Food 4 Thought

As shareholder primacy gets dethroned, will executives lose focus?

Wouldn’t it be wonderful if we lived in a world where everything is not presented in simplistic polar oppositions? For example assuming that not prioritising shareholders implies prioritising the whole world, that all shareholders are the same and opposed to the sustainability world, that assessing financial impacts implies excluding sustainability impacts, and that the enterprise communicates through either a financial report or a sustainability report.

A decision last month by The Business Roundtable of the USA was followed by the usual array of responses reflecting extreme opposites. It among others illustrated the ongoing relevance of the AA1000 standard for stakeholder engagement, including its guidance on prioritising stakeholders. Consider the critical response by the American Council of Institutional Investors, who argued that the decision to drop the doctrine of shareholder primacy would lead to “accountability to no one”. It also criticised the listing by the Roundtable of five stakeholder groups, listing shareholders last and on top of it describing them not as “owners” but simply as “providers of capital”.

The statement by The Business Roundtable on the purpose of the corporation acknowledged that the duty of management and directors is not foremost to maximise shareholder value. The leadership needs to exercise accountability towards not only shareholders but all stakeholders. The almost 200 CEOs of the largest US corporations stated that business decision-making today should be guided by the undertaking to deliver value to all stakeholders.

Some praised the statement. It puts to end the doctrine of shareholder primacy as originated in the US since the 1930s and driven by the likes of Milton Friedman. It was never written into law, but found its way into common law through a series of court decisions. Today the view is, as The Wall Street Journal put it: “Move over shareholders. Top CEOs say companies have obligations to society”. From those who have worked in the environmental, social and governance (ESG) field since decades, there was also scepticism. Some saw it as another public relations statement in an Anglo-Saxon debate. Some noted that this is nothing radically new and that the five commitments in the Roundtable statement reflects corporate social responsibility as seen back in the 1990s.

In South Africa, a country that has been a central reference in the corporate social responsibility movement since the 1980s, the commitment to a stakeholder-inclusive approach is nothing new. This was among others reflected in the take-up by South African business of non-financial reporting and experimentation with integrated reporting over recent years. The approach is also engrained in the King Code that has steered corporate governance since the arrival of democracy in 1994. Making the case for a stakeholder-inclusive approach, the King Code puts all stakeholder types on an equal footing and notes that directors owe their duties to the company. Duty to the company is enshrined in the Companies Act. The company is represented by several interests, including those of diverse stakeholders.

The move away from prioritising shareholders and their returns was frowned upon by commentators on the Squawk Boxprogramme of CNBC television in the US. Running a profitable business is an essential component of contributing to the welfare of society. Former Nasdaq CEO Robert Greifeld sought to put Milton Friedman in perspective, noting he said “you have to maximise profit within the confines of the law and the moral ethos of the time”. The debate illustrated the common error of framing the issue in terms of two simplistic opposites, i.e. making profit (thinking of shareholder return) versus doing the right ESG thing (thinking good of society), or the sequence within which these have to be done.

Who is that shareholder that the agent is accountable to? As the recent Steinhoff accounting scandal in South Africa and Germany illustrated, there are various layers of accountability at stake. It involves owners who may be pension-holding citizens, their institutional investor funds, the asset managers responsible for investment decisions, as well as a corporate governance structure that may involve a two-tier board structure as is practiced in for example Germany and The Netherlands. It can be argued that democratic or societal interest is represented in various ways, including the presence of independent or non-executive directors on either a unitary or two-tier board.

A separate issue is that of “profit maximisation”. Profit is probably the most abused term in debates on business performance. Any financial analyst knows that profit is only one of various key indicators. In the 1980s the father of shareholder value underlined that cash flows, and their sustainability in the longer term, is more important than profit. Alfred Rappaport insisted on the need to focus on longer-term value creation. He was highly critical of short-termism.

The intention was never to “maximise profit” at any cost. Yet as industrial disasters and accounting scandals have shown, many executives and managers have fallen into the trap of maximisation, growth at any cost and short-term targets. Here also lies an onus on those defining public morals, guarding accounting norms and shaping laws to keep abreast of an evolving global sustainability agenda. This includes standards setters, market regulators and those leading government, sharing a public duty to ensure proper standards, regulations and laws are effectively enforced. What society found acceptable twenty years ago may be unacceptable today.

We will not secure sustainability by simply saying all stakeholders are relevant, and shareholders are not the top priority. Stating all stakeholders are relevant implies the ability of decision-makers to prioritise different stakeholder groups and exchange information in a manner that speaks to the needs of different user groups. If the new doctrine is to be that of Capital Providers, Employees, Customers, Suppliers and Community or CPECSC primacy, then we need to take a closer look at the information needs and level of understanding of each of these groups, ones that are interested and affected in different ways. It also requires us to improve the education of our board members and investors, enabling them to ask the right questions.

