the cost of sustainability capital and the creation of sustainable value by companies

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FORUM The Cost of Sustainability Capital and the Creation of Sustainable Value by Companies Frank Figge and Tobias Hahn Summary We develop and apply a valuation methodology to calculate the cost of sustainability capital, and, eventually, sustainable value creation of companies. Sustainable development posits that decisions must take into account all forms of capital rather than just economic capital. We develop a methodology that allows calculation of the costs that are associated with the use of different forms of capital. Our methodology borrows the idea from financial economics that the return on capital has to cover the cost of capital. Capital costs are determined as opportunity costs, that is, the forgone returns that would have been created by alternative investments. We apply and extend the logic of oppor tunity costs to the valuation not only of eco- nomic capital but also of other forms of capital. This allows (a) integrated analysis of use of different forms of capital based on a value-based aggregation of different forms of capital, (b) determination of the opportunity cost of a bundle of different forms of capital used in a company, called cost of sustainability capital, (c) calculation of sustainability efficiency of companies, and (d) calculation of sustainable value creation, that is, the value above the cost of sustainability capital. By ex- panding the well-established logic of the valuation of economic capital in financial markets to cover other forms of capital, we provide a methodology that allows determination of the most efficient allocation of sustainability capital for sustainable value creation in companies. We demonstrate the practicability of the methodology by the valuation of the sustainability perfor- mance of British Petroleum (BP). Keywords British Petroleum (BP) eco-efficiency industrial ecology natural capital opportunity cost sustainability indicators Address correspondence to: Tobias Hahn Institute for Futures Studies and Technology Assessment Schopenhauerstr. 26 14129 Berlin, Germany <[email protected]> <www.sustainablevalue.com> © 2005 by the Massachusetts Institute of Technology and Yale University Volume 9, Number 4 http://mitpress.mit.edu/jie Journal of Industrial Ecology 47

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Page 1: The Cost of Sustainability Capital and the Creation of Sustainable Value by Companies

FORUM

The Cost of SustainabilityCapital and the Creation ofSustainable Value byCompaniesFrank Figge and Tobias Hahn

Summary

We develop and apply a valuation methodology to calculatethe cost of sustainability capital, and, eventually, sustainablevalue creation of companies. Sustainable development positsthat decisions must take into account all forms of capital ratherthan just economic capital. We develop a methodology thatallows calculation of the costs that are associated with the useof different forms of capital. Our methodology borrows theidea from financial economics that the return on capital hasto cover the cost of capital. Capital costs are determined asopportunity costs, that is, the forgone returns that would havebeen created by alternative investments. We apply and extendthe logic of opportunity costs to the valuation not only of eco-nomic capital but also of other forms of capital. This allows(a) integrated analysis of use of different forms of capital basedon a value-based aggregation of different forms of capital,(b) determination of the opportunity cost of a bundle ofdifferent forms of capital used in a company, called cost ofsustainability capital, (c) calculation of sustainability efficiencyof companies, and (d) calculation of sustainable value creation,that is, the value above the cost of sustainability capital. By ex-panding the well-established logic of the valuation of economiccapital in financial markets to cover other forms of capital, weprovide a methodology that allows determination of the mostefficient allocation of sustainability capital for sustainable valuecreation in companies. We demonstrate the practicability ofthe methodology by the valuation of the sustainability perfor-mance of British Petroleum (BP).

Keywords

British Petroleum (BP)eco-efficiencyindustrial ecologynatural capitalopportunity costsustainability indicators

Address correspondence to:Tobias HahnInstitute for Futures Studies and

Technology AssessmentSchopenhauerstr. 2614129 Berlin, Germany<[email protected]><www.sustainablevalue.com>

© 2005 by the Massachusetts Institute ofTechnology and Yale University

Volume 9, Number 4

http://mitpress.mit.edu/jie Journal of Industrial Ecology 47

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Introduction

Sustainable development is a normative con-cept that calls for “development that meets theneeds of the present without compromising theability of future generations to meet their ownneeds” (WCED 1987); that is, it calls for somekind of intergenerational equity (e.g., Good-land and Daly 1996). This aspect of intergen-erational equity is often modeled using a capitalapproach (Harte 1995; Stern 1997). Accordingto the constant capital rule, a development mustleave the capital stock per capita at least un-changed to meet the normative demand of sus-tainable development (e.g., Harte 1995; Stern1997). Although it is a commonplace notion thata society needs several different forms of capi-tal, there is a debate about how many groupsof capital should be distinguished and takeninto account (e.g., Dyer and Poggie 2000; Ekins1992). Next to economic (here used synony-mously for human-made or manufactured) cap-ital, there are, for example, natural and socialcapital. For the purpose of this article, a sub-division of the different forms of capital is notnecessary.

