(CSj Honk Kong) – In the global investment community, there have been discussions about the importance of integrating environmental, social, and governance factors into corporate strategy and disclosures, and a movement to encourage integrated reporting. Robert Eccles, Chairman of Arabesque Partners and a retired tenured professor at Harvard Business School, shares his insights into integrated reporting in conversation with Professor Christine Chow, Associate Director, Hermes EOS, Hermes Investment Management.
Professor Chow: What is integrated reporting?
Professor Eccles: To the extent to which people have heard of integrated reporting, the common perception is that it is kind of a mash-up of a company’s financial report and sustainability report. That is not true. An integrated report is defined as follows by the International Integrated Reporting Council (IIRC): ‘An integrated report is 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 in the short, medium and long term’. In other words, an integrated report contains information on financial and environmental, social, and governance (ESG) performance that is important to investors – the primary audience of an integrated report. The concise International Integrated Reporting Framework (IR Framework) actually only uses the word ‘sustainability’ three times. Of course, others interested in a holistic view of a company’s performance and prospects will find an integrated report useful as well.
Professor Chow: Why is it important?
Professor Eccles: The accounting standards and reporting requirements upon which financial reporting is based were established many years ago, long before talk of the ‘knowledge economy’ and concerns about issues such as climate change, water, and the use of dwindling natural resources. What the IR Framework makes clear in its ‘value creation process’ model (see ‘Figure 1: The value creation process’) is that companies use and have impact on six capitals: financial, manufactured, intellectual, human, social and relationship, and natural.
Financial reporting does a good job of reporting on how a company has used the first two capitals, the equity and debt of financial capital and cash generated from operations, and the hard assets of manufacturing capital which go on the balance sheet and are depreciated. But financial reporting has virtually nothing to say about the intangible assets of intellectual, human, and social and relationship capital which are increasingly important in today’s knowledge economy. Similarly, it does not account for how a company is using natural capital and the positive and (usually) negative externalities it is creating on it through its operations.
Intangible assets and natural capital now represent around 80% of a company’s market value and hence the importance of managing and reporting on intellectual, human, and social and relationship capital. As society recognises the dangers of climate change and the stress that our growing population is putting on natural resources, regulators and civil society are increasingly expecting companies to be responsible in how they are using and impacting natural capital.
Professor Chow: How is integrated reporting different from CSR reports, ESG reports, and sustainability reports?
Professor Eccles: In a nutshell, it is explained in the diagram below (see ‘Figure 2: Sustainable value matrix’). An early concern of proponents of sustainability reporting – called by many different names – is that integrated reporting would make sustainability reporting less relevant or even disappear. This is far from the case. In my first book on integrated reporting – One Report: Integrated Reporting for a Sustainable Strategy (co-authored with Mike Krzus) – I made it clear that integrated reporting and sustainability reporting are in fact complementary.
The former is for investors and what I call ‘significant audiences’ (explained in more detail in my second book – The Integrated Reporting Movement: Meaning, Momentum, Motives, and Materiality (with Mike Krzus and Sydney Ribot). Sustainability reporting is for other stakeholders. While the issues for these stakeholders may not be important, at least for now, for a company’s ability to create value over the short, medium, and long term, a company has an obligation to report on those issues which stakeholders deem important. After all, a company’s licence to operate ultimately comes from civil society. So in the end, integrated reporting and sustainability reporting are quite complementary. They respond to the information needs of different audiences.
Professor Chow: There are many different reporting standards which companies can choose to follow, such as: the Global Reporting Initiative; the UN Global Compact; the Sustainability Accounting Standards Board; the Carbon Disclosure Standards Board, and the International Integrated Reporting Council. How are these different standards related to each other?
Professor Eccles: Good question. There is a real ‘alphabet soup’ of reporting organisation acronyms out there. It can sound complicated to the everyday business person and there is no reason he or she should have to keep track of this stuff, so let me try to clear it up. I actually think it’s pretty simple. First, we need to distinguish between frameworks and guidelines, and measurement and reporting standards. The IR Framework is just that. It is a short (around 40 pages) principles-based document that provides guiding principles and content elements for integrated reporting. It does not take a position on what measurement standards should be used.
For the financial information in an integrated report a company will use International Financial Reporting Standards, US GAAP, or whatever the standards are that are required in the company’s jurisdiction. For ESG information the company can choose among a number of standards. In my view, the most appropriate standards for an integrated report are those of the Sustainability Accounting Standards Board (SASB). Like the IIRC, SASB’s audience is investors. The origins of the Global Reporting Initiative (GRI) are in stakeholder reporting and so these standards are well-suited for sustainability reporting. The Carbon Disclosure Standards Board (CDSB) has its expertise in climate, water, and forestry and so their standards can be used for these topics. The UN Global Compact simply requires its participants to provide an annual ‘Communication on Progress’ (COP) and is very flexible about what this can be. For example, an integrated report or a sustainability report can be used to fulfil the COP requirement.
