Significant progress has been made towards improving the reporting of sustainability metrics, such as the Carbon Disclosure Project and the Global Reporting Initiative. However, most disclosure is still not conducive to mainstream use by investors, since it typically lacks clear links with the company’s financial performance and long-term prospects.
Moreover, some companies that can measure non-financial data (many already do so for internal purposes) hesitate to publish any information that goes beyond regulatory requirements for fear it may help their rivals or increase their exposure to lawsuits. This is one of many reasons that new regulation must be enacted to level the playing field.
Few fund managers have analysts with the skills needed to perform bottom-up analyses of non-financial metrics. Understandably, most therefore look to third-party rating agencies to analyse company sustainability disclosures and provide ratings for them to interpret.
With more than 100 rating agencies providing such advice, there is significant variation in the quality and value of rating systems. We applaud the commitment that some mainstream data companies, such as Bloomberg and Thomson Reuters, have made toward sustainability and support their efforts to increase standardisation and improve quality.
However, we believe that the best-run companies are those that are not only already making the links between sustainability and financial performance internally, but are also sharing those links in their investor communications.
Integrated reporting provides the framework to ensure that a company has a sustainable strategy and can improve internal decision-making by exposing itself to the discipline of the market. A handful of companies have already begun to make the switch to the integration of sustainability and financial metrics in their annual reports, explicitly showing the link between the two and, in the process, reinforcing the business case for sustainable capitalism.
Given that privately held companies have a greater degree of flexibility in reporting, they are in a position to provide leadership in developing integrated reports. Many leading global private equity funds, such as KKR and Doughty Hanson, have already taken steps to invest in improving the sustainability of their portfolio companies and are reporting on sustainability metrics. Funds could go further and persuade those companies comfortable with reporting the financial benefits of these activities to do so prior to going public.
We support efforts by Professor Bob Eccles at the Harvard Business School, the International Integrated Reporting Council, and Aviva Investors, who collectively are pioneering the field of integrated reporting. Yet while these actors are playing a critical role in shaping this nascent idea and encouraging voluntary action by companies, it is clear that significant, widespread change will come about only when integrated reporting is mandated.
Although this policy intervention will vary country by country, securities regulators and stock exchanges are well suited to oversee the requirement for integrated reporting. In South Africa, the Johannesburg Stock Exchange set an exemplary precedent in its 2011 decision to require all listed companies either to produce an integrated report or explain why they were not doing so. Even so, the mandating of integrated reporting is just the first step, as reporting standards around ESG (environmental, social and governance) information and its link to financial metrics will need to be refined continuously.
What is critical is that the information provided is material to investors and relevant to the specific sector and company. ‘Cookie-cutter’ forms that do not take into account variations in what is most relevant from one sector to another are not adequate. Accountants must also work to provide assurance on non-financial information that is comparable to what they provide on financial metrics, and provide integrated assurance on both.
We propose that integrated reporting should be mandated for publicly listed companies by the appropriate regulatory agencies and we encourage these companies to take voluntary action in the short term to provide integrated reports until such regulation appears. We also encourage investors, including private equity investors, to ask for integrated reports from their portfolio companies and incorporate this in their investment decisions. We also support the growing commitment by privately held companies to produce integrated reports.
Quarterly earnings guidance
Another key action that will accelerate the development of sustainable capitalism by 2020 is ending the default practice of issuing quarterly earnings guidance.
In the modern world, we often appear virtually hypnotised by the short term in our politics, our culture, business and well beyond. In business specifically, the vast majority of managers are now clearly choosing short-term profits over sustainable long-term growth. We have long known that an important part of the reason for this distortion is that executives are encouraged – by investor behaviour, incentives and business cultures – to focus on the business’s short-term earnings.
Investors have become increasingly impatient with the CEOs of publicly listed companies who focus on longer-term value creation, and are too quick to penalise stocks for short-term underperformance even if that occurs in the context of a long-term investment plan.
In many cases, a company’s ability to meet quarterly earnings guidance trumps the long-term performance incentives for CEOs and makes it much harder for them to focus investors on the long-term strategy.
An empirical investigation conducted by Murad Antia, Christos Pantzalis and Jung Chul Park reveals that shorter CEO decision horizons are in fact ‘associated with more agency costs, lower firm valuation, and higher levels of information risk’.
Research by John Graham, Campbell Harvey and Shiva Rajgopal shows that 78% of managers will reject a project with a positive NPV (net present value) if it lowers quarterly earnings below consensus expectations. And an astonishing 80% would focus on this recurring, short-term metric – at the expense of building long-term shareholder value – by making cuts in discretionary spending, including R&D and advertising. This kind of practice is managing for the short term, not managing sustainably.
Work by John Asker, Joan Farre-Mensa and Alexander Ljungqvist reveals that this value-destroying habit is clearly manifested in data showing publicly held companies invest at half the rate of privately held companies when the gains from such investments will not be realised on a quarterly basis. They also show that this applies when an individual company switches between public and private ownership. And they make the obvious point that it leaves public companies less able to exploit new business opportunities.
Not providing quarterly earnings guidance would help some companies alleviate the pressure on managers to meet financial expectations on a quarterly basis, and allow them to focus on building the business for long-term profitability.
However, because most public companies provide quarterly earnings guidance, there is a ‘collective action’ problem for CEOs and boards that wish to end the practice. We applaud the few CEOs who, despite criticism, have decided to end earnings guidance and have talked openly about what investors should expect from the management time horizon. For other companies, quarterly guidance may be appropriate, but the decision to offer it ought to be part of a well-justified strategy and not simply an unthinking response to the prevailing habits of the market.
We propose bringing together a significant group of CEOs who have already stopped providing quarterly earnings guidance with others who pledge to stop doing so as a catalyst for change around this practice.
Generation Investment Management recently published Sustainable Capitalism, a white paper that highlights the need for a paradigm shift to a more sustainable capitalism. It makes the economic case for mainstreaming sustainable capitalism by highlighting the fact that sustainability does not represent a trade-off with profit maximisation, but actually fosters superior long-term value creation
.In this article, which is based on excerpts from the paper, the firm’s founders, Al Gore and David Blood, look at integrated reporting and the default practice of issuing quarterly earnings guidance. These themes embody two of the five key actions that the paper presents to accelerate the transition towards sustainable capitalism by 2020.
Other key actions include the alignment of pay structures with long-term sustainable performance, the encouragement of long-term investing with loyalty-driven schemes, and the identification/incorporation of risks from stranded assets.
The paper defines sustainable capitalism as a framework that seeks to maximise long-term value creation by reforming markets to address real needs, while considering all costs and stakeholders in a world facing such challenges as climate change, water scarcity, poverty, disease, growing income inequality and urbanisation.
Former US vice president Al Gore is co-founder and chairman of Generation Investment Management, a partnership focused on a new approach to sustainable investing. He is also chairman of the Climate Reality Project and author of Earth in the Balance, An Inconvenient Truth, The Assault on Reason, and Our Choice: A Plan to Solve the Climate Crisis. He is co-recipient of the 2007 Nobel Peace Prize for ‘informing the world of the dangers posed by climate change’.
David Blood is co-founder and senior partner of Generation Investment Management. Previously, he spent 18 years at Goldman Sachs, and served as co-CEO and CEO of Goldman Sachs Asset Management from 1999–2003. He is on the boards of Harvest Power, New Forests, SHINE, Social Finance UK, Social Finance US and the Nature Conservancy.