Investors are realising that sustainable business models often mean higher shareholder returns
Interview with Prof. Pavan Sukhdev by Mauro Meggiolaro
Prof. Sukhdev, which are the main advantages of non-financial indicators compared to traditional financial ones?
Conventional financial indicators that are part of statutory financial repoorting (as part of Profit & Loss Accounts & Balance Sheets) are inadequate for companies to measure stakeholder value creation/destruction as a result of their business practices. Designed to cater specifically to shareholders, these financial indicators disregard the legitimate impacts & dependencies that companies have on other stakeholders such as employees, government, local communities, consumers, etc.
Additional indicators of impacts on capital categories and ownership classes (other than impacts on financial capital owned by shareholders) enables companies to measure their business holistically, and are essential for any company to
a) Identify risk “hotspots” associated with business externalities, impacting any class of capital in any category of ownership, and mitigate such risks across their value chain
b) Avail of new business opportunities linked to development of technology & new products.
This allows companies to adopt better business strategies – addressing all stakeholder values and not just shareholder value – which facilitate better adaptability, risk mitigation, production efficiency and access to new markets or segments. These additional indicators may be non-financial, or they may be valued in financial terms where possible and appropriate. They are increasingly needed to address the demands of investors, regulators and consumers seeking sustainable solutions.
How can non-financial indicators be a driver for sustainable, long-term corporate growth?
Using indicators other than financial indicators from statutory financial reports enables business responses to externalities to be prioritized, appropriate, effective and efficient in reducing or offsetting negative externalities and increasing positive externalities. This also allows companies to focus on their most material impacts, whilst looking to make improvements which can contribute to further business growth and improvements in public wellbeing.
For example, developing their integrated report enabled “back-to-nature” luxury hospitality providers Soneva to not only illustrate the value that they are generating for local communities, employees and the natural environment; but also identify additional avenues for reducing the total environmental impact of their food & beverage supply chain and luxury resorts. Responses designed by Soneva Group included a 2% environmental levy on room revenues and switching to more renewable energy (such as solar PV). As a result Soneva continues to provide exemplary hospitality services whilst driving better business decisions, improving resource allocation and exerting positive influence over business decisions of their suppliers and value chains.
Shareholders have historically been focussed on traditional short-term financial indicators to evaluate investments in a company. Is this still true? If not, what is changing in the investors' perception in your opinion?
Companies are becoming increasingly aware for the need to move beyond reporting only on shareholder wealth generation and are beginning to realize the urgency and the need for incorporating stakeholder value creation in their business reporting.
This is a direct response to the growing demand for a wider set of performance indicators fuelled by new trends amongst investors in general (and not just specialist sustainability portfolios) of actively checking, filtering, and finding businesses that are both sustainable and profitable. According to the 2016 Review Report by Global Sustainable Investment Alliance, as of 2016 global sustainable investments had reached an estimated US$ 22.89 trillion – almost a tenth of all global financial assets – following several years of record growth.
This change in investor mind-set is being driven by the realisation that sustainable business models do not necessarily mean lower shareholder returns. On the contrary, companies with good sustainability track records are increasingly capable of managing risk, better able to adapt to changing regulatory climate, deliver better operational performance, build longer lasting consumer relationships, enhance brand and positively influence stock performance both in the short and the long run. In short, sustainability is both good for business and good business.
Which possible disadvantages of using non-financial indicators should be avoided and how? (Excessive internal bureaucracy, excessively time-consuming procedures, lack of causal links to financial performance, etc.?)
A key challenge when using non-financial indicators, or monetized indicators of natural, human and social capital, is the trade-off between accuracy and comprehensiveness. This is linked to the current status of big-data frameworks that most businesses implement. While there is significant volume and high quality of financial information generated along value chains, comparable non-financial data for generating comprehensive analysis of a company’s performance is generally lacking. To address this challenge, companies need to invest both time and resources in an efficient manner towards setting up better data capture and processing frameworks and systems..