Companies, SustainableDevelopment, and Efficiencyof Capital Use

The concept of sustainable development andthe capital approach to sustainability have alsobeen applied to companies (e.g., Atkinson 2000;Huizing and Dekker 1992). On one hand, compa-nies use capital, which is undesirable because cap-ital is valuable and limited. On the other hand,companies’ output, that is, the products and ser-vices they produce, is desirable.1 Companies thusneed to optimize the way in which they use cap-ital. Put differently, companies need to enhancetheir efficiency.

In this article, efficiency refers to the ratioof value created to capital used (Freeman et al.1973; Schaltegger and Sturm 1990) and we inter-pret value created as a form of economic value.2

Efficiency will be enhanced whenever more valueis created for a given amount of capital or less cap-ital is used for a given amount of value created.

The conservation of capital stock as requiredby the constant capital rule will be more eas-ily achieved the more efficiently capital is used.Thus, companies must aim at high efficiency ofcapital use if they are to contribute to sustain-able development. More efficient use of resourcesis of course no guarantee of less capital beingused (e.g., Berkhout et al. 2000; Herring and Roy2002; Mayumi et al. 1998). Improvements in ef-ficiency can be overcompensated if companies’economic growth exceeds the improvement oftheir efficiency (rebound effect).3 On the otherhand, if the use of capital is to be reduced for agiven amount of value created, efficiency mustbe enhanced. It follows that, ceteris paribus, in-crease in efficiency is a necessary but not suffi-cient condition for reduction of capital use, if theamount of value created is not to be reduced.Furthermore, an increase in efficiency does notgive any information about how value is createdand how the different forms of capital are dis-tributed. A change of the distribution of valuecreated and/or capital can have a negative im-pact on sustainability performance. It is for thesetwo reasons that the ceteris paribus assumption isof crucial importance when the relationship be-tween efficiency and sustainable development isanalyzed. The same assumption is also made bythe approach presented in this article.4

If we interpret corporate sustainability perfor-mance under the ceteris paribus assumption, theefficiency of corporate capital use must be de-termined. A company contributes to sustainabledevelopment whenever it uses every single formof capital more efficiently than another company.But this is rare. Companies will usually use someforms of capital more efficiently and other formsof capital less efficiently than other companies.To evaluate the use of capital in these cases, itmust be determined if the higher efficiency of theuse of one form of capital can compensate for thelower efficiency of the use of another form of cap-ital. This aggregation problem appears wheneverwe have different forms of capital that are mea-sured in different units and therefore cannot beaggregated easily.

In the field of natural capital, this aggregationproblem has been dealt with by environmentalimpact assessment approaches (e.g., Fava et al.1991; Heijungs et al. 1992a; 1992b; Odum 1996;

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Wackernagel and Rees 1996). Impact assessment,though, has exclusively approached this aggre-gation problem by aggregating different envi-ronmental impacts5 according to their relativeburden. In general, for this purpose burden-basedapproaches convert all environmental impactsinto equivalents of one of the impacts.

Put generally, this is expressed as follows:

EI1 − equivalents = EI1 + w2

w1· EI2

+ . . . + wn

w1· EIn (1)

with EI = environmental impact and w = relativeburden of an impact (weight).

This aggregation is based on the relative bur-dens of different environmental impacts. To de-rive these relative weights, different logics areapplied. One frequently used approach is to clas-sify environmental interventions according totheir contribution to a group of environmentalproblems that serve as impact categories (e.g.,Heijungs et al. 1992a; 1992b). Other examplesare, for example, energy- (e.g., Odum 1996) orspace-oriented (e.g. Wackernagel and Rees 1996)methods.

All these approaches have in common thatthey allow (1) determination of the burden ofone environmental impact relative to anotherenvironmental impact and (2) optimization ofthese burdens based on this information. It is forthis reason that we refer to these approaches asburden-based approaches.

Most environmental impact assessment ap-proaches, though, do not allow the aggregationof all environmental impacts into a single figure.Furthermore, they do not allow consideration ofother forms of capital such as, for example, socialor economic capital. To integrate different formsof capital based on a burden-based approach, therelative burdens of the different forms of capi-tal that are generally accepted would have to beestablished. In our view, no existing impact as-sessment approach meets this criterion.6

In this article we fundamentally shift the per-spective of the analysis to concentrate on valuecreation (i.e., on the numerator of efficiency ra-tios) instead of damage caused (i.e., the denom-inator), as in burden-based approaches. To de-termine the value created, we fall back on the

concept of opportunity costs. The suggestion toconsider the opportunity costs of the use of eco-nomic and natural capital can be traced back tothe end of the nineteenth century.

