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Master Thesis

Accounting, Strategy and Control (ASC)

MSc in Economics and Business Administration Copenhagen Business School

–––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––

Student: Anna Hsiu-Nu Yu Fagerberg (58602) Student: Ching Yi Chung (114755)

Supervisor: Ole Vagn Sørensen Total of characters:218,089

Number of pages: 114 Hand in date: 16th May 2021

In the proliferation of sustainable investing, factoring sustainability in conventional

fundamental analysis

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Abstract

With huge surge in sustainable funds inflows and empirical studies showing a better risk-adjusted return, interest in sustainable investing has burgeoned. However, how to fully reflect sustainability issues in the valuation of firms is rather unknown.

Consequently, the research question of “How to factor sustainability performance of a firm in fundamental analysis?” has been raised. This leads naturally to the discussion of conventional fundamental analysis and why it has been missing its relevance in the modern context. Grounded on Stakeholder theory as well as the Triple Bottom Line, and by following the structure of conventional fundamental analysis, a sustainable fundamental analysis model, which aims to accounts for sustainability performance, has been formulated.

The model theorizes that when examining a firm’s impacts on all its stakeholders and on economic, social and environmental dimensions, the materiality of those impacts would unfold. A material impact would then become a strategic value driver. By aggregating the strategic value drivers’ material impacts on the financial value drivers, a firm’s value from a sustainability perspective could then be determined by following the standard valuation approaches. In order to elaborate on the transition from sustainability performance to firm value, a case study, which is a valuation of Vestas Wind Systems A/S, has been performed to exemplify the implementation of the proposed model in a real-life context and how sustainability issues drive value creation.

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Table of Contents

ABSTRACT ... 1

1. INTRODUCTION ... 4

1.1. BACKGROUND &MOTIVATION ... 4

1.2. RESEARCH GAP AND PROBLEM STATEMENT... 5

1.3. PURPOSE AND THESIS STRUCTURE ... 8

2. METHODOLOGY ... 10

2.1. RESEARCH PHILOSOPHY... 10

2.2. RESEARCH APPROACH ... 12

2.3. RESEARCH DESIGN ... 12

2.4. RESEARCH STRATEGY ... 14

2.5. RESEARCH DATA SOURCE ... 14

2.6. RESEARCH VALIDITY AND RELIABILITY ... 15

3. THEORETICAL FRAMEWORK ... 16

3.1. SUSTAINABLE INVESTING ... 16

3.2. A STAKEHOLDER THEORY OF FIRM &STAKEHOLDER MODEL ... 18

3.3. SUSTAINABILITY THEORIES ... 21

3.3.1. Corporate Social Responsibility (CSR) ... 21

3.3.2. The Triple Bottom Line ... 22

3.3.3. Corporate sustainability ... 23

3.3.4. Measure Sustainability ... 25

3.3.5. The implication of environmental performance on financial performance ... 26

3.3.6. The implication of social performance on financial performance ... 28

3.4. A CONVENTIONAL FUNDAMENTAL ANALYSIS MODEL ... 29

3.5. A SUSTAINABLE FUNDAMENTAL ANALYSIS MODEL ... 32

3.5.1. Focal firm stakeholders’ interests ... 33

3.5.2. Supply chain stakeholders’ interests ... 34

3.5.3. Beyond supply chain stakeholders’ interests ... 36

3.6. THE CONSTRUCT OF THE PROPOSED MODEL ... 38

4. COMPANY PRESENTATION ... 41

4.1. COMPANY BACKGROUND ... 41

4.2. COMPANY ACTIVITIES ... 43

4.3. OWNERSHIP STRUCTURE AND MANAGEMENT ... 44

4.4. CORPORATE SUSTAINABILITY ... 45

5. STRATEGIC ANALYSIS AND DISCUSSION ... 48

5.1. ECONOMIC DIMENSION ... 49

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5.1.1. Focal firm stakeholders ... 50

5.1.1.1. PEST analysis ... 50

5.1.1.2. Porter’s five forces analysis ... 53

5.1.1.3. VRIO analysis ... 58

5.1.1.4. Employee salary and career development ... 60

5.1.2. Supply chain stakeholders ... 60

5.1.3. Stakeholders beyond the supply chain ... 62

5.2. SOCIAL DIMENSION ... 63

5.2.1. Focal firm stakeholders ... 63

5.2.2. Supply chain stakeholders ... 64

5.2.3. Stakeholders beyond the supply chain ... 65

5.3. ENVIRONMENTAL DIMENSION ... 67

5.3.1. Focal firm stakeholders ... 67

5.3.2. Supply chain stakeholders ... 69

5.3.3. Stakeholders beyond the supply chain ... 71

6. FINANCIAL ANALYSIS AND VALUATION ... 74

6.1. REFORMULATION OF THE FINANCIAL STATEMENTS ... 74

6.2. FORECAST ASSUMPTIONS ... 76

6.2.1. Revenue growth ... 77

6.2.2. EBITDA Margin ... 79

6.2.3. Depreciation and amortization ratio ... 81

6.2.4. Tax rate ... 82

6.2.5. Net borrowing rate... 83

6.2.6. Intangible and tangible asset ratio ... 84

6.2.7. Net working capital ratio ... 85

6.2.8. NIBL/IC ratio ... 86

6.2.9. Summary of forecast assumptions ... 88

6.3.VALUATION ... 91

6.3.1. Valuation model ... 91

6.3.2. Weighted average cost of capital (WACC) ... 93

6.3.3. Pro forma statement and expected market value of equity ... 101

6.4. SENSITIVITY ANALYSIS ... 104

7. CONCLUSION & CONTRIBUTION ... 106

7.1. SUMMARY ... 106

7.2. ACADEMIC CONTRIBUTION ... 108

7.3. EMPIRICAL IMPLICATIONS ... 109

8. LIMITATIONS AND FUTURE RESEARCH ... 113

REFERENCES ... 115

APPENDIX ... 133

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1. Introduction

1.1. Background & Motivation

Sustainable investing has hit the mainstream over the past few years, nevertheless, the Covid- 19 pandemic has brought it further under the spotlight of the capital market. All major investment firms have launched multiple funds incorporating environmental, social and governance (ESG) metrics, such as BlackRock, J.P.Morgan, Vanguard, Fidelity, etc. According to a recently published statistic by Statista, the value of sustainable investment assets grew by more than 68 percent on a global scale between 2014 and 2018 (Norrestad, 2020). Moreover, the expansion of ESG funds has reached a record pace in 2020. As reported by MorningStar, sustainable funds in the United States alone have attracted more net flows in the first 7 months of 2020 than they did in all of 2019 (Hale, 2020). Likewise, governments and intra- governmental organizations have been strong advocates for sustainable investments. In January 2020, the European Commission released the European Green Deal’s Investment Plan aiming to mobilize at least €1 trillion to support sustainable investments over the next decade.

