T4- Part B – Case Study Papy – Sustainable trading case – September 2011 REPORT by Chartered Institute of Management Accountants

T4- Part B – Case Study Papy – Sustainable trading case – September 2011 REPORT To: Chief Executive of Papy From: Management Accountant Date: 31 August 2011

Review of issues facing Papy Contents 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Introduction Terms of reference Prioritisation of the issues facing Papy Discussion of the issues facing Papy Ethical issues and recommendations on ethical issues Recommendations Conclusions

Appendices Appendix 1 Appendix 2 Appendix 3 Appendix 4 Appendix 5 Appendix 6 Appendix 7 Appendix 8

SWOT analysis PEST analysis Carbon emission targets Savings in carbon emissions from the solar panels proposal Evaluation of proposal for new freezer cabinets Summary of savings in carbon emissions and comparison to targets Comparison of capital costs and carbon emissions savings between the 2 proposals Part (b) - Presentation and graph on proposals to reduce carbon emissions

1.0 Introduction Papy is a large food retailer with over 1,100 stores across 8 European countries. A new Chief Executive, Lucas Meyer, has recently been appointed and he would like to change Papy in order for the company to become a more sustainable retailer. A small team has been established, headed up by Arif Karp, the newly appointed Corporate Affairs Director, to identify and implement proposals to reduce carbon emissions. This team is also tasked with bringing about change within the company. 2.0 Terms of reference I am the Management Accountant appointed to write a report to Lucas Meyer, Chief Executive of Papy supermarket chain which prioritises, analyses and evaluates the issues facing Papy and makes appropriate recommendations. I have also been asked to prepare a presentation on the savings in carbon emissions that could be achieved by the proposals to replace the freezer cabinets at 500 stores and install solar panels at 200 supermarkets, together with a graph showing Papy’s carbon emissions as measured by “carbon emissions in kilograms (kg) per square metre of sales area”. This is included in Appendix 8 to this report.

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3.0 Prioritisation of the issues facing Papy 3.1 Top priority – Management of change The top priority is the need to manage the change in Papy in order for it to become a more sustainable retailer and to meet the new targets for carbon emissions If Papy is serious about becoming more sustainable then there is a need to change the culture of the company. Changing a company’s culture takes time but the process needs to be started. Papy currently rewards its employees with free shares based on a range of financial targets but this will need to change to include a wider range of measures including Papy’s level of carbon emissions. 3.2 Second priority – Carbon emission targets This is considered to be the second priority as the Chief Executive wants to make substantial reductions in carbon emissions by investing in new technology, such as solar panels and freezer cabinets, in order to achieve these carbon emission reductions. The targets cannot be achieved without investing in new initiatives. Papy’s current levels of carbon emissions are higher than all 3 of its direct competitors and therefore its competitive advantage will be reduced unless action is taken. 3.3 Third priority – Solar panels This large scale investment at 200 supermarket stores will reduce electricity usage, by generating up to 30% of these stores’ current electricity needs by the solar panels on the roof of each store. This is a large investment for 200 supermarket stores at a capital cost of €3 million each. This proposal represents a total investment of €600 million which is a very significant investment. However, it would clearly show to all stakeholders that Papy is serious about reducing its carbon emissions. The project will also generate significant operating cost savings. However, an investment of this size would significantly increase Papy’s gearing. 3.4 Fourth priority – Freezer cabinets The fourth priority is considered to be the proposal to change the freezer cabinets at 500 stores in order to bring about energy savings and reductions in carbon emissions. The total capital expenditure is €85 million. This is still a large investment, but much less significant than the proposed investment in solar panels. This investment would affect 500 stores in total and would also result in a one-off write off against the current year’s profits of €25.0 million for the old freezer cabinets.

A SWOT analysis summarising the strengths, weaknesses, opportunities and threats facing Papy is shown in Appendix 1. A PEST analysis is shown in Appendix 2.

4.0 Discussion of the issues facing Papy 4.1 Overview Papy operates a successful and profitable chain of supermarkets, which generated revenues for the year ended 31 December 2010 of almost €13 billion. The profit for the last financial year was €454.4 million after tax and finance costs. Papy’s gearing was only 29.25% (debt of €870.0 million / debt plus equity of €870.0 million + €2,104.4 million) which is materially lower than its competitors’ gearing levels at 40%. Papy has also repaid debt of €150 million in the last financial year. So there is room to increase debt financing in order to fund the proposals to reduce Papy’s carbon emissions which are set out in this report. Papy’s interest cover is 9.5 which is high and demonstrates a good ability to pay the interest on its current debt.

