Working Transition into the Equation

    Stockholm (NordSIP) – One of the key challenges within sustainability is how to translate the excellent work being done in academia into effective, widespread business practices.  Many universities around the world are endeavouring to bridge this gap, for instance by joining forces with the private sector or building dedicated research platforms to produce output that can be easily accessed and incorporated by businesses. Given the interrelation and complexity of sustainable business issues, these academic platforms need to be truly interdisciplinary in their approach.

    The Rotterdam School of Management, Erasmus University (RSM) set up the Erasmus Platform for Sustainable Value Creation with a view to developing practical solutions for the achievement of the UN’s Sustainable Development Goals (SDGs). One of their latest publications, Valuing companies in transition, seeks to bridge the gap between transition management and corporate finance. Published this month, the working paper is co-written by Professors Dirk Schoenmaker and Willem Schramade. The duo is perhaps best known for co-authoring Principles of Sustainable Finance, an acclaimed pedagogical manual for aspiring responsible investors.

    The aim of the paper is to help analysts value companies more accurately by including the impact of transition (or a lack of it) in their models. Schoenmaker and Schramade begin by examining the characteristics and dynamics at play within the transition process. Some of the concepts are not necessarily unique to the current transition to a sustainable economy. The “creative destruction” process of new technology and business models rendering the elements of the old regime obsolete were already described by Schumpeter in the 1940s.

    While there are many socio-economic transitions occurring right now, including digitalisation and ageing, Schoenmaker and Schramade have chosen four main sustainability-related themes on which to focus:

    1. Climate – energy transition
    2. Raw materials – circular economy
    3. Biodiversity – healthy food and regenerative agri/aquaculture.
    4. Labour practices – social transition.

    The first step in their modelling involves expected transition losses, on the assumption that companies that completely ignore transition will ultimately cease to be viable. The effects of transition can be positive or negative and are a function of several variables including exposure at transition and the probability of transition for their respective sector. Actual loss at transition will also depend on a company’s capacity to recover or retain value by adapting to the new regime.

    The authors also emphasise the importance of including management quality in the total equation. Nimble, forward-looking companies will invest in innovation and benefit from first-mover advantages that help minimise expected longer-term transition losses. This does involve some early-stage technological risks and higher research and development costs, but these can be mitigated by product differentiation and thus higher profit margins.

    For those readers less keen on equations, Schoenmaker and Schramade do a great job of bringing the concepts to life with some real-world examples. The first case study contrasts the situations of 100% electric car maker Tesla with the historically successful, but less well positioned Volkswagen. Those of us old enough to have grown up with film photography will also remember the sorry fate of their second case study, Eastman Kodak, whose management decided digital was a flash-in-the-pan. The authors emphasise the importance of closely examining company strategy for evidence of genuine adaptation measures. They also refer to a behavioural bias that makes it all too easy for company management to extrapolate current cash flows to future earnings.

    According to the authors, well-run companies that make timely investments towards transition and rid themselves of potentially stranded assets will perform better long-term than those focused only on “business as usual”. Traditional corporate finance analysis does not incorporate transition risks and opportunities. By building in well-defined factors relating to adaptation to transition, investors can optimise not only their stock selection but also better inform their engagement discussions with portfolio companies.

    Image by Stan Petersen from Pixabay

    Richard Tyszkiewicz
    Richard Tyszkiewicz
    Richard has over 30 years’ experience in the international investment industry. He has worked closely with major Nordic investors on consultancy projects, focusing on the evaluation of external asset managers. While doing so, Richard built up a strong practical understanding of the challenges faced by institutional investors seeking to integrate ESG into their portfolios. Richard has an MA degree in Management and Spanish from St Andrews University, and sustainability qualifications from Cambridge University, PRI and the CFA Institute.

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