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SPECIAL REPORT: Investors and Integrated Reporting

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Growing global sustainability risks and the expectations of fund beneficiaries require the investment industry to take action, writes David Couldridge

In 2009 Angel Gurría, Secretary-General of the Organisation for Economic Co-operation and Development (OECD), said:

“We have to restore the conditions for growth driven by innovation, trade and investment … Notwithstanding the immediate crisis, we must also apply new thinking to tackling climate change and poverty, as these remain systemic threats to our common future. Sharing the benefits of prosperity and opportunity and ensuring fair social protection are also key to restoring trust in the system”.1

Unfortunately innovation, trade and investment were not the “weapons” of choice for the financial crisis. The vulnerability of many emerging-market economies to an eventual tightening of monetary policy is a reminder that further global structural reforms are required.

The central banks’ action to keep interest rates artificially low has encouraged distortions in the valuation of asset classes and enabled countries and individuals to maintain high debt levels. Institutional investors and individuals face investment risk as global liquidity is reduced and interest rates normalise.

Is there risk that the financial crises could be followed by a sustainability crisis? The systemic threats of climate change and poverty have received limited attention. “All hands on deck” were focused on tackling the global financial crises – the refrain “we will do what it takes” was unfortunately big on liquidity but limited in terms of variety. In an integrated world, attention to one variable will not support the outcome that the OECD sought and will lead to unintended consequences.

The 2014 global risks perception survey of the World Economic Forum (WEF) highlights the ten global risks of highest concern to the WEF’s multi-stakeholder communities. Among the top five were water crises; severe income disparity; and failure of climate change mitigation and adaptation.2

EY recently highlighted that water had become one of the most material risks for the mining industry. They pointed out that BHP Billiton and Rio Tinto are investing US$3 billion to build a desalination plant at Escondida, a Chilean copper mine. Recent strikes in the South African platinum industry have had a material impact on the sustainability of their business models, while extreme weather events increases the risk that governments will price carbon at a higher price and sooner than the market expects. These are a few examples of what we call the “creeping risks” that eventually reduce corporate earnings, ratings, and the resultant market price.

Investors are faced with significant challenges and questions as they invest client funds into an uncertain future. There is a global growing awareness that the need to support generations of beneficiaries means pension funds require an investment strategy that embraces responsible and sustainable choices. Change has been slow. The growing global sustainability risks and the expectations of fund beneficiaries require the investment industry to take action.

RESPONSIBLE INVESTMENT

Awareness of these sustainability risks and opportunities led to our early integration of material sustainability factors into our investment process. The start of Element Investment Managers in 2001, Element’s 2006 signing of the Principles for Responsible Investment, our 2010 signing of the UK Stewardship Code, and our participation in the development and commitment to CRISA (the Code for Responsible Investing in South Africa) have moulded our understanding of responsible and sustainable investment. There is no doubt that responsible investment improves our investment process, ensuring greater understanding of investment risks and opportunities.

CRISA was the second investor-centred code after the UK Stewardship Code, but is the first code to require the integration of sustainability issues into investment analysis and decision-making. The Pension Fund Act Regulation 28 requirement in South Aftica to adopt a responsible investment approach for the deployment of capital has caught the attention of the investment industry. More recently, the Sustainable Returns Project for Pensions and Society, an industry-driven partnership to integrate sustainability into mainstream retirement industry investment practices, has developed a guide to assist retirement funds to comply with Regulation 28 and CRISA.

Responsible investment means different things to different people, but awareness is growing that responsible investment is the integration of material sustainability factors into the investment process and the use of active ownership (engagement and proxy voting) to add value and reduce risk. This evolution from screening out unacceptable investments based on investor values has more recently resulted in the development of funds that target specific social and environmental outcomes as well as economic returns. Impact investing therefore allocates capital to investment projects that also benefit society.

INFORMATION

Screening, integration and impact investing all require the understanding of business models and the trade-offs inherent in running a business over the long term.

Element is a value investor. We require information to undertake a valuation of the company. If the intrinsic value provides an adequate buffer for the share price, we will consider buying the share and use active ownership to reduce risk and unlock the intrinsic value.

Better information leads to better valuations and therefore a better investment decision on behalf of our clients. Statutory annual financial statements are basically made up of the financial position at a company’s financial year end (balance sheet) and the earnings results and cash flow for that year. Our valuation process requires future earnings and cash flows. We need to understand the business model, strategy, risks (including sustainability risks) and system of governance. This understanding helps us estimate as accurately as possible the capacity of the company to create sustainable value in the short, medium and long term.

