May 18, 2016
Value and a new disclosure paradigm
I was rapporteur for the session on ESG disclosure at the European Commission’s 2010 Multistakeholder Forum on CSR. The Forum was a watershed. It saw the agenda move on from the entrenched debate between mandatory and voluntary corporate Environmental, Social and Governance (ESG) disclosure.
The debate was now framed in terms of – 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 on holding companies to societal account. The Commission began its work on the new directive and I was a member of its so called ‘Experts Group’.
The outcome was a classic fudge between the two positions. But it’s unfinished business. A consultation on Guidance for companies has just closed and it is due to be published by November 2016. I have seen surprisingly little debate in business circles around the directive. Business has to get its act together; all listed companies with 500 or more employees – an estimated 6,000 companies across Europe – are required to report in 2017.
Business is confused as to the purpose of disclosure
A recent webinar poll of around 120 largely UK corporate sustainability people asked who was their primary reporting audience. 55% said investors and analysts, by far the top answer. Yet only 5% saw increasing investor confidence as the primary purpose of reporting.
So investors and analysts are the perceived primary audience but meeting investor expectations is not the primary purpose. Business is not sure who it is disclosing non-financial information to or why. That probably indicates that business is not clear about what investors want and how they can be influenced. Moreover, it probably betrays a lack of faith in the ability to reach the right investors and re-orient their view of the company based on non-financial information.
So it’s no surprise then that financial analysts, when asked recently by the CFA, which were their 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. Non-financial information from companies does not rank.
Yet the case for better non-financial information is unanswerable.
The material drivers of value
For four years I have been working with Project Delphi – a group of around 40 Asset Managers, Asset Owners, and investment consultants – drawing on the intellectual property of analysts and researchers across the investment industry. Amongst other things, our focus has been to define the material drivers of company value and the ESG factors that influence them.
We are 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 to make effective judgements.
We have developed a framework that seeks to define the parameters of non-financial performance, and the contributory ESG Factors, which drive financial performance. It is not intended to be a corporate reporting framework.
But, inevitably, comparisons are made with other initiatives; primarily the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB). There is one stark difference. Delphi has defined materiality in quantitative, financial terms. It is about the non-financial and ESG drivers of financial performance. It is more about value and less about values.
It is not a stakeholder initiative. Project Delphi is a project led by investors, with investors, for investors. It needs to inform investment thinking and modelling, particularly quantitative modelling. But, in so doing, it poses significant challenges for corporate disclosure. It highlights the huge gaps in non-financial and ESG data disclosure that need to be filled.
The shortcomings of existing frameworks
As it stands, the EU directive is no more all-encompassing and prescriptive than the UK’s Strategic Report requirements or, indeed, current US SEC requirements. That is unless, as an outcome of its current deliberations, the EU Guidance requires reporting against a specific standard or framework.
I think that’s unlikely for two reasons. First, the compliance burden for companies, many of whom are not currently reporting in any form other than financial, would be too great for most of the member state regulators to stomach. Second, and paradoxically, the shortcomings of existing reporting frameworks are increasingly being exposed as more companies explore them.
GRI is the most obvious example. It is the most widely referenced by companies. Referenced, but I would hesitate to say used. A literal interpretation of the G4 Guidelines means companies potentially reporting against indicators representing between 3 and 500 individual metrics. The supposed rationalising of this through some form of materiality assessment is problematic when GRI’s materiality definition is based on some woolly acknowledgement of stakeholder expectation.
By contrast, the SASB Framework suffers from a lack of completeness. A recent authoritative report from KKS and Generation Investment Foundation, some of whose authors are very close to SASB, found it necessary to helpfully supplement a SASB sectoral outline with other non-financial indicators.
I am not sure if this is because of the environment in which it is emerging; US business tends to take a rather selective view of what constitutes ESG or sustainability. Or if it is the product of a rather hazy stakeholder focused process with the US business environment as context. Maybe it’s their materiality definition, based on the US Supreme Court definition, which I paraphrase as factors being considered material if they subsequently prove to be material, and appears rather Post Hoc.