The principle of stakeholder responsiveness (AA1000) also requires a new look at how corporate reporting meets the information needs of different stakeholder groups. The annual report was historically seen as the primary vehicle through which management and directors report to their principles. In our digital age, large and complex corporations have the ability to disclose their performance and value creation story in different ways, through different vehicles. Consider the annual report (AR) as a compliance document that speaks to regulators, the integrated report (IR) as a forward-looking communication that speaks to investors and employees, and sustainability reporting (SR) as a communication that goes into the details required by for example consumer groups and community organisations. And of course these different communications need to be aligned and not contradict one another. As the CEO of the Global Reporting Initiative (GRI) commented: “corporate (and investor) interests are served when companies consider, and meet, the needs of all stakeholders”.

The IR Framework of the International Integrated Reporting Council (IIRC) defines the target audience of the IR as “the providers of financial capital”. The South African IRC gives this a broader interpretation, encouraging reporting that engages all stakeholders. Experience to date shows the risk of reports that lack focus (in terms of target audience) and continue to display a fragmented approach. Integrated reporting needs to go beyond simply presenting financial and non-financial capitals side-by-side. If CPECSC primacy is to respect the interconnection between different capitals, then the integrated report has to show the ability to translate ESG performance into financial performance. Doing this with a longer-term and future stakeholder perspective is critical in maintaining the focus of executives and their ability to effectively engage the responsible investor.

Corporate Governance in Integrated Reporting: Do we have a power failure?

Corporate governance was again frontpage news in November 2018 as Carlos Ghosn, head of the Renault-Nissan-Mitsubishi Motors auto alliance was arrested by Japanese authorities on suspicion of underreporting his income by half over the last five years. It highlights ongoing corporate governance challenges among corporations in Japan, including lack of independent oversight for executive pay. The Nissan case illustrates failure of corporate safeguards and internal control, at a company that lacked committees for audit, nominations and remuneration.

In another country where Integrated Reporting <IR> is also well established, the South African government is struggling to clean up corporate governance at state-owned enterprises. In November the Finance Minister suggested that the highly indebted South African Airways should be shut down. Governance at the company has progressively failed amidst alleged corruption during years of the Zuma presidency. The same scenario is evident at the power utility Eskom, which Government is seeking to revive with a new Board and reforms to control state-guaranteed debts of over US$ 30bn.

Failure in governance as illustrated by these cases raises questions about the impact of transparency and disclosure to combat fraud and improve the quality of governance. In both Japan and South Africa, new corporate governance codes explicitly promote principles such as ethical leadership, transparency and independence. The first principle of the King IV Code of 2016 is that “the governing body should lead ethically and effectively”. This includes transparency and the view that “sunlight is the best disinfectant”, as famously stated by US Supreme Court Justice Louis Brandeis in 1914. But how and where best to disclose information on corporate governance, in a manner that avoids the “mindless compliance” often attacked by IIRC Chair Mervyn King?

In its latest assessment of what material topics the 60 Industry Leaders of the Dow Jones Sustainability Index (DJSI) most report on, Materialitytracker noted a significant trend in how and where corporate governance is reported on. An automated analysis was done by Datamaran of latest annual reports published up to October 2018 by 48 of the Industry Leaders. Using natural language processing (NLP) in scanning the sustainability reports (SRs), integrated reports (IRs) and financial reports (FRs) of the companies involved, the Artificial Intelligence technology found (as in the past) that Governance is a thematic area most covered in FRs.

While business ethics and corruption are among a top 10 issues most emphasised in SRs and IRs, the Datamaran screening found that the 15 IRs published to date this year by DJSI Industry Leaders do not devote significant attention to governance. This is rather addressed in FRs. The top 10 most emphasised topics in FRs include the governance-related topics of employee compensation and benefits (#1), anti-corruption and bribery (#2), business ethics (#3), executive compensation (#8) and board compensation (#9).

Considering that governance is one of the key content elements of the <IR> Framework, it is surprising that sustainability leaders do not devote more attention to governance in their <IR>s. While governance as a compliance theme is traditionally dealt with in FRs as statutory reports, one would expect the more strategic content of <IR>s to clearly address the role of governance as part of integration in reporting, processes and thinking. This is all the more important considering recent findings by the South African IRC (2017) on weaknesses in reporting on governance. A clear weakness was found to be lack of explanation of how governance structure, processes and practices contribute to the value creation process.

Consultations on the IIRC <IR> Framework in 2017 showed limited uptake of the required responsibility statement by “those charged with governance”. This raises the challenge of ethical and effective leadership. Effective disclosure on corporate governance in <IR>s deserves closer examination. As Judge Brandeis added many years ago, “electric light (is) the most efficient policeman”. While some powerful corporations struggle to keep the lights on, we are best advised to pay closer attention.