Not only time and strength, but commodities,capital, and many of the free gifts of nature,such as mineral deposits and the use of fruit-ful land, must be economized if we are to actreasonably. Before devoting any one of theseresources to a particular use, we must considerthe other uses from which it will be withheldby our action; and the most advantageous op-portunity which we deliberately forego con-stitutes a sacrifice for which we must expectat least an equivalent return. (Green 1894,p. 224)

Unfortunately to date very few scholars (Figge2001; Figge and Hahn 2004a; 2004b) have takenup this suggestion to assess the value of capitalbeyond economic capital.7 Opportunity costs are,up to this point, only applied in the valuation andallocation of economic capital. In an earlier arti-cle, we introduced the value-based logic for themeasurement of corporate sustainability perfor-mance for the first time (Figge and Hahn 2004a).Although sharing the fundamental value-basedlogic and the notion of opportunity cost, themethodology described in the present article rep-resents a significant further development. Thethree fundamental innovations of this article arethat it (1) considers the total amount of capitalused rather than just the change of capital use,(2) integrates all different forms of capital ratherthan just addressing the use of natural capital, and(3) provides a methodology to evaluate the useof all different forms of capital similar to the wayeconomic capital is valued on financial marketstoday.

Thus, in this article we take up Green’s sugges-tion to consider the opportunity costs of all formsof capital. We call the entirety of all differentforms of capital a company uses its sustainabilitycapital.8 Our approach allows determination of acompany’s cost of sustainability capital. Follow-ing the example of the financial markets, we usethe cost of a company’s capital to determine howmuch value a company has created after deduc-tion of its cost of sustainability capital. We callthe value that exceeds a company’s sustainabilitycapital its sustainable value.

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The next section shows how the cost of cap-ital is determined in the financial markets. Thislogic is then extended to sustainability capitaland applied to the real world example of BritishPetroleum.

Economic Cost of Capital

In the financial markets it is commonly as-sumed that capital should be allocated where itcreates most value. For this purpose the expectedrisk-adjusted return for alternative uses is calcu-lated and capital is allocated where maximumreturn is expected (e.g., Brealey and Myers 1996,12). In financial economics it has been proposedfor quite some time (e.g., Green 1894; Haney1912) that economic capital is invested in a com-pany whenever the expected return of the invest-ment lies above the opportunity cost of capital.Opportunity costs indicate the value that wouldhave been created by an alternative use of capi-tal. In the financial markets opportunity cost ofcapital corresponds to the yield of an investmentwith a similar risk.

In practice the opportunity cost and thus thecost of capital is determined by the equation

CC = VCM

CEM (2)

with CC being the cost of capital, VCM the valuecreated by the market, and CEM the amount ofcapital employed by the market.

In the financial markets a profit (e.g., Stewart1991) or free cash flow (e.g., Rappaport 1986)figure is usually used as an indicator for valuecreated. But the same relationship can be usedwith a broader definition for value created (e.g.,value added).

A company creates value when it uses capitalmore efficiently than the market. To determineif and how much value has been created, theyield of the capital employed by the company iscompared to its cost of capital. For this purposethe cost of capital can be subtracted from theyield of a company’s capital. The result is calleda value spread,

VS = VCC

CEC − VCM

CEM (3)

with VS being the value spread, VCC the valuecreated by the company, and CEC the amount ofcapital employed by the company.

The value spread shows how much value iscreated per unit of capital employed. The valuespread can be used to calculate the excess valuecreated by the company by multiplying the valuespread by the amount of capital employed by thecompany,

EVC = VS ∗ CEC (4)

with EVC being the economic value created.In other words, a company creates a posi-

tive economic value if the value created by thecompany is higher than the opportunity cost ofthe capital employed, that is, higher than thevalue that would have been obtained by investingthe same amount of capital in the market. In thefollowing, we use this logic to determine the op-portunity cost of sustainability capital use andsustainable value creation.

