Today’s externalities, tomorrow’s internalities

Why impact matters for company valuations

  • May 17, 2023

As more businesses recognise the importance of assessing and reporting their positive and negative impact, there is a need to factor this into everyday decision-making and to disclose in a consistent and comparable way the effects on enterprise value. Investors are looking for information on the monetary value of that impact. 

There is a need to develop a mechanism to take impact into account and creating it will require collaboration.

When nearly two thirds of investors globally say they want sustainability reporting to describe the impact a company has on the environment and society, it’s time to listen. That’s what we heard in our most recent global investor survey. The sentiment was reiterated in the investor workshops we facilitated with the World Economic Forum, where investors told us that “there needs to be a meaningful way to articulate the value of the impact of sustainability action or inaction and how it is associated with financial impact”. 

In a previous article, we discussed why sustainability reporting has reached an inflection point where we need a common language to provide a holistic view of company performance, and then why it’s now critical to bring together the various emerging definitions of materiality in a sustainability context. In this article, we build on the previous two by asking whether a company’s external impact can and ultimately will affect its valuation. We believe the answer is yes. 

Today, society pays when business does not. That may start to change.

A company’s impact on the world around it has not always been attributed to an economic value or cost. The widely-held assumption has been that any actions a business takes that have a negative impact on others – provided those actions stay within the law – are externalities for which society and the environment pays rather than the company. The result? Until a company’s impact starts to affect its finances, it will likely have limited effect on its enterprise value. 

This assumption is, however, starting to be questioned. There is a growing recognition that, over time, externalities will become internalised and directly affect a company’s cash flows, its access to finance and, therefore, its enterprise value. For example, in a world of constant scrutiny, a company exposed as behaving in unsustainable ways may face higher costs, lose market share, struggle to attract talent, or even forfeit its licence to operate in some communities or countries. Conversely, a company that demonstrates its positive impact consistently over time builds trust with consumers, investors and others, which may create a positive contribution to cash flow and thus to value.

Take two identical beverage companies for example, where the only difference is one is very efficient in how it uses water (Company X) and the other is highly inefficient (Company Y). The  price of water is unlikely to currently show up in the financial statements even given forecasts of unthinkable global shortages of fresh water. But, there is an exposure. If the price of water were to reflect market realities and rise, there would be a big difference in the cost to each of the companies. Investors will be interested to understand this so that they can gauge how likely it is that Company Y will need to change its operating model, when this might happen and what it might cost. 

Our global investor survey showed that of those investors who want impact information, 66% want to see companies disclose the monetary value of that impact. They believe that disclosing this information would help companies understand the full economic effect of their business decisions and encourage them to address the ESG-related issues to which they contribute. But currently, 87% of investors think that corporate reporting contains at least some greenwashing. These concerns erode trust in what companies say about how they are addressing sustainability risks and opportunities and make it difficult for the investment profession to allocate capital where it needs to go. Most instances of greenwashing arise when organisations don’t realise they’re providing an incomplete picture of their external impact, or lack the ability or information to assess it. As a result, they’re more likely to judge their negative external impact to be immaterial to their future cash flows.  

Valuation models might not adequately capture sustainability factors.

There is some concern that today’s valuation models might not adequately capture sustainability factors, even if they have the potential to affect cash flows or cost of capital in the not-too-distant future. This points to a need for greater transparency and a more holistic view of value and risk. We often see the backlash from businesses’ impact hitting them at high speed once stakeholders become aware of it. The effect is that the pricing of externalities tends to be abrupt rather than gradual. The capital markets need a mechanism to capture this in order to improve the allocation of capital, while business needs the management information to inform itself and be prepared to effectively allocate resources. But even when these preparations are made, currently they are often carried out in an inconsistent and unsystematic way. 

How different sustainability strategies could affect valuation over time

To gauge the consequence of external impact, it’s first necessary to put an economic value or cost on that impact. Quantifying the monetary cost to society of unsustainable strategies and business practices will enable companies and stakeholders to compare different areas and types of impact across different businesses, while also empowering management teams to prioritise actions to improve their impact. 

By way of example, take two identical coal producing companies. Company A is fully committed to achieving net zero greenhouse gas emissions by a target date and transparently communicates the plan to achieve this, while Company B plans to keep operating as it always has for the foreseeable future. The two businesses have the same enterprise value today because there’s currently no internalised cost resulting from the impact of either strategy. 