Climate-related financial disclosures: Task Force seeks to nudge-rock the system

A decision last month by The Business Roundtable of the USA was followed by the usual array of responses reflecting extreme opposites. It among others illustrated the ongoing relevance of the AA1000 standard for stakeholder engagement, including its guidance on prioritising stakeholders. Consider the critical response by the American Council of Institutional Investors, who argued that the decision to drop the doctrine of shareholder primacy would lead to “accountability to no one”. It also criticised the listing by the Roundtable of five stakeholder groups, listing shareholders last and on top of it describing them not as “owners” but simply as “providers of capital”.

Some praised the statement. It puts to end the doctrine of shareholder primacy as originated in the US since the 1930s and driven by the likes of Milton Friedman. It was never written into law, but found its way into common law through a series of court decisions. Today the view is, as The Wall Street Journal put it: “Move over shareholders. Top CEOs say companies have obligations to society”. From those who have worked in the environmental, social and governance (ESG) field since decades, there was also scepticism. Some saw it as another public relations statement in an Anglo-Saxon debate. Some noted that this is nothing radically new and that the five commitments in the Roundtable statement reflects corporate social responsibility as seen back in the 1990s.

The move away from prioritising shareholders and their returns was frowned upon by commentators on the Squawk Box programme of CNBC television in the US. Running a profitable business is an essential component of contributing to the welfare of society. Former Nasdaq CEO Robert Greifeld sought to put Milton Friedman in perspective, noting he said “you have to maximise profit within the confines of the law and the moral ethos of the time”. The debate illustrated the common error of framing the issue in terms of two simplistic opposites, i.e. making profit (thinking of shareholder return) versus doing the right ESG thing (thinking good of society), or the sequence within which these have to be done.

IIRC London conference makes the case for change in values and culture

Values, culture and the meaning of numbers and time were key themes of discussion at the annual conference of the International Integrated Reporting Council (IIRC) held in London on 6-7 December. The event was co-hosted with the International Corporate Governance Network (ICGN), helping the IIRC to boost its outreach to the investment community.

“We don’t talk about profit, we talk about value creation,” said IIRC Chair Judge Mervyn King as he set the tone for the event with his opening address. He highlighted new features of the King IV Code of Corporate Governance that was launched in South Africa in November. An important aim with King IV was to boost mindful governance versus mindless checklisting or a compliance driven approach that in some cases resulted from the long list of principles that featured in earlier versions of the Code. The new version with its “apply and explain” regime has a consolidated list of 16 basic principles or outcomes that define quality of governance.

King also made a plea for not getting stuck in financial figures, as opposed to focusing on broader corporate performance. His new book The Chief Value Officer (Greenleaf 2016) argues the case for the Chief Financial Officer (CFO) to become a Chief Value Officer. The role of the CFO cannot be reduced to overseeing the preparation of financial statements. Rather, it should be the role of being custodian of the values of the corporation. This also requires not getting stuck in data and senseless information. Don’t let knowledge get lost in information, is the motto. King was a well deserved recipient of the ICGN Lifetime Achievement Award given to him.

“Money is an incredible servant but a very poor master,” said Bertrand Badre, former CFO of the World Bank in his opening keynote. He gave a historical overview of loss of trust in the financial system following the global crisis of 2007 onwards. Questions remain about the role and profitability of banks, who are supposed to be utilities and key foundations of a stable system. Loss of trust in the system globally again underlined the importance of multilateralism and collaborative standards that are internationally recognized. Today the Financial Stability Board (FSB) continues to explore uncharted territory.

On 14 December 2016 the FSB Task Force on Climate-related Financial Disclosures (TCFD) published its recommendations for public comment. The Task Force was asked to propose voluntary, consistent climate-related financial disclosures that would be useful to investors, lenders, and insurance underwriters in understanding material risks. Providing core recommendations related to governance, strategy, risk management as well as metrics and targets, the Task Force recognizes the importance of organizational context. It noted governance and risk management context as key to appropriately understand the financial and operating results of an enterprise.

Bertrand Badre challenged participants to go back to basics and ask what finance is really all about. This set the scene for the first plenary session on “Aligning the capital market system for 21st Century needs” chaired by David Pitt-Watson of London Business School. When I interviewed Pitt-Watson in 2012 for the publication Making Investment Grade: The Future of Corporate Reporting (Deloitte et.al. 2012) he emphasized the impact of reporting requirements on listed companies in expecting them to account for themselves. The mere requirement and sense of being observed enhances behavioural change in the first place. Of course, he added, the more relevant and clear the information the company discloses, the more likely it is to gain the trust of investors.

One key reminder of the session was that trust is the lifeblood of the financial sector. And in the case of investment management, earning that trust today requires a new interpretation of fiduciary duty. It also requires rethinking the meaning of terms such as “value” and “wealth”, and re-examining current regulatory frameworks and standards that work against as opposed to in favour of long term decision-making.