Cost of Sustainability Capitaland Sustainable Value Creation

The preceding section has shown how the (op-portunity) cost of economic capital is calculatedin the financial market. This logic can be appliedfruitfully to a whole set of different forms of cap-ital and to a broader definition of value created,as required by the normative concept of sustain-able development. Similarly to the interpretationof opportunity cost in the financial markets, wenow interpret the average value created by a formof capital in the market as its opportunity cost.The opportunity cost of different forms of capi-tal thus corresponds to the efficiency of the useof these different forms of capital on the level ofa benchmark. We assume in the following, first,that this benchmark is the economy of a coun-try. In this case, opportunity cost is determinedby the ratio of the value created on the level ofthe entire economy per capital used. We assume,second, that the economic value created corre-sponds to the value of all products and servicesproduced within a country. If we subtract depreci-ation, this value corresponds to the net domesticproduct (NDP).9 In general, the opportunity cost

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of capital can thus be defined using the equation

OCCi = NDPCE

i

(5)

with OCCi = opportunity cost of capital i ,NDP = net domestic product, and CE

i = amountof capital i used in the economy.

The opportunity cost of capital indicates thevalue that is created per unit of capital in aneconomy on the average. We can now turn tovalue creation on the corporate level. For thispurpose we calculate the return on each form ofcapital. The complement to net domestic producton a corporate level is net value added. Net valueadded corresponds to the value created within acompany after depreciation. It excludes any valuethat has been created by suppliers or that will becreated by customers. The net domestic productof an economy is made up of all net value addedfor all economic entities. The return on capitalthus corresponds to

RCi = NVA

CCi

(6)

with RCi = return on capital i , NVA = net valueadded, and CC

i = amount of capital i used in thecompany.

As described above, value is only created if thereturn on capital exceeds the opportunity cost ofcapital. Therefore, and similarly to the way valuecreation is calculated in the financial markets, wenow calculate value spreads,

VSi = NVA

CCi

− NDPCE

i

(7)

with VSi = value spread of capital i . The valuespread reflects the hyper-efficiency of the use of aform of capital, that is, how much more efficientlya form of capital is being used in comparison toa bench-mark. To establish how much value hasbeen created by the use of capital by a company,following the example of the financial markets,we now multiply the value spread of each formof capital by the amount of capital used by thecompany,

VCi = VSi × CCi (8)

with VCi = value created through the use ofcapital i .

By calculating VSi and VCi for every formof capital i , one can determine whether a com-pany uses the different forms of capital in avalue-creating way. It is important to note that atthis stage we are relating the entire value, that is,NDP and NVA, several times to different formsof capital. Although this is current practice inthe calculation of return on economic capital, itis misleading. The companies of an economy usea bundle of different forms of capital and it is theentire bundle that creates value. It is necessary tocome up with an integrated appraisal of the valuethat has been created by a company by using abundle of different forms of capital. Assuming thatwe consider n forms of capital, simply summingup the value created for every form of capitali ∈ [1; n] overestimates the value created by a fac-tor n. To correct for this we must divide by factorn. As a result we obtain sustainable value, thatis, the value created by a hyper-efficient use of allforms of capital: A positive (negative) sustain-able value indicates that a company uses its cap-ital base more (less) efficiently than the bench-mark. In other words, sustainable value expresseswhether the value created by a company exceedsthe opportunity cost of its capital use. Sustainablevalue can therefore be calculated as

SV = 1n

n∑

i =1

VCi (9)

with SV = sustainable value created by the com-pany.

One could now be led to believe that divid-ing by n attributes the same weight to all forms ofcapital. We show that this is not the case but thatthe weight of each form of capital depends on itsimportance for value generation. Recall that incalculating VCi for each form of capital i , wemultiply the amount of each form of capital bythe corresponding VSi . The weight with whicheach form of capital i enters the calculation ofsustainable value is thus determined by how muchmore or less efficiently each form of capital i isused compared to the benchmark. Thus, dividingby n does not serve to weight the different formsof capital but only to avoid double counting ofvalue creation. The different forms of capital areweighted by their over- or underefficiency com-pared to the benchmark or—in other words—by

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the degree to which they succeed in or fall shortof covering their opportunity cost.

In a next step we can now also determine thesustainability efficiency10 of capital use. Capitalefficiency can be expressed by relating value cre-ated to the cost of capital. We know that themore sustainable value is created, the more theNVA of a company exceeds the opportunity costof its capital base. The total opportunity cost of acompany’s capital base, or, in other words, its costof sustainability capital, is thus given by the dif-ference between NVA and the sustainable valueof a company. Sustainability efficiency can thusbe defined as the ratio of NVA to the cost ofsustainability capital,

SEC = NVACSC

(10)

with SEC = sustainability efficiency of the com-pany and CSC = cost of sustainability capital.

