Corporate Reporting: Enabling a Long-Term Orientation in Investment Analysis
In the last few months, several publications have exhorted regulatory authorities to craft policy interventions that would incentivize a long-term analytical orientation of companies’ disclosures and within investment research content. These publications include:
- Aviva Investors (2017): Investment Research: Time for a Brave New World? The Aviva report highlights findings from a survey of sell-side analysts and points to systemic and structural factors that incentivize a heavy focus on the short-term analytical horizon at the expense of analysis oriented toward the long term. The sell-side respondents indicated that only 12% of their time is spent researching companies’ prospects beyond a 12-month horizon. The Aviva report anticipates that the ongoing implementation of MiFID II, with its requirements for asset managers to make a distinction related to and provide transparency on charges incurred for execution of trades versus those for research, will likely enhance the quality of research but at the same time, only partially incentivize the production of sell-side research that is tailored for long-term investing horizons. The report argues for a greater focus by policymakers and actors across the investment value chain (i.e., asset owners, asset managers, sell-side firms, investment consultants, and issuers of securities) on further addressing the systemic factors that impede a long-term orientation of information.
- 2° Investing Initiative (2°ii) (September 2017): Limited Visibility: The Current State of Corporate Disclosure on Long-Term Risks. Based on an analysis of 125 global companies, the 2°ii report highlights that the horizon of disclosed forward-looking information (e.g., investment plans) within corporate communication channels (i.e., annual reports, management presentations) tends to be shorter than the actual horizon of companies’ long-term plans.
- Japanese Institute of Certified Public Accountants (JICPA) (May 2017): How Can Corporate Reporting Practice Support Long-Term Oriented Behaviour of Institutional Investors? The JICPA report articulates guiding principles to help issuers communicate information that is useful for long-term investors – including the application of the International Integrated Reporting Council (IIRC) integrated reporting framework.
- EU High Level Expert Group on Sustainable Finance (HLEG) (January 2018): Financing a Sustainable European Economy: Final Report 2018. HLEG was established to help stimulate sustainable finance with a requirement for an incremental funding of €180 billion a year for strategic investments — a key factor in the attainment of EU’s long-term decarbonization target (i.e., 40% reduction of carbon emissions by 2030). In its final report, HLEG calls for listing authorities to promote disclosure of environmental, social, and governance (ESG) information. One of the report’s chapters calls for an upgrade of disclosure rules to make sustainability risks more transparent; the report strongly endorses the adoption of the Financial Stability Board Task Force on Climate-Related Financial Disclosures (TCFD), particularly as more than 230 firms with a market capitalization of €5.1 trillion have voiced support for these recommendations. HLEG has also proposed aligning the TCFD recommendations with the EU nonfinancial reporting directive.
Enhancing ESG Reporting—A Core Plank of Facilitating Long-Term Investing
The Aviva and HLEG reports mentioned above emphasize the importance of and need for reporting guidance that ensures the availability of high-quality ESG information for long-term investing decisions. The growing level of integration of ESG information into investment analysis and the need for enhanced reporting of such information have also been accentuated by CFA Institute surveys [Environmental, Social, and Governance Survey (2017), Environmental, Social, and Governance Issues in Investing (2015)] as well as by HSBC’s report Surveying Corporate Issuer and Investor Attitudes to Sustainable Finance (2017). Furthermore, sustainability factors such as climate risk and water scarcity risk are increasingly being recognized as systemic risk factors. In particular, climate risk has fallen under the attention of several prudential regulators and central bankers. For example, in late 2017 the Dutch central bank published Waterproof? An Exploration of Climate-Related Risks for the Dutch Financial Sector, the results of its assessment of the impact of climate risk on banks and insurance companies.
With the growing demand for high-quality ESG information, it is not surprising that numerous ESG initiatives are aiming to redress the deficiencies associated with this information (i.e., incompleteness, lack of comparability in reporting across similar business models, inclusion of immaterial information, inconsistent and biased reporting). Reporting guidance includes 32 stock exchanges with either mandatory or voluntary guidance, several country or region-level requirements, and different but relatively global reporting initiatives such as those of the Sustainability Accounting Standards Board (SASB), Global Reporting Initiative (GRI), Climate Disclosure Standard Board (CDSB), and the FSB-TCFD recommendations.
At the same time, as highlighted by a previous blog and a CFA Institute webinar hosted in September 2017 (Unpacking the Alphabet) that involved representatives from SASB, GRI, CDSB, and the International Integrated Reporting Council (IIRC), investors are faced with the “tyranny of choice” due to the multiple ESG reporting requirements, which in itself is an impediment toward effectively relying on and integrating ESG information. Suggested steps to improve ESG reporting including the following:
- Lessening the “tyranny of choice.” Investors would undoubtedly benefit from an increased alignment across the different ESG reporting initiatives as well as from increased coordination between these initiatives and the authoritative accounting standard-setting bodies. Alignment — and where possible consolidation — could lessen the burden investors face in having to distil the unique features of each reporting initiative (e.g., assessing what is material information). It would also foster more comparable sustainability reporting across the globe. The corporate reporting by former International Accounting Standards Board (IASB) vice chair Ian Mackintosh seeks to foster this type of alignment and coordination across the most influential organizations (SASB, GRI, CDSB, IIRC) as well as to strengthen their dialogue with the two main accounting standard-setting bodies (IASB and US FASB).
