By Gerrit van der Merwe – Chief Executive Officer, Candor Governance
Humanity has evolved to the level where two dominant systems reign supreme: democracy and its sibling capitalism. The difference between the twin systems is that democracy implies that the average member of society rules mankind’s destiny and capitalism elevates the financially endowed above all others. Should we be concerned?
Comparing large companies rated by revenue and large countries rated by GDP, we note that the aggregate of the top 10 companies’ revenue is greater than all but the top four countries. Those top four countries, of course, include the top 10 companies’ revenue, enhancing the skewed power distribution towards companies. The handover of power was only temporarily from kings and emperors to presidents and prime ministers, as chairmen and managing directors have largely usurped that power.
Considering the effect that capitalism has had on the Earth’s resources, we’re confronted with the realities of climate change and stark wealth inequality. Notwithstanding the identification of several stakeholder groups, boards and company executives have maintained their short-term focus on keeping shareholders happy. There remains a preoccupation with enhancing financial capital, often at the expense of other interests. This makes sense in the prevailing system – not only does a financial focus remunerate the executives the most efficiently, but it also represents the de facto capitalist scorecard. Tracking financial growth is also the most comfortable way to track progress.
This systematic comfort is a concerning aspect – from the time when Italian monks devised the double entry bookkeeping method to current international technology firms coding financial systems, the entire capitalist foundation has been built for supporting financial capital. In comparison, non-financial measurement systems are fledgling upstarts, struggling to gain acceptance.
The United Nations estimated the Earth’s population at 7.5 billion in April 2017, with an expected slowdown of population growth until 2050. Note a slowdown in growth rate, not a decline in population. Therefore, we can project more people competing for the same, or declining, resources. Environmentally, it is clear that a lack of resources, other than financial capital, is fast becoming Earth’s major priority.
With companies’ power growth gaining momentum, and with their focus on short- term financial capital growth in the face of a failing environment, governance systems are critically important to maintain Earth’s equilibrium. The world has governance systems – plenty of them, in fact. Unfortunately, regardless of all the governance legislation, codes and standards, there doesn’t seem to be much of a dent in the harm capitalism is causing our planet.
Perhaps integrated reporting (IR), and the holism and transparency it requires, is the very mechanism we need to ensure that our planet’s sustainability is preserved.
Integrated reporting and governance
Before considering the full impact of what integrated thinking requires of organisations, the way integrated reporting dovetails with governance methodologies needs to be considered. Governance, after all, primarily addresses the way the leaders of organisations wield their power.
The International Organization for Standardization (ISO), held its first plenary session in Quebec City in May 2017 to consider an international standard for the governance of organisations. The discussions indicated an appreciation for the recently completed King IV Report on Corporate GovernanceTM in South Africa 2016 (King IV). Arguably, South Africa leads the world in its adoption of integrated reporting. The fusion of King IV and integrated reporting capably acts as a prototype for the world.
The King IV Report adeptly summarises the leadership duties of the governing body. The governing body should:
- Determine strategy
- Approve policies that give effect to organisational strategy
- Provide oversight of the effective implementation of strategy and policies
- Disclose on performance and sustainable value creation
Enter integrated reporting
John Elkington coined the phrase ‘triple bottom line’ of ‘people, planet and profit’, which has been expanded into six capitals by the International Integrated Reporting Council (IIRC) – financial, manufactured, intellectual, human, social and relationship, and natural capital. Instead of merely requiring organisational disclosure on how the six capitals were affected, the IIRC craftily requires ‘integrated thinking’, which is ‘the active consideration by an organisation of the relationships between its various operating and functional units and the capitals that the organisation uses or affects. Integrated thinking… considers the creation of value over the short, medium and long term’.
If an organisation is to disclose the impact that its business model, both use and outcome, had on the capitals, it stands to reason that its strategy, policies, procedures and reporting mechanisms should be similarly designed. Integrated reporting therefore requires integrated thinking at board level, which, in turn, requires integrated operational business models that cater for all capitals.
By requiring integrated reports to be issued by companies, we require the responsible and sustainable treatment of the Earth’s resources.
Integrated reporting defined
The IIRC defines an integrated report as a ‘concise communication about how an organisation’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term’. In no uncertain terms, the integrated report is the responsibility of the governing body, or board of directors.