I took part in one of their sectoral discussion. It seems to me there is more an emphasis on current vogue stakeholder issues than fully assimilating the non-financial, ESG or sustainability contributors to business performance.
Fit for purpose?
Project Delphi is responding to trends in the investment industry where there is a growing perception that the current conventions in company valuation and investment modelling are no longer fit for purpose. The rapid growth of ESG investing, whichever figures you accept, is one sign. So is the scramble to reflect broader management orthodoxy into more sophisticated quantitative modelling. The paucity of traditional Alpha-generating activity in mature markets is fuelling the growth of so-called impact, smart Beta and other alternative investment strategies.
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. This is the 80:20 flip in complexion of market value since the 1980s – between tangibles and (unexplained) intangibles – in that graph you may have seen based on original research by Accenture and now Ocean Tomo. That is the gap between market value and book value of the S&P500 (and most other mature markets). At today’s prices, a US$50 trillion gap between the value put on companies by investors and the value put on those same companies by their accountants.
And that’s just equities. Private equity and capital markets, and dare I say even the ratings agencies, are waking up to this, too.
A challenge to the dominant conventions
So what is driving that gap. It is the dominant convention of Discounted Cashflow and other Quantitative methods of valuing business that have grown over the past 30 years with the advent of technology that makes it possible. It is reflected in Shiller’s well known charting of Cyclically (and Price) Adjusted average annual PE ratios from 1890 to date. Since 1985, the average S&P 500 PE ratio has been above 20 every year except 2009. Even without the dot com boom, for the last 30 years the developed markets have been geared at a higher level than any previous period since 1929.
In simple terms, the market values companies on their cumulative future projected growth in annual earnings. This is subject to the dampening effect, and some bundling of perceived risks to earnings growth, of a discount factor that is meant to reflect the cost of a company’s capital.
Investors and analysts have been interested in earnings and earnings growth to the exclusion of all else. That’s what feeds their models. But now they have to better understand the factors that will determine that future growth, many of them non-financial or intangible. Not just in the next 5-10 years where the bulk of the discounted value will be generated. But over the next 10, 20, maybe even 30 years
If a company can credibly demonstrate its ability to remediate risks over these timeframes, their discount factor should be lower so potentially more of the projected actual future earnings growth will contribute to current (and therefore higher) valuations.
A new understanding
So the market is making long-term judgements about the future cashflows of companies and using those judgements to make decisions – to buy, sell or hold – today. That requires better understanding of the ability of companies to, inter alia: maintain their brand and 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 future accessibility of energy, water, and raw materials.
That’s where the Delphi Value Driver Model comes in. Classic value levers – earnings growth, the profitability of investment and risk management – connected to broad non-financial value drivers reflecting performance in a range of ESG Factors. The ESG Factors are derived from a comprehensive materiality analysis by the project participants drawing on their knowledge and expertise. The logic flow is underpinned by a narrative that sets out the potential impact of ESG factors on the relevant value driver.
It is crystallising the current state of knowledge, not just in ESG investing but the most authoritative sources of research and analysis across the investment industry and beyond. The Delphi Framework is differentiated from other initiatives not only by its quantitative and financial materiality focus but by its emphasis on the most material – the principle of Parsimony – as well as our intent that the Framework should be forward looking, predictive, and dynamic. It will evolve over time.
The relationship between the Value Drivers and ESG Factors are reflected in metrics that are more industry specific. Metrics that both effectively measure relevant performance and reinforce the materiality of the Factor. The materiality and parsimony principles means that the number relevant for each of the 10 standard industry classification ranges from 18 Factors and 60 metrics in the Oil and Gas sector to 7 Factors and 18 metrics in Consumer Services.
And this is where it gets slightly contentious. Some of our Factors are deemed so material that they are included even though there is not, as yet, entirely satisfactory metrics to capture performance. For example, the importance of strategic innovation – in new products, new markets, new production methods and, ultimately the capacity to develop new business models – is obvious. But how do you measure that capacity?
