For most of this millennium, companies and their investors have seen the creation of sustainability focused non-financial metrics, protocols, disclosures and reporting frameworks. Nowadays most investors and asset owners are comfortable talking about their portfolio’s Scope 1, 2 & 3 carbon emissions, diversity & inclusion statistics and supply chain audits. In today’s ARCUS, I hope to share with you how the saying, “what gets measured, gets managed” is finally heralding an era of financial reporting change that will need investors to review how they value their investments.
Sacred Lake – Karnak Temple, Luxor, Egypt (1473-1458 BC)
What gets measured gets managed
I personally have seen an example of what gets measured, gets managed from the time of Egyptian Pharaohs. The Sacred Lake at Karnak Temple on the banks of the Nile was not only used for rituals and libations by the Priests, but also provided the Pharaoh’s Chief Treasurer with much needed information. The Sacred Lake’s supply of fresh water came from the underground water table and the Nile floods. And as the lake filled, each step in the lake (seen in the picture above) indicated to the Chief Treasurer the expanse of irrigation along the Nile. This measure would give an estimate of that year’s harvest, and thus taxes the Chief Treasurer could expect. A simple measuring device allowed for the Pharaohs and their officials to manage their treasury and also their people.
Here as a Panvestor, I saw how by measuring, the Egyptians were trying to understand the balance between Financial, Environmental, Human and Social Capital. With the help of the Sacred Lake water level measurements, which were recorded and then disclosed to local tax collectors, they could garner enough information for a consistent policy on tax collection. The more “sustainable” Pharaohs, I presume, would have used this to instruct their officials to sustain their farming population, rather than overtax and cause a rebellion. A good example of ESG and finances at work thousands of years ago.
Not everything that we can measure matters
What does matter to us as investors? Since the 1930s, we have seen the creation of the U.S. Securities and Exchange Commission (SEC) and the establishment of the Generally Accepted Accounting Principles (GAAP), which regulate disclosures by companies and determine the method of financial accounting (measuring), respectively. Because of their efforts, we have become accustomed to financial accounting standards to provide harmonized financial metrics. These standards have been imposed on companies to help us as investors decide on the MATERIAL financial risks we are willing to take.
The notion of Materiality mentioned above was formed to ensure shareholders and potential shareholders had the right information to assess the level of risk involved in making an investment.
In 1997, the creation of the Global Reporting Initiative (GRI) broadened this concept of Materiality beyond financial metrics found in P&L, Cashflow and Balance Sheet statements. Since then, we have been introduced to the concept of Single and Double Materiality, through TCFD, SASB, GRI and CDP, to name a few. Single Materiality includes all non-financial factors that could have a material impact on a firm’s Risk and Return, such as carbon or virgin plastic taxes, employee satisfaction & retention, etc. Double Materiality encompasses the actual Impact the firm’s business is having on other stakeholders, e.g., a company’s use of water and waste to ground, etc.
In the diagram above, we share with you just some of the main protocols, initiatives and reporting frameworks that help companies, and thus investors, to identify Single and Double Materiality issues.
For over 20 years, we have seen the proliferation of non-financial metrics, standards, protocols, goals and even regulations relating to Environmental, Social and Human Capital. Up until now, most of these have been voluntary, BUT that is all changing.
A sea change is here for investors
As investors, we can no longer ignore the above material non-financial issues. Why? Simply put, in the years to come we expect to see some of these Single/Double Materiality issues to become material financial issues and therefore part of financial reporting. This will have an impact on a company’s value and therefore the investment thesis.
The first big change that is occurring is that the disclosure and reporting of material non-financial issues is becoming mandatory, not only for companies but also for investors. The EU is currently leading the way. Under the recently legislated Corporate Sustainability Reporting Directive (CSRD), the EU will start putting in place the European Sustainability Reporting Standards (ESRS) by mid-2023, and this will change how European companies will fundamentally operate. Many of these changes will have to be reflected in their accounts as their actions will impact their balance sheet and income statements. We believe this will have a knock-on effect globally.
The second big change we expect to see is that measurement methods will become standardized as reporting and disclosure requirements move from being self-reporting to mandatory reporting under administrative decree or legislation. As a result, many material non-financial metrics with different measurement methodologies will finally find consensus agreement, and thus become part of formal accounting standards. Carbon accounting is one area which will find its place in balance sheets and income statements within this decade.
Why are regulators globally coming together (not yet with complete support, as seen in the US) to harmonize directives on reporting of material non-financial issues? They seem to be responding to the need by investors for clear, consistent and comparable reporting from companies in order to produce useful investment insights. In the case of Environmental Capital, which is advanced in its metrics courtesy of decades of voluntary disclosures, it is to ensure financial markets can properly price and act on the physical and transitional risks and opportunities of climate change.
Won’t this take a long time as it did with financial reporting standards? We don’t think so. We see a fast-paced adoption of material non-financial capital metrics into accounting standards. Global standard setters have learned from 70 years of harmonizing financial capital standards and are deploying that into a global consensus on non-financial standards much faster. The International Sustainability Standards Board (ISSB) which was only created at COP26 at Glasgow in 2021, has already taken on board much of the work done by previous standard setters and will be releasing accounting standards within the next few years. The SEC, with its proposed Climate Disclosure Rules, has already adopted many TCFD and GHG Protocols methodologies.
Material issues that get measured, get valued
Almost 3,400 years after the Pharaohs, we saw a more advanced form of ‘managing what you can measure’ lead to valuation impact and investment outcomes. This time it was with modern companies (the new Pharaohs) and their Human Capital (employees). In 1990, under SFAS 106, companies were asked to account for post-retirement health care costs. It forced companies to face up to the true cost of their obligations for health care benefits they had granted to employees over many years.
This saw General Motors recognize a first-time expense and liability of $20.8bn, which constituted 77% of its shareholders’ equity at the end of the previous year. The shareholders’ equity balances of Chrysler, Ford Motor, AT&T and IBM were also hit hard by the newly recognized liability.
Accounting standards have already forced companies to measure, report and manage their future healthcare obligations, thereby giving both the shareholder and employee a sense of comfort. There is every reason to believe that in the coming years we will see carbon accounting standards harmonize globally, leading to regulators requiring a carbon liability to be created on a firm’s balance sheet. Similarly, as measurements around a firm’s ability to help clients avoid their carbon emissions harmonize globally, we could see avoided emissions being treated as an asset or an intangible.
At Panarchy Partners, my team and I believe that we are entering a period similar to that which we saw in the 1980s and 1990’s. At that time global accounting standard setters such as IAS (now IASB) globally and FASB in the U.S. were busy introducing and finessing new financial accounting standards which were then adopted and mandated on companies by the regulators such as the SEC. Another outcome of the accounting changes of the 1980s and 1990s was the start of many new, and now successful, investment strategies, such as Quality, Franchise and even Value variants. Going forward, we expect strategies such as our “Purpose” to be better equipped to identify and utilize the new information provided via material non-financial capital disclosures. Under our Purpose as a strategy, we expect to identify when material issues get measured, get managed and valued.