A company is the more efficient the more itsnet value added exceeds its cost of sustainabil-ity capital. Sustainability efficiency is unity whennet value added corresponds to the cost of sus-tainability capital and below one when the com-pany is overall less efficient than its benchmark.In contrast to single capital efficiencies, the sus-tainability efficiency considers all forms of capitalsimultaneously and relates them to the value cre-ated. It relates the total value created to the op-portunity cost of the bundle of the different formsof capital used.

In the following, we apply the valuation ofthe cost of sustainability capital to the real worldexample of the capital use of British Petroleumin 2001.

Practical Application

The preceding section explained the theo-retical concept of cost of sustainability capitaland Sustainable Value creation. This section nowdemonstrates the application of the methodologyusing the example of British Petroleum (BP).

Prior to calculation of the sustainable valuecreated by BP, some methodological issues con-cerning the application of the approach haveto be considered. Three questions need to beaddressed for the application of the sustain-

able value methodology. These questions are ex-plained using the case of BP as an example.

First of all the scope of the analysis has to bedetermined. This includes (1) the choice of theeconomic activity or entity to be analyzed and(2) the choice of the forms of capital to betaken into account. Conceptually, the methodol-ogy is suitable for the analysis of the sustainabil-ity performance of any form of economic activityor entity such as companies, regions, nationaleconomies, processes, or products. In this article,we focus on companies and have chosen BP andits performance in 2001 as an example. Further-more, the analytical scope of the analysis has tobe determined; that is, the forms of capital to beincluded in the analysis have to be chosen. Con-ceptually, the choice of the different forms ofcapital should include those forms of capital thatare most critical to the sustainability performanceof a company. From the viewpoint of sustainabledevelopment, the criticality of the capital formsused by a company can be judged by the scarcityor degree of depletion of the capital form. In prac-tice this choice is often limited by the availabilityof the relevant performance data. For the case ofBP we have taken into account the forms of cap-ital listed in table 1.

Table 1 shows the economic, environmental,and social performance data for BP in 2001. Forthe construction of efficiency indicators, it isimportant that the value figures and the figureson capital use have the same scope (UNCTAD2003). Therefore, we only consider the impactscaused directly by BP, because they cover thesame scope as the value term used for the analysis.If we considered impacts caused by suppliers orcustomers of BP, the value term would have to beadjusted accordingly. We use environmental andsocial impacts as proxies for the use of environ-mental and social capital. The use of natural andsocial capital translates into a flow of resources.These flows of resources can be measured interms of environmental and social impacts.11

In this practical application we consider thefollowing eight different forms of capital: Non-financial assets, CO2, CH4, SO2, NOx, CO, workaccidents and PM10. Net value added representsBP’s contribution to the United Kingdom’s netdomestic product.12 To analyze the amountof economic capital that is tied up by BP’s

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Table 1 Performance data of BP in 2001

BP (2001) Amount Sources

Net value added [£] 15,563 BP 2002, authors’ calculationsNonfinancial assets [million £] 69,885 BP 2002, authors’ calculationsCO2 [t] 73,420,000 BP 2004aCH4 [t] 367,201 BP 2004bSO2 [t] 224,541 BP 2004bNOX [t] 266,133 BP 2004bCO [t] 124,584 BP 2004bWork accidents [number] 83 BP 2004cPM10 [t] 16,666 BP 2004b

Note: t = metric tonne = megagram (Mg) = 103 kilograms (kg, SI) ≈ 1.102 short tons.

operations we have estimated BP’s nonfinancialassets. The financial assets (e.g. shares) must notbe included because they represent assets thatare accounted for in the balance sheets of othercompanies (OECD 2001, 116). BP’s nonfinancialassets were estimated by subtracting all financialassets (e.g., securities) from BP’s total assets.

The second question to be addressed is thechoice of the benchmark level. The choice ofthe benchmark reflects a (normative) judgmentbecause it determines the cost of sustainabil-ity capital of a company, that is, the efficiencythat a company has to exceed. Consequently,the benchmark level chosen determines the ex-planatory power of the results of the sustainablevalue analysis of a company. It should thereforebe chosen with great deliberation. Conceptu-ally, different efficiency figures could be consid-ered as benchmarks. On one hand, the efficien-cies of other economic entities, such as nationaleconomies, regions, industry sectors, or compa-