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In order to become more sustainable and reduce its carbon emissions, Papy will need to change the way in which it operates in order to reduce electricity consumption which in turn will result in long-term savings in operating costs. European companies which do not reduce their carbon emissions will be subject to possible fines in the future as the first deadline of 2020, which was agreed in the Kyoto protocol, becomes closer. Therefore, the proposals for change in order to become more sustainable and to set reduced carbon emission targets and 2 proposals to reduce carbon emissions all reflect the right attitude for a large listed European company to embrace. 4.2 – Management of change There is a need to get all employees involved in Papy’s proposed change to become a more sustainable retailer. Without employee “buy in” the company will not be successful. The case material states that many members of Papy’s senior management team consider themselves too busy to become involved. This is a disappointing response from some of Papy’s senior management. There needs to be a full commitment from all members of the management team and this must be driven by the new Chief Executive, Lucas Meyer. Many managers and employees consider the subject of climate change not worthy of the attention, especially in difficult trading times where costs are being cut and growth in revenues are difficult to achieve. It is necessary to brief them and explain what Papy’s new targets are and why and to explain the need for them to be involved. Perhaps some of the senior management team do not appreciate the importance of long-term objectives and are focused too much on the achievement of short-term profitability targets. Therefore there needs to be new targets established on a range of aims, but specifically to make these new targets based on nonfinancial measures, such as carbon emissions, electricity usage, plastic bags and waste materials. The introduction of the Balanced Scorecard could help Arif Karp and Lucas Meyer to set a range of meaningful targets. The Balanced Scorecard views profitability as being a “lag” rather than a “lead” as an indicator of the business’s performance. The management of change is not an easy thing for organisations to undertake, and perhaps Arif Karp is right to bring in the help of IT consultants, although they may be unable to help in the required change management process itself. There is a need to re-align the way free shares to employees are awarded. Therefore, targets need to be changed from just financial targets towards the achievement of a range of targets more focused towards reducing carbon emissions and becoming a more sustainable business. Papy could introduce the Balanced Scorecard to measure its key business statistics. An article in Financial Management (March 2011 article) referred to the United Nations Global Compact (UNGC) survey of global CEO’s and highlighted that one of the main challenges facing organisations wishing to improve their sustainability practices, is the transition from strategy to the execution of their plans. It is suggested that a “top down” approach is started, with all senior managers being briefed by Lucas Meyer and Arif Karp to explain what they are trying to do. They should explain how cultural change in Papy could be brought about and explain that this is a new long-term objective for the company. It will then be necessary to communicate the need for change with all store managers and finally with all store employees. Change cannot be “enforced”. Instead it must be embraced and accepted by the employees if the company is to re-focus on being a sustainable retailer, rather than a profit-driven retailer. Therefore a series of “road shows” to brief managers in each of the 8 European countries will be required and communication documents drawn up to explain the changes to all employees. The use of external consultants who are not familiar with the supermarket industry should be discouraged as this could further antagonise store managers. It is important for Papy employees

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and managers to be involved and not consultants, except where expertise on specific aspects is required. Employees may be naturally fearful about change and not understand what is expected from them. The reason for new requirements for data must be explained and they must understand what is required and for what reason, in order for them to become actively involved. Within Arif Karp’s team, it is suggested that a small team should be exclusively committed to communication with managers and employees throughout the company. Communications could be face to face, by web cast, email or by posters in the staff areas of each store. In summary, a range of initiatives that Arif Karp could consider introducing are: 1. To ask Lucas Meyer or possibly Abdul Yarkol, Finance Director, to be the senior champion for environmental issues within Papy and to work across the company to align financial and non-financial results. The introduction of a performance management system such as the Balanced Scorecard could be helpful in providing a focus for the Board, and store managers in particular, on a much broader range of performance measures linked to sustainability. 2. Arif Karp could benchmark what other leading supermarkets are currently doing and compare each of their competitors’ targets to Papy’s. For example, some initiatives from Tesco’s latest annual Corporate Responsibility Report include supporting Climate Week in the UK (21-27 March 2011) and introducing an “energy league” between stores in Malaysia to reward lower energy usage. If successful, this energy league concept will be rolled out across other countries. 3. As it is stated many of Papy’s employees either do not know, or understand, what Arif Karp is trying to do, then they could consider following Tesco’s lead which has trained thousands of employees to be “Energy Champions”. All of the employees appointed as “Energy Champions” are tasked to reduce energy and to encourage colleagues to do the same within each store or within stores in their region. 4. The use of management frameworks that organisations can use to help manage the process of change. These include, for example, Kurt Lewin’s Change Management Model of “unfreeze, change and refreeze”, and developments of Bruce Tuckman’s model of “Forming, Storming, Norming and Performing”. Models such as these are commonly used as tools to help bring about changes in employees’ behaviour. Perhaps Arif Karp’s leading global consultancy company where he used to work before he joined Papy, could assist with helping to bring about change. However, it must be stressed that it is Papy’s employees who need to understand the need for change, but external consultants can usefully act as facilitators for change. 5. There is a clear need for an IT system such as the Environmental Management System (EMS) in order to capture non-financial data on a wide range of issues such as waste, recycling (by type of material), energy usage, carbon emissions etc, by store, for each country and for the Papy group. It is necessary for senior managers to become involved with specifying the data requirements and sources of data and whether the data is currently being measured or not. Only Papy employees and managers understand this data and therefore the use of external consultants should be minimised. They do not know the business or the people and it may engender a “them and us” attitude. It is necessary for Papy’s management to become much more involved.

4.3 - Carbon emission targets The best way to monitor and compare carbon emissions between years, with Papy’s expanding number of stores, is the measure “carbon emissions in kg per square metre of sales area”. It is not possible to compare Papy’s total volume of carbon emissions between years, as the total volume will be distorted by the increase in new stores.