Fiona Reynolds, Managing Director of the Principles for Responsible Investment (PRI) reported their current examination of the role of regulation and culture in the system. With its current membership representing 62 trillion US$ in assets under management (AuM), the PRI has had to ask some critical questions about the pace of progress in its 10th anniversary year. Its 2016 Practical Guide to ESG Integration for Equity Investing gives an overview of integration techniques, including traditional, fundamental strategies and quantitative, systemic strategies. The CFO of United Utilities argued the value of accounting in being quantitative first and foremost, which enables more easy comparison between companies. Important to note is that accounting as discipline was not just created to draw up financial statements. It was established as profession with the purpose of enabling accountability and stewardship.

In a session on C-suite perceptions on long-term value creation, it was mentioned that the annual report (AR) will exist as long as the regulator thinks it has to exist. The integrated report (IR) holds the prospect of a more authentic communication on the vision and direction of an enterprise. Communications agency Black Sun stressed the importance of the process, versus something like an AR that in some respects just becomes a filing cabinet. Jonathan Labrey, Chief Strategy Officer at the IIRC, argued that ARs just give you a databank, with P&L data out of context. In contrast, the IR starts with a discussion on business model and strategy, which only thereafter is followed by disclosure of data in as far as relevant.

On the relative merits of more qualitative versus more quantitative and financial metric approaches, Itau Unibanco Group Finance Director Alexsandro Lopes cautioned that the only precise figure on a balance sheet is the date. Some argued the case for using the term “pre-financial” as opposed to “non-financial” information, aware that in the longer run all relevant information translates into implications for corporate financial performance. Interserve Plc reported that its experience of experimenting with alternative or integrated P&L statements was one of getting stuck in technical details and losing sight of the bigger picture. When dealing with multicapital dynamics, the fact is that some things are simply not measurable.

But some surprising lessons are being learned about measuring the seemingly unmeasurable. SAP described ways in which it links human and intellectual capital performance (including related IP) with financial performance metrics, among others tracing revenue from new products as percentage of new order value. Eisai Company from Japan mentioned how skepticism regarding corporate governance quality leaves as much as a third of listed Japanese companies trading at a market value below their book value. This contrasts with companies such as SAP that has had a Price to Book Value (P/BV) ratio in 2016 of often well over 3.50.

A session on corporate governance and ESG in long term investing hosted by MSCI Inc illustrated the fact that aspects of Governance (G) are better defined, more consolidated and more easily linked with better financial performance in ESG investment analysis. As a result, noted MSCI Global Head of ESG Research Linda-Eiling Lee, “G” aspects are today more factored into mainstream investment analysis than “E” and “S” aspects. This complicates research to demonstrate superior performance of ESG-rated stocks, in as far as all equities already have governance criteria applied in their weighting. It signals the complications of attribution, seeking to map cause and effect relations in making the business case for an ESG approach. Looking at the time dimension, Will Oulton of First Estate Investments and co-author of Taking the Long View by the Cambridge Investment Leaders Group (ILG), indicated that based on typical market cycles they consider 5-7 years as “long-term”. The ILG surveys investors to track how the investment management culture is evolving. It is an evolution in which some prefer to speak of a movement towards “sensible investment”. Rather than existing, “alternative” terms such as “(socially) responsible” investment, this is meant to signal a new understanding of what constitutes quality of management and governance.

A plenary session on investor views showed different perspectives on what constitutes effective stewardship and different levels of activism in ownership or asset management. Stewardship can take many forms, of which active voting is only one. The process of engagement with investee companies can be invaluable, among others in bringing Investor Relations and Sustainability departments to the same table. Michelle Edkins, Global Head of Investment Stewardship at BlackRock stressed the importance for asset managers to explain to clients how ESG information is actually used.

Again the shortcomings of numbers cropped up. No accounting figure is absolute and plenty of subjective managerial estimates are involved in corporate financial as well as investment decision-making. Coming up with future estimates, estimating the ability of a company to generate certain cash flows in future, cannot be seen as a mechanistic exercise. The need to put numbers in appropriate context was also evident from a closing keynote address by Sir Win Bischoff, Chair of the UK Financial Reporting Council, who spoke of the importance of a healthy corporate culture, with supportive values and quality in leadership. With this comes the expectation of improved reporting on culture, enabling the better application and assessment of stewardship.

Discussions also showed uncertainty about the role of new information and communication technologies (ICTs), including artificial intelligence, in enabling sustainable investment. This was also the theme of a Responsible Investor webinar on which I was panelist in September, entitled “Can FinTech and AI solve the ESG data puzzle?”. Does an increase in more passive investment strategies, electronic trading and indexed funds by definition lead to a dominance of market short-termism? Is the share just casino chip, an up/down directional bet? This was asked by Saker Nusseibeh, CEO of Hermes Fund Managers.