Table 2 Performance data of the United Kingdom in 2001

UK economy (2001) Amount Sources

Net domestic product [million £] 884,718 National Statistics 2003Total net wealth [million £] 4,375,200 National Statistics 2003CO2 [t] 572,500,000 Baggott and colleagues 2003CH4 [t] 2,195,238 Baggott and colleagues 2003, authors’ calculationsSO2 [t] 1,125,000 DEFRA 2003NOX [t] 1,680,000 DEFRA 2003CO [t] 3,966,500 National Statistics 2003Work accidents [number] 132,696 Office for National Statistics 2003,

authors’ calculationsPM10 [t] 178,000 DEFRA 2003

nies other than the one under examination, couldbe used as benchmarks. On the other hand, onecould also use performance targets such as emis-sion reduction targets to form the benchmark ef-ficiencies. This option is particularly useful if theanalysis is to take into account the normativegoal that companies should reduce the amount ofcapital they use over time. For the case of BP, weuse the efficiency of the British economy in theyear 2001 as benchmark. It follows that BP cov-ers its cost of sustainability capital if and only if ituses its different forms of capital more efficientlythan the British economy.

Table 2 shows the corresponding economic,environmental, and social performance data ofthe United Kingdom in 2001. Total net wealth asreported by the national accounting system hasbeen chosen as an approximation for the eco-nomic capital base of the United Kingdom.

The indicators shown in tables 1 and 2 do notreflect all forms of capital that BP uses. Other

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important forms of natural and social capital aremissing. This is due to the fact that BP has notreported them up to this point and/or that theyare not available on the benchmark level. Infor-mation on additional forms of capital can be in-cluded analogously, though, as it becomes avail-able.13

Finally, and in order to achieve valid results,it is important that the performance data on thecorporate level and on the benchmark level cor-respond. This refers to the time period as well asto data quality and scope.

Based on the performance data at the corpo-rate and the benchmark level, sustainable valuecan now be calculated in the five steps describedin the preceding section:

1. Calculate the opportunity cost of each formof capital by relating the United Kingdom’snet domestic product to all eight forms ofcapital as introduced earlier on page 52.

2. Calculate BP’s return on capital by relatingBP’s net value added to all eight forms ofcapital, respectively.

3. Calculate the value spreads by subtractingfor each form of capital the results of step1 from the results of step 2.

4. Calculate the value created by each form ofcapital by multiplying the total amount ofeach capital used by BP by its correspond-ing value spread.

Step 2 Step 1 Step 3 Step 4Return on

capital [Mio £/unit] [Mio £/unit] [Mio £/unit]

Opportunity cost of capital

Value spread Amount

Value created [Mio £]

Economic capital ( 0.2227 - 0.2022 ) 0.0205 * 69,885 Mio £ = 1,431CO2 ( 0.0002 - 0.0015 ) -0.0013 * 73,420,000 t = -97,897CH4 ( 0.0424 - 0.4030 ) -0.3606 * 367,201 t = -132,425SO2 ( 0.0693 - 0.7864 ) -0.7171 * 224,541 t = -161,020NOX ( 0.0585 - 0.5266 ) -0.4681 * 266,133 t = -124,587CO ( 0.1249 - 0.2230 ) -0.0981 * 124,584 t = -12,225Work accidents ( 187.5060 - 6.6673 ) 180.8388 * 83 = 15,010PM10 ( 0.9338 - 4.9703 ) -4.0365 * 16,666 t = -67,272

Step 5 -72,373 Mio £ Sustainable value

Figure 1 Calculation of BP’s sustainable value for the year 2001. Note: Mio = million (106).

5. Calculate the sustainable value by sum-ming up the results of step 4 and dividingthem by the number of different forms ofcapital considered, that is, by eight.

Figure 1 shows the results of the calculationsfor all five steps. Overall BP creates a sustainablevalue of −£72,373,000,000.14 As can be readfrom figure 1, the use of only two resources (eco-nomic capital and work accidents) contributespositively to sustainable value. The use of allother resources has a negative impact on sustain-able value creation.

These results can also be used to calculate thesustainability efficiency of BP in 2001. The op-portunity cost of the bundle of BP’s sustainabilitycapital, that is, BP’s cost of sustainability capi-tal, sums up to 87,936 million £. We can nowrelate BP’s value added to the opportunity costof BP’s sustainability capital to come up withBP’s sustainability efficiency—it is calculated tobe 15,563 million£

87,936 million£ = 0.177. This number shows thatBP earns only 17.7 pence (p) per pound (£) ofopportunity cost of sustainability capital. Conse-quently its sustainability efficiency is below unity.BP thus falls short of covering its cost of sus-tainability capital. A total of 72,373 million £sustainable value is lost. Put differently, we mayexpect that had the resources been allocated tothe British economy on average rather than toBP, an additional 72,373 million £ more valuewould have been created.