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The original targets of 948 and 874 kg per square metre of sales area for 2012 and 2013 already represent a real reduction as compared to the 2010 actual levels of 1042 kg per square metre. However, the 2009 and 2010 levels have been found to be understated by 5%. Therefore the re-stated 2010 level is 1,094 kg per square metre. This is shown in Appendix 3. Appendix 3 also shows Lucas Meyer’s proposed new target for 2012, based on a 25% reduction from 2010 revised level of 1094 = 821 kg per square metre. The new target for 2013 is a further reduction of 15% from 2012’s new target = 698 kg per square metre. The new target of 698 kg per square metre for 2013 is challenging and represents a reduction of 36% from the adjusted 2010 level of 1094 kg per square metre. Papy can only achieve these reduced carbon emission targets if it invests in new technology to help deliver large volumes of savings in carbon emissions. Additionally, the company would need to change its strategy and focus away from pure financial results and be more focussed on carbon emission targets. This will necessitate a change in performance related pay and employee attitudes, as discussed above in the need for change. There will also be a need to capture and monitor a range of non-financial data in order to manage the process and to try to achieve the new targets. This will almost definitely require the investment in an Environmental Management System (EMS). As Papy opens more stores in the next few years, it is hoped that these new stores will be more energy efficient and have lower levels of carbon emissions. Other competitor supermarket chains would already appear to be moving to reduce their carbon emissions. For example Tesco has made a commitment to halve its global footprint by 2020. The Case Study pre-seen material showed that Papy had the highest levels of carbon emissions amongst its competitors and indeed “Competitor 2” had already reduced its carbon emissions to only 243 kg per square metre of sales area. All these factors point to the need for Papy to do something on carbon emissions, and to do it quickly. Doing nothing does not appear to be an option for Papy. Referring to the UNGC survey again (Financial Management, March 2011), if a company is seen to be paying lip service to sustainability it runs a high risk of damaging its brand. Further, Lucas Meyer in his press announcement of 24 June 2011 (Pre-seen material Appendix 5) has already raised stakeholder expectations of where he sees Papy needing to go in terms of sustainability. Key stakeholders (using Mendelow’s analysis) such as employees, investment analysts, and competitors in particular, will now be expecting Papy to make significant progress in reducing its carbon emissions. The 2 proposals in this case study are forecast to save significant amounts of carbon emissions. For the year 2013, the new freezer cabinet proposal is forecast to deliver savings of 47 million kg of carbon emissions. This is equal to 32 kg per square metre. The solar panels proposal is forecast to deliver savings of 180 million kg of carbon emissions when they are operational at all 200 supermarket stores. This is equal to savings in carbon emissions of 124 kg per square metre. Appendix 6 shows a summary of the savings in carbon emissions that these proposals could make and how they help to reduce Papy’s overall level of carbon emissions. In summary these savings are as follows:

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Total carbon emissions

Current plan

1,274

Carbon emissions per square metre of sales area 2013 kg per square metre 874

Solar panels

(180)

(124)

(47)

(32)

Based on average square metre of 1,457,000 for 2013

Freezer cabinets Revised forecast including these 2 proposals

2013 kg millions

1,047

718

The table above shows that these 2 new investment initiatives could bring carbon emissions down to 718 kg per square metre which is very close to the target of 698. Together with other initiatives, or perhaps installing solar panels at a few more supermarket stores, these 2 proposals would help to meet Lucas Meyer’s proposed new target. 4.4 – Solar panels This is a large investment, totalling €600 million (€3 million for 200 supermarket stores). However, it will also deliver significant reductions in carbon emissions at 900,000 kg reduction per store. 100 supermarket stores will result in a reduction of 90 million kg in 2012 and the first full year effect on carbon emission reductions on the 200 stores will be in 2013, generating savings of 180 million kg. This is a very large reduction in carbon emissions and represents around 12% of Papy’s entire carbon emissions for 2010 (180 / 1495 million kg for 2010). There is a big question as to how this project could be financed. The Chief Executive states that “financing for capital investment projects to reduce carbon emissions will be given top priority” – but could this have an impact in Papy’s planned expansion in store numbers. In the current economic conditions, there is a question of whether Papy will be able to raise this level of borrowings from banks, many of whom are still restricting lending. However, Papy’s gearing ratio is only 29.25% at the end of December 2010 (debt of €870.0 million / debt plus equity of €870.0 million + €2,104.4 million). This is materially lower than its competitors’ gearing levels at 40%. So there is room to increase debt financing in order to fund this proposal. Papy’s interest cover is 9.5 which is high and demonstrates a good ability to pay the interest on its current debt. If Papy were to be able to borrow the full €600 million, then its gearing would rise to 41.1% based on 2010’s figures (€600 million + €870 million = €1,470 million total debt / €2,104 million + €1,470 million). However, equity will increase each year with the level of retained earnings and this would reduce the level of gearing slightly. This would bring Papy in line with some of its competitors’ gearing levels of around 40%, so a reasonable level, but riskier for Papy. However, operational savings would help cover additional interest costs. Papy has adequate cash flows to service this additional debt. Alternatively, Papy could have a rights issue, but this is expensive and will take time (around 12 – 18 months) and could delay the start of the implementation of this proposal. Another alternative could be to temporarily reduce dividends for 1 or 2 years, but shareholder re-action would have to be gauged. The technology for solar panels to generate power continues to change and improve. It is estimated that better technology will be available in 2017. So should Papy install solar panels in as many as 200 supermarket stores now? A delay in the implementation of this proposal would also mean a delay in achieving reductions in carbon emissions. Also, if Papy were to delay until 2017 for the better technology, then it may find that even better technology is a further 5 years away. Papy is planning to invest in solar panels for only 200 of its 422 supermarket stores, so