Here we have drawn on the knowledge and expertise of our participants to begin developing effective composites – drawing together a number of metrics included elsewhere in the Framework. So factors influencing the ability to recruit, retain and develop the required skills sets are critical. So, too, is the propensity for research and development in the business. Employee Engagement scores also say something about the corporate culture; if you have people with the right skills sets and capacity for innovation but the culture does not facilitate extension of their capabilities, it should show up.
The holy grail?
The next stage of Delphi is to go beyond the existing narrative and seek to bed the relationship between ESG Factors, non-financial drivers and value levers in hard financial terms. This might seem like the pursuit of the holy grail. But there is already compelling evidence for a number of the most material factors.
Looking at Factors and associated metrics through the prism of value drivers and levers opens up the wealth of correlation and directional evidence that already exists. One of the participants in Delphi has been involved in a recently published meta-analysis of over 2,000 such meta-analyses.
Indeed, our starting point was the outputs of the European Commission inspired Laboratory on Valuing Non-Financial Performance which I co-led and incorporated the views of hundreds across business, investment industry, and leading consultancies, as well as a parallel research project led by three top European business schools. It was exposed to evidence for more robust relationships based on individual company research and consultancy collaboration but evidence that is unlikely to ever be made public.
And that’s the limitation in our endeavours – the willingness of companies to provide data and share their experiences. But that is where the prizes are.
Those companies who can articulate their management of non-financial and links to strategy and financial performance, and make it material, will win the better ratings and the premium they think they deserve.
Disclosure: the art of the possible
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 issensitive. 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 – a company’s employees, customers, suppliers, local communities. 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?
Delphi can give greater clarity to Integrated Reporting. The two initiatives have grown up together.
It is perfectly possible to overlay the Delphi Framework on the IIRC Six Capitals Model and measure the (most material) capital inputs, the impact of (most material) internal strategic and operational processes and the growth, or otherwise, of (most material) capital outputs.
But with great respect to my IIRC colleagues, what we are seeing at the moment are best practices in combined reporting not integrated reporting. When companies have the confidence, or the compulsion, to connect the non-financial and financial, then we will begin to see integrated reporting.
But more than that. Companies who can go beyond articulation to valorisation will be in a position to convince investors of the positive impacts of what they’re doing on current and future earnings. If they can convince on their management of downside risks they will influence their cost of capital.
That will be factored into investors’ Discounted Cashflow analysis and that’s when we will see more appropriate valuations.
Delivering the business case
But there’s another benefit. If companies can deliver an effective basis for calculating the future value of their current investment, they can also deliver an effective basis for valuing the current value of their future investment.
That’s the Net Present Value calculations central to the myriad business and investment cases companies make every day. NPV analysis is currently based on financial factors where the non-financial is, at best, a narrative caveat.
The environmental impacts of big CAPEX schemes are relatively easy to factor in to this sort of analysis. But what about smaller programmes or the less obviously valued factors. Or what of the external factors that are not being internalised? What would that ability to valorise the non-financial across the board, in every business unit, bring?
An end to waiting
Firstly, it would bring the long-term forward. Breaking down the long-term mega-challenges into constituent elements that can be measured and valued and inputted effectively into decision making now.
It would make the business case for investment in the non-financial or ESG more credible and enhance the chances of that investment happening…..or ill-advised investment not happening.
It would bring into play the elements of non-financial and ESG performance that influence the factors that can be valued where now they are only aspects of the narrative that rarely influence the final decision. And then there are the externalities which, if they were measurable or could be valued, would be brought more fully into the equation rather than largely ignored.
History is littered with examples of investment projects that, with hindsight, would have not made the starting blocks, or done very differently, had the non-financial been more appropriately included in the business case.
But above all, we can stop deferring ESG or sustainability issues to the long-term. They’re not all long-term or they’re not wholly long-term.
After all, as we know, in the long term we’re all dead.
Article on Market Mogul
This article is based on a presentation at the Edie Live event in Birmingham on 17 May 2016
The text being discussed is available at