- That said, the problem of multiple ESG-related reporting initiatives may be overstated for two reasons. First, two of the most influential organizations — CDSB and IIRC — have put forward reporting frameworks and do not have detailed standards with specifically defined metrics. A high-level guiding framework can be concurrently supportive of different specific standards. Hence, an integrated report might disclose information defined by SASB standards as well as by GRI. In similar fashion, the CDSB framework supports the implementation of FSB-TCFD recommendations and considers how IFRS requirements are applicable for reporting climate risk impacts but it could also support SASB or GRI standards.
- Second, the audiences for and objectives of two of these flagship initiatives (GRI and SASB) differ. GRI standards are focused on multiple stakeholders and the materiality assessment is based on a company’s impacts on the environment, society, and the economy. In contrast, SASB is primarily focused on investors’ information requirements and the assessment of materiality is anchored to how external factors affect the company. On a bilateral basis, GRI and SASB are actively collaborating and aligning in their approaches to the TCFD recommendations and also have an ongoing collaborative project to map out their respective metrics to each other.
- Strengthening the requirements within the most influential initiatives. Both SASB and GRI continue to update their standards. At the end of January 2018, SASB closed its comment period for a consultation on updates to its provisional standards related to 11 sectors and 79 industries.
- Increasing the uptake of the most impactful guidance. The various ESG reporting initiatives (SASB, GRI, and FSB-TCFD) are all voluntary reporting initiatives, creating an inevitable challenge of limited and inconsistent adoption of voluntary guidance by companies. Similar to the endorsement accorded by the EU HLEG and individual governments (France, Sweden, and the United Kingdom), there have been calls for the International Organization of Securities Commissions (IOSCO) to endorse and support the implementation of the TCFD recommendations.
- Effective implementation of ESG reporting guidance hinges on companies, investors, and other stakeholders being equipped to produce and analyze this information. In October, the Bank of England (BoE) and FSB-TCFD organized a conference in London to discuss the implementation of scenario analysis, one of the TCFD recommendations. A summary of event report presents insightful conclusions, data sources, data gaps, and illustrative scenarios showing how these scenario analyses can be applied for financial analysis and strategic planning. In the United States, SASB hosted its third annual symposium in November 2017 and on its website includes useful case studies of ESG integration. To my mind, sustainability analytics present an important subset of the next generation of company analytics, particularly as forward-looking information is enhanced. It behooves investors to ensure they attain or update the skills required to perform this type of analytics.
Long-Term Information Entails More Than ESG Reporting
Clearly, a lot of firepower is being expended on enhancing ESG reporting. Nevertheless, as conveyed by the JICPA report and a forthcoming CFA Institute member survey report on the usefulness of key performance indicators, investors depend on much more than ESG information when deciphering companies’ value creation story. Herein, the effective adoption of the IIRC’s integrated reporting (IR) framework — with its emphasis on connecting business model, strategy, and all material capitals deployed by a business while conveying the value creation across multiple time horizons — can significantly contribute to enhancing the overall quality and insight of corporate reporting information, including long-term information. This is especially the case as the IR framework goes beyond financial and ESG information and includes intellectual capital information.
The challenge, however, is that the IR framework is a voluntary and relatively high-level guiding principle for reporting. In my opinion, the IR framework needs to be embedded within authoritative literature to get the most traction. Hence, there is also a need to enhance authoritative guidance such as the US SEC update of management, discussion, and analysis (MD&A) guidance; other country/region-level guidance (e.g., UK strategic report); and the IASB management commentary practice statement that influences narrative reporting in IFRS-reporting jurisdictions. A welcome development occurred in November 2017 when the IASB Board approved a project to update the management commentary practice statement. As pointed out by the IASB’s management commentary practice statement update staff paper, this update has the potential to strengthen narrative reporting across multiple jurisdictions. Some of the ideas enunciated in the IASB staff paper are to a) strengthen and make explicit the linkage principle, which is analogous to the IR connectivity principle; b) augment the reporting of forward-looking information; c) enhance business model and strategy description; and d) augment the principles of performance reporting (non-GAAP, financial, operational, customer KPIs, and intellectual capital metrics) and risk disclosures.
In sum, there is still some way to go before companies adequately provide long-term oriented analytical information. Various reporting initiatives have emerged in response to this information gap, but increased alignment is needed across the multiple initiatives, as well as implementation endorsement (e.g., by IOSCO) of the desirable aspects of the individual initiatives. Finally, the more authoritative MD&A/narrative reporting guidance should be updated to address the need for long-term analytical information.
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