6. Discussion

The Adjusted Present Value (APV) framework is a very general and useful framework to assess the potential financial impact of deviations from market values or other modifications of the project. It is heavily used in the real world, mostly in the context of tax savings surrounding financing decisions.

    

In this section, we have briefly seen how to extend the APV-framework to incorporate important environmental, social, and governance (ESG) elements of investment decisions, for which there is no binding market price. The proposed procedure is as follows:
 

  • Base Case NPV: First, compute the project's base case NPV using binding market prices throughout the valuation (put differently, ignore the non-binding carbon price for the moment).
     
  • Adjusted Present Value (APV): Then investigate how the Base Case NPV changes if we incorporate non-binding market prices, in our case a price estimate for the social costs of carbon emissions. 
     
  • (Qualitative) Discussion of other side effects: Finally, discuss in detail what other relevant non-financial side effects the project might have, and how they could be measured.

    

Such a capital budgeting framework allows decision makers to make more sensible investment decisions, as it shows the different sources of value (destruction) explicitly and in a transparent way. Equipped with this information, managers should be better able to make capital budgeting decisions that secure an adequate long-term return for the financial investors, while adhering to important environmental, social, and governance criteria. Ultimately, is will be up to the top management of the company to define specific guidelines with respect to how to solve the trade-off between purely financial and non-financial goals. 

  

Market Integration

Finally, it is important to note that the framework presented above is by no means a static framework:

  • The increasing pressure from investors and the general public will inevitably lead to the emergence of market or quasi-market mechanisms to internalize some of the most important environmental, social, and governance costs of corporate investment decisions.
     
  • As a result, many of the elements that can only be qualitatively described today (step 3 above), will be easier to price with such (quasi-) market mechanisms, so that they can be reflected in a standard APV framework (step 2 above).
     
  • Moreover, many government and regulatory initiatives indicate that some of the factors that are non-binding today will eventually be mandated by law. As a result, they will reflect an "objective market price" and they will become an integral part of the base case valuation of a project (step 1 above). For example, such a move from step 2 to step 1 could occur if the government decides to levy a carbon emission tax on fossile fuel prices.

 

In fact, many of the achievements of modern social market economies have undergone the stepwise evolution from an originally qualitative element to a legally binding factor cost. Think of all the achievements in the context of worker protection and welfare (e.g., job safety, retirement planning, maternity or paternity leave, etc.). 

 

We should therefore be confident that the market will eventually find appropriate solutions to the pressing challenges surrounding the sustainable use of the available resources. The primary role of the regulators and the international organizations will be to define the legal framework and to provide the necessary incentives so that market solutions can emerge in a timely manner.