The business case for sustainable investing seems to be rather sound. The business case here denotes the underlying rationales supporting the capital market’s preference for sustainable investing. Friede et al. (2015) in their meta-analysis of over 2000 empirical studies have found that around 90% of studies exhibit a non-negative relation between ESG criteria and corporate financial performance. Further, the majority of studies even exhibit positive relation, where the positive ESG impact on corporate financial performance has shown to be stable over time (Friede et al., 2015). Lodberg et al. (2020) have reached a similar conclusion by comparing investment returns with and without the demand for sustainability during the period from the end of 2007 until the end of April 2020. Their empirical study has shown that adding a sustainability element in investment portfolios can actually improve the average risk-adjusted

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return and reduce portfolio volatility, both in stable periods and in times of crisis, such as the subprime mortgage crisis, corona pandemic, etc. (Lodberg et al., 2020).

Despite its popularity, there has not been a formal definition of sustainable investing and the scope covered by the term seems to be rather broad. Before diving further into the discussion, sustainable investing/investment in this research would be referred to creating businesses of enduring value through ensuring that all relevant economic, social and environmental factors derived from both the short-term trends and secular forces are accounted for when assessing risk and return. In other words, to invest in companies aim to optimize and prudently balance theirs financial, social and environmental value in the long term (KPMG International, 2020;

PRI, 2019; Schoenmaker, 2018).

1.2. Research gap and problem statement

Under the context of sustainable investing, investors and other stakeholders seeking to comprehend a firm’s risks and opportunities increasingly demand to consider its sustainability issues (Koller, 2017), as the ever-changing societal value affects the business environment.

For instance, the growing concern for the environment and health has created a lucrative market for the organic food industry, with the compounded annual growth rate (CAGR) of the organic food market projected to land at 17% (2018-2027), comparing to the 3.1% (2021-2025) for the overall food market (Statista, 2021). Consequently, an organic food production firm will no doubt have a better growth opportunity than a non-organic food production firm, which could be materialized into financial gains. However, sustainability efforts are only material to a business to the extent they affect cash flows, which means diverse sustainability factors might not have identical material impact on the cash flows of firms (Koller, 2017). For instance, companies with a traditional corporate social responsibility (CSR) program that supports employee volunteering in the community are unlikely to produce extra value, as in most of the

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times this type of effort does not intersect with their business (Whelan & Fink, 2017). Thus, a fundamental analysis, which assesses a firm’s business model and its underlying value drivers, is required to translate a firm’s sustainability efforts into plus or minus numbers on its cash flow (Schoenmaker, 2018).

However, the conventional fundamental analysis approaches focusing solely on the economic and financial dynamics, such as market size, productivity, labor as well as material cost, financial cost, etc. (De Luca, 2018; Petersen et al., 2017), have long overlooked the social and environmental factors that also constitute the world that a business operates in. As discussed in the aforementioned example, changes in societal values affect consumer preference over products and services. In this sense, given the material effect of social and environmental factors on a business’s cash flow, conventional fundamental analysis approaches that disregard those impact cannot fully capture the value of a firm. As a matter of fact, some investment firms have been enforcing the integration of the ESG analysis into the fundamental financial analysis carried out by analysts and portfolio managers (Eccles & Klimenko, 2020). Thus, in order to accurately assess the true value of a firm and perform sustainable investing, a fundamental analysis approach that enables insights into social as well as environmental impacts is indispensable.

Through a quick search in the database of Web of Science with key words, such as sustainable investing, ESG integration, value driver, and sustainability/long-term, we have found over 100 articles. After screening through the articles, around 40 research were relevant to the subject of sustainable/ESG investing. Based on our search result, 20 out of 40 research done on sustainable investing have been concentrated on whether portfolios constructed with ESG scores elements can increase risk-adjusted return (Hua & Michalski, 2020; Kaiser, 2020; Kang et al., 2020; Stotz, 2021; Maxfield & Wang, 2020; Bodhanwala & Bodhanwala, 2019; Durán- Santomil et al., 2019; Mikołajek-Gocejna, 2016; Lesser et al., 2016; Utz et al., 2015; Teti,

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2015; etc.) and quite some research looked at the current development of sustainable investing (Zaccone & Pedrini, 2020; Pinney et al., 2019; Cappucci, 2018; Kotsantonis & Serafeim, 2016;

etc.). Nevertheless, we have found only three studies (Schramade, 2016; Schoenmaker &

Schramade, 2019; Chowdhury et al., 2019) that have touched upon the materialization of ESG issues in the valuation process.

Chowdhury et al. (2019) investigated the effects of a firm’s CSR activities on its value in the oil and gas industry and discovered that CSR activities were not equally value‐additive. And activities within employee well‐being and community development had more significant impact on the market value of firms than environmental activities in the oil and gas industry (Chowdhury et al., 2019). In order to invest in long-term value creation, Schoenmaker and Schramade advocated in their article for a fundamental analysis approach rather than a ESG ratings approach (2019). They further elaborated the reason for institutional investors struggling to invest sustainably and proposed changes in financial system to facilitate this process (Schoenmaker & Schramade, 2019). Lastly, Schramade suggested a Value Driver Adjustment approach, which specified the process of linking ESG factors to value drivers from conventional fundamental valuation (2016).

Thus, this paper intends to complement the few extant research on full ESG integration in the valuation of firms, through constructing a fundamental analysis model that integrates sustainability issues in the valuation process. Accordingly, the problem statement of this research is:

How to factor sustainability performance of a firm in fundamental analysis?

In order to address this problem statement, the following sub-questions need to be answered:

1. Who would be affected by a firm’s operation?

2. What are the impacts of a firm from a sustainability perspective?

3. How could those impacts translate into value?

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1.3. Purpose and Thesis structure

Much discussion has been on whether sustainable investments generate a higher return.

