Milan, 18 October 2024.
Jesús López Zaballos on the business and investor case for integrated reporting, “Integrated Reporting must not lose sight of the methodological restrictions to be useful, ensuring that financial and sustainability-related disclosures are not presented as ‘mixed’ or only ‘‘connected.’”
Introduction: The business and investor case for integrated reporting.
Dear Chairman Mr Poletto, Dear IASB and ISSB Chairs and Vice-Chairs, ladies and gentlemen.
On behalf of EFFAS, I would like to thank the IFRS Foundation, the OIBR Foundation/WICI Italy for giving me this opportunity to share some thoughts on the importance of Integrated Reporting for investors and financial analysts.
“In awareness of our responsibilities as a corporate citizen, we define economy, ecology and social commitment as objectives of equal rank. We seek to retain society’s confidence through performance, flexibility and open communication as we work in pursuit of our overriding corporate goals: to steadily create corporate value and generate high value-added for the benefit of our stockholders, our employees and the community in every country in which we operate”.
This quotation is from a major European chemical company (*) and it was at the core of its Annual Report 20 years ago in 2004. Thus, the connection between a company and the “capitals” -as defined in the Integrated Reporting framework-although using different labels, were already reported more than 20 years ago.
This was not an isolated case of comprehensive reporting. Yet, the scope of this type of reporting was very limited.
The changing landscape of reporting
Over the years the situation has considerably changed. The reporting, in fact, in certain cases has gone the other way, as it provides more information than needed and in many instances the information is not as relevant as investors need (greenwashing).
However, the point that remains open for investors is: if the holistic and comprehensive reporting approach now taken by many companies provides the necessary material information that adds value to investors to make an investment decision.
In this regard let me say that for investors, a major milestone was when in August 2022 the IFRS Foundation assumed responsibility for the Integrated Reporting Framework and when the Value Reporting Foundation (VRF) was consolidated into the IFRS Foundation.
We have a lot of hope riding on this consolidation.
We expect that the Integrated Reporting Framework can become the North Star for corporate disclosure as the IASB and the ISSB boards jointly assume its responsibility.
For investors, Integrated Reporting already provides material information to understand a company’s business, its governance model, the risks and opportunities they face, its dimension, its products lines and its environmental and social impact and any other aspect that can affect its ability to create value. In one sentence, the organization’s strategic objectives and its resource allocation plans to implement its strategy.
I think that this point can only be answered when three (3) major aspects of companies are aligned when reporting the capitals.
In other words, when the different aspects and elements that contribute to create value in a company are linked.
Expectations from Integrated Reporting
We expect that the Integrated Reporting Framework can become the North Star for corporate disclosure as the IASB and the ISSB boards jointly assume its responsibility.
For investors, Integrated Reporting already provides material information to understand a company’s business, its governance model, the risks and opportunities they face, its dimension, its products lines and its environmental and social impact and any other aspect that can affect its ability to create value. In one sentence, the organization’s strategic objectives and its resource allocation plans to implement its strategy.
I think that this point can only be answered when three (3) major aspects of companies are aligned when reporting the capitals.
In other words, when the different aspects and elements that contribute to create value in a company are linked.
Key Aspects for Investors
Investors need a clear and useful interrelation between the so-called financial and sustainability-related financial disclosures -what we refer to as connectivity-, continuity and consistency in the information, and that the information is material and comparable.
Connectivity: this is already a key point for integrated reporting. As it has been mentioned on numerous occasions the link between financial information and sustainability-related financial disclosures particularly through the general purpose financial report is necessary.
And let me give you a couple of examples:
– Accelerated depreciation of a certain fixed asset to leave room for a sustainable and more energy efficient asset would be reflected in the balance sheet -as well as capex. The company will finance the new asset through borrowings or cash-flows. Definitively there is a connection with the financial statements.
– A better assessment of labour cost -for instance due to increasing costs for training programmes,
– The application of social principles are examples of items not originating directly from the financial information yet affecting the income statements and therefore with a potential impact on net earnings and valuations.
Integrated Reporting already facilitates the link between the organization’s environmental, social activities, and intangible investments and expectations of future performance or risk.
Integrated Reporting also provides investors with a better understanding of the labour and governance policies of a company. These policies have become a key aspect of an entity’s corporate strategy to provide capital markets with a broader more comprehensive understanding of the potential social impact of an entity’s activities.
Moreover, the information reported should be material. And if it is quantified, the narrative to explain it should be relevant. The so-called financial materiality of ESG or sustainability-related aspects is key to helping investors understand how companies create long-term value. Issues that are not currently reflected in financial statements but that have a significant impact on them.
This will also facilitate comparability, which is another key aspect of corporate reporting for investors. Comparability helps us to better understand the performance of companies and to identify the key players in the economic, social and environmental transformation that stakeholders’ expectations place on companies.
Summary of Key Points
To summarise, the information reported should be balanced while providing material qualitative and quantitative information to permit a comprehensive understanding of a company, which is needed to make an investment decision.
And, one final observation, the information has to be integrated, not “blended”, or only ‘’connected’’.
There is a