Acknowledging that appropriate time frames are different for different industry sectors, the FSB Task Force in its latest recommendations noted that many organizations conduct operational and financial planning over a 1-2 year time frame and strategic and capital planning over a 2-5 year time frame. It encouraged climate reporters to consider appropriate longer term time frames within their industry context, considering the life of their assets and the profile of the climate-related risks they face. Michel Prada, Chair of the IFRS Foundation Trustees that oversees the International Acounting Standards Board (IASB), argued that he doesn’t necessarily see an inherent tension between short term and long term considerations in decision-making. When you run a marathon, you need regular time updates even while you are certainly intent on running the full marathon.

Marathon is what came to mind in discussion of the international corporate reporting infrastructure. Many called for convergence between different reporting standards. New IIRC CEO Richard Hewitt told the story of a driving instructor who gave him an invaluable lesson many years ago: Do not be fixated by the dashboard indicators right in front of you… look at the road ahead and watch where you are going. He has full confidence in the Corporate Reporting Dialogue initiated by the IIRC and other reporting standard setters. Transparency International Chair Huguette Labelle highlighted two outputs of the Dialogue to date, namely the Reporting Landscape Map and Common Principles of Materiality Document published in 2016. Both documents are very introductory and only scratch the surface. Clearly there is room for plenty more dialogue in years to come. This includes dialogue to bridge the gaps between different professional cultures of the different standard setter networks involved.

* I attended the ICGN-IIRC Conference as representative of BSD Consulting, headquartered in Zurich, which was announced in early 2016 as the IIRC’s first global certified <IR> Training Partner. Information on the IIRC Training Partners and <IR> Training Programme can be found on the IIRC website.

Materiality: Talking heads, talking numbers and talking finance…

Materiality had some sober moments at the GRI Global Conference in Amsterdam this May. It was evident that established reporters are asking more pertinent questions about the value of the materiality determination process. Some are starting to do it less frequently (for example every three years, not annually). This raises three important questions:

The frequency or timeliness of the materiality determination processes;
The level at which the process is conducted – for example from local community engagement to global “expert” stakeholder panels; and
The extent to which reporters build in a forward-looking dimension and ask stakeholders about “actual” versus “potential” significance.

On the time dimension, RobecoSAM noted during the Sustainalytics Master Class that the time horizon it applies for specific issues is typically three to five years. Applicable time frame is influenced by both the industry sector and the issue context involved. In the case of an issue such as climate change, significant events can range from very long term to very short term developments. The Conference featured findings from the first report of the Financial Stability Board (FSB)’s Task Force on Climate-Related Financial Disclosures. The report states that climate risks can result in disruptive events, and that such cases require a timely update of climate-related disclosures. At the same time its recommendations expect longer term, forward-looking information that is backed up by scenario analysis. The implies adequate research. Note that international reporting standards typically recommend five tests for applying the principle of materiality (see Materialitytracker for a comparative overview). They imply not only stakeholder engagement but also a fair amount of desk research. In its materiality methodology the Sustainability Accounting Standards Board (SASB) has described it as examining evidence of interest, evidence of financial impact and consideration of forward-looking impact (including possible systemic disruption). With respect to time frames in the context of specific industry sectors, ABN AMRO noted that private banks (working with family money) would tend to think longer term, corporate banks would tend to focus more medium term and retail banks more short term. Compared to other financial subsectors, retail banking is more regulated and exposed in offering products of relatively small amounts at high interest rates to for example households. Being more regulated and exposed to consumer pressure also leaves retail banking or consumer finance with topics such as affordability and privacy as highly material issues according to the sector standards of SASB. On the other hand, SASB does not list business ethics as a material topic for consumer finance, but rather for commercial banking, investment banking and asset management among seven subsectors of the “financials” sector category.

For leading reporters the prioritization of stakeholder groups are becoming more refined. This includes being more focused in targeting certain business unit leads, rating agencies and investors for engagement. Experts on global stakeholder panels can provide valuable advice to multinationals, often free of charge mind you, but after years of operation some of those “critical friends`’ can become too “friendly”. Some business managers express the sentiment that much of the materiality determination process boils down to common sense or gut feeling, and that there is little need for doing an extensive process every 1-3 years. For some simply going through the materiality process annually becomes a “tick the box procedure” that risks no longer being strategic.

Some exclude from the materiality determination process discussion of topics seen to be “universally material” – topics such as governance and ethics noted Deloitte in its Materiality Master Class. Describing its approach, RobecoSAM explained that some “cross-cutting topics” are evaluated irrespective of their position on its industry sector materiality matrix. These are topics such as corporate governance, codes of conduct and reputational risk (assessed through media analysis)

The special status of some topics brings to mind an issue raised by the online hub Materialitytracker, namely level of aggregation and the level of specificity at which material topics are defined. Materialitytracker identifies the key material topics reported across sectors by the DJSI Industry Leaders since three years. Some define material topics at the level of “Aspects” (as per GRI G4), listing topics such as “governance”. Others go to a deeper (in some cases indicator) level and prefer to be more specific in defining topics – for example “director remuneration” and “scope 3 emissions” – i.e. subthemes of “governance” and “climate”.