Nevertheless, this research aims to formulate a fundamental analysis model that accounts for sustainability issues, which influence the intrinsic value of a firm. With a sustainable fundamental analysis model, the transition from sustainability performance to firm value would become more tangible, in the sense that the sustainability impacts are linked with financial value drivers, which determine future cash flow generation capability. Unlike most extant research, which examine the artefacts (market data) to verify whether sustainability performance generates a higher value, the formulation of a sustainable fundamental analysis model in this research is to better understand how sustainability affects firm value.

In order to construct such a model, theories in sustainable investing, fundamental analysis, firm theory, and corporate sustainability would be explored to identify who would be affected, what are the impacts from a sustainability perspective, and how those impacts translate into value. However, the model can only showcase how sustainability affect value in theory. In order to elaborate on the transition, a case study, which is a valuation of Vestas Wind Systems A/S (Vestas), would be performed to exemplify the implementation of the proposed model and how sustainability issues drive value creation.

This paper has, as aforementioned, identified a research gap, where few sustainable investing research has been conducted on integrating ESG factors in the valuation process. The problem statement reflects the concern of the gap in the theoretical field. The investigation of the relevant literature and theories bridges the gap and further delves into the development of a model, which is to be applied to a case company. It is noteworthy that the case example is not to substantiate the model but to show the application of the model.

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The thesis encompasses this idea and is structured in the following manner (Figure 1). Firstly, it starts with an introduction to elaborate the motivation for the chosen topic and present the problem statement and research question in addition to the structure of this paper. The second chapter presents methodology, including the research philosophy, research approach, research design, research strategy, data source, and research validity as well as reliability. Chapter 3 looks into the relevant literature and theories, including the stakeholder theory, Triple Bottom Line, conventional fundamental analysis and the development of the sustainable fundamental analysis model. The basic information of the case company is provided in chapter 4. In Chapter 5, the strategic analysis based on the model is conducted. The relative financial analysis and valuation of the case company are carried out in Chapter 6. Chapter 7 concludes the findings and academic as well as empirical implications. Lastly, the final chapter elaborates on the limitation of this thesis and the future research recommendations.

Figure 1: Thesis structure flow chart (the authors’ own creation)

Motivation & Research Question Chapter 1 Introduction

Chapter 2 Methodology

Chapter 7 Conclusion and contribution Chapter 3 Theoretical Framework

Chapter 4 Case Company

Chapter 5 Analysis and discussion

Chapter 6 Forecast and valuation

Chapter 8 Limitation and future research

Research approach and design

Stakeholder theory and TBL

Case Company presentation

Sustainable fundamental analysis

Assumptions and DCF&EVA

Summary & Implication

Limitation and recommendation

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2. Methodology

The aim of this section is to shed light on the research methodology used to answer the research question in this paper. Firstly, the section will introduce the research philosophy and research approach. Secondly, the research design, strategy and date sources will be elaborated. Finally, the validity and reliability of the research will be presented.

2.1. Research philosophy

The research philosophy contains important assumptions about the way in which the researcher views the world as well as shapes all aspects of the research paper (Saunders et al., 2015). The research is formed by ontological and epistemological orientations by the researcher (Bryman & Bell, 2015). Ontology refers to assumptions about the nature of reality and that determines the way how the researcher sees and studies the research objects (Saunders et al., 2015). Epistemology concerns the assumption about knowledge and how to communicate knowledge to others (Saunders et al., 2015). This paper’s ontological assumption is that the concept of sustainability does not only offer the ethical and moral value of a firm but also, to some extent, it has material effects on the firm’s value. The epistemology of this paper is a theoretical sustainable fundamental analysis model described in text and visualized as a diagram.

Saunders et al. (2015) describe that “positivism relates to the philosophical stance of the natural scientist and entails working with an observable social reality to produce law-like generalizations”. This paper relies on the use of strategic analysis to develop strategic value drivers as objectively as possible, thus a Positivism is deemed suited. It builds on epistemological objectivism which seeks to discover the truth about the material values of

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sustainability through observable and measurable facts and numbers (Saunders et al., 2015).

Positivism focuses also on causality and generalizations, and that is the intention of the paper to examine the causal relationship of sustainability and firm’s value in order to construct a more comprehensive model from current conventional fundamental analysis.

Further, this research paper operates in the objective functionalist paradigm from one of Burrell and Morgan’s (1982) four paradigms (Figure 2).

Figure 2: Four Paradigms for the analysis of social theory (Source: Burrell & Morgan, 1982)

This paradigm concerns rational explanations and develops sets of recommendations within the current structures (Saunders et al., 2015). The key assumption underlying is that organizations are rational entities, in which rational explanation offers solutions to a rational problem (Saunders et al., 2015). That aligns with our paper aiming to objectively find the set of strategic value drivers linking with sustainability attributing to the financial value drivers within the current fundamental analysis. The purpose of the model is to lead to the production of a more credible firm valuation.

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2.2. Research approach

This paper adopts a deductive approach as a process that employs existing theories to deduce a proposition that is subjected to empirical findings (Bryman & Bell, 2015). The conclusion based on the deductive approach is true when all the premises are true (Ketokivi & Mantere, 2010). The existing theory will be applied to the literature reviews and trend observations and leads to findings. For this study, the premises deducted from our research question is based on current literature and previous research on the connection between sustainability and the firm’s value. It explores the existing theory of fundamental analysis and developing a contemporary model incorporated with sustainability perspective.

Using a deductive approach enables the search to explain causal relationships between sustainability concept and variables and establish the reasoning for including the sustainability perspective in fundamental analysis (Saunders et al., 2015). Additionally, the concept of sustainability values is constructed in a way to make the material effect measurable. The deductive approach is chosen for this paper because it offers the researcher a wealth of literature from which a theoretical framework can be formulated (Saunders et al., 2015).

2.3. Research design

According to Kerlinger and Lee (2000) that research design is a plan, structure and strategy of investigation conceived with respect to obtain answers to research questions and to control variances. It involves the collection, measurement, and analysis of numerical or non-numerical data. The paper adopts a mixed qualitative and quantitative method and is descripto- explanatory study in nature.

The qualitative approach emphasizes words rather than quantification in the collection and

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analysis of data (Bryman & Bell, 2015). It is an attractive method as it provides the researcher rich data for the research topic. The qualitative research strategy in this paper starts with a deductive approach to review existing theories, such as sustainability and finance literatures, using qualitative procedure (Yin, 2014). Later, the qualitative method is also used to analysis qualitative data from public sources, such as news/articles, market reports, press releases, annual reports, industry research, in the case study. The qualitative assessment of the material effects is conducted through strategic analysis by means of the newly formulated sustainable strategic analysis framework.

