The challenges and opportunities of connecting financial reports with sustainability reports.
- Assessing whether a company’s sustainability reporting is painting the same picture as its financial reports can help analysts to build an investment case.
- However, several practical challenges exist when trying to connect sustainability and financial information; for example, there is a lot of inconsistency in sustainability reports, and sustainability targets are often expressed using non-financial units.
- Better information on the materials, energy and labour used will help to provide a more complete view of a company’s past, current position, and prospects.
This blog is based on my comments at the EFRAG symposium at the 45th European Accounting Association Annual Congress in Espoo, Finland where I presented at a panel looking at connectivity between financial reporting and sustainability reporting.
Doctors are advised to ‘treat the patient not the X-ray’, a straightforward message to remind us to consider the holistic picture of the human being receiving care. Investors should apply the same principle and ‘analyse the company, not just the financials’, a reminder that the financials will never tell us the whole story.
As an equity analyst, my goal is to identify stocks where something good is underappreciated or something bad is overappreciated.
Connectivity between sustainability reporting and financial reporting is a fascinating topic, but in many ways it is nothing new: investors have always considered non-financial information, such as how much trust we have in management, when making investment decisions.
Before joining Newton, I worked as a management consultant, and I can still remember some wise words of advice I was given: always look carefully between departments, as this is where problems often lie. For example, I worked in one company where the research and development (R&D) department assumed the sales department understood all the technical features of the products. At the same time, the sales department assumed that the R&D department understood all the customer feedback. Neither was true, and the result was that the company designed products which were not always valued by customers.
As an equity analyst, I always try look carefully between perspectives: is the sustainability reporting painting the same picture as the financial reporting?
Connectivity in theory
Let’s consider three general cases when comparing how a risk is described in a sustainability report with the way it is described in a financial report:
- If there is complete overlap, I need to make sure that I do not double count the risk in my valuation.
- If there is no overlap, I need to make sure that I do not ignore the risk.
- If there is partial overlap, I need to be very careful when I connect and combine perspectives. For example, a rising number of employee injuries per annum is clearly a labour-related risk, but the additional working days lost will also be reflected in the financial performance reported in the period.
The challenges of connectivity in practice
I believe there are four key practical challenges when trying to connect sustainability and financial information.
Different reporting boundary
There is a lot of inconsistency in sustainability reporting. For example, I know of one company that currently reports emissions for its consolidated businesses only, but from next year will also start to report its share from its joint ventures.
Should sustainability reporting be based on control or ownership?
Climate-related ambitions stretch decades into the future, but very few line items on the balance sheet consider the same time horizon. Over time, some of these climate-related risks will become recognised as financial liabilities.
How should we define this dynamic boundary between sustainability and financial reporting?
Sustainability reporting targets are typically expressed in non-financial units such as tonnes of carbon emitted, or number of hours worked. It is really challenging to connect these targets to financial information expressed in currency units.
Should companies be required to break down their financial forecasts into volume and value if volumes relate to sustainability targets?
Sustainability reports contain more estimates than financial reports owing to missing data and some data being outside the organisation in the supply chain. Sustainability reports have less assurance than financial reports, which have established accounting and auditing standards.
How can users increase their trust in sustainability reports?
The opportunities of connectivity in practice
I want to share three examples where we have connected sustainability information with financial information to inform our investment decisions.
A power-generation business closing its coal mines
A company that was closing a coal mine was required to spend a considerable amount for many years to cover and repair the land. The investment question was what would happen if the mines were closed a few years earlier.
On the balance sheet there was an environmental provision, and in the notes the company disclosed sensitivity of this liability to the discount rate, but not the start date. Fortunately, the company separately disclosed its environmental cost forecasts, which allowed us to flex the value of the liability using different start dates.
Our conclusion was that even if the mines were closed earlier, the valuation was still attractive.
The lesson here is that we need better disclosure for material provisions. Disclosing cash-flow forecasts, where possible, would allow users to calculate their own view of the liability, using their own start dates and discount rates.
An airline with poor labour relations
For many years an airline’s pay and conditions were very poor, which led to very high staff turnover – on average employees only remained with the airline for one year. Things came to a head and employees began to strike and flights were cancelled. Management quickly did a deal to recognise the unions, which was enough to get their planes back in the air.
The investment question was whether the deal was a long-term fix – with further strikes being unlikely – or just a short-term solution meaning that we would need to consider the prospect of more strikes in future.
The responsible investment team researched the settlement, engaged with the company, and talked to labour experts. They concluded that the deal was just a short-term fix, and the relationship between management and employees remained tense.
We decided not to buy the stock as we believed that the risk of further strikes was not fully appreciated by the market.
The lesson here is that we need much better information about employee satisfaction. We get employee costs in aggregate, but we also require employee numbers and attrition rates, disaggregated as much as possible, such as by division, by geography and by function.
An auto company ramping down internal combustion engine vehicle production
With internal combustion engine vehicle sales set to be banned in the European Union from 2035, the investment question was how much of the company’s plant and workforce used to manufacture internal combustion engines could be transferred to manufacture electric vehicles.
One could imagine that a lot of the equipment used to manufacture internal combustion engines would not be required for electric-vehicle production. However, when reviewing the accounts for one manufacturer we did not see any material write-down of plant or any change to the remaining useful economic life assumption. The practical problem was that fixed assets were not disaggregated by engine type.
The lesson here is that we need much better segmental disclosure, especially when companies are in transition. Many renewable businesses have different return-on-invested-capital prospects and risk profiles, so we think they should be valued separately from existing businesses.
Connectivity at Newton
At Newton, how we use sustainability information depends on the strategy’s mandate. In our core strategies, sustainability information is used as an input by research analysts, alongside other information, to assess the overall risk and reward.
In our sustainable strategies, the sustainability information is used as part of an inclusion test which helps our sustainability portfolio managers decide, with support from the responsible investment team, which stocks are suitable for the sustainable mandates.
Connectivity in future
Historically, corporate reporting has been centred on financial reporting, but this is just one limited perspective. Financial reports can be likened to an X-ray of a body: a lot can be inferred from an image of a skeleton, but it does not show the whole person.
In future, I hope that sustainability reporting will be as helpful as an MRI scan in medicine, providing another image of the company. I look forward to much better information on the materials, energy and labour used. Together, these operational aspects will help to provide a more complete view of a company’s past, current position, and prospects.
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