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there is still the option to invest and install the new solar panel technology in 2017 at more of Papy’s stores. The case material states it will generate a positive NPV of €91 million over a 10 year time frame. This is a long period but reasonable for this type of investment. The discounted payback period is 8 years. This cannot be directly compared to the un-discounted payback period of just under 5 years for the freezer cabinet proposal, as the cost of capital has not been used to discount the freezer cabinet proposal. They have been appraised using different methods. There is also a conflict of interest here as Arif Karp wants to make a large reduction in Papy’s carbon emissions both to meet the targets set by the Chief Executive but also to gain from his personal performance related bonus, which is linked to the volume of reductions in carbon emissions. Overall, this proposal will generate a 30% saving in electricity costs for each store which is fitted with solar panels and it will also achieve significant reductions in carbon emissions. However, the investment cost is high. The capital cost for each store is €3.0 million to save 900,000 kg of carbon emissions. This represents a cost of €3.33 million per 1 million kg of carbon emissions reduced. This is shown in Appendix 7. This represents a high capital cost for the volume of reduction in carbon emissions. This compares to between €1.6 to 1.8 million per 1 million kg of carbon emission reductions for the replacement freezer cabinet proposal shown below. In summary, we can use the J&S framework to assess whether the proposal is suitable, acceptable and feasible, as follows: Suitability This proposal would go a long way towards achieving the carbon emission reductions proposed by Lucas Meyer. Acceptability This would result in total annual savings in carbon emissions of 180 million kg. Based on the 2013 forecast total sales area of 1,457,000 square metres this would result in additional carbon emission savings of around 124 kg per square metre of sales area. The project is financially feasible as it has a positive NPV of €91 million and achieved a discounted payback within 8 years. Feasibility New debt would be required to finance the large investment of €600 million. In the current economic environment, Papy may not find it easy to borrow this level of funding. However, with some new debt and a mixture of current cash balances (which is a significant €603.9 million at the end of 2010), and a small reduction in the level of dividends paid, then the funding could be secured. 4.5 – Freezer cabinets This proposal makes commercial sense and will result in reduced electricity costs and has a relatively low investment cost. The total investment will cost €85.0 million and generate electricity savings for the 500 stores (400 supermarket stores and 100 small convenience stores) of €25.8 million each year. The financial analysis of this proposal is shown in Appendix 5. This proposal also saves carbon emissions. The total reduction in carbon emissions from this proposal is 47 million kg. This is equal to 32 kg per square metre for 2013 (47 million / 1,457,000 square metres).

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Lucas Meyer’s new target of 698 kg per square metre for 2013 represents the need to save an additional 176 kg per square metre from the latest forecast of 874 kg per square metre. This proposal will save the equivalent of 32 kg per square metre, which represents around 18% of the reduction required. The practice of reducing carbon emissions from freezer cabinets is a popular investment within the supermarket industry, and The Co-operative Group recently announced their achievement in reducing carbon emissions from freezers two years earlier than its planned date of 2011. Furthermore, the capital cost per 1 million kg of carbon emissions savings is low at €1.81 million (total investment = €85 million to produce carbon emission savings of 47 million kg). This is substantially lower capital investment cost per 1 million kg of carbon emission savings than the solar panel proposal, which is €3.33 million per 1 million kg of carbon emission savings. This is shown in Appendix 7. However, it is forecast that there is a risk of reduced volumes of sales as customers have to open the freezer cabinet doors to access frozen food products, rather than just reach into the older style freezer cabinets. This is forecast to result in a lower gross margin of €18,480 per supermarket store, resulting in an overall reduction in gross margin across 400 supermarket stores of €7.4 million. The investment proposal is shown in Appendix 5. This shows that using the undiscounted payback method, this proposal breaks even during year 5 (4.3 years). This meets the requirement set out by the Finance Director, as the proposal’s payback period is within 5 years. Undiscounted payback is not a very sophisticated method for investment appraisal as it does not take account of the cost of capital used to finance the investment, and it also does not take into account the diminishing value of future cash flows. However, it does demonstrate that this investment is financially viable and produces a payback in a relatively short time frame. The supermarket industry in particular is faced with many powerful influences (using Porter’s 5Forces framework), and in particular the power of customers and global supermarket companies such as Walmart and Tesco, as well as the growing influence of low-cost food retailers such as Aldi. It should be noted also that this method, from research into management practices, is consistently the most popular method of capital expenditure appraisals. This proposal also reduces Papy’s carbon emissions. Therefore, this seems like a good investment as it is generating long-term positive cash flows by reduced electricity costs and is also reducing carbon emissions. How can Papy finance the investment cost of €85 million? It has cash reserves of €603.9 million at 31 December 2010 and the company is producing positive cash flows from operations and therefore this should be possible, depending on the capital expenditure constraints due to the solar panel proposal. There is a further question as to why Papy is not proposing to roll this proposal out to all convenience stores, as only 100 small stores are included in the proposal. Papy had 742 small stores in operation at the 31 December 2010. If it were to install these new freezer cabinets in more smaller stores, then even higher levels of savings in carbon emissions could be achieved. If this proposal is approved, then there would be a one-off effect on profit in the current year (but no effect on cash flows) due to the write-off for the old freezer cabinets. The write-off of the net book value (NBV) of the old freezer cabinets is €25.0 million. This is quite a large write-off and represents 5.5% of the 2010 post-tax profits.