In the most recent edition of Defining What Matters (2016), the GRI and RobecoSAM differentiates their definitions of materiality as being about “reporting materiality” versus “financial materiality”. A graphic in the report (see below) illustrates that the list of topics that represent “reporting materiality” and “financial materiality” overlaps but that neither fully encapsulates the other. Traditionally, certainly in financial accounting, the assumption is that”materiality” is about content that goes into a report. The question then becomes: Which report?

During a session presentation of their study (covering the three sectors mining, metals and utilities) at the Global Conference, GRI’s Alyson Slater posed a question about possible differences between what is reported to be material versus what the sustainability rater finds to be material. Why did some participants expect any difference between what reports from a particular sector disclose to be material versus what RobecoSAM in its analysis of that very same group of reporting companies may found to be most material. I argued it depends which report you are looking at. If it were a sustainability report, its content may be highly material in the eyes of diverse stakeholders. However, if it were an integrated report, the content may more specifically be “financially material” in the eyes of the providers of financial capital. RobecoSAM is quick to point out that its sectoral materiality matrices reflect the views of RobecoSAM as investor (asset manager). Its focus on “financial materiality” or what I would call “integrated materiality” therefore resembles the content one would expect in an integrated report as defined by the <IR> Framework of the International Integrated Reporting Council (IIRC).

The Sustainalytics Master Class included a panel discussion with RobecoSAM, ABN AMRO , E&Y and an academic from City University London. Sustainalytics highlighted the findings by Harvard researchers Khan, Serafeim and Yoon(2015) that firms with good performance on material sustainability issues significantly outperform firms with poor performance on those issues. This is based on their examination of the stock performance since the 1970s of 2307 firms from the MSCI KLD dataset and cross-referencing sector-based material topics as identified by SASB in the USA. They conclude that investments in sustainability issues are indeed shareholder-value enhancing.

In describing its value-added analysis to support more informed investment decisions, Sustainalytics noted that certain “key ESG issues, if unmanaged, may have significant negative impacts on an issuer’s business and/or the environment and society”. This raises the possibility of certain issues – such as human rights – not being viewed as “financially material” to a reporting organization even though it may have significant negative impact on society.

RobecoSAM described how it feeds “financially material sustainability data” into its integrated analysis to determine fair value. Just to be clear, the latter refers to the value of a share price. Based on its assessment of sustainability risks and opportunities, a certain percentage gets added or subtracted from share price to determine the eventual “fair value”. Annual reportback by members of the UN Principles for Responsible Investment (PRI) suggests that this integration with the fair value analysis of listed equities is still a minority practise. While possibly half (USD 60 trillion) of Assets under Management (AUM) world-wide are signed up to the PRI today, this obviously does not imply that all signatory members overnight apply all the principles to 100% of their portfolios. In the recent independent evaluation of the PRI following ten years of its existence, the PRI itself acknowledges that its signatories’ implementation still lacks depth

RobecoSAM assured participants that it considers both the downsides (risks) and upsides (opportunities) when adjusting value, despite using (like IIRC) the risk analysis matrix and considering magnitude alongside probability as framing criteria. Its integrated analysis involves assessing financial materiality by examining impact on the business value drivers – namely revenue growth, profitability, capital efficiency and risk profile. This is based on the financial value drivers identified by Alfred Rappaport in the 1980s, as I highlighted before (see Integrated Reporting of 21 November 2014). They are also employed in the methodology of Sustainalytics, which in its Extended Shareholder Value Model makes the link between ESG issues and the financial value drivers – including cost of capital and tax rates.

The “financial” impacts are also the focus of the FSB Task Force, which highlights the lack of “reporting regimes” or disclosure instruments that specifically extend the analysis to this level (in particular financial risks). The first of its seven recommended principles for climate disclosure addresses materiality, stating that “Disclosures should present relevant information”. In explaining this principle, it zooms in on “business model and strategy” (like the IIRC <IR> Framework). It argues that a company “should provide disclosures to the extent the underlying aspects can have a significant impact on the business model, strategy risks, or future cash flows”. Traditionally, the latter is of primary interest to financial analysts and investors. The primary interest of the Task Force is financial reporting (considering disclosure venue / placement), and it displays greater concern about “risks”. Its definition of “materiality” describes it as being about “information on economic, environmental, social and governance performance or impacts that should be disclosed” (own emphasis).