The key to achieving higher levels of effectiveness is a focus on materiality. Companies need to identify their material impacts on all stakeholders, public or community or private, and invest in developing key performance indicators (KPIs) addressing the most significant classes of impacts, i.e. physical, natural, human and social capital.
Unlike accounting measures, non-financial data are measured in many ways, there is no common denominator. Many companies attempt to overcome this by rating each performance measure in terms of its strategic importance for the company. Is this correct in your opinion? What else could be done
Currently companies report on non-financial indicators using multiple standards / frameworks which are being developed at an international level, whether it be the Natural Capital Protocol (NCP), the Global Reporting Initiative (GRI) Standards, the Carbon Disclosure Project (CDP), International Integrated Reporting Council (IIRC) framework, Inclusive Wealth (IW), etc. depending on their materiality requirements. All these are steps in the right directions, but to say that there is no common denominator is inaccurate.
Of late, reporting practices are evolving to enable companies to not only quantify impacts across multiple dimensions of wealth, but also to measure stakeholder value creation on a monetary basis –enabling comparison with traditional financial reporting practices.
For example, In 2014, AkzoNobel released their 4D P&L Report based on a pilot study of their Pulp and Performance Chemicals business in Brazil, which specifically looked at the company’s environmental, human, social and financial impact – making it the first company to truly present a quantified integrated report.
Integrated reporting provides companies with the necessary tools to measure their impacts across multiple dimensions of wealth, and furthermore enables them to monetize their material impacts. Acknowledging value generation/destruction associated with business practices in a common language (the language of currency) is essential for corporate managers, investors, governments, civil society and customers to differentiate their responses to different corporations on the basis of their real performance.
Additionally, companies need to focus on integrating the information provided by such KPIs into their business strategy, in order to offset the costs incurred as a result of negative externalities with benefits generated via positive externalities across same dimensions of wealth, to achieve net positive value. Only then can a company be truly said to reflect its real performance.
How can non-financial indicators be integrated in the remuneration of managers? To what extent does it make sense to include non-financial indicators in short- or long-term incentive plans?
Financial performance indicators (PBT; PAT; EBITDA; etc) enable businesses to incentivize managers to achieve specific targets set by the company. Similarly, non-financial indicators too can be used to galvanize management towards improving company’s stakeholder performance and measure such performance on a year-on-year basis.
From an internal perspective, such non-financial indicators are a superior way to present business performance, using metrics that can be easily integrated and benchmarked, allowing managers to balance the short-term and long-term creation of value; and enabling board members and investors to determine whether management’s policies and the company’s share price are on target.
Non-financial indicators normally focus on long-term strategic goals while traditional financial indicators are oriented to short-term performance. How can these two sets of indicators be successfully integrated? Is it always appropriate to identify a link between single non-financial indicators and their impact on the financial performance of a company?
When considering business externalities, one must remember that eventually most business externalities can get internalized: either by design, decree or disaster (the” 3 D’s” of internalisation of business externalities). In the medium and long-term, businesses that evolve to identify and measure material externalities across all capital dimensions will set themselves on a trajectory that enables them to design responses to their externalities and thereby internalize them “by design”, i.e., in a manner that is not disruptive, and indeed can be rewarding in many instances.
If business fail to do so, they will be forced to correct course as a result of regulators demanding higher control and accountability “by decree”, which invariably will lead to either escalation in costs or loss of revenues for concerned businesses. The UK’s sugar tax and EU’s carbon tax are good examples of such decree-based internalization of externalities.
What company must be cautious of foremost though is internalisation “by disaster”, since for companies not cognizant of the extent of their negative externalities this can occur at any time. And when this disaster does occur, it levies a substantial cost on the company in the form of damage mitigation, compensation, penalties, loss of investments and damage to brand. British Petroleum, Volkswagen, Samarco (Brazil) are all poignant reminders of internalisation "by disaster."
The valuation and disclosure of corporate externalities, so that environmental and social performance can be factored into investment decisions, will be increasingly crucial to drive corporate performance in the future. As a result, a new type of corporation will emerge that better aligns social benefit with profit generation, driving the transition towards a "green economy".