This blog is a much expanded version of my speaking notes used in a presentation to the COMMUNICATE MAGAZINE CONFERENCE on 30 September 2015
I was rapporteur for the session on ESG disclosure at the European Commission’s 2010 Multistakeholder Forum on CSR. That conference was a watershed. It saw the reporting agenda move on from the entrenched debate between mandatory and voluntary disclosure.
The fact that some EU members states had already implemented their own statutory requirements – in Spain, even 3 autonomous regions introduced their own separate statutes – led those, like me, who opposed mandatory action, to accept that EU wide consensus was the lesser evil than European business having to accommodate 29 different national regulatory regimes
The Commission began its work on the new directive thereafter and I was a member of its so called ‘Experts Group’
The debate was now framed in terms of – in my shorthand – materiality versus transparency. That is between those who see ESG disclosure as a tool to better articulate the drivers of business value and those less interested in value and more in shining a light on business operations and holding companies to societal account.
The directive published in October 2014 is a classic fudge between these two positions. But it’s unfinished business. Guidance on how to meet the directive are due to be published by November 2016.
So business has to get its act together.
In a recent webinar poll of around 120 largely UK corporate sustainability people. They were asked who was their primary reporting audience. 55% said investors and analysts. Yet only 5% saw increasing investor confidence as the primary purpose of reporting.
60% said meeting broad stakeholder expectations was their primary purpose – presumably stakeholders doesn’t include investor……or employees, cited by only 5%. It might include customers – at 20% thay at least rated more highly than ‘other stakeholders’; academics, NGOs, think tanks and governments.
These results are what I would expect. Confused. And they’re not unusual – in the UK or anywhere else.
Business is not sure who it is disclosing non-financial information to or why?
So it’s no surprise then that financial analysts, when asked recently by the CFA, which were the most valuable sources of information, 39% said financial statements and another 33% said trusted analysts – predictably more on the buy-side than the sell-side.
Sustainability/ESG sources are somewhere in the 9% ‘other’.
Yet the case for better non-financial information is unanswerable.
The EU directive should be addressing a long accepted market failure – the disconnect between business which argues that investors need to better understand what drives business performance and investors who argue that business needs to provide better, more usable information.
But its hybrid nature means it is unlikely to do this OR shine a light on the darker recesses.
The Directive requires a non-financial statement of policies outcomes and risks against a suggested shopping list of favourite ESG issues.
There’s a nod to what’s material against what’s not but material is not defined.
There’s reference to the usual standards and frameworks but no imposition……….yet.
And there’s the comply or explain opt out.
So all in all, probably no more all-encompassing and prescriptive than the UK’s Strategic Report requirements or indeed current US SEC requirements.
When it comes to what companies deem material, one has only to look at what’s in the brightly coloured charts in the annual report or a quick review of the risk sections in a company’s 20-F or 10-K filing to see how such a reporting requirement could be met.
But that misses the point. There are trends which are overtaking the regulators. Challenges which companies have to be prepared to meet.
For one, there is public expectation……or lack of. I suspect that VW will have more impact on the future of non-financial reporting than the EU.
Second is the growth of ESG investing. Whether you believe what figures, there is no doubt this is growing rapidly. It is becoming mainstream.
I am currently working with a group of around 40 or so asset managers, asset owners and their consultants in Project Delphi. Some usual suspects, some not.
Don’t expect to find our website – there isn’t one.
But the investment framework we are developing links ESG factors and the most material metrics to a well used Value Model – anyone who has any dealings with McKinsey will recognise it.
When I say material I mean financially material. The Delphi Framework is premised on a materiality definition that is quantitative and financial – financial in Discounted Cashflow and Net Present Value terms.
We are working on connecting metrics, not indicators, to value drivers. Those connections require an understanding of the impact of factors and metrics on hard financial metrics.
And its parsimony – it ranges from 18 Factors and 60 metrics in the Oil and Gas sector to 7 Factors and 18 metrics in Consumer Services – means the focus is on the MOST material by industry.
This is a framework being developed by investors, with investors, for investors. But it’s relevance for companies will be obvious.
It is not a reporting framework driven by stakeholders for stakeholders like GRI or by stakeholders for companies like SASB.
But it will give greater clarity to the third trend. Integrated Reporting.
With respect to my IIRC colleagues, what we are seeing at the moment are best practices in combined reporting not integrated reporting.
Once companies have the confidence to connect the non-financial and financial, inevitably in narrative terms first but ultimately in quantitative terms, then we will have integrated reporting.
Why is this happening? Because the market is waking up to the fact that it is only accounting for a fraction of the value of the assets it is managing.
That is the 80:20 intangible:tangible complexion of market value in the Ocean Tomo graph you no doubt have already seen. It is the gap between market value and book value of the S&P500 (and most other developed markets).
I prefer the term ‘unexplained value’ used in the original Accenture research that sits behind this graph. US$40 trillion of unexplained value as at today.
And that’s just equities. Private equity and capital markets, dare I say even the ratings agencies, are waking up to this. Maybe even the banks and their business lending algorithms.
And why are they waking up? Because of what is driving that gap.
I like the IIRC Capital Models concept.
But it does not explain why that gap exists. It is the dominant convention of DCF and other Quant methods of valuing business that has grown over the past 30 years.
Shiller’s Cyclically (and Price) Adjusted average annual Price Eearnings ratios chart – Google it – shows from 1890 to date. Since 1985, the average S&P 500 PE ratio has been above 20 for every year except 2009.
Even without the dot com boom, for the last 30 years the market has been geared at a higher level than any previous year except 1929.
The market is making long-term judgements about the future cashflows of companies – over 10, 15, even 20 years – and using those judgements to make decisions today……on your companies.
That judgment on the ability of companies to maintain its brand, consumer perceptions, recruit and retain skilled people and knowledge to drive innovation and design, to manage reputational risks and contain the costs of climate change or just volatility in the price and accessibility of energy, water, and raw materials. ETC. ETC. ETC.
So these are not long-term issues. They’re here and now issues.
Those companies who can articulate their management of non-financial and links to strategy and financial performance, and make it material, will win better ratings and the premium they think they deserve.
Those who can’t – well what’s the downside – your stock price bumps along where it is.
Or maybe you can’t because the strategy and management and the performance just isn’t there.
The downside may be one day to wake up and find you’re dealing with a VW style crisis.
And then there is the fourth trend. The growing availability of data.
We all know that what is measured is managed.
But what is measured is not always disclosed. Yes, sometimes it’s sensitive. And sometimes it really is sensitive. And sometimes there are credibility issues with the robustness. Or top management will not want to raise expectations on measures they are not confident they can manage and prepared to be judged.
So we all know that non-financial reporting is the art of the possible.
That is why so little of the data that Delphi deems MOST material is not reported by many companies.
Even the explosion in scope and scale of mainstream data providers is not delivering this.
But sometime soon those decisions may be taken out of company hands. The era of big data is already upon us.
Already there is a mini-big bang in the way the investment industry works and the role of analysts in the UK. It is not the primary intention but it could bring in non-traditional source of analysis including those capable of analysing and applying big data.
That is data provided direct from millions of transactions from millions of people – your employees, customers, suppliers, local communities, etc etc.
For example, will we need employee engagement or Net Promoter Scores from companies in future when Glassdoor or Google could do a more thorough and independent job?
It’s an alpha opportunity for investors. It’s a challenge companies will soon be facing.
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