Quantitative research is generally associated with a deductive approach, where the focus is on using data to test the theory. It refers to the generation or the use of quantifiable data and has an objectivist conception of social reality (Bryman & Bell, 2015). Using a quantitative method in this paper, the quantitative data, such as the financial performance data of the case company, is collected, and financial analysis of the quantitative data is conducted based on financial models and formula.

A descriptive research is to gain an accurate profile of events, persons or situations where an explanatory research establishes causal relationships between variables (Sanuder et al. 2015).

Descriptive research can be seen in the middle of the order, usually functioning as an extension of a previous exploratory, or as a forerunner to an explanatory research (Saunders et al., 2015).

Based on the topic and the purpose of the research, this thesis includes certain descriptive elements, which investigate and describe how sustainability fits in the conventional valuation model. The purpose is in pursuit of explaining the connection between sustainability and firm value. In other words, this research paper utilizes descriptive research as a means to be a precursor to explanation which represents a descripto-explanatory study.

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2.4. Research strategy

The research strategy in this paper divides into two, the literature review and case study (Saunders et al., 2015). The digitalization and online search increase the scope of research and provide a rich source of data, both qualitative and quantitative. The literature review fits this paper in gaining insight on sustainability topics and in formulating a sustainable fundamental analysis. A case study is an in-depth inquiry into a topic or phenomenon within its real-life setting (Yin, 2014). Saunders et al. (2015) define that an explanatory case study is using theoretical propositions to test their applicability in the case study, to build and verify an explanation. In the scope of this paper, the case study is to perform a valuation on a case company, specifically Vestas. However, the purpose of the case study is not to validate the model but to illustrate how the model can be implemented in real-life context.

2.5. Research data Source

This research paper is conducted preliminary through desk research. The theoretical and empirical data as well as information collected in this thesis are not primary data but secondary draws upon secondary sources. Secondary data can be understood as all extant information and data that have been collected by others in the field already (Saunders et al., 2015). The main objective was to gather financial data, statistics, trends, and information about sustainable development and investments. The secondary data can be sourced variously from economic literature, scientific and business journals, government publications, annual reports, press releases, PowerPoint presentations, internet searching, social media posts, database, and so forth. Thus, all data and information in this paper are collected from secondary sources.

The secondary data will be analyzed and applied to the constructed model and to the valuation of the case company.

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2.6. Research validity and reliability

Reliability and validity are central to judgment about the quality of research in the natural sciences and it refers to replication and consistency (Saunders et al., 2015). A study is reliable if consistency is ensured during the research and the same findings could be replicated by another researcher provided the same data collection techniques and analytical procedures (Saunders et al., 2015). The research follows a positivistic philosophy and is done in a value- free way to keep objective on the data collection and quantitative analysis as much as possible.

This ensures other researchers could use the same data and methodology to replicate the same findings in the case study. This paper is based on secondary data from public sources and the financial reports are audited, which minimizes the bias characteristics and increases reliability.

Validity refers to the suitability of the measures employed, the accuracy of the analysis and the generalizability of the findings (Saunders et al., 2015). The sustainable fundament analysis model, which demonstrates a causal relationship between sustainability performance and their material effects on firm value, draws upon existing academic theories. Thus, it is believed that the model has internal validity. However, since it is not the purpose of the research to verify the formulated model, the authors cannot be certain of its level of generalizability.

Nevertheless, a case study has been conducted to illustrate the implementation of the model in real-life context, which might be able to enhance the model’s external validity.

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3. Theoretical framework

3.1. Sustainable investing

The past few years has seen a marked growth in interest in sustainable investing from both retail and institutional investors, and the millennial and female investors are believed to be the driving force of such shift in wealth management (Pinney et al., 2019). Sustainable investing is an investment approach that takes both financial and non-financial dimensions of a firm’s performance into account when analyzing and assessing firm value (Duuren et al., 2016;

Eurosif, 2016). This investment approach is rooted in the belief that including ESG information would benefit both investors and society (Duuren et al., 2016). While sustainable investing practices performed by investors vary (PRI, 2019), there are seven common strategies in use (Eccles & Klimenko, 2020; Duuren et al., 2016). Specifically, negative/exclusionary screening - where certain companies or industries such as tobacco are excluded from investment portfolios; norms-based screening – to eliminate companies that violate norms and regulations; positive screening – where investment cluster around some particular industries; Best-in-class investing – to select companies with strong ESG performance; impact investing – looking for companies that work to produce positive impact;

active ownership – where investors actively engage with the management of the companies;

and ESG integration – where ESG factors are included in the investment process (Eccles &

Klimenko, 2020; Duuren et al., 2016).

It is said that early adopters embarked the sustainable investing journey with negative screening strategies, where they just simply excluded stocks deemed unethical. Consequently, some idiosyncratic risks were not properly diversified, while delivering effortless, handsome profits to unethical stockholders (KPMG International, 2020). In order to realize the positive impact of sustainable investing, a full integration of ESG factors in the investment process is

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required to best exploit both ESG risks and opportunities (Cappucci, 2018). However, as mentioned earlier in the Introduction, much recent academic research have been concentrated on the financial performance of the inclusion of ESG factors with similar methods and yielding similar results (Duuren et al., 2016), where they benchmark performance of high ESG scored portfolios with low ESG scored ones or the market. This bears a close resemblance to most investment professionals’ approach in sustainable investing, where they apply aggregated ESG ratings to buttress their investment portfolios (Schoenmaker, 2018; Schoenmaker &

Schramade, 2019).

Despite its pronounced efficiency in providing a quick view of a firm’s sustainability effort, ESG ratings have been criticized as imprecise approximation of a firm’s sustainability performance, as materially negative ESG issues can be compensated by high scores on immaterial ones, due to non-transparent, ‘industry neutral’ methodologies in calculating the ESG scores (Schoenmaker & Schramade, 2019; Pinney et al., 2019). Adversely, there has been reported a low correlation in scores between rating agencies (Entine, 2003; PRI, 2016;

Schoenmaker & Schramade, 2019; Pinney et al., 2019). Sustainable investing is about material ESG performance, which varies by industries (Eccles & Klimenko, 2020). Thus, a proper ESG integration approach would require careful interpretation of multiple sources of ESG-related opinions and linking it to the value drivers of a firm (PRI, 2016; Schramade, 2016; Eccles &

Klimenko, 2020).

