Friday, November 21, 2014

Integrated Reporting: I think integrated, therefore I am...

Photo: Eugene Weber © California Academy of Sciences
"Integration" again found itself in the domain of popular terminology in recent years as managers, policy makers and others contemplated ways of dealing with mainstreaming, fragmented information and inconsistencies as demonstrated in the market failures of financial crisis. Integration is a beautiful word, bringing to mind images of integral whole, unified pattern and harmony. Who would not want to be integrated, at least in thinking? What would be the alternative? A fragmented, incoherent enterprise?

In developing its International Integrated Reporting <IR> Framework, the International Integrated Reporting Council (IIRC) has considered various interpretations of "integration", including reference to a "process" of reporting, a way of "conducting management", linking various streams of information, as well as a "philosophy" of integrated thinking. Its <IR> standard defines "Integrated Reporting" as a "process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation".

And while the integrated report is meant to be a concise document that builds on annual financial and sustainability reporting, it is supposedly more than just an executive summary of information found elsewhere. Rather, it is meant to make explicit "the connectivity of information to communicate how value is created". One of the guiding principles of <IR>, "connectivity of information" refers to "a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the organisation`s ability to create value over time".

When one then examines the integrated report of an enterprise, one would expect common sections such as the CEO Statement, company profile and strategy, financial and sustainability performance highlights, overview of risks and opportunities, and corporate governance disclosure to show a certain consistency and common thread. But instead, many so-called integrated reports still reflect the lumping together of a conventional annual report (including financial statements) with sustainability reporting content (including environmental and social sections). They display little integration, certainly not between sustainability performance and financial performance.

Attempts to integrate lists of sustainability risks and business risks often result in an odd mix of some top material issues such as climate change with a legalistic boilerplate description of conventional categories of business risks (e.g. operational risk, market risk, financial risk). The lumping together without real integration of financial and sustainability information components have been most evident in early versions of lengthy "integrated" or rather "combined" reports by corporates from South Africa, where <IR> is a listing requirement of the Johannesburg Stock Exchange (JSE). Being an early mover can involve making blatant mistakes, but also provides the opportunity to lead in fixing them and defining innovative solutions.

Examining integrated reports of South African corporates of 2011, Deloitte highlighted some progress in the "integration of economic, environmental and social goals into the overall business strategy" - which was evident from the reports of about half the top 100 JSE listed corporates. At the same time, it noted "continued difficulty in addressing the sustainability / development agenda", which remained the lowest scoring element of its analysis of the integrated reports (Deloitte South Africa, "Navigating your way to a truly Integrated Report", 2012). One of the better examples of "integration" has come from power utility Eskom, surprising for a state-owned enterprise not normally known as a leading innovator. It lists various business risks "related to" its listing of material topics as identified through stakeholder engagement (Eskom Integrated Report 2014). This means that the listing of material issues is linked with the listing of business risks and opportunities, an exercise in which companies display varying degrees of well thought-out integration.

So what is the ideal type integration that a quality enterprise is expected to display? The following types of integration are at stake:
  • Organisational integration: displaying integration in the internal value chain through collaboration and alignment between different departments, or in the external value chain through various degrees of integration with partners upstream (suppliers) and downstream (e.g. clients, customers).
  • Issue integration: displaying a balanced, systematic and holistic approach to a range of sustainability (ESG) issues, able to deal with trade-offs (e.g. the water-energy-food nexus) and seeking to optimize mutually supportive economic, social and environmental outcomes.
  • Financial Non-financial integration: displaying an ability to make the connection between financial and non-financial information, having aligned business financial and sustainability accounting systems that facilitate the translation of sustainability performance metrics into financial performance metrics.
The first of the above is the oldest and most known problem in large organizations. The second is a challenge companies have been grappling with since the 1980s with the advent of the social responsibility debate in its current form. It remains an ongoing challenge, today framed in terms of integration involving not only "three pillars" but "six capitals" as included in the IIRC Framework. 

The third of the above types of integration is a more recent addition and one most critical in capturing the interest of the providers of financial capital (banks, insurers, investors). Slow progress with this type of integration is symptomatic of the fact that often regulations do not exist to ensure that externalities are adequately priced and thus automatically find their way into corporate balance sheets. The result is an endless experimentation in innovative ways to best capture the value of various forms of capital (e.g. natural, social) in financial terms. In the absence of this type of connected information, many integrated reports still fail to disclose the inter-connectivity between the different capitals as highlighted by Ernst & Young in its 2014 Excellence in Integrated Reporting Awards in South Africa. For example, if a process uses 10% less water, what are the financial consequences? What is the effect in terms of risk exposure?