Back at the Conference master classes, Jean-Pascal Gond of Cass Business School described the focus on the financial dimensions of ESG impacts as a form of legitimization. With it comes the risk of being too narrow or reductionist in focus. Heather Lang of Sustainalytics described it as thinking more about financial materiality as you narrow it down. Their approach to thresholds in determining materiality is not focused exclusively on “financial” materiality though. It is not a simple mathematical formula of determining significance only in financial terms. Clearly the unpacking of costs and benefits is not an exact science (as yet). Even financial accounting standards have always made clear that materiality involves (experienced) judgment, one that considers of both quantitative and qualitative information, as well as financial and non-financial information.

Read Part I on the GRI Global Conference 2016, 31 May

Big Data and Materiality: Lost in translation?

Data was the centre of excitement at the GRI Global Conference held in Amsterdam this past May of 2016. Having been part of the GRI process since its foundational days, it has been fascinating to see the movement evolve from the early mission “for sustainability reporting to become as routine as annual financial reporting” to the new mission “to liberate sustainability data from reports”. Only in this way can the data be analyzed and integrated in a meaningful way, argues GRI chief executive Michael Meehan.

And while many assume that more data will bring us closer to solutions, wise words at the Conference came from statistics professor Enrico Giovaninni from the University of Rome. He cautioned that data also creates new divides. For one, the data debate tends to be dominated by IT specialists, statisticians and consultants throwing about the latest jargon. It tends to be a technical or expert debate that may very well leave many GRI stakeholders feeling alienated. This brings the challenge of turning complexity into simplicity, an art for which one needs Steve Jobs-type technology visionaries.

As we weigh the opportunities offered by more data, do not forget the old phenomenon of “information carpet bombing”. It is one that sustainability thought leaders like John Elkington himself identified in the early 2000s. What is really Big Material in the face of Big Data? During a plenary debate at the Conference someone mentioned that the predictions made by the Club of Rome in the early 1970s are still surprisingly accurate. The global trends and exponential growth in world population, food production and resources depletion as focused on by the Limits to Growth (1972) computer simulation study may indeed leave us with global system collapse by 2050. If they were so accurate and common sensual over fourty years ago, based on data available back then, what more do we really need today? At what point does common sense kick in? What should make us conclude that so much more data in the 2010s will suddenly help us to see the light of day and dramatically transform in a ways we have not been able to do in the last five decades?

During the launch event of the 10th anniversary edition of our report Carrots & Sticks with KPMG, UNEP and GRI, I pointed out that the Sustainable Development Goals (SDGs) can be thought of as a “shortlist” of the key material topics for our globe at this point in time. Despite the interest in these themes, what was coming short at the GRI Conference was making the connection between the SDGs, Big Data and the new GRI standards. Often lacking in plenary discussions on data was:

Associating the data with the performance of individual organizations (i.e. reporting companies), being entity specific and making the macro-micro link as opposed to a generic discussion on all sorts of data (including Big Data); and
A lack of appreciation of the mass of contextual data that has been collected by governmental institutions and international public research initiatives since decades. (These include the data collected by institutions such as NASA, the World Bank and UN Global Observing Systems.)

The first above is addressed more or less directly by initial recommendations from the new GRI Technology Consortium on the future of sustainability data, made public at the Conference. One of its five recommendations is the need for a public and open global repository of public sustainability data. One could argue that this is provided by platforms like Corporate Register, which hosts over 75000 corporate reports accumulated since the 2000s. But the Consortium’s interest is in making it easier to access, extract and compare data outside of “reports”, in a world beyond paper and PDF documents. The easier access and comparability of data also makes the case for more specific GRI standards (on subcomponents of the GRI Guidelines).

The focus on digital information presents all sorts of challenges for old disciplines such as the legal profession as I’ve argued before (see “Good bye sustainability reports, hello sustainability reporting“, May 2014). The Consortium recommendation is also different in that it asks for a public good. This is different from the equivalent information service provided on commercial terms by the likes of Bloomberg and Thomson Reuters to investors. An example of what the Consortium may have in mind is the new Wikirate, a platform profiled in a workshop on “Radical Transparency” hosted before the Conference by the Reporting 3.0 initiative. Wikirate relies on crowdsourcing to compile data and information on various aspects (as per GRI G4 and others) of a company’s operations. This includes data reported by the company itself, as well as data available publicly from other sources.

The Wikirate approach reminds of recent reports by Thomson Reuters and BSD Consulting on the GHG emissions of the Global 500, in which publicly available information was used to estimate the GHG footprints of almost 150 of the Global 500 who still do not disclose their GHG emissions. As exciting as Wikirate is, the Berlin-based initiative will be challenged in (a) mobilizing public support (beyond mainly post-graduate students from say Europe) and (b) looking beyond the usual suspects, for example a top 100 companies who report extensively, versus thousands of lesser known, large companies world-wide who in many cases do not even disclose significant sustainability data in the first place.