To ensure a systematic assessment of material ESG issues in the investment process, Schramade has proposed a Value Driver Adjustment approach (Figure 3) that factors sustainability issues in conventional fundamental analysis by linking ESG factors to value drivers (2016). This three-step approach starts with reviewing the industry, the company and identifying material ESG issues. Once material ESG issues are located, an analyst can embark on assessing the impacts and linking them to financial value drivers (Schramade, 2016). The

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theoretical framework presented later in this research is heavily inspired by Schramade’s Value Driver Adjustment approach (2016).

Figure 3: Value Driver Adjustment approach. (Source: Schramade, 2016)

3.2. A stakeholder theory of firm & Stakeholder model

Stakeholders are defined by Freeman et al. (2010) as groups and individuals that can affect or be affected by activities associated with value creation of a firm. And stakeholder theory underscores the interest of a variety of stakeholders, who are capable of exerting impact on the viability of a firm if their interests are not met (Garvare & Johansson, 2010). Thus, stakeholder theory, which aims to facilitate understanding of the complexities of business, postulates that a firm should aim to create as much value as possible for all stakeholders via effective management of stakeholder relationships, which would result in financial gains – the ultimate goal (Freeman et al., 2010).

Institutional theory explains the behaviors and practices of an organization as its attempt to conform to external pressure, such as the cultural-cognitive, normative, and regulative structures. Consequently, the theory predicts that companies would adopt similar behaviors over time as a result of imitation or similar external constraints (Herold, 2018). Similar to the stakeholder theory, institutional theory emphasizes an organization’s dependence to the external environment. However, the institutional theory is less comprehensive, as it focuses

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only on external pressure and homogeneity of behaviors but neglects internal stakeholder’s interest and the heterogeneity of organizational responses (Herold, 2018). On the contrary, resource-based view suggests that sustained competitive advantage derives from the resources and capabilities of a firm, including tangible and intangible assets, management skills, information and knowledge it controls, etc. (Barney et al, 2011). The theory shifts the focus on a firm's internal resources but ignores dependencies of a firm to external environment.

Hence, stakeholder theory, which accounts for both internal and external factors, seems to hold a rather holistic view of firms.

As affirmed by Jensen (2001), the objective of a firm according to the stakeholder theory is highly in congruence with the value maximization proposition rooted in 200 years of wisdom from economics and finance research. He further states that long-term market value of a firm cannot be created without accounting for its stakeholders’ interests in which the firm exists (Jensen, 2001). Accounting for a broad group of stakeholders’ interests can also be seen as an analogy for the internalization of externalities from economics theories. Due to the complexity in business environment, what is financially viable today may incur losses in the future.

Likewise, negative externalities that are accepted today might induce huge financial penalties tomorrow under societal pressure. Thus, firms that can anticipate and internalize externalities (stakeholder interests) would be more capable of creating value (Schoenmaker & Schramade, 2019).

Moreover, stakeholder theory acknowledges the potential conflict of interests among stakeholders and states that it is the executive’s job to manage and shape these relationships, and the tradeoffs are made to the extent that it creates even more value for each stakeholder (Freeman et al., 2010). On the other hand, it highlights the underlying mutual interests and interdependencies of stakeholders, which significantly affects the total value created by a firm (Harrison & Wicks, 2013). Lastly, stakeholder theory extends the view beyond short-term

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shareholder value maximization and adopts a broader societal embeddedness perspective of a firm, which is in consistent with the principle of corporate sustainability, where the emphasis is on the interdependencies between firms and its societal and ecological environment (Hörisch et al., 2014). Thus, in this research, we adopt a stakeholder perspective in viewing a firm and share its understanding of a firm’s objective, where effective management of stakeholder relationships is regarded as a means to an end, where the end is firm value creation (Benson & Davidson, 2010).

Grounded on stakeholder theory and corporate sustainability, in order to achieve sustainable competitive positioning and ensure long-term enterprise success, it is required to take explicit consideration of the focal firm, its supply chain and the broader context within which the firm operates (Searcy, 2016; Edgeman & Eskildsen, 2014). Thus, a three-level stakeholder model (Figure 4) was proposed by Searcy (2016) to comprehensively identify the stakeholders and measure not only the economic impact but also the limits and demands on environmental and social resources. Specifically, the stakeholders are divided into three levels, namely focal firm level, supply chain level and beyond the supply chain level. Employees, unions, managers, and owners/investors are regarded as focal firm stakeholders. In terms of supply chain level, both forward supply chains and reverse supply chains are accounted for, as end-of-life product management is of essential significance in measuring the full impact of the supply chain.

While forward supply chain denotes the activity flow from raw materials to finished goods and then consumption, reverse supply chain consists of activities necessary to dispose or recover value from the consumed product. Thus, suppliers, distributors, consumers, and reclaimers are all included as supply chain stakeholders (Searcy, 2016).

Without consideration of the context where the business operates, performing valuation of a firm is of limited value. In this sense, the interests of external stakeholders such as government, communities, competitors, NGOs, and media should be taken into account to generate a

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holistic insight of a firm. Nevertheless, it is important to stress that a firm’s control over and accountability to various stakeholders would not be identical and its impact on each stakeholder might also vary over time (Searcy, 2016).

Figure 4: Key stakeholders for enterprise sustainability. (Source: Searcy, 2016)

3.3. Sustainability Theories

3.3.1. Corporate Social Responsibility (CSR)

The concept of Corporate Social Responsibility (CSR) was traced back to 1953 where American economist Howard Bowen discussed the business ethics and social responsibility of a company toward society and its relevance toward stakeholders (Taticchi & Demartini 2021).

CSR grew its attention in 1970 where Milton Friedman’s ‘Social Responsibility of Business’

theory induced debates whether the social responsibility of businesses is to create profit for its shareholders while complying with basic rules in society or businesses have a greater social responsibility beyond simply producing goods and services for a profit. The latter is the theory

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behind the concept of CSR (Carroll, 2013). Caroll expresses that CSR “encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time” (Carroll, 1979).