Cross-referencing financial and sustainability performance information can be illustrated with the below Green Business Case Model. I developed this based on research I did for UNEP two years ago, examining leading research papers and business publications on "the business case" published from 2002 to 2012. The analysis showed a collection of indicators typically employed in business case analysis, ones that can best be categorized in three groups that refer to "sustainability action areas" (input), intermediary or lead indicators (connectors), and their impact on "financial value drivers" (output, impact on financial performance). The seven financial value drivers listed in the business case model are well known to financial analysts and investors, having been defined by scholars working on shareholder value in the 1980s.

Source: Bertoneche, M. and Van der Lugt, C.T. 2014. Sustainability and Firm Performance" in 
Sustainability Matters, The Conference Board Research Report R-1538-14-R
Based on the Green Business Case Model, each row of indicators can be captured in a hypothesis that illustrates a suggested cause and effect (if a + b à c) relation, making the integrational link between sustainability performance and financial performance. The ideal type hypotheses would read as follows:

Argument 1:  As market and regulatory demand for sustainability grows, the business that (i) makes effective use of design for sustainability and delivers greener products and services will be in a position to (ii) boost its innovation ability and attract more customers, which (iii) will show positive results in its growth of sales.

Argument 2: The business that (i) introduces greener goods and services in the market, backed up consistently by recognised standards and labels, will (ii) reap the benefit of greater brand value and reputation, which again will (iii) enable the business to sustain a good growth of sales with longer duration.

Argument 3: Through (i) the use of recognised standards and cleaner technologies in its own operations to use resources more sustainably, plus advancing those through its supply chain, a business can (ii) improve its operational efficiency - its ability to turn inputs into productive outputs in a cost-effective manner - as a result of which (iii) it will improve its operating margin or net profit margin and optimise its capital expenditure.

Argument 4: (i) Use of recognized environmental (and other) standards, combined with proper education and training in the use of such standards, and promotion of such training among suppliers, enables a company (ii) to improve its attractiveness to employees and the productivity of its employees and those of its suppliers, which (iii) serve to boost operating margin and optimal capital expenditure. Better trained employees manage fixed assets more efficiently, operating under better environment, health and safety conditions.

Argument 5: Having (i) procedures in place for systematic and principled stakeholder engagement is key for (ii) securing the local license to operate, on the basis of which a company (iii) can improve the conditions under which it operates, including an optimal tax regime under which its green innovations are recognized and rewarded.

Argument 6: A company that (i) has effective environmental (and other) risk management systems in place, communicating its use effectively through reporting and other means, is in a position to (ii) secure a better risk profile which again opens the way for (iii) obtaining capital at a lower cost. This applies to both debt capital and equity capital.

A good integrated report should provide examples of the above. This type of integrated disclosure in <IR> is still surprisingly hard to come by. One for example sees companies that report on investment in green R&D or the launch of new, green product ranges, yet making the link with overall sales growth is not evident. Others report various examples of efficiency improvements and reduction in polluting substances or waste, yet stop short of translating this into impact on overall profit margins and capital expenditure.

Could it be that (a) they lack the necessary data to quantify the cause and effect connections? Or (b) do they have the data, but hesitate to disclose it (to the general public and regulators) as the results are not seen to be sufficiently impressive? Or (c) if they have impressive data, do they not disclose it due to an unwillingness to share the information (with the general public and competitors)? If this type of integrated information does not find its way into concise, integrated reports, is it shared behind close doors, e.g. bilaterally with investors?

Not all agree with the prioritization of the third type of integration listed above, namely integration between financial and non-financial information. The IIRC has after all not positioned financial capital at the centre of its Six Capital Input-Output Model. The Reporting 3.0 conference hosted by BSD Consulting in Berlin this past October illustrated that some fear an obsession with monetisation, translating sustainability metrics into financial metrics. The emphasis on financial valuation has also drawn criticism - some ideological - in debates on Natural Capital. In the field of economics, some academics have expressed their worry that "the current enthusiasm for ecosystem service methods (used in tandem with contingent valuation methods) has locked the rhetoric of environmental valuation in a vary monistic, utilitarian, and economic vernacular that leaves little or no room for other social scientific methods, or for appeal to philosophical reasons".*