Sustainability or ESG (environmental, social and governance) information is becoming more widely available. Element participated in the Emerging Market Disclosure Project (EMDP), helped bring the Carbon Disclosure Project (CDP) to South Africa, and became an investor signatory to CDP Water, the Extractive Industry Transparency initiative (EITI), and the Global Investor Statement on Climate Change. The data is now beginning to be integrated more coherently in integrated reporting. The final International Integrated Reporting Framework, released in December 2013, is a useful guide for companies to produce an integrated report.

INTEGRATED REPORTING

The primary purpose of an integrated report is to explain to providers of capital (investors) how an organisation creates value over time (short, medium and long term). Investors want to understand how the company will generate sustainable value in the context of the environment in which it operates:

What is the selected business model?

What are the risks and opportunities?

What is the system of governance?

Investors in the equity of companies have limited rights – the right to vote, attend AGMs and receive a dividend if declared. If you are investing client funds into an uncertain future, it is important to undertake a valuation that is as accurate as possible and understand the company’s system of governance. A sound system of governance provides comfort that the projected earnings for the company have a greater chance of being realised. Companies with systems of governance that are poor will either be avoided or the valuation discount rate will reflect the uncertainty, thus providing a lower intrinsic value. The detailed valuation process also provides the opportunity to identify material valuation variables where engagement can improve value and reduce investment risk.

REALISING THE BENEFITS OF INTEGRATED REPORTING

Element contributed to the International Integrated Reporting Framework by serving on the South African and international pilot programme investor networks. We have noticed how South African companies are improving their integrated reporting – from clear explanations of the business model that helps investors to better understand the inherent risks and opportunities, to inclusive stakeholder integration and reporting. South Africa’s early start, prompted by King III, is beginning to deliver.

Paul Druckman, CEO of the IIRC, recently commented that the business case for integrated reporting was clear and highlighted 2014 research by Black Sun. Some of the findings are:

One of the most important and common benefits that organisations experience is a new and better understanding of how they create value.

As the understanding of value creation changes, decision-making changes.

New approaches to value creation and decision-making require new approaches to assessing performance and measurement.

Providers of capital develop a better understanding of strategy and the longer-term objectives of the company.

The change to reporting is also changing the way companies work and think.3

To us as an investor with responsibility to invest client funds into an unknown future, all of the above findings are important. It means there is a better understanding of value creation, the risks, and what has to be done and by whom to generate sustainable value.

CONCLUSION

Well-resourced companies can and do use consultants to perfect their reporting. Making yourself look good without substance to your integrated reporting discredits your leadership. Responsible investment requires accurate and transparent information. If your integrated reporting resources include consultants, ensure accuracy and completeness of information dominates the mandate. The medium- to long-term reward will be lower assurance costs and a lower cost of capital.

Use integrated reporting to tell others what you do – this is the platform to demonstrate you understand your risks and whether you are disclosing all the risks (including ESG risks) that you should be disclosing.

Use disclosure requirements that are appropriate for your specific company. Choose metrics important to your business – your system of remuneration should be designed around these. Demonstrate balance, transparency and accountability to stakeholders. To be accountable you have to be understandable, so use clear language.

Most important, the board must understand the purpose of an integrated report and hold the executive team accountable for thinking through and managing the integrated reporting journey. Integrated thinking will help break down silos, communicate your strategy across the organisation, and help your people better understand the purpose of the company and what they are expected to do to create and sustain value. ❐

Notes

  1. OECD strategic response to the financial and economic crisis: contributions to the global effort, 3, http://www.oecd.org/economy/42061463.pdf.
  2. World Economic Forum, Global risks perception survey 2013–2014, 5,                http://www3.weforum.org/docs/WEF_GlobalRisks_Report_2014.pdf.
  3. Black Sun, Realizing the benefits: the impact of integrated reporting,                http://www.theiirc.org/wp-               content/uploads/2014/09/IIRC.Black_.Sun_.Research.IR_.Impact.Single.pages.18.9.14.pdf.

Author: David Couldridge CA(SA) is senior investment analyst at Element Investment Managers and serves on the International Corporate Governance Network (ICGN) Board of Governors