Shift Happens

Integrated reporting as a strategic initiative

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Organizations often spend a disproportionate amount of time focused on writing and publishing an integrated report rather than on the more difficult considerations that will make the report a reflection of the way a company ethically and responsibly delivers superior financial performance.

But the benefits of integrated reporting are derived from strong governance processes, a culture that shares a common understanding about the role of the corporation in society and the ability to focus on environmental, social and governance (ESG) issues that have the greatest ability to create shareholder value and drive major innovations. Consider the following: 

  • A letter from BlackRock CEO Laurence Fink to the CEOs of S&P 500 companies stated, "Generating sustainable returns over time requires a sharper focus not only on governance, but also on environmental and social factors facing companies today. Over the long-term, environmental, social and governance (ESG) issues — ranging from climate change to diversity to board effectiveness — have real and quantifiable financial impacts."
  • The CalPERS Board of Administration revised its Global Governance Principles (PDF) to call on boards to "provide an integrated report that puts historical performance into context, and portrays the risks, opportunities and prospects for the company in the future, help shareowners understand a company’s strategic objectives and its progress towards meeting them."
  • During research for a Harvard Business Review (HBS) case (PDF) on integrated reporting at Novo Nordisk, an investment firm partner explained that from a stock-price perspective, Novo Nordisk did not receive a premium because it won corporate reporting awards. "People won’t pay half a point more of P/E multiple for that; it’s a company’s approach to integrated reporting that drives better earnings and market performance."

These points focus on integrated thinking — the development of a business model, strategy and decision-making that integrates concerns for society and the environment into the pursuit of profitability and growth.

Building a foundation for integrated thinking

Governance

The role of the board in oversight of ESG performance and how that affects financial performance is a critical issue. Should boards consider the concerns of the broad stakeholder community? In the U.S., state corporation law governs the entity and defines the fiduciary duties of the board of directors. In some states, directors owe the fiduciary duty only to the corporation; in others, the duty is to both the corporation and shareholders.

When considering the corporation's impact on people who are not shareholders or on the communities where a company operates, "The United States is a ‘shareholder primacy’ jurisdiction, meaning that the primary focus of corporations is to return profits to shareholders. If stakeholder needs are considered, they are a secondary concern," stated the American Bar Association Task Force on Sustainable Development in a 2015 letter (PDF).

However, the interpretation of whether boards of directors are permitted to consider a company’s impact on stakeholders is nuanced and allows a great deal of latitude in decision-making. The ABA Task Force on Sustainable Development (PDF) also stated:

"Though U.S. law has no mandate to consider stakeholder needs, directors have discretion to include stakeholders concerns in their deliberations. So long as their decisions serve a rational business purpose, directors may consider and act on issues concerning the company’s impacts on non-shareholders. The root of this discretion is the business judgment rule.

"Some question the extent to which the business judgment rule provides management or the board with protection for considering interests beyond shareholder gains. Directors can undertake these actions in the name of protecting the company’s social license to operate."

These ABA statements reinforce the belief that directors cannot meaningfully represent shareholders unless they take all stakeholders’ interests into account.

The Corporation and Society

Research by Calvert Investments and Professor George Serafeim (PDF) explored the valuation implications of a balanced approached to simultaneously creating shareholder and societal value. They found that ESG performance correlates with better management and that better ESG performance is reflected in higher expected growth and lower cost of capital.

The chart below demonstrates the relationship between a company’s market value and its ESG performance. Organizations with better ESG performance have higher valuations (3.29 times book value) compared to a multiple of 2.95 for firms with low ESG performance. Calvert-Serafeim believed that investors were willing to pay a premium for these higher performing companies in expectation of higher future profitability. The findings also suggest a correlation between higher ESG performance and better management or business model quality.

Meanwhile, this chart in Figure 2 shows the valuation multiple assigned on net income on an equity valuation basis. All firms in the sample had an average valuation multiple on profitability of four. However, companies with high ESG performance have a valuation multiple of seven. These results support the belief that investors expect higher growth and require lower cost of capital from organizations with higher ESG performance.

Source: Calvert Investments and George Serafeim, "The Role of the Corporation on Society: Implications for Investors," from Thomson Reuters ASSET4, Calvert-Serafeim Research. Firms ranked by their ESG score. 

The Calvert-Serafeim research found that ESG performance correlates with better management. One attribute of better management is a sense of duty to provide superior market returns in balance with best in class social and environmental performance, something that should be at the very core of an integrated report.

Materiality and Innovation

In their econometric analysis of over 3,000 companies, Professors Robert Eccles and George Serafeim found, "In the absence of substantial innovation, the financial performance of firms declines as their environmental, social, and governance (ESG) performance improves. To simultaneously improve both kinds of performance, they need to invent new products, processes, and business models." This is illustrated in Figure 3, the chart below:

Source: Robert G. Eccles and George Serafeim. "The Performance Frontier: Innovating for a Sustainable Strategy." Harvard Business Review, May 2013.

The lesson from this research is that companies should concentrate their investments on the most material (most critical) ESG issues because they have the greatest ability to produce innovation in business models, products and services. That’s the only way organizations can create long-term value for shareholders and society.

Next steps

Adoption of integrated reporting is a daunting task. It is built on a foundation of governance and a culture that understands how to create the business models and strategies needed to drive long-term viability. The challenge for companies is where to begin.

One approach is to "just do it." For some organizations, "do it" might mean an initiative to publish an integrated report at the end of the next reporting cycle. For others, "do it" could mean a prototype report focused on critical concepts such as governance, stakeholder engagement, materiality, strategy, risks and opportunities. A prototype can be published on an internal website to illustrate concepts and vet the content with executives and the board.

Whichever approach best fits your company, you are encouraged to take the necessary steps to evolve your reporting to effectively respond to increasing investor and societal expectations.