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

TLDR

Sustainable development requires considering all forms of capital, not just economic, and the return on capital must cover its cost. The study develops and applies a valuation methodology to calculate the cost of sustainability capital and assess sustainable value creation in companies. The methodology calculates opportunity costs of different capital forms, aggregates them into a cost of sustainability capital, and derives sustainability efficiency and sustainable value creation. The methodology enables efficient allocation of sustainability capital for value creation and is demonstrated by valuing BP’s sustainability performance.

Abstract

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 opportunity costs to the valuation not only of economic 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 expanding 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 performance of British Petroleum (BP).