the investor required return as a function of the return on risk free assets and the premium investors demand to invest in a diversified ‘market portfolio’ of risky assets (i.e. equities), scaled by a beta factor. In effect the model measures the required return based on the contribution a stock makes to the risk of a diversified portfolio, and not the absolute risk of the stock itself. While CAPM may not be perfect, in our view it does provide a sound conceptual basis for discount rate adjustments.
Investment required return = Risk free rate + Equity risk premium x Investment beta
For more about the assumptions behind CAPM and the estimation of beta factors see our article ’Calculating and analysing the drivers of equity beta’.
Risk affecting cash flows may not affect the discount rate
Risk factors that are relevant when measuring cash flows may not be relevant when considering the discount rate that should be applied to those cash flows. Uncorrelated (specific or unsystematic) risks should be included when forecasting expected cash flows, but should not (at least in a perfect CAPM world) affect the investor required return.
In the case of climate related risks, the question is whether these affect the cost of capital and, if so, is there any need to make special adjustments in your calculations. In our view, most climate and sustainability related risks are likely to be entity specific and uncorrelated with market movements.9Academic evidence for our assertion is mixed. Some studies claim to show that exposure to sustainability risks increases the costs of debt. However, measuring such effects is challenging and the focus tends to be on debt yields which is not the same as the underlying cost of debt. It is even more difficult to obtain empirical evidence regarding the cost of equity. Overall, we do not believe the case is settled either way, but in the meantime, investors need to take a view; however difficult that is. On this basis there is no need to separately adjust equity beta factors and discount rates. Furthermore, even if some such risk factors do impact non-diversifiable risks, we think that these effects are likely to already be reflected in observed equity betas and in a market-derived implicit equity risk premium.
Of course, this ‘no separate adjustment to the discount rate’ approach assumes that cash flows are probability weighted amounts that fully allow for the estimated effects of climate change and different scenarios that may arise. If your cash flow forecasting ignores the potential net negative effect of climate risks, you will need to add a risk premium to the discount rate, as we explain above.
Sustainability reporting and the ISSB
Due to the importance of sustainability and climate related risks and opportunities, and the incomplete information available in financial statements, sustainability reporting has evolved to fill the information gap. Various Sustainability Reporting Standards have been developed over the last several years, some of which have global application, and some jurisdiction focused. Their diverse nature and different objectives10For example, the European sustainability standards focus on both information relevant for investors making investment decisions and in addition the impact of a company on, for example, climate even if not relevant for investors. This is a so-called double-materiality test. creates confusion for investors (at least it has confused us), which explains the recent establishment of the International Sustainability Standards Board (ISSB).
The ISSB is a sister body to the IASB and is charged with developing sustainability standards that have global application. Some jurisdictions are already in the process of adopting these standards and others are seeking to align their own requirements with those of the ISSB. Here is the ISSB’s own explanation of their objective:
- to develop standards for a global baseline of sustainability disclosures;
- to meet the information needs of investors;
- to enable companies to provide comprehensive sustainability information to global capital markets; and
- to facilitate interoperability with disclosures that are jurisdiction-specific and/or aimed at broader stakeholder groups.
Click here for an introduction to the ISSB and IFRS Sustainability Standards
Sustainability reporting standards should help ensure that investors receive the forward looking information that is necessary to facilitate the cash flow and risk forecasts that we highlight, and to better understand the effects of sustainability on current financial statements. The first standard (S1) issued by the ISSB provides general requirements for the disclosure of sustainability related financial information. The focus on investor needs and information about valuation inputs is clear from the first 4 paragraphs, which we show below:
IFRS S1: General requirements for Disclosure of Sustainability-related Financial Information
IFRS Foundation The full text of S1 and of S2 on Climate-related Disclosures can be found here.
Sustainability reporting is still developing, and company adoption is in progress. However, we are already seeing how companies are shifting their focus to forward looking information.
The extract below is from the US Steel 2023 Task Force on Climate-related Financial Disclosures report. The climate disclosure recommendations of the TCFD have now been incorporated into the work of the ISSB and support the requirements in S2, the ISSB climate-related disclosure standard.
US Steel Climate related Transition Risks extract – Carbon pricing
US Steel 2023
US Steel states that developments in carbon pricing are a potential risk to future operating margins and explains various mitigating strategies that may minimise this impact. Clearly this is a major consideration for companies in several sectors and needs to be factored into any projections of operating margins used in equity valuation.
The challenge is taking this type of disclosure and converting it into a specific operating forecast. We hope that companies will be as specific as possible. Identifying risk factors (and related opportunities) is useful, but what would really help investors are scenarios showing how margins are actually expected to be affected.
Insights for investors
- Sustainability related risks and opportunities, including those arising from the effects of climate change, may have a significant impact on forecast cash flows and investment risk.
- The effect of sustainability risks on accounting assets and liabilities should already be factored into financial statements. However, many sustainability risks will only affect future recognised assets and liabilities and future business performance, and do not show up in current financial statements.
- When deriving forecasts for use in valuation, ensure that the full range of potential outcomes are considered, including low probability negative effects. Include sustainability related risks as part of this analysis.
- Only if expected cash flows are too difficult to estimate should you instead consider adding an additional risk premium to the discount rate in DCF valuation; but check to ensure that the absolute effect of this appears reasonable.
- Be careful when considering sustainability related adjustments to the discount rate. In many cases the risk is likely to be company specific and diversifiable. Furthermore, any systematic risk effects may already be captured in your normal discount rate inputs.