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5.0 Ethical issues and recommendations on ethical issues 5.1 Range of ethical issues facing Papy There are 3 ethical issues that will be discussed and recommendations made. These are: 1. Cancellation of 2 supplier contracts 2. Changes in the measurement of waste materials 3. Arif Karp’s performance related bonus and a possible conflict of interest 5.2 – Cancellation of 2 supplier contracts 5.2.1 Why this is an ethical issue This issue has both a business and an ethical aspect. From a business point of view the issue seems clear cut. The profit margins for these products have significantly reduced. Rafael Lucci, Operations and Logistics Director, has proposed to cancel the contracts for these 2 suppliers in 3-months time and this would seem to be justified from a purely business perspective. However the two contracts affected are Fair Trade contracts, and Papy, like other major supermarket chains would wish to support such suppliers from an ethical point of view. Therefore, this is an ethical issue because the cancellation of these 2 supplier contracts would impact greatly on the local farming co-operatives in this African country. Papy would be operating unethically by not supporting these farmers and putting profits ahead of its suppliers’ needs. The Fair Trade brand is well recognised by customers. For example, The Co-operative Group has increased its Fair Trade purchases by 280% over the past three years. So to some extent there is a business case to be argued for Fair Trade. The question about wastage of these fresh products and levels of demand should be reviewed. Is it possible for Papy change its retail prices or promote these products more, in order to increase sales volumes? Instead of cancelling the contracts entirely, Papy could agree to reduce the volumes of products procured temporarily or to procure a reduced range with the farming co-operatives. 5.2.2 Recommendations for this ethical issue It is recommended that Papy does not cancel the 2 contracts. It is further recommended that store managers investigate the high level of waste from these products as to the causes. Alternatively, Papy could reduce the purchases of competing products from other non-Fair Trade suppliers, or the waste levels may be due to storage or handling problems within the supply chain including at Papy’s own stores. It is recommended that Papy procures lower volumes of products from both suppliers temporarily rather than cancels the contracts entirely. It is also recommended that Papy should increase its marketing of these products in order to stimulate demand. 5.3 – Changes in the measurement of waste materials 5.3.1 Why this is an ethical issue This is an ethical issue as Arif Karp’s proposal is to “move the goalposts” in respect of the measurement of waste, to make it appear as if Papy has achieved greater reductions in waste than it has really achieved.

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Under the current measurement of waste materials by volume, the forecast reduction per year would be only 4.4% in 2011 and 4.9% in 2012. By using an alternative way of measuring waste materials by using weight, the reduction in waste materials would appear to be greater at 13% in 2011 and 26% in 2012.

5.3.2 Recommendations for this ethical issue It is recommended that Papy should collect and publish data on waste materials using both measurements. It is recommended that Papy is transparent in its published statistics for the measurement of waste materials and that it does not attempt to show the company in a better light than it really is. It is therefore recommended that Arif Karp’s proposal is not accepted. Papy should be honest and not change performance measures to make it appear that it is performing better than it is. 5.4 Arif Karp’s performance related bonus and a possible conflict of interest 5.4.1 Why this is an ethical issue This is an ethical issue as Arif Karp has a conflict of interest. Whilst his role is to help to reduce Papy’s levels of carbon emissions and to help make the company more sustainable, his contract of employment includes a performance related bonus which is related to reductions in carbon emissions and waste materials. Therefore he may choose to take on additional carbon emission reduction proposals to achieve his bonus whereas they may not be the most effective or cost efficient proposals for Papy to undertake. There is also the conflict with how waste is measured and a change in the way in which waste is measured may make Papy appear to be doing better than it really is, resulting in a higher bonus for Arif Karp. 5.4.2 Recommendations for this ethical issue It is recommended that Arif Karp’s performance related pay is changed or re-negotiated (if this is possible for his current signed contract) so that it is linked to a range of measures which includes the reduction in carbon emissions as well as business and financial targets. It is recommended that Papy should introduce the Balanced Scorecard for the purposes of performance related pay both for Directors and all of Papy employees to help achieve goal congruence.

6.0 Recommendations 6.1 – Management of change 6.1.1 Recommendation It is recommended that the company supports Arif Karp in his initiatives to bring about change within Papy. If the company is to achieve Lucas Meyer’s stated aim to become more sustainable, then a change of attitude is needed from the Board of Directors down to all employees across all stores. Change is not easy to bring about, but can happen if it is driven from the top.