The movement for large-scale disclosure and collection of information, engaging diverse stakeholders, brings us to the decision-usefulness of information or more specifically data, who the target decision-maker is and materiality. Discussions in recent years on “integration” and the need to replace information “clutter” with concise, strategically relevant information have highlighted the need to align the understanding by different professions of what “materiality” really means.

In its latest annual Reporting Awards, Corporate Register (see CRRA 2016) employed “Relevance and Materiality” as one of its criteria. It describes it as focusing on:

“the report which cuts to the chase and tells us about the material issues (those that are specific to the company performance and sector, the risks and opportunities), clearly and succinctly“.

Most will agree that this sounds attractive indeed. Such clarity (or the lack thereof) also has important implications for business model innovation. Being clear on materiality is key for making the business case, having a convincing value proposition and defining a business model that has sustainability built into it. So argued Knut Haanaes, Geneva-based partner of The Boston Consulting Group (BCG) in a recent webinar on their latest annual survey report with MIT Sloan Management Review. The 2016 edition of their Global Executive Study on corporate sustainability highlights that senior executives underestimate the level of interest that senior investment managers are showing in ESG data.

The GRI Technology Consortium members include MIT Sloan. Its survey with BCG hints at a certain skepticism about sustainability ratings today (were they able to predict BP and VW type scandals?) and the possibility that more companies are developing their own benchmarkings in-house. In defence of sustainability ratings, service providers such as Sustainalytics would argue that more advanced rating today has become more dynamic in reflecting changes in the materiality of topics. The new GRI standards approach also recognizes the evolving nature of an ESG agenda and will allow for the formulation of individual topics and indicators to undergo revision on a “when required” basis. Furthermore, agencies such as Sustainalytics would argue that more integrated rating today is also applying more rigorous weighting based on materiality considerations informed by quantitative data analysis. The emerging ESG Ratings Hub of the Global Initiative for Sustainability Ratings (GISR) will provide more transparency about the nature and quality of methodologies applied by rating agencies (including those accredited for applying the GISR principles).

Somewhat data-bombed and lost in translation at the GRI Conference, I attended materiality-focused discussions and two Master Classes on Materiality presented by respectively Deloitte and Sustainalytics. Two themes that struck me was (a) perspectives on the materiality determination process, including how the time dimension is dealt with, as well as (b) making the link between sustainability data and financial data. Let me start with the process.

Materiality process and its value
The master class by Deloitte among others highlighted the apparent disconnect between, on the one hand, (i) a resource intensive process of determining materiality that companies conduct every 1-3 years, involving often diverse stakeholders, and, on the other hand, (ii) the content provided in sustainability reports or content tabled at senior / top management discussions. If a company invests all the effort in determining material topics through an inclusive process, it is puzzling and a missed opportunity if strategic and Board level discussions do not effectively make use of the resultant information. The latest WBCSD Reporting Matters (2015) study found from its examination of 169 WBCSD members’ non-financial reports that while 82% of them disclose the use of a materiality determination process, only 30% focus their reporting on those issues they consider to be material to their business.

Talking to South Africa’s Mervyn King afterwards, he underlined to me the importance of exposing Board members and ensuring they hear what diverse stakeholders have said. This was echoed in the second Master Class, hosted by Sustainalytics, where Jean-Pascal Gond of Cass Business School (City University of London) argued that the materiality analysis has institutional value in that the matrix tool presents broader societal concerns, helps to renegotiate boundaries and coordinate the actions of people.

Who to involve in the materiality determination process and at what level remains open to experimentation. In the 2000s I worked with AccountAbility in developing The Stakeholder Engagement Manual (2006). Its guidance on how to prioritize stakeholder groups remains highly valuable. Describing its process, ABN AMRO bank highlighted its categorization of stakeholders in four priority groups: clients, investors, employees and society at large. Producing an integrated report based on the IIRC <IR> Framework, it describes its value creation process in terms of the six Capitals. Under Financial Capital, it highlights with respect to inputs its reliance on investor equity and client deposits. Also under Financial Capital, it highlights with respect to outputs the bank’s contribution to the national economy by providing debt capital (lending) to households, small businesses and corporates as well as its improving Return on Equity (RoE) to ensure a good dividend paying capacity vis-a-vis its shareholders (investors).

As one of the three biggest banks in The Netherlands, it is no wonder that three of the top material topics reported by ABN AMRO is the privacy, security and stability of digital services to its clients. Another is compliance with legislation and regulations. The new Carrots & Sticks report indicates that financial institutions have received special attention in many new disclosure requirements introduced by diverse instruments (regulations and other) over the last five years. If what is required by law to be included in an annual report (for example a statutory document) were to be material by definition, one cannot help wondering if in some cases what is material may not be strategic.

More on this in Part II of my GRI Global Conference 2016 blog.