The following is an extract, to which I contributed, from the Network for Sustainable Financial Markets’ submission to the public consultation on the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations. The full response can be found here.
Dominance of short-term thinking in the financial system and society has created a dysfunctional “tragedy of the horizons” phenomenon that can make even critically important information appear immaterial. As a result, climate risk is not the only issue being discounted that can impact enterprise valuation and ability to create long term value. We believe that the benefits of greater climate disclosures should be presented in this broader context, not just through the lens of a sweeping environmental concern.
Company reports and effective disclosures for shareholders should include recognition of the extent to which the company’s current valuation is based on a long-term and strategic business model, its value drivers and the expected future positive economic profit growth. For example, positive Return on Invested Capital (ROI), or Cash Flow Return on Investment (CFROI), is key to measuring the competitiveness of a company’s business strategy, business model and its value creation capacity.
In order for company directors and management and investors to gain insight into the drivers of the future value component of current company valuation, disclosures should include how much of a company’s current stock price and enterprise value is generated by the expected future value and innovation at the company.
On average, at least 40 to 50 percent of a company’s valuation is tied to creation of expected future value, growth and innovation. The strategic horizon for most breakthrough innovation ranges from three to ten years or longer and is embedded in company valuation. Reporting of this information is critical to understanding how current and future valuations are impacted by climate change and other long horizon issues.
In the end this is about more than just disclosures and reporting. The dialogue between companies and investors at every level should (seek to) infuse the issues related to intangible capital value drivers into the dominant finance, accounting, investment and management conventions and reporting standards. The need to improve this dialogue by achieving
investment industry consensus and standards as to which factors and or value drivers are significant or truly material for them and communicating this to reporting companies is recognised within the industry itself and has emerged from the recent Delphi Project.
The Delphi Project purpose was to explain the difference between market value and book value. The definition of materiality was very specific and tightly to aligned to financial value creation outcomes. A key finding from the Delphi Project was that material intangible capital and ESG drivers that impacted long term sustained company performance and valuation and were segmented into three main integrated Value Levers: Growth, Return on Capital, Governance & Risk. The three Value Levers were further sub-segmented into 10 Value Drivers and related metrics that drive performance and wealth creation over the long term.
The “Growth” value lever included metrics for Customer Strategy and Market Share, including new products, new markets and new business models, brand and reputation. The “Return on Capital” value lever included: employee engagement, talent management, greenhouse gas (GHG) emissions, and energy efficiency. The “Governance/Risk” value lever included:
operational risk; corporate governance risk incorporating performance metrics plus incentive design risk, regulatory risk, and licence to operate risk. Thus this leading group of institutional investor insiders created an integrated performance measurement, reporting and disclosure architecture that has been validated. The metrics for GHG emission and energy efficiency are only two of a much larger and integrated metrics suite for long term performance and sustained value creation that requires effective disclosure for the purposes of capital markets participants.
Short-term thinking, design and use of typical operational performance metrics, and long term incentive design engineered at less than four years are primary drivers of the climate change disaster that lies at the heart of the TaskForce’s mandate. We believe the Task Force should explicitly recognize that climate-related financial reporting shortcomings are not an isolated environmental problem but part of the consequences of dysfunctional myopia. This myopia is a failure of the due care strategic duty of most officers and directors to plan for the longer term (10 years and greater) and to invest in R&D, innovation, organizational and human capital, and brands necessary to sustain business model viability, positive economic profitability and cash flows over the 10- to 20-year strategic horizon and longer.
We also think the Task Force needs to stress that climate change is a “material” consideration for company disclosures of most (if not all) companies. Unfortunately, some market players are currently seeking to label climate-related considerations and many other long-term or systemic factors as immaterial information sought by special interests to further social or political objectives. The mischaracterizations made by the short-term special interests must be called out for what they are in order to foster a shift toward longer-term and sustainable business planning and investment.