However, over time the cash flows will diverge.  Company A may need to incur capital expenditure to transition its operations, while Company B may incur capital expenditure to expand its capacity.  Depending on coal prices, either strategy could lead to higher profits in the near term.  In the longer term, driven by factors like increasing environmental regulation and taxes, carbon pricing mechanisms, and customers seeking lower-carbon alternatives, there is an increased risk that Company B will have more stranded assets than Company A. This is the type of insight the market needs to assess the value impacts over the medium and long term.

Visibility into impact is increasingly important to achieve but complex to have. 

Having a clear and comparable view of a company's external impact—positive and negative—could profoundly change decision making, ranging from investors' voting decisions and assessments of management's stewardship of assets, to customers’ buying choices, to the company’s internal operating and strategic decisions, and ultimately its enterprise valuation. In terms of consumers’ behaviour, we’ve already seen shifts where sustainability impacts are driving changes, for example buying electric vehicles or eating a plant-based diet. And as for investor choices, suggestions of greenwashing have been enough to trigger sharp falls in some companies’ stock prices. What’s more, similar dynamics could apply in the social domain. Take board diversity for example, if one company takes credible steps to improve board diversity and another doesn’t, the one that does will have a larger pool of human capital to draw from. Over time, being the first mover may have real economic implications.

While the benefits of putting an economic value on external impact may be clear, the solution is less so. Today’s methods have significant shortcomings. For example, a carbon market price is usually a poor proxy for the cost of the environmental impact on society, as it’s actually a reflection of the market setup – essentially the supply of and demand for allowances. Carbon offset credits are a price for the cost of an investment to remove emissions, meaning they also bear no direct resemblance to impact. And while the cost of carbon mitigation is a useful figure, it too is not a measure of impact. In each case, the social cost of carbon would typically be far higher, amounting to the economic damage resulting from emitting one additional tonne of carbon dioxide into the atmosphere. Putting a monetary value on this damage is an important step towards factoring it into decisions. However, this still leaves unclear the timing and extent to which this cost might ultimately be borne by the business.  

As companies do more to take action on their impact - there is a need to work towards a standardised methodology to factor this in to decision-making.

Some companies are getting ahead of the curve. For example, Walmart has pivoted over the years to embrace the robust business case for investing in sustainability: its initiatives today include the world’s largest private sector supply chain decarbonisation programme – Project Gigaton – as well collaborations with NGOs ranging from the Environmental Defense Fund to the World Wide Fund for Nature. In the US, Big Tech companies’ demand for sustainable energy is pushing electricity generators to invest in more wind and solar power. Chemical companies are also collaborating with their customers to improve impact: take BASF’s partnership with Samsung Heavy Industries around Onboard Carbon Capture and Storage (OCCS).

The reality is that external impact can – and likely ultimately will – come back to bite or benefit the business causing it. And this cycle of cause-and-effect is accelerating as stakeholders become better informed. The companies and industries we’ve just mentioned are pursuing the upside opportunity this presents. As to the downside, even if management currently sees little prospect of the impact becoming internalised in the foreseeable future – whether through the traditional route of regulation or through the newer, fast growing route of changed behaviour by stakeholders – that’s no reason to ignore the risks it presents. There have been examples where the dramatic knock-on effect of health and safety incidents involving workers have accelerated and catalysed business to improve its impact. 

The inescapable conclusion? Even if negative impact currently appears to present little financial risk to the business, there’s a likelihood that – one day – customers, employees, regulators, NGOs and other stakeholders will care about it. At that point, the business will have a problem to solve. So companies should be looking to put an economic value on their external impact, and run scenarios for the effects on their business if and when it becomes internalised. While they’re distinct from the externality’s cost to society, those effects could extend to the business’s operating model, market share, talent, licence to operate – even to disruption of its entire industry. To be fully prepared, management needs to clarify the value at risk, quantify the effect if the impact is fully priced in, and factor this assessment into everyday decisions, including on capital planning and allocation.