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6.1.2 Justification Papy needs to change and adapt in order to survive and stay competitive. Papy’s carbon emissions are materially higher than some of its competitors (pre-seen material page 5). At some stage in the next 5 to 10 years it is expected that the European Union (EU) will tax or impose fines on companies that do not make substantial reductions to their carbon footprint. It will be better to change voluntarily than to have changes, or substantial fines, imposed on the company. Therefore, the rationale is that unless employees’ attitude to sustainability is achieved then the company will not achieve its desire to reduce carbon emissions, despite large capital investments, such as in solar panels. 6.1.3 Actions to be taken 1. Lucas Meyer should take on the responsibility of being the senior champion for the environment, and to work across the company to align financial and non-financial results. It is necessary to ensure commitment from the top management team by holding briefings with Lucas Meyer and Arif Karp and his team 2. The Balanced Scorecard should be introduced in order to provide a focus for the Board and for store managers on a much broader range of performance measures including those linked to sustainability. A specific internal business measure should be “Reduction in carbon emissions” 3. The employee share scheme should be changed to link it to targets including the reduction in carbon emissions. 4. As many of Papy’s employees either do not know, or understand, what Arif is trying to do then the company should train a number of employees in each store to be “Energy Champions” who are tasked to reduce energy and to encourage colleagues to do the same. 5. It will be necessary to hold ”Road Shows” for managers and staff in each country and for communication on sustainability targets and plans to be cascaded down by store managers in each store. It is necessary for employees to understand why Papy needs to change. 6. The establishment of “League tables” of carbon emissions by store should be introduced and linked to monthly awards for achievements. 7. Arif Karp should seek advice from his previous consultancy company, and appoint it to advise him on other practical ways in which Kurt Lewin’s Change Management Model of “unfreeze, change and re-freeze” could be used to change organisational culture within Papy. 8. To introduce and communicate ways of measuring energy and waste management and getting employee involvement. 9. To invest in a new IT system to capture a range of non-financial data, such as an Environmental Management System (EMS). 6.2 – Carbon emission targets 6.2.1 Recommendation It is recommended that the challenging target of 698 kg per square metre is agreed for 2013. It is a hard target to achieve, but it will focus the company on finding ways to meet it. Doing nothing and not attempting to reduce its carbon emissions significantly is not an option for Papy.

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6.2.2 Justification If Papy were to set a target that was not as challenging as 698 kg per square metre then it will not encourage the company to invest or to change its focus towards becoming more sustainable. Papy’s carbon emission figure of 1,094 kg per square metre for 2010 is higher than the worst figure of its competitors (of 1,005 – as shown in the Pre-seen material), and is significantly higher than the 681 and 243 of competitors 1 and 2. Tesco’s carbon emissions per square metre are only 574 kg, as shown in its latest annual Corporate Responsibility Report. It is recommended therefore that Papy does take positive action to reduce its carbon emissions, where this is feasible. If it does not then this is very likely to erode Papy’s marketing position in comparison with other supermarket chains, and hence have an adverse effect on its financial performance in the long-term. 6.2.3 Actions to be taken It is recommended that Papy should invest in both of the proposals (solar panels and new freezer cabinets). These proposals would achieve operating cost savings and both of the proposals have reasonable payback periods (discounted payback is 8 years for solar panels (per unseen material) and undiscounted payback of only 5 years for the freezer cabinets (per Appendix 5). Some of the supporting recommendations and necessary actions to take are covered in the recommendations on Solar panels and Freezer cabinets below. 6.3 – Solar panels 6.3.1 Recommendation It is recommended to accept this proposal assuming that financing of €600 million for the proposal can be identified and agreed. This is a major investment and would demonstrate to shareholders, employees, customers and other stakeholders that Papy is serious about changing and reducing its carbon emissions. 6.3.2 Justification This investment would generate huge savings in carbon emissions of 180 million kg by 2013. This is equivalent to 124 kg per square metre and would deliver over 70% of the additional carbon emissions savings required by Lucas Meyer (new target of 698 kg per square metre for 2013 represents the need to save an additional 176 kg per square metre from the latest forecast of 874 kg per square metre). There is always a reason to delay or postpone investment proposals. Technology is moving fast and delaying the decision to invest in solar panels until 2017 could be seen as a missed opportunity to make substantial reductions in carbon emissions over this period. In 2017 there will, no doubt, be even better technology that will be few years away from commercial availability. It is recommended that Papy should not delay and should make the decision to invest now. Together with the proposal to replace the freezer cabinets, as well as install solar panels at 200 stores, this would result in Papy’s carbon emissions reducing to 718 kg per square metre. This is only just a little higher than the target of 698 kg per square metre.