Later in 1991, Carroll constructed the CSR pyramid and rephrased discretionary responsibilities to philanthropic responsibilities, and it has become one of the most influential models helping managers to integrate social responsibility into economic concerns. The pyramid claims that the businesses have responsibilities for a range of stakeholders other than owners, and it suggested that a firm “should make a profit, obey the law, be ethical, and be a good corporate citizen via philanthropy” to be socially responsible (Caroll, 2013). Firms started to engage in CSR initiatives in the 1990s, but the scope was rather small and often limited in specific activities. Many firms, then and now, see CSR as another cost or tax of doing business (Taticchi & Demartini, 2021).

3.3.2. The Triple Bottom Line

The phrase, "people, planet, and profit" (3Ps) to describe the concept of the Triple Bottom Line, was coined by John Elkington in 1994 and that changed the narrative on CSR scope (Taticchi & Demartini 2021). Triple Bottom Line is derived from the “pressure growing from governments and their citizens for business to measure and manage the impacts and outcomes of its behavior in a range of areas” (Elkington, 1998). The idea of Triple Bottom Line encourages businesses to track and manage economic, social, and environmental responsibilities and their value added (Elkington, 2018). These three areas of responsibility represent the elements of a new equation of accessing a company’s sustainability involving economic prosperity, environmental quality, and social equity. (Elkington, 1998).

The Triple Bottom Line posits that profitability requires people and social capital and presents

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firms with a business case to make decisions that are socially and environmentally responsible while pursuing the financial bottom line. The firm can be considered sustainable, when it can manage all three dimensions of performance (Taticchi & Demartini 2021). Figure 5 illustrates the idea of the Triple Bottom Line where sustainability occurs in the intersection of the three dimensions. The Triple Bottom Line concept has been adopted by many organizations and agencies. United Nation in its 2005 World Assembly reaffirmed that sustainability achievement is in balancing economic, social and environmental aspects (Wilson, 2015). Perroni et al. in 2006 also incorporated Triple Bottom Line concept to define CSR as

“the voluntary integration of economic, social and environmental objectives in the relationship with company stakeholder network”. Triple Bottom Line consisting of the three pillars of economic, social and environmental responsibility is rooted in pursuing and accessing sustainability.

3.3.3. Corporate sustainability

Taticchi & Demartini (2021) in their book “Corporate Sustainability in practice” elaborate on corporate sustainability with three prominent concepts. Firstly, the concept of ESG describes the integration of environmental, social and governance factors into corporate’s investment

Figure 5: Triple Bottom Line 3P Formulation. (Source: Kisacik & Arslan, 2017).

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processes (Taticchi & Demartini, 2021). Governments, consumers and investors are pushing companies to incorporate ESG practices into their business operations. The corporate leaders are therefore held accountable by shareholders for ESG performance and need to integrate sustainability into their investing criteria (Eccles & Klimenko, 2019). A firm is generally being measured by ESG indicators for its ESG performance. A strong management of material ESG issues brings a real competitive advantage (Schoenmaker & Schramade 2019).

Secondly, the concept of “Creating Shared Value” introduced by Porter & Kramer in 2006 proposes to “look at sustainability based on the principle of shared value to achieve economic value by reconnecting business to social progress and create social value” (Taticchi & Demartini, 2021). Creating shared value lies at the core of new business opportunities and pushes the company to integrate sustainability into its business strategy and create competitive advantages (Taticchi & Demartini, 2021).

The third concept is the “purpose” related to sustainability that emerged both from the company and various stakeholders. The purpose forms a powerful force giving the company a direction on what to focus on in order to attain competitive advantages and achieve sustainability. To sum up, corporate sustainability is the sustained creation of shared value with stakeholders and the integration of ESG factors in business practices (Taticchi & Demartini, 2021).

The discussion encompassing corporate sustainability is incomplete without recognizing the

“triggers'' that push firms to attain sustainability. Based on the extensive literature review, Seuring and Müller identify legal demands and regulation as the most prominent pressures and followed by the response to stakeholders mainly government and consumers (2008). These stakeholders support the companies that making money but at the same time also contribute to the society. This stakeholder perspective is away from the traditional focus only on creating

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profits on financial bottom line for shareholders. These pressures give the companies the incentives to do well by doing good. The stakeholders hold the businesses accountable for their code of conduct in sustainability dimensions. This is crucial in helping firms to develop long-term strategic objectives and achieving higher economic performance.

3.3.4. Measure Sustainability

It is important to address the measurability of sustainability. The metrics are evolving in the three dimensions and need to be considered in an integrated way (Elkington, 1998). There are no universal standard measures for calculating the impact from three dimensions.

Stakeholders will be the force who drive the Triple Bottom Line calculations, which are subject to the experts and data availability and are vary from company to company (Fernandes, 2020).

The economic bottom line is the profit, the tangible figure on the financial statement. But how should a company access its business operations being economically sustainable? It is to measure the economic capital, which includes not only the financial capital and physical capital but also human capital in the knowledge economy we are in today (Elkington, 1998).

The indicators for the economic bottom line, such as a company’s investments, its sustainable products or services, its sustainable innovation programmes and its 'business ecosystem', can reflect its long-term economic sustainability (Elkington, 1998).

The Environmental bottom line is to measure how environmentally responsibly a firm carries out its business operations. It is to access the environmental impact of the usage of its natural capital (Elkington, 1998; Księżak & Fischbach 2018). Many governmental regulators held companies accountable for their environmental performance. Likewise, the environmentalist and media campaigns do hold companies responsible in this aspect as

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well. The environmental performance indicators related to materials, energy and water are the ones that are directly related to the production processes and costs (Hourneaux et al., 2014). Other indicators such as emissions, effluents and waste, environmental aspects of products and services, biodiversity, compliance, and general environmental issues could have a direct or indirect impact on production process and costs (Hourneaux et al., 2014). A number of companies take the impact of environmental externalities on to their financial statement such as provision for fines, legal costs, decommissioning costs, etc. (Elkington, 1998).

The social bottom line is to measure how socially responsible a firm carries out its business operations. It represents the assessment of the firm’s social capital of “the ability of people to work together for common purposes in groups and organizations” (Elkington, 1998). Familiar social performance indicators are animal testing, community relations, employment diversity and equity, labor working conditions, irresponsible marketing, political contributions, etc.

