In this, the first in a series of three blogs exploring the utility of Net Present Value (NPV) in relation to sustainability, I’ll seek to challenge the prevailing chasm between NPV and sustainability valuation. To begin with, let’s layout the traditional relationship between NPV and sustainability and set the scene for further exploration.
NPV is a well understood method of cost benefit analysis used to aid financial and investment decisions. It balances the future costs and benefits of a project and applies a discount rate to account for the time value of money. The discount rate allows the future cash flows to be converted to current values. In doing so, the total net value of the project today can be determined. Thus alternatives can be compared on the same time scale and at the same rate. A project is deemed acceptable if the net present value is positive over the expected lifetime of the project.
NPV usually focuses on shorter term thinking and that is the main reason people believe that it is a dichotomy with sustainability, which focuses on long term timeframes. Traditional NPV discounts the future in many ways which can overlook sustainability issues. So, is there any place for NPV in the ESG decision toolkit, or is it, in fact, just another distraction?
I was at a graduation ceremony recently and during the commencement speech, the speaker argued that the true benefit of education was not just in the specific content learnt in lectures, but in the skills and approach to learning and the capability for further improvement a graduate develops from the studying process. Beyond the value of grades and awards, the true value is in the skills picked up and way of thinking attained during the studying process. These are values that transcend the modules, exams or coursework where they were developed and are truly valuable for the person now and in the future. This got me thinking about value, both from a personal perspective and in a wider business sense. For most, the tendency is to think of something’s value by quantifying it in a monetary terms and to evaluate something’s worth in its ability to make a profit. However, this way of thinking isn’t really sufficient for more complex problems such as the earth system. We’d all agree that a different approach is required.
The value of natural capital has to be measured on a different spectrum to financial capitals. Numerous examples exist of natural capital that has intrinsic value whose scope stretches beyond material and financial realms. What is the monetary value of a stable climate? What is the monetary value of the ozone layer? The arctic ice sheets? Biodiversity? The list is extensive. The true and intrinsic value of natural capital cannot be easily quantified. I think its for this reason that for most, NPV and sustainability are wholly incompatible and NPV is disregarded. However, this assessment could well be mistaken and the benefits of NPV to sustainability largely overlooked.
In the traditional sense, NPV operates on the presupposition that capital in the present is more valuable than it is in the future. This is well founded in the financial sector because of the benefits of investing earlier and the assumption that there’s a risk in holding capital that is likely to depreciate in value over time. However, with natural capital, the narrative is fundamentally different. The true value of ecosystems and the earth system as a whole is there purely through its existence. The value is therefore maintained into the future and so the discounting process requirements are significantly different and should be treated accordingly. An inverted NPV approach if you will. Logically, the more natural capital is preserved, the more true value of the project. This, in any responsible organisation, should be factored in and accounted for when using NPV for investment decisions.
Consider applying an inverted NPV approach to a 5 year logging project, in which 10% of the forest is required for wood. In this instance the true value of the project comes from the forest. Although this value isn’t purely monetary, for simplification and the purposes of example we can give the forest a monetary value of £500,000. Now consider two options of logging. The first method will be to deforest without any protective measures. The price of this method is £10,000 per year. The second method will be a sustainability orientated approach in which trees will be replanted for every tree chopped down. The price of this option is £15,000 per year. In both cases the logs are sold for the same price. Because the value of the forest doesn’t depreciate over time, it doesn’t need to be discounted as would usually be the case with purely financial NPV. The total operation cost for each option over the 5 years are £50,000 and £75,000 for options 1 and 2 respectively. However in Option 1, 10% of the forest value has also been lost through failure to replant. The total values of each option are as follows:
Option 1 = operational costs of £50,000 + 10% of £500,000 = £50,000. Total cost is £100,000
Option 2 = operational costs only of £75,000. Total cost is £75,000
Therefore although Option 2 operational costs are more, the value of the forest is maintained and thus is the preferred option. To simplify this example we ascribed a financial value, but this value isn’t necessarily required, so long as we understand and quantify the intrinsic values of the earth system and associated natural capitals and services.
This sort of calculation and inverted NPV can be applied to numerous natural capitals whose value is intrinsic. The intrinsic value of a stable climate, promotes measures to reduce greenhouse gas emissions for example, or the intrinsic value of maintaining biodiversity promotes the preservation of ecosystems. This form of NPV assessment provides an impetus for action against harmful practices and motivates sustainable behaviour. Its about getting people to realise the dangers of degrading intrinsic value things through a NPV approach. Therefore marrying together NPV and sustainability can make a strong and powerful case in a financial way to help push forward sustainable thinking and behaviour. Using the same tools to make the case for environmental protection is a good way to compare and persuade traditionally purely financial actors towards sustainable practices. Using an NPV approach would help raise awareness of how earth systems could be discounted to help us understand the implications of future capital degradation. This will in turn have a positive effect on sustainability action. Overlooking a NPV approach to sustainability could be ‘missing a trick’ and its application is something that should be understood in more detail.
In the next blog, I’ll start to look at how NPV can drive natural capital returns, support decision-making and lead to greater non-financial capital stability.