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Conclusions

Companies must earn their cost of capital tocreate value. In the financial markets this state-ment is widely accepted. Unfortunately, the fi-nancial markets take into account only one formof capital when calculating the cost of capital.Companies, however, need many different formsof capital. Considering only economic capitalmight be acceptable when only the stakeholdergroup investors need to be considered. If a broaderview is taken, such as in the context of sustain-able development, more forms of capital must beconsidered.

This article shows how the cost of sustainabil-ity capital can be determined analogously to theway the cost of economic capital is determinedin the financial markets. By taking up a value-based perspective as opposed to the burden-basedlogic applied in the literature so far, we provide amethodology that allows integrated aggregationand evaluation of the use of all different kinds ofcapital used for value creation in companies. Forthis purpose we fall back on the trusted notion ofopportunity costs. In the financial markets, an in-vestment is only regarded as successful if it coversits cost of capital, that is, its opportunity cost. Weexpand this logic to the use of all forms of capitaland argue that sustainable value is only created bycompanies that cover the opportunity costs of allforms of capital used. We develop a methodologyto determine the cost of sustainability capital andsustainability efficiency of capital and, ultimately,the level of sustainable value creation.

Clearly the usability of such a methodologyis limited by the data that are available on cor-porate capital use, on one hand, and on the op-portunity cost of the different forms of capital,on the other. To test the applicability of our ap-proach under real world conditions, we have ap-plied the methodology to the example of BritishPetroleum. The analysis is done on the basis ofinformation that is freely available in the markettoday. The methodology yields illuminating andrevealing results. This underpins the practicabil-ity of the approach.

The choice of benchmark is central to thecost of sustainability capital. It determines theexplanatory power of the analysis. The method-ology introduced in this article shows how much

more value is created when a set of capital is usedin a company rather than in the benchmark. Thebenchmark should be chosen to match the de-sired analysis. It might be useful, for example, touse an international benchmark when analyzinga multinational company such as BP or to usea sector benchmark for a best-in-class analysis.Another possibility is to use a desired efficiencyas benchmark instead of an observed efficiency.This could, for example, be derived from inter-national treaties (e.g., the Kyoto protocol) anddesired economic growth to construct a desiredtarget efficiency.

The concept developed in this article eval-uates the use of different forms of capital rela-tive to a benchmark. A weakness of this value-based approach in comparison to burden-basedapproaches is that it does not indicate whetherthe overall capital use is sustainable. It showshow much a company contributes to making theuse of capital more sustainable. If current capitaluse is unsustainable, reallocating capital from lessefficient to more efficient users based on the sus-tainable value approach can help to make cap-ital use more sustainable. But sustainable valuedoes not indicate if and when a sustainable useof capital has been attained. To overcome thisweakness, a further conceptual development tointegrate value- with burden-based approaches isnecessary.

As mentioned in the Introduction, the con-stant capital rule is the key to the capital approachto sustainability. It is thus necessary to discuss theapproach presented in this article in the light ofthe constant capital rule. Our approach relatesthe efficiency of capital use by companies (microlevel) to the efficiency of a benchmark (macrolevel). Companies earn their cost of sustainabil-ity capital whenever they use their set of differentforms of capital more efficiently than the bench-mark. Two major implications result from this.Concerning the micro level, the approach showswhether the different forms of capital have beenallocated to the most value-creating uses and thevalue created accordingly. With respect to themacro level, the approach leaves the total amountof each form of capital unchanged and constant.Sustainable value thus expresses the excess valuecreated by a company while preserving a constantlevel of capital use on the macro level. Because

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it leaves the amount of capital unchanged onthe macro level, the approach presented in thisarticle is based on the notion of strong sustain-ability (analogously to Figge and Hahn 2004a).Moreover, as shown above, the approach can in-tegrate reduction targets if there is a need to re-duce the amount of capital used.

Because this article represents a paradigmaticshift from burden-based to value-based assess-ment of corporate sustainability performance (seealso Figge and Hahn 2004a; 2004b), there is aneed to apply and test the approach on a widerempirical basis. This should be of interest not onlyto academic researchers but also to practition-ers. Environmental and sustainability managersare increasingly assessed as to whether they havecontributed to more efficient use of economiccapital. Sustainable value allows integration ofother forms of capital. Environmental and sus-tainability managers can now demonstrate theircontribution to enhanced use of overall capital.External stakeholders such as financial and sus-tainability analysts can use this concept to con-duct an integrative analysis of the sustainable per-formance of companies. Financial analysts cancontinue to use their trusted approaches and willonly need to broaden the capital base of theiranalyses.

