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green@work : Magazine : Back Issues : May/June 2003 : Analyze This

Analyze This
What can a company's energy expenditures tell potential investors about the performance of its stock?

by Jackson W. Robinson


Apparently, plenty. In fact, those at the U.S. Environmental Protection Agency’s Energy Star® program are so convinced that energy management can play a role in determining stock performance, they have introduced new metrics designed to help potential investors judge how a company manages energy. While it will take time to prove the effectiveness of these new metrics, money managers that practice green investing or socially responsible investing are likely to embrace and test them, because the metrics can provide another valuable tool for predicting company performance.

One of the shortcomings of traditional financial analysis is that it does not adequately measure intangible factors, such as corporate responsibility and the quality of management—even though these factors can have a profound impact on stock prices. Having a means to measure these factors could prove invaluable.

So is there a relationship between energy management, which is measurable, and the overall quality of management? Energy Star thinks there is. In fact, evidence is mounting that says managers who care about energy conservation and the environment also care about their shareholders. Likewise, companies that use energy efficiently are likely to operate efficiently in other areas as well. More importantly over the long run, companies that use energy efficiently are reducing investor risk stemming from global climate change.

New studies by Innovest Strategic Value Advisors, a financial research firm, support these conclusions:

* Innovest studied 12 companies in the commercial real estate sector and found that, during the past two years, stocks of companies with above-average energy efficiency outperformed stocks of companies with below-average energy efficiency by 34 percentage points.

Note that the spread is not 34 percent, but 34 percentage points. The six most energy efficient companies finished the two-year period ending in June 2002 with a return of just over 30 percent, while the six least energy efficient companies finished with a return of minus four percent. Anyone investing in the below-average companies would have a loss of four cents for every dollar invested in the six companies for the past two years, while anyone investing in the top six companies would have a two-year gain of 30 cents for every dollar. (See chart 1, page 40.)

* In a separate study of 12 retail foods companies, Innovest found that companies with above-average energy efficiency outperformed below-average companies by 17 percentage points over the past three years.

Innovest does not claim that energy management is solely responsible for the superior performance of the companies it studied, but that energy management has a “proxy value for management quality.”

“Effective environmental management is one of the most complex challenges facing management,” according to the Innovest report. “It is implied that companies dealing well with this high level of complexity have the sophistication to succeed in other parts of the business and thereby earn superior returns.”

Although the number of companies included in the studies is small, they represent a majority of each industry on a market-cap basis. In addition, Innovest has studied the broader environmental performance of stocks in more than 50 different sectors and has concluded that stocks of companies with above-average environmental performance outperform those of companies with below-average environmental performance by three to 30 percentage points a year.

Likewise, Energy Star has found that public companies that have joined the Energy Star program have thus far outperformed companies that are not participating by more than six percentage points a year. No wonder green portfolio managers are beginning to look for the Energy Star label when they consider new investments.

Why Energy Matters
The link between performance and energy efficiency is likely to become even more pronounced with the recent surge in energy prices caused by war in the Middle East and the political turmoil in Venezuela and Nigeria. This link is probably clearest in the commercial real estate industry, where energy is the single largest operating cost, accounting for a third of all operating expenses, according to Environmental Quality Management. Energy Star reported that the best performing buildings use only about a fourth as much energy as poorly performing buildings.

As a result, energy upgrades in commercial buildings typically have a 20 to 30 percent rate of return and require little risk. Based on a 10 percent capitalization rate, a building owner can generate two or three dollars in incremental asset value for each dollar invested in energy conservation.

A 30 percent reduction in energy costs can increase net operating income by five percent, according to Innovest. Using the income approach to appraisal, a five percent increase in net operating income would result in a five percent increase in the asset value of the building. If the building is in the portfolio of a real estate investment trust (REIT), the higher asset value would support a higher share price. Likewise, if the building is owned by a public company, it can have a positive impact on the value of company shares, and signal to analysts and money managers that the company is well managed and is operating efficiently.

Energy Star has plenty of anecdotal evidence to support these conclusions. One real estate company involved in the Innovest study compared operating costs in buildings that meet Energy Star criteria with those that do not and found that operating costs were 5.17 percent lower in buildings that met the requirements, which translated to a savings of $13 million a year. Energy costs alone decreased by 19 percent.

Likewise, a grocery store chain calculated that its energy program generated enough savings to improve earnings per share for its parent company by 10 cents in 2002. The chain created a “Team Energy” task force that targeted its 250 least energy efficient stores. Once energy management was improved at those stores, the task force shared what it had learned with others throughout the company, so that energy costs could be managed better at all 1,222 stores in the chain. (See chart 2, page 41.)

Companies can improve their performance when they reduce energy costs, because by reducing operating expenses, they free up cash that can be put to other, more productive uses, boosting profit margins. Energy conservation can also improve the company’s public image, create a competitive advantage, improve employee morale and perhaps even create new business opportunities. In addition, when companies reduce their energy use, they also reduce their greenhouse-gas emissions, which reduces their exposure to liability from climate change, which is expected to become a major issue over the next few years.

These benefits can act as a catalyst to encourage businesses to undertake energy efficiency programs, but only if the new metrics are adopted and supported by the financial community.

Energy Star’s Metrics

While the metrics being introduced by Energy Star will be useful to investors, they will also help managers of companies within each of the 26 different industries for which metrics have been developed.

Businesses don’t invest significant amounts of capital into new projects unless they can reasonably determine the potential return on their investment. Energy Star’s metrics will help managers measure energy costs relative to other variables, and to compare the results with the collective average of similar companies within their industry. Commercial real estate companies, for example, will be able to compare their energy costs in relation to sales, cash flow, net operating income, operating expenses and assets to see how they measure up with other companies in their industry.

To use Energy Star’s Energy Exposure Index (EEI) to calculate energy expenditures as a percentage of cash flow, for example, the equation EEI = (EX/TCF) can be used, where the energy efficiency index equals energy costs divided by total cash flow.

By itself, the percentage of cash flow that goes to pay energy costs is useless, but Energy Star will provide an opportunity for businesses to compare their performance with that of other businesses not only in their own industry, but with similar operating conditions. A commercial real estate manager, for example, will be able to use a whole-building performance rating, comparing each building with results from other buildings that are similar in size and construction, that are located in a similar region, and that are being used for a similar business activity.

Energy costs for a building in Boston, MA, obviously will differ from the costs of a building in San Diego, CA. By taking these differences into account, a company will be better able to determine where it stands, relative to other companies in the same industry and with the same operating conditions.

A Positive Program

The new metrics are an extension of an already successful program. Energy Star already represents more than 5,700 organizations that have committed to invest in energy efficiency. The Energy Star label is ubiquitous on appliances and electronic equipment. Now, in addition to introducing its new metrics, Energy Star is forming affinity relationships with investment firms that are willing to use its metrics as a non-exclusive screen.

Clearly, Energy Star is working because it works with businesses to help them reduce costs. It demonstrates that being green can be good for the environment and the bottom line. Environmental regulators are often criticized by businesses for imposing costly restrictions that make it more difficult for them to compete, but Energy Star’s new metrics demonstrate that environmental responsibility can benefit businesses and the environment at the same time.


Jackson W. Robinson is president and portfolio manager of Winslow Management Co., an investment management firm specializing in green investing based in Boston, MA.

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