Show Me The Money

In ‘Reflect, Reset, & Go’ (2024), the argument was once again made that sustainability initiatives must be explicitly tied to future cash flow generation. These notes have long contended that sustainability has opened a new chapter in corporate finance, one that demands measurable value creation for shareholders. Show me the money!

But it is easier said than done. While the costs of implementing sustainability initiatives are typically well-defined, their benefits are often uncertain. For instance, how can savings be financially modeled without any reasonable view of the long-term price of externalities such as carbon emissions, water, air pollution, or biodiversity degradation? To a frequent and thorny investor topic, based on what financial assumptions should capital be allocated between climate mitigation and adaptation?

I would argue that the challenge posed by these questions is not fundamentally distinct from the traditional risks inherent in investing in innovation. Consider that many R&D projects span five to ten years, if not more, with firms similarly unable to predict future market dynamics, consumer preferences, regulations, or technological advances—witness the disruption caused by DeepSeek this week.

And yet, institutions routinely allocate substantial budgets to innovation. Private corporations invest more than $1 trillion in annual R&D investment globally, with R&D-to-sales ratios ranging from about 5% in capital goods to 20% in pharmaceuticals – huge costs for uncertain, if not questionable, benefits. Even a posteriori, R&D productivity is notoriously difficult to measure.

Notwithstanding, investors institutionally accept that, under a proper governance setup, R&D helps build competitive advantages, leading to superior financial performance. Sustainability warrants the same latitude as R&D: both are bets on future relevance and financial performance.

So, what can be learned from best practices in R&D portfolio management?

First, sustainability initiatives must be fully aligned with corporate strategy.

Second, consistent with the main theme of this note, projects must be ruthlessly prioritized using financial criteria (e.g., net present value, internal rate of return, payback time) based on reasonable scenarios.

Third, the project portfolio must be balanced across several dimensions, including risk/return and time horizon. Sustainability cannot be exclusively a long-term game. Short-term wins (e.g., energy-efficiency retrofits with short-term paybacks) are critical to build credibility and fund longer-term bets.

Finally, projects must be regularly reviewed following a stage-gate strategy, ensuring continuous portfolio pruning and capital reallocation.

Firms have an opportunity to develop and market their approach to sustainability innovation to stakeholders, building on their approach to traditional R&D. They can lead investors to the right questions, be ready to provide the right answers, and, in doing so, establish themselves as (financial market leaders – as anticipated in ‘Just Imagine (A 2025 Investor Day)’ (2022).