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6.3.3 Actions to be taken Agree how this proposal is to be financed. A total of €600 million is required. A mixture of cash generated from operations and new debt is recommended. It is not recommended to reduce dividends as this could send mixed signals to shareholders. The Finance Director should arrange new debt finance with a range of lenders over a 10 year period. To make a final selection of exactly which 200 supermarket stores in Southern Europe should have solar panels installed in order to maximise the benefits and to arrange for the necessary site surveys to be undertaken. Orders should be placed for solar panels for the first 100 stores where solar panels are to be installed. The Procurement Director should seek to obtain a bulk discount for this large expenditure totalling €300 million in the first year and to ensure that contract specifies the agreed delivery and installation schedule. A second order for the remaining solar panels at 100 stores should also be negotiated. Monitoring of electricity consumption, by store, after installation of solar panels to see if the planned 30% saving is being achieved or not. 6.4 – Freezer cabinets 6.4.1 Recommendation It is recommended that this proposal to change the freezer cabinets at 400 supermarket stores and 100 small convenience stores is approved. The total investment cost is only €85 million and would save 47 million kg of carbon emissions. It is further recommended that Papy should review these new freezer cabinets once installed with a view to changing the freezer cabinets at all 760 small convenience stores (end 2011 store numbers) during 2012. It is also recommended that all new stores opened should have these new low-carbon emission freezer cabinets installed. 6.4.2 Justification This is a good way to reduce electricity costs and reduce carbon emissions. The investment cost is not too large at €85 million and this proposal will help Papy to go part of the way to meeting the challenging target of 698 kg of carbon emissions per square metre by 2013. This proposal would save 47 kg million each year which is equivalent to 32 kg per square metre for 2013. This proposal achieves undiscounted payback in less than 5 years and therefore meets the criterion set by the Abdul Yarkol, Finance Director, for undiscounted payback by end of year 5 and is financially acceptable. 6.4.3 Actions to be taken Orders for the new freezer cabinets should now be placed as soon as possible. Papy has adequate cash resources to fund this capital investment. The current freezers should be disposed of in an environmentally friendly way if possible. The net book value of these old freezers, of €25 million, will need to be written off in the current year’s accounts (year ended 31 December 2011).

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7.0 Conclusions Papy needs to change in order to achieve its plans to become a more sustainable retailer. Lucas Meyer has set some challenging targets which could almost be achieved if both of the proposals for solar panels and new freezer cabinets were to be agreed and implemented. The future for the Papy chain of supermarkets will be greatly enhanced if it is able to embrace and achieve its desire to become more sustainable. Its long-term future will be improved if the management team is able to bring about change throughout the company and to get employees involved in the achievement of the new targets. This is a long-term objective and changes in employeesâ&#x20AC;&#x2122; attitudes can take time to happen. The Papy brand will be greatly enhanced by the proposals outlined in this report.

ÂŠ The Chartered Institute of Management Accountants 2012

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Appendix 1 SWOT analysis

Strengths Successful and profitable listed company New Chief Executive with determination to bring about change Environmental expertise and experience of Arif Karp Strong CSR objectives Increase in customer numbers Growing market share in its home country High operating profit margin compared to 2 of its competitors Good IT systems Reduction in long-term debt in last financial year Increase in cash balances over the last financial year

Opportunities To change to become a more sustainable retailer To reduce carbon emissions Proposal to install solar panels at 200 stores Proposal to replace freezer cabinets with low-carbon technology freezer cabinets To measure waste materials in alternative ways to demonstrate the commitment to reducing waste materials To create a new EMS IT system to capture and report on a wide range of nonfinancial data To develop Internet shopping and increase the number of non-food products and “own brand” products To expand outside of Europe in the future

Weaknesses Difficulty in bringing about change and employees’ resistance to cultural change Employee morale and scepticism about changing the focus from profit targets to reduction in carbon emissions Papy has the highest carbon emissions per square metre in comparison with 3 of its competitors Dependent on store managers to achieve targets set How to measure carbon emissions and discovery of understatement for 2009 and 2010. How to measure CSR targets Sales reduction for a small range of fresh produce Papy does not offer Internet shopping

Threats To invest heavily in projects to reduce carbon emissions and to put the company under financial strain from increased debt finance or reduced dividends to shareholders Investments not achieving the planned savings in electricity costs or not achieving planned reduction in carbon emissions Losing key staff whilst Papy undergoes a period of change Long-term damage to Papy brand if reduction in carbon emissions is not achieved

Note: The above SWOT analysis is detailed for teaching purposes. However, in exam conditions a SWOT containing fewer bullet points, which cover the main issues from the case and the unseen material, is expected.

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Appendix 2 PEST analysis Political or Legal Possible future fines or taxes based on levels of carbon emissions Pressure from different EU governments to reduce carbon emissions to meet EU targets Possible subsidies from EU governments for investment in low carbon technologies

Economic Pressure from competitors and the need to maintain market share Shareholders’ demands Will finance be available for the proposed investment opportunities due to bank lending restrictions Shareholder reaction to possible reduction in dividends so that cash from operations could be used to finance investments in low carbon technologies

Social Customer reaction to Papy’s changes – will becoming a more sustainable retailer attract more customers? Greater awareness of carbon emissions and the need for investment in low carbon technologies to meet EU carbon emission reduction targets Customer choice of products and store layout – changes in tastes and choices could affect Papy’s success in future Alternative ways to shop, such as Internet shopping, which Papy does not offer, could lead to a fall in its market share

Technological New low-carbon technologies becoming available New low-carbon freezer cabinets reducing Papy’s carbon emissions Solar panel technology – how efficient is it and how quickly will improved technology become available and perhaps at lower prices?