(Elkington, 1998). The social dimension relies on improving the standard of living to develop a good relationship between society and the focal firm (Księżak & Fischbach 2018). It could have a direct or indirect impact on the firm’s business. For instance, corporate governance addresses the firm’s efforts to comply with the regulations that are related directly to business operation such as uphold the minimum wage requirement, which can help to secure employee’s well-being. Firms can also act socially responsible to avoid possible ethical conflicts. For instance, using animal testing in developing products or using child labor to assemble products, both consequently can have a significantly negative impact on a firm’s reputation.

3.3.5. The implication of environmental performance on financial performance

A review of extant literature in recent years on the relationship between environmental performance and financial performance shows the positive links between them. Manrique and

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Martí-Ballester (2017) conducted a sample of 2982 large firms from 2008 to 2015 and found that the adoption of environmental practices significantly and positively affects the corporate financial performance in developed and developing countries, especially in developed countries. A study of firms in the S&P 500 concluded that a 10% reduction in emissions of toxic chemicals results in a $34 million increase in market value, though these effects vary across industries (Konar & Cohen, 2001). Guenster et al. (2011) also found that eco-efficiency relates positively to operating performance and market value. Likewise, several other studies have confirmed the positive relationship between corporate environmental performance and corporate financial performance (Nakao et al., 2007; Albertini, 2013; Muhammad et al., 2015).

Firms with better environmental performance are consistently found to have higher market value than firms with poor environmental performance. Some studies furnish evidence of an inverse relationship between a firm’s environmental performance and its market value. For example, the low polluting firms are evaluated with a market value higher than the high polluting firms that have concealed environmental liabilities (Jones & Ratnatunga, 2012). The decrement is found economically meaningful, ranging from between 15% and 25% of market capitalization (Jones & Ratnatunga, 2012). Similarly, the firms that act proactively in supporting early environmental management practices contribute to the positive relationship between corporate environmental performance and corporate financial performance (López- Gamero et al., 2009).

“It pays to be green” suggests that all firms should adopt a proactive environmental strategy which can help the firm to gain competitive advantage (Orsato, 2006). The economic benefit of becoming green tends to appear to occur 1-2 years later in the sequent period after adopting the proactive environmental strategy (Jones & Ratnatunga, 2012). Advocates argue that pursuing green is no longer a cost of doing business. It is, on the other hand, a catalyst for

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innovation, new market opportunity, and wealth creation (Clarke 1994). Sharfman and Fernando’s study (2008) of 267 U.S. firms shows that environmental performance reflects the level of risk, and it matters to investors as firms exhibiting better environmental performance benefit from a lower cost of capital. Significant improvements in environmental performance are associated with a higher level of financial performance such as return on assets (Ramanathan & Ramanathan, 2018) as well as cash flow from operations (Jones & Ratnatunga, 2012). The firm’s environmental performance is also associated with the riskiness of future cash flows in respect to the changes in environmental legislation, possible litigation and other uncertainties related to environmental issues (Jones & Ratnatunga, 2012). Additionally, environmental information disclosures reduce the information asymmetric and consequently decrease the corporate risk (Chang et al., 2021).

In respect to the relationship between environmental performance and stock performance, for environmental performance to have share price implications, the firm has to reveal sufficient and quality environmental information, so the investor can evaluate the impact on its financial performance and risk profile (Jones & Ratnatunga, 2012). The share price reaction is associated with relevant environmental information and the stock market reacts especially at the company’s published news about environment pollution fines (Lorraine, 2004). Moreover, the return of the green fund is higher than that of the non-green fund is found in the Chinese Green mutual funds study in the period of 2010-2016 (Yuan, 2017).

3.3.6. The implication of social performance on financial performance

Research in this field suggests that good corporate social performance can improve corporate financial performance. However, although the relationship between corporate social performance and corporate financial performance is generally positive, it is inconclusive about the relationship between corporate social performance and the bottom line

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(Schnietz & Epstein, 2005). Corporate social performance improves financial performance in terms of helping firms to build a positive reputation and goodwill. This strengthens the trust relationships with stakeholders and investors and can even cushion the stock price during prickly market tides. Internal financial measures such as return on asset and external measures like stock price are strongly related to corporate social performance. A bi-directional relationship between corporate social performance and corporate financial performance implies that corporate social performance impacts subsequent corporate financial performances and corporate financial performance impacts subsequent corporate social performance (Rakowski, 2010). In other words, a firm that is social responsible can positively impact its finance performance and a firm with good finance performance can devotes more into societal investments which lift up its social performance.

Socially responsible policies transform into higher profits and higher profits transform into socially responsible policies (Rodriguez-Fernandez, 2016). Margolis and Walsh (2001) summarized the 95 empirical studies and found that the majority of results point to a positive relationship between corporate social performance and corporate financial performance. Some empirical evidence shows that during the 2008–2009 financial crisis, firms with high social capital, as measured by corporate social responsibility (CSR) intensity, had stock returns that were four to seven percentage points higher than firms with low social capital (LINS et al., 2017). There are studies also showing that social programmes may lead to better corporate social reputation and indirectly to increased sales (Gimenez et al., 2012).

3.4. A conventional fundamental analysis model

Fundamental analysis is a method of valuing a security’s intrinsic value through examining its business activities and making financial projections with respect to macro factors.

Fundamental analysis approaches are built on the premise that business operation is the main

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momentum underlying a firm’s value creation (Petersen et al., 2017). Consequently, it is meaningless to analyze a firm financial performance and ratios without reference to its business model, when assessing a firm’s viability (Petersen et al., 2017; De Luca, 2018).

Likewise, it is impossible to investigate a firm’s ability to create value, if the economic and financial impacts of those strategic choices are not measured (De Luca, 2018). Thus, both the qualitative analysis of strategic as well as operational activities and the quantitative analysis of financial measures are crucial to estimate a firm’ value (Petersen et al., 2017; De Luca, 2018).

Petersen et al. have defined operational actions of a firm as its strategic value drivers, while a firm’s financial measures are termed financial value drivers (2017). They further articulate that strategic value drivers such as market expansion, new products, and technological advancements are the input factors that affect financial value drivers such as revenue growth rate, profit margins etc. - the output factors. Through aggregating varying impacts on financial value drivers, a firm’s intrinsic value is then measured (Petersen et al., 2017). As various fundamental analysis models are inherently identical, in this research, we would adopt the fundamental analysis model (figure 6) suggested by Petersen et al. (2017).