Furthermore, the new perspective taken upin this article offers an array of promising re-search avenues, one of which would be a com-parative assessment of the implications for sus-tainability capital use and allocation drawn froma value-based perspective versus the establishedburden-based logic. Most importantly, however,the methodology developed in this article repre-sents an important contribution to applying goodand well-established economic thinking to sus-tainability assessment and to furthering the ideaof sustainable and reasonable use of the capitalstock with which we are endowed.

Notes

1. In this article we are only concerned with the useof capital and not with its formation. The prod-ucts and services produced could either be con-sumed or invested, that is, be used to create cap-ital in turn. However, because capital is scarce,

companies must use capital as efficiently as possi-ble irrespective of how the value created is usedlater on.

2. The methodology presented in this article is notrestricted to a specific notion of value. Other formsof value could be integrated into our analysis.However, because we introduce the methodologyin a corporate and thus economic context, we con-tinue to use an economic notion of value created.

3. For a discussion of the role of the rebound effectin industrial ecology, see the recent article in thisjournal by Hertwich (2005).

4. At first sight the ceteris paribus assumption seemsto be quite drastic. It is important to point out,however, that we distinguish between a macro anda micro level in this article. Sustainable develop-ment refers to the macro level, whereas individualcompanies act on a micro level. The ceteris paribusassumption can therefore still be given when acompany (micro level) uses more capital as longas the overall use of capital on the macro level(e.g., the national economy) is not affected. Thiscan, for example, be the case when a more effi-cient company replaces a less efficient company.For an in-depth discussion see the article by Figgeand Hahn (2004a).

5. In this article we use the term “environmentalimpacts” analogously to “natural capital.” When acompany causes environmental impacts, it makesuse of natural capital.

6. We gratefully acknowledge the diverging opinionof one of the reviewers of this article. We agree thatburden-based approaches to impact assessment areconceptually sound and burden-based aggregationof different forms of capital is possible in theory.However, we disagree that in practice it can bedone in such a way that it meets general approval.Value-based impact assessments are based on thecurrent (or projected) value of the use of differentforms of capital and thus reflect the outcome ofmarket or other social processes. In our view itis therefore fair to assume a considerably higherdegree of general social approval for value-basedaggregations.

7. Integrating opportunity costs of protected areasinto valuation and priority setting in biodiver-sity conservation are subjects of ongoing debate(Balmford et al. 2000; Lovett 2001). However,these approaches only value one form of naturalcapital, that is, land, by opportunity cost and donot conduct an integrated assessment of differentforms of capital.

8. The term sustainability capital does not expressany normative statement on the characteristics of

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the different forms of capital. Rather it addressesthe entirety of different forms of capital that aresubject to the (normative) constant capital rule,that is, the entirety of the capital that should bemanaged in a sustainable way.

9. We consider depreciation to be the pro rata cost ofcapital that has been used up. It is for this reasonthat we propose to subtract depreciation from theeconomic value created.

10. The term sustainability efficiency reflects the inte-grated efficiency of the use of all different forms ofcapital under the condition that the total amountof capital used on the benchmark level remainsconstant.

11. Physically speaking, the resources listed are (unde-sired) outputs rather than inputs. Companies needto be able to emit pollutants to be able to produce.It is for this reason that they can be considered tobe inputs from an economic point of view.

12. Strictly speaking, the net value added representsBP’s contribution to the United Kingdom’s netnational product, because BP is active not only inthe United Kingdom but in other countries of theworld. Unfortunately, it is not possible to sepa-rate BP’s international operations from its domes-tic operations or to estimate the different forms ofcapital for all countries in which BP operates.

13. Conventional economic assessments of corporateefficiency are based on economic capital as theonly form of capital. They (implicitly) assumeeither that only economic capital constitutes arelevant scarcity or that the other forms of capi-tal are used as (in)efficiently as economic capital.For the sustainable value methodology the secondassumption applies.

14. 1 pound (£) was equal to approximately1.61 Euros and about US $1.44 in 2001.

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About the Authors

Frank Figge is a lecturer at the Sustainability Re-search Institute in the School of Earth & Environmentat the University of Leeds in the United Kingdom. To-bias Hahn is a senior researcher at the Institute forFutures Studies and Technology Assessment (IZT) inBerlin, Germany.

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