Professor Chow: Who should be involved in making a decision on what types of reports companies should produce? What are the considerations? What are the challenges?
Professor Eccles: Another very good question. Integrated reporting actually starts with a company’s board of directors. The board should issue an annual Statement of Significant Audiences and Materiality (The Statement). These audiences, for example long-term shareholders and a few key stakeholders, establish the audience for the integrated report. They also determine which issues are ‘material’ for the company. Both the IIRC and SASB call for a rigorous materiality determination process. These are the issues that go into the integrated report. Issues that are not material for the company but that are important to stakeholders who are not significant audiences go into the sustainability report.
I think a company’s Chief Sustainability Officer (CSO) should be responsible for the production of the sustainability report. The CEO, however, should bear ultimate responsibility for the integrated report, and this requires a collaboration between the CSO, CFO, and others who are responsible for generating material ESG information, such as marketing (for customers), human resources (for people), and environmental health and safety (for natural resources).
I don’t know of a single example of high quality integrated reporting – defined as action on integrated thinking as opposed to a kind of bolt-on document prepared at the end of the year that has nothing to do with how the company is being managed – that didn’t have the direct and enthusiastic support of the CEO. This support is often over and above the reticence of the CFO. CFOs tend to be uncomfortable with integrated reporting since they are used to dealing with financial information only, and are rightly concerned about the quality of the internal controls and measurement systems for ESG information. High quality and timely ESG information is one of the biggest barriers to integrated reporting, but the necessary software and internal controls are improving thanks to the work of organisations like SASB and the CDSB. Another barrier is perceived lack of investor interest. Although this is changing and rapidly so. Investors are now learning how to use ESG information in their resource allocation decisions, just as companies are learning to do so as well. For a company that has never done integrated reporting, there is obviously no process for doing so. This needs to be created. The CEO needs to appoint the right person to head up this collaborative process that will involve people in a number of different functions and business units.
Professor Chow: How can I determine what resources I need to prepare for integrated reporting?
Professor Eccles: I’d actually ask a different question: Does every company have the resources it needs to do integrated reporting? The answer is an unequivocal ‘yes’ since integrated reporting is an act of will and commitment. No integrated report is perfect the first time out. Integrated reporting is a journey, not a destination. Trite to say, I know, but still true. The commitment to integrated reporting will then enable the company to determine what capabilities exist and which ones need to be developed.
And remember – it’s not the report per se that’s important; it’s the integrated thinking around how a company is using and impacting the six capitals that is facilitated and reflected in integrated reporting. The company needs to start with getting the board involved through ‘The Statement’ in which the board identifies the company’s significant audiences and the timeframes it uses to assess its impact on them. Audiences determine issues which leads to the need to put in place a rigorous materiality determination process to create a ‘sustainable value matrix’ (SVM). The SVM identifies what ESG information goes into the integrated report and what information goes into the sustainability report. This process will involve both internal and external data collection, the latter requiring genuine stakeholder engagement. The company then needs to assess the quality of the material ESG information that goes into the integrated report. In the early stages, it will often need improvement but this shouldn’t stop a company from moving ahead with its integrated report. And here’s another trite but true saying: ‘Don’t let the perfect be the enemy of the good’. The company simply discloses its view on information quality and the degree of assurance that has been done. Each year the integrated report will get better. Don’t wait, get started now and reap the reinforcing benefits of integrated thinking and integrated reporting, both of which will increase year after year once the journey has begun.
Professor Chow: Anything else you’d like to share with readers?
Professor Eccles: Thanks for asking. Yes, five quick things. First, the most immediate benefit a company will get from integrated reporting is greater employee engagement that comes from a better understanding of how the company is managing the six capitals. This is particularly important to millennials.
Second, getting benefits with investors is harder and takes time. They need to be educated on how to use the information in an integrated report. The company needs to explain the relationship between financial and ESG performance, or what the IR Framework calls ‘connectivity of information’.
Third, we need to get away from thinking about integrated reporting (and sustainability reporting for that matter) as a static document, like a PDF posted on the company’s website. The action is on the internet, which can be leveraged in a number of ways to make information easy to find and use and to create a conversation with the audience of the integrated report.
Fourth, I think that ultimately an integrated report should have an integrated assurance opinion. Yes, I can already hear companies moaning about higher audit expenses and audit firms moaning about increased audit liabilities, but I don’t buy it. Until ESG information is subjected to the same strict positive assurance as financial information, the integrated report will not have the same legitimacy as today’s financial reports. And the internal benefits to the board and management of better quality ESG information and an understanding of the relationship between financial and ESG performance will far exceed these additional audit costs.
Fifth and finally, thanks for the opportunity to talk to you to get the word out on integrated reporting to an Asian audience. It’s been a fun conversation!