Most capital allocation frameworks in use today are focused on assessing investments in tangible assets and other established areas such as R&D and brand building, but are insufficient for scenario planning for events whose scale and timing remains unclear. So, where to begin? In our view, the vital first step is the creation of an agreed, standardised and globally-accepted methodology for quantifying the societal cost or economic value of external impact. Agreement on such a methodology would enable comparisons between the impact created by different companies, and provide companies themselves with a robust basis for assessing what that impact would mean in financial terms. 

An important component of a suitable methodology will be the right ‘coefficient’ – defined as the relationship between sustainability KPIs that track impact of various types and the related economic effect on people and the planet. Initiatives like the Value Balancing Alliance, the Capitals Coalition and the recently-formed Harvard Business School International Foundation for Valuing Impacts (IFVI) are working to meet this need. Meanwhile, the Global Reporting Initiative (GRI) Standards provide information about the types of corporate activities that can lead to externalities – i.e., what the impact is. Identifying the right coefficient will not only provide an economic ‘amount’ at the micro level that could enable external impact to be factored more accurately into internal decision-making, external risk assessment and ultimately enterprise valuations. It will also open the way to faster and more aligned progress towards tax regimes that take impact into account, and rebasing measures of countries’ growth from ‘pure’ financial GDP to GDP net of impact.

A number of pioneering companies are already voluntarily providing detailed impact reporting. For over a decade, PwC has been using its Total Impact Measurement & Management (TIMM) framework to advise some of them. As more organisations join the movement, progress on determining how to attribute an economic value to impact will accelerate. Past experience from other areas of reporting, such as intangibles, shows that the standards ultimately follow the practice established by the early innovators. So to pave the way for standard-setting and mandatory reporting on impact, we need a groundswell of companies to start testing new approaches, identifying what works and then report voluntarily.

Three steps to assess your company’s impact

There are three steps you can take now to understand and communicate your company’s impact on the environment and society, helping you build trust with your stakeholders and inform your own business decision making.

  1. Assess the effect your activities may be having on the environment or communities around your business. Ask yourself:

    • Who are your key stakeholders – investors, employees, regulators, local communities and more – and how much does your external impact matter to them?

    • How is your impact creating, exacerbating or helping to solve massive systemic issues like climate change, loss of biodiversity, income inequality, racial injustice, plastic pollution or tech-driven disruption of jobs?

  2. Consider

    • Whether this impact affects your cash flows and/or access to finance today. 

    • Whether it could start to influence cash flows and/or access to finance in the future. Economic modelling techniques can be used to calculate both the external cost or benefit to society and the internal financial effect. Many traditional valuation tools may be applicable here, such as running scenarios to see how different events might change the future value of customers and the workforce.

  3. Report your impact. 

    • Focusing on what your stakeholders need to know about your impact and how you are managing it. 

    • Be balanced in reporting your positive impact and transparent about your negative impact.

We all need to take part in developing a systemic solution.

As we embark on this journey, time is short. We’re already over two years into the “decade of action” to tackle the climate crisis, and need to collaborate and develop the standard methodology quickly. If the speed of the world’s response is to match the urgency of the challenge, we must have information on the economic value of impact flowing through the system as soon as possible.

Our overall message? We believe there’s an increasingly urgent need to assign an economic value to a company’s external impact and, in turn, find a way to internalise it in its decision making and valuation. Businesses, standard setters and capital market participants all have a role to play in making this happen. As the world strives to address many daunting global issues, companies should actively seek to become part of the solution, even if this uncovers uncomfortable facts. Quantifying the economic value of impact will provide a more holistic picture of corporate performance, enabling management teams to make more informed decisions and helping stakeholders – including consumers and investors – make better choices about their relationship with each business. All of which will incentivise more sustainable corporate behaviour, to the benefit of all. And the time to begin this journey? Today.

We thank Aaron Gilcreast, Ellen O’Rourke, Hendrik Fink, Pragya Jain, Susanne Stormer and Will Evison for their insightful contributions to this article.

Follow us

Contact us

Nadja Picard

Nadja Picard

Global Sustainability Reporting Leader, Partner, PwC Germany

Tel: +49 (0)211 9812978

Andreas Ohl

Andreas Ohl

Global Sustainability Technical Leader, PwC US

Tel: +1 973 236 4000

Tom Beagent

Tom Beagent

Partner, PwC United Kingdom

Tel: +44 7973 565380