As the boundary of financial relevance expands and policymakers reach for new solutions, they must incentivise behaviour that builds long-term value and give businesses and investors the right tools, argues Jonathan Labrey, Chief Strategy Officer, IIRC
Policymakers around the world are starting to grapple with a fundamental economic truth: that the boundary of financial relevance has expanded, yet there remains no single formula for making sense of this new reality. Heads were scratched in Frankfurt and New York in July when Japanese media giant Nikkei bought the Financial Times for 35 times its operating profit. What Nikkei was buying was a stake in something more profound than a growing balance sheet: it was buying access to a global marketplace in a deal that cemented upwards of US$50 billion of international investments by Japanese companies so far this year. Could there be a clearer demonstration of the seriousness of Prime Minister Shinzo Abe’s ambition to transform the profile of Japanese companies driven, as readers of this blog will know, by reforms to corporate governance and reporting?
The widespread use of the investor Stewardship Code and better quality reporting (evidenced by around 180 integrated reports published by Japanese companies this year) are forcing a more profound dialogue between boards and investors, reflecting the wider boundary of financial relevance that Integrated Reporting captures through the six capitals. The six capitals model gives parity to stocks and flows of value that have historically not been managed or disclosed. They force connections to be made in a borderless, interconnected world, a practice that reflects the megatrend of individual empowerment that is now part of every sphere of day-to-day life. As Robert Monks, ex-Chairman of Institutional Shareholder Services, wrote in his book, Uninvested: How Wall Street hijacks your money and how to fight back, “The most rewarding (and financially productive) investments offer investors the opportunity to open a dialogue, exert influence, and express an opinion”.
In the past, the stocks of value reported on by an organization would have included, principally, the land, buildings, equipment and inventory owned by the business. Even the language of this sentence tells the story of a different age. Think of some of the largest corporations in the world today. Google. Apple. Mitsubishi. Amazon. Tata. Microsoft. For these companies, and many more, the foundation of their value creation potential lies in their ability to attract talent, ideas and build strong brands that sustain customer loyalty and trust.
New business models are forcing disruptive change on the corporate reporting system.
Integrated Reporting gives full expression to this expanded boundary of financial relevance. By explaining the value-creating potential of the multiple capitals, it forces changes to corporate governance, abolishing internal silos and managing risks and opportunities that may not have been triggered through an isolated focus on the financial statements alone.
This new system creates powerful multiplier effects. Many of the stocks of value drawn upon by a business – such as human and intellectual capital – will have the potential to create value for the company well into the future, and in a sustained and stable way over the business cycle – the people we recruit, the technology we use and the relationships we build in time. While financial reporting helps to provide confidence in the past financial performance of the business and the ability of management to execute strategy in the short-term, reporting on these broader factors (the multi-capitals) orients the company in the present and the future, enabling an investor or potential investor to take a much longer-term view, attracting capital to industries and sectors of the economy that will power future growth, such as infrastructure, technology and bioscience. Information about how these stocks of capital are being managed over the business cycle will provide much needed insight into the future financial viability of the organization.
A new corporate reporting model cannot be created in a vacuum and it cannot be created around a broken capital markets system that incentivises short-term behaviour and actively deters investment over the long-term.
In the last three months, two mainstream policymakers with an international reputation have entered the debate about changing the capital markets system to promote more long-term behaviour – the Bank of England’s Andrew Haldane and US Presidential candidate, Hillary Clinton. Haldane has challenged company law in the UK and other countries that gives primacy to the investor over other stakeholders. His argument is that investors cannot be the guardians of the long-term interest when the average share in the average company is held for less than seven months today, compared to over seven years in 1950.
Clinton, in two speeches, set out more than 15 policy solutions including changing the capital gains tax regime to promote longer-term investment. She also proposed an end to the “tyranny of the quarterly earnings report”, which she argued distorts business decisions.
While both Clinton and Haldane reach for solutions that are worthy of profound consideration, and Hillary Clinton’s call for an end to quarterly reporting is one that we would support, it is vital that policymakers reach for the right tools that address the causes of the current system failure and also that changes to legislation do not lead to unintended consequences. It is unlikely that profound change will be implemented unless it is coordinated internationally.
We would like to contribute two ideas for consideration. First, we believe that Stewardship Codes, with clear principles and institutional support within countries, can deliver important incremental improvements to corporate governance and specifically lead to a better and deeper flow of information between the board and institutional investors based on the business model, strategy and value creation over the short, medium and long-term. Second, perhaps the time has come to establish a global business and investor-led taskforce, under the auspices of the Financial Stability Board (modelled on the Enhanced Disclosure Task Force) to identify ten globally accepted principles of corporate reporting that contribute to financial stability and long-term investment.
As the recent outbreak of capital market instability showed, caused by an apparent slowdown in China’s economic growth, there is an increasing mismatch between financial market activity and the “real” economy. Yet when stock markets sneeze, we all catch a cold as the value of our savings falls and business confidence is shaken. As value investor Neil Woodford commented, “It is always difficult to remain focused on fundamentals when markets fall dramatically. The distraction of seeing share prices fall indiscriminately can be overwhelming and distort rational perspectives”.
These events, and the reaction to them, strengthen the argument made by Mark Carney, Christine Lagarde and others in favour of inclusive capitalism, where a focus on short-term financial management is tempered by incorporating social and human considerations into the management of our economy and businesses. It is thanks to the foresight of Lady Rothschild and her Coalition for Inclusive Capitalism that these issues are being raised in such a powerful and impactful way within the global financial and policy communities.
To implement change, ideas – however powerful – need practical and implementable solutions. The International <IR> Framework should be part of the toolkit for inclusive capitalism: it speaks the language of modern business and reflects the radically transparent nature of our economy and society. It reflects the expanded boundary of financial relevance yet maintains a laser-like focus on value creation. It includes financial reporting, but it does not exclude factors that are equally valuable to sustaining viable organizations into the future.
Our capital markets system is in urgent need of reform. So too is our system of corporate reporting. Integrated Reporting provides an important link that can accelerate a process of positive change.