Figure 6: Fundamental analysis model. (Source: Petersen et al., 2017)

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In the model constructed by Petersen et al. (2017), eight financial drivers are proposed based on the sales driven principle, where different accounting items are driven by level of business activity. Specifically, the eight financial drivers are revenue growth, profit margin, depreciation and amortization ratio, tax rate, interest rate (net borrowing rate), intangible and tangible asset ratio, net working capital ratio and net interest-bearing liabilities ratio. These eight key financial value drivers together with their relevant accounting items quantify the financial performance of a firm. Additionally, the proposed financial value drivers can be disaggregated into several financial value drivers when more detailed information is available (Petersen et al., 2017). For instance, revenue growth can be replaced with revenue growth by regions or by business units.

On the other hand, the exact value of each financial value driver is dependent on its related strategic value drivers. In other words, a strategic analysis is required in order to estimate the level of each financial value driver. Thus, a top-down strategic analysis, where firstly macro factors, then industry factors and lastly firm-specific factors are identified and their effects on a firm’s operation are assessed, should be performed before making any assumption on the level of and trend in financial value drivers. PEST analysis, which stands for political, economic, social, technological factors analysis, is frequently applied to detect macro factors that might potentially affect a firm’s financial performance.

In terms of industry factors, Porter’s five forces analysis is best fit to illustrate the competition and earning potential of an industry. Value chain analysis or VRIO analysis derived from Resource Based View (RBV) can be adopted to assess a firm’s competitive advantages gained from effectively utilization of internal resources (Barney, 1991), while a SWOT matrix can be used to summarize the findings from PEST analysis, Porter’s five forces analysis, and Value chain analysis/VRIO analysis into strengths, weaknesses, opportunities and threats. Once the strategic analysis is finalized and strategic value drivers are identified, linkages between

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financial and strategic value drivers can be established, assumptions are to be made and firm valuation will be able to be conducted. Lastly, it is important to stress that the presented approach rests on the assumption that there is access to public information only (Petersen et al., 2017).

3.5. A sustainable fundamental analysis model

It is apparent that there is a distinct difference in the underlying principles between sustainable investing/stakeholder theory and the conventional fundamental analysis approaches. While literatures on sustainability and stakeholder theory repeatedly emphasize a firm’s accountability to all levels of its stakeholders, mutual interests of stakeholder and potential tradeoffs, conventional fundamental analysis approaches focus only on the direct impacts from the macro, industrial, firm-specific factors to the financial performance of a firm. As indicated by Freeman et al. (2020), the real issues lie in a value chain (narrow) versus a value network (holistic) view on business. A value chain perspective sees all other players that are directly or indirectly involved in a business/transaction as a means to the desired outcome for the shareholder, where as a value network sees the interdependencies of stakeholders and each stakeholder must contribute and benefit from the business/transaction to achieve continuing flourishing (Freeman et al., 2020). Thus, in order to construct a sustainable fundamental analysis model, the strategic analysis must be expanded and adopt a stakeholder perspective to comprehensively identify all relevant strategic value drivers that can affect the financial value drivers.

Grounded on the Value Driver Adjustment approach (Schramade, 2016), Key stakeholders for enterprise sustainability model (Searcy, 2016) and Triple Bottom Line (Elkington, 1998), an expanded strategic analysis would require the inclusion of social and environmental dimensions as well as supply chain and beyond supply chain stakeholders. Further, as

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stakeholder theory is built on the assumption that balancing different stakeholders’ interests is the key to value creation, the focus of an expanded strategic analysis would be to list stakeholders’ interests on economic, social and environmental dimensions, rather than following a top-down approach that reflects a one directional linear relationship. Given stakeholders’ various interests, an interest that is well or improperly managed might become a strategic value driver dependent on its potential material impact. In the remaining section, we will explore the interests of all levels of stakeholders on economic, social and environmental dimensions.

3.5.1. Focal firm stakeholders’ interests

Investors’ interests have been well covered by abundant economic researches and they are generally concerned about the return on their investments – a firm’s profitability. As discussed earlier, macro, industry, firm-specific factors influence a firm’s earning potential (Petersen et al., 2017). For instance, economic and social factors, such as recession caused by the COVID- 19 pandemic and rising awareness of heathy lifestyle, affect market growth; whereas political and technological factors, such as social welfare (e.g. free education in Europe vs high tuition in US generates a gap in salary level), employment law and government spending on research, affect a company’s cost in operating in a market. Thus, the existing strategic analysis, comprised of PEST, Porter’s five forces and VRIO analysis, is well-equipped to advocate for investors’ interest on the economic dimension.

In terms of social dimension, investor’s interest would be concentrated on corporate governance, as rigorous corporate governance lowers the risk of corporate scandals, reduce agency costs (Aras & Crowther, 2008) and attain societal legitimacy through conforming to political, social and ethical norms (Nwabueze & Mileski, 2008). Consequently, business ethics (bribery and corruption), management of the legal and regulatory environment (compliance)

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and incident risk management are suggested as elements for measuring the effectiveness of the corporate governance of a firm (SASB, 2018; Ruggie & Middleton, 2019).

A firm as a whole must be concerned of the carrying capacity of the ecosystem, as the production inputs rely on the availability of resources (Aras & Crowther, 2008). For instance, paper manufacturers cannot produce any papers without trees, and fishing industry would not exist without fishes. Eco-efficiency, which denotes the efficiency of the use of environmental resources (Figge & Hahn, 2013) and concerns the efficiency in the consumption of energy, raw materials and the emissions of greenhouse gases (GHGs) (Park & Behera, 2014), has been widely adopted to showcase a firm’s interest on environmental sustainability.

Lastly, employee well-being is frequently associated with concepts such as health and safety, better work‐life balance, diversity and equal opportunities, working hours and wages, staff development and training (Kobayashi et al., 2018). These concepts can then be viewed as an employee’s interest in an organizational context.

3.5.2. Supply chain stakeholders’ interests

The stakeholder model for enterprise sustainability constructed by Searcy (2016) defines a supply chain from a life-cycle perspective, where end-of-life product management is also considered as a part of the supply chain. In order words, the stakeholders within a supply chain would include companies (e.g. reclaimers) that specialized in recycling and disposal of products. On the economic dimension, economic benefits (Yang et al., 2017) together with supply chain disruption (Hofmann, 2014) have been found to be important factors for sustainable supply chain implementation. Suppliers, distributors and reclaimers’ economic interest would thus be their individual value creation potential in a supply chain, while customers generally demand value (measured by utility) for money – product quality and

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