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Appendix 3 Carbon emission targets

2009

2010

2011

2012

2013

Published

Forecast

Published data

1,077

1,042

Revised data for 2009 and 2010 to reflect the understatement of published data by 5%

1,131

1,094 1,022

948

874

kg per square metre

Forecast carbon emissions

Lucas Meyerâ&#x20AC;&#x2122;s proposed targets: 25% reduction from revised 2010 levels for 2012

821

698

Further 15% reduction from 2012 for 2013 Therefore reduction required

ÂŠ The Chartered Institute of Management Accountants 2012

127

176

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Appendix 4 Savings in carbon emissions from the solar panels proposal

Year 1

Year 2

2012

2013

Cumulative number of stores where solar panel are installed

100

200

Total carbon emissions savings (at 900,000 per store)

180

1,425,400

1,457,000

124

Savings in carbon emissions is 900,000 kg per store per year

kg million

Forecast total sales area for all Papy stores - per unseen material (square metres) Carbon emissions savings â&#x20AC;&#x153;per square metre of sales areaâ&#x20AC;?

ÂŠ The Chartered Institute of Management Accountants 2012

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Appendix 5 Evaluation of proposal for new freezer cabinets Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

2011

2012

2013

2014

2015

2016

€ million

Electricity savings: €60K for supermarket stores €18K for small stores

24.0 1.8

Forecast fall in gross margin: Supermarket stores (workings below) Small stores – no change

(7.4) 0

(85.0)

18.4

21.3

(4.6)

Net cash flows post tax

(85.0)

39.7

13.8

Cumulative post tax cash flows

(85.0)

(45.3)

(31.5)

(17.7)

(3.9)

9.9

Capital costs: €200 K for supermarket stores €50K for small stores

Net cash flows Tax at 25% 1 year in arrears

(80.0) (5.0)

Undiscounted payback:

In Year 5 4.28 years

Expected value for forecast fall in gross margin of sales at supermarket stores: € 60% x 3% fall x €560,000 10,080 30% x 5% fall x €560,000 8,400 10% x no change x €560,000 0 Expected value of fall in gross margin

18,480 per store

€18,480 fall in gross margin x 400 supermarket stores = €(7.4) million reduction each year. Savings in carbon emissions from proposal to install new freezer cabinets:

Supermarket stores Small stores Total

Savings in emissions Per Store each year Kg

No of stores for new freezer cabinets

Total savings in carbon emission

110,000

400

30,000

100

3 47

Kg million

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Appendix 6 Summary of savings in carbon emissions and comparison to targets

Forecast carbon emissions before these 2 proposals (per Appendix 3 of answer) Savings in carbon emissions from proposals: Solar panels (Totals per Appendix 4) Freezer cabinets (Totals per Appendix 5) Revised forecast for carbon emissions if both of the proposals were to be implemented

2012

2013

2012

2013

Total kg million

kg per square metre of sales area

1,351

1,274

948

874

(90)

(180)

(63)

(124)

(47)

(33)

(32)

1,214

1,047

852

718

821

698

(31)

(20)

Lucas Meyerâ&#x20AC;&#x2122;s proposed targets (per Appendix 3) Shortfall even if both proposals are implemented

Note: The forecast sales area in square metres is as follows (per unseen material): 2012 2013

1,425,400 square metres 1,457,000 square metres

ÂŠ The Chartered Institute of Management Accountants 2012

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Appendix 7 Comparison of capital costs and carbon emissions savings between the 2 proposals

Savings in carbon emissions

(before tax relief)*

Capital cost per 1 million kg of carbon emissions saved

€ million

Solar panels – per store

900,000

3.0

3.33

Freezer cabinets: Supermarket stores

110,000

0.200

1.82

30,000

0.050

1.67

47,000,000

85.0

1.81

Small stores

Overall for freezer cabinets

Capital cost

*Note: The above comparison of capital costs ignores any tax relief or capital allowances that these alternative investment projects will attract.

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Appendix 8 Part (b) – Presentation and graph on proposals to reduce carbon emissions The savings in carbon emissions from the solar panels proposal is 180 million kg by 2013. This is equivalent to 124 kg per square metre in 2013 The savings in carbon emissions from the replacement cabinet proposal is 47 million kg. This is equivalent to 32 kg per square metre in 2013 Together these 2 proposals could bring Papy’s carbon emissions down to 718 kg per square metre by 2013, which is only just above the new target figure for 2013 of 698. Total investment required for both proposals is €685 million. It is recommended that both proposals are accepted, assuming the debt financing and other sources of funding can be secured.

Graph showing Papy’s carbon emissions expressed as “kg per square metre of sales area” for the 5 years 2009 to 2013. This graph includes the savings in carbon emissions that could be achieved if Papy were to implement both of the proposals (solar panels and freezer cabinets)

Carbon emissions (kg) per square metre of sales area kg per square metre

1,200

1,131

1,094

1,022

1,000

852 718

800 600 400 200 0 2009

2010

2011

2012

2013

End of answer document

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