“Considering the effect that capitalism has had on the earth’s resources, we’re confronted with the realities of climate change and stark wealth inequality. Notwithstanding the identification of several stakeholder groups, boards and company executives have maintained their short-term focus on keeping shareholders happy”
There are three concepts key to IR: the capitals and integrated thinking, the IR guiding principles and the IR content elements. Integrated thinking and its value creation process is intuitive, and it makes sense that organisations use the same six capitals that the value creation (or destruction) process affects. Let’s consider the six capitals:
Financial capital This capital represents the standard, though very important, measures of success that accountancy disciplines record
Manufactured capital Those physical objects that are available for use in production, such as buildings, equipment and infrastructure
Intellectual capital Intangible, knowledge-based assets, such as patents and know-how
Human capital Represented by people, their skills and experience, including their motivation, loyalty and ability to innovate
Social and relationship capital Communities and stakeholder groups, their shared values as well as the organisation’s social licence to operate
Natural capital Renewable and non-renewable resources, including air, water, land, minerals, fauna and flora as well as biodiversity and eco-system health
The IR guiding principles
Interestingly, an independent 2016 KPMG study in 16 countries regarding integrated reports, determined several overlaps of investor requirements and IR guiding principles. Larry Fink, CEO of the largest institutional shareholder BlackRock, was prominently quoted with requirements for long-term, strategic insights. The IIRC describes the following IR guiding principles:
Strategic focus and future orientation Insight into an organisation’s strategy and how it relates to its ability to create value in the short, medium and long term and to its use of and effects on the capitals
Connectivity of information A holistic view of the combination, interrelatedness and dependencies between factors that affect the organisation’s ability to create value over time
Stakeholder relationships An insight into the nature and quality of the organisation’s relationships with its key stakeholders, how and to what extent their legitimate needs are considered
Materiality Disclosure only of information about matters that substantively affect the ability of the organisation to create value over time
Conciseness While this points towards materiality, it also considers a balance between materiality and other guiding principles, a logical structure, plain language and links to other sources of relevant information
Reliability and completeness All material matters, both positive and negative, are disclosed in a balanced and accurate way
Consistency and comparability Consistency over time with comparatives to previous periods, benchmarks and industry norms
IR content elements
With the value creation impact on the capitals and guiding principles in place, the IIRC suggests the following components to an integrated report:
Organisational overview and the external environment What does the organisation do and what are the circumstances under which it operates?
Governance How does the organisation’s governance support its ability to create value in the short, medium and long term?
The business model What is the organisation’s business model – i.e. its inputs, activities, outputs and outcomes?
Risks and opportunities What are the specific risks and opportunities that affect the organisation’s ability to create value over time, and how is the organisation addressing them?
Strategy and resource allocation Where does the organisation want to go and how does it intend getting there?
Performance To what extent has the organisation achieved its strategic objectives and what are its outcomes in terms of effects on capitals?
Outlook What challenges and uncertainties are the organisation likely to encounter in pursuing its strategy and what are the implications for its business model and future performance?
Basis of preparation and reporting guidance How does the organisation determine what matters to include in the integrated report, and how are such matters quantified and evaluated?
What is holding back an international roll-out of integrated reporting?
Silos in a multi-code world
There are at least three distinct governance philosophies in the world: the US rules-based approach: the UK-initiated principles-based approach; and the delegation of power between executive- and non-executive directors (blended boards vs separate advisory and executive boards).
With these differences among jurisdictions, it is little wonder that there seems to be such an apparent lack of alignment between stock exchanges. Had there been alignment, a listing requirement mandating integrated reporting – such as that which exists in South Africa and Brazil – would have been a simple matter. Following that would have been the establishment of international assurance codes, similar to IFRS, resulting in spotlights on unsavoury practices. Instead, a mixture of financial, sustainability, annual and integrated reports, often voluntary, has resulted in disclosures that are difficult to standardise and control.
Initial governance measures were instituted to guard against agency risk – that risk that exists if ownership and management vest in different bodies. Audit committees, remuneration controls and the elimination of conflicts of interests are, in theory, well managed. However, corporate governance requires that owners assume some responsibility. This responsibility has become more difficult to ensure, as there has been a marked ownership shift from individuals and families to institutional shareholders to index funds. A static index fund, with hardly any movement in its asset holding, is hardly likely to vote on company resolutions and even more unlikely to make its environmental requirements known to company boards of directors.
Institutional shareholders rely on proxy advisors, such as Glass Lewis and Institutional Shareholder Services. They require these proxy advisers to analyse and advise on the corporate governance aspects of resolutions that require voting at company general meetings. The proxy advisory business model is not quite as fragile as that of the credit rating agencies – often paid by the issuers – which eliminates some aspect of independence. The advice is costly, necessary and usually conservative, though accurate. It is, perhaps, the conservative service that eliminates an advisory notice regarding an investee company’s integrated report. Similarly, international investment research firms could enhance their services, such as ‘Morningstar Sustainability Rating’ by noting the existence or quality of integrated reports of the companies they research.
The International Integrated Reporting Council reports that more than 1,000 companies in the world are using the International Integrated Reporting Framework to communicate with their stakeholders. The natural progression towards an integrated methodology that encompasses organisations’ strategy, business processes and reporting, while also considering the Earth’s capitals in a way that will ensure those resources for our children, simply seems like the most logical end ethical step in our corporate governance path. International acceptance and development of this evolutionary step may be exactly what our planet and our children demand.
About the Author:
Gerrit is CEO of Candor Governance, a corporate governance solutions provider. He is co-creator of GovN®, a governance methodology and integrated content framework. His specific interests lie in risk management, strategy and governance integration.
Gerrit regularly presents governance and risk management topics, including the King Codes, ISO 31000 and Social & Ethics Committee legislation. Recent events include Risk Governance training for SAICA and facilitating Social & Ethics workshops for listed companies and the South African state-owned companies.
Before getting involved with corporate governance, Gerrit launched specialist finance house Mettle’s services into Namibia, Zimbabwe, Kenya and Botswana. He then headed Mettle’s European business from its London base. Other experience includes consulting to insurance, print, tourism and hospitality businesses on financial and tax matters. Gerrit has been a board director in several jurisdictions, including South Africa, the United Kingdom, Spain, Luxembourg, Namibia and Zimbabwe.