Criticisms of the emphasis on financial values can be based on three arguments. Firstly (i), many sustainability or ESG issues are too complex to be realistically captured and communicated in financial terms. It would for example be futile to reduce a discussion on human rights to financial values, considering for example only the likely costs of liability for human rights violations. Secondly (ii), it can be argued that certain issues involve matters of principle and business ethics, where financial valuation is misplaced. Even accounting standards recognise that materiality decision-making involves consideration of also qualitative information. An example is corruption, which is wrong as a matter of principle irrespective of the amount of money involved. Thirdly (iii), it can also be argued that an obsession  with monetisation leads to analysis that is backward looking and gets stuck in fine accounting details, loosing sight of broader strategic and forward looking questions. Against this background, a fourth type of integration can be identified:

  • Strategic integration: the integration of relevant sustainability and financial information into core business planning and strategy, including the business model and value chain approach pursued by an enterprise. 

This fourth type of integration highlights the fact that accounting, be it the financial or sustainability variant, will not save the enterprise or our planet for that matter. Diverse disciplines need to be engaged in the strategic transformation of business, showing an ability for multidisciplinary and interdisciplinary teamwork. But for strategic integration to effectively happen, the integration or connection of non-financial and financial information has to be made. It is a critical building block in the making of strategic integration.

Here is a call for both sustainability and financial accountants. Over the last three decades few CSR or sustainability experts have bothered to develop an understanding of corporate finance. Similarly, few financial experts and accountants have bothered to develop an understanding for the sustainability or ESG agenda. This needs to change. Sustainability accountants and financial accountants need to discover each others` domains. Considering Natural Capital, the Association of Chartered Certified Accountants (ACCA) has encouraged Chief Finance Officers to consider whether and how Natural Capital can be incorporated into financial accounts (ACCA, KPMG and F&FI. Is Natural Capital a Material Issue? 2012). This comes at a time when attempts at mainstreaming is presented in all kinds of catchy formats, from "environmental financial statements" or "environmental P&Ls" to "ethical" or "common good balance sheets".

Pressed for clarity on the business case, managers in a commercial enterprise will always need to compile in as far as possible quantitative information and translate these into financial values. The reason for this is simply that cash flows represent the blood of the commercial enterprise. It does not imply ignoring the diet of the body involved. But it highlights a liquid that is a central conveyor of vital signs, the resources and health of the enterprise. This does not imply an obsession with short termism and quarterly "vital signs". Any decent financial analyst will admit that a key performance indicator of a healthy enterprise is not short term profit, but rather sustainable cash flows in the longer term. Therefore, integration between financial and sustainability metrics is not the sole criteria but certainly one of the decisive factors in the making of quality performance. We need to see more of this type of connected information in integrated reports, if <IR> is to live up to its mission statement.

* Norton, B.G. and Noonan, D. 2007. "Ecology and Valuation: Big Changes Needed" in Ecological Economics, Vol 63, pp 664 - 675.

1 comment:

  1. Comment received from Bill Baue, Corporate Sustainability Architect, Massachusetts, USA, 29 November 2014: "Great post Cornis -- especially the notion of strategic integration. And I very much appreciate your nod to the conversations between you, Mark McElroy and me (among others) at the Reporting 3.0 Conference in Berlin in October. I imagine space considerations kept you from fleshing this line of discussion out more fully, so I wanted to add here that the point we all seemed to agree on is that monetization / pricing can only be accurate and hence effective when conducted *after* assessing a company's impact on vital common capitals within thresholds of their carrying capacities. Right now, this last step -- of assessing capitals against carrying capacity thresholds -- is almost universally neglected, hence any ensuing pricing / monetization is not really tethered to the relevant realities, and therefore arguably sending distorted signals to the market. In the IIRC literature, the best statement of the need to measure capitals against their carrying capacities comes in the last paragraph (58) of the Value Creation Background Paper: "58 Ultimately value is to be interpreted by reference to thresholds and parameters established through stakeholder engagement and evidence about the carrying capacity and limits of resources on which stakeholders and companies rely for wellbeing and profit, as well as evidence about societal expectations. Interconnections between corporate activity, society and the environment and the purpose of the corporation should therefore be understood in terms of what the corporation, society and the environment can tolerate and still survive – that will be the main determinant of value. The challenges will be to reach agreement at corporate, national and international level on what those thresholds and limits are, how the resources within those limits should be allocated, and what action is needed to keep activity within those limits so that value can continue to be created over time." "


Thank you for your comment. It will be published as soon as approved. Best Regards, Cornis