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 this 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.
You can read Sustainable Capitalism, which includes footnotes not shown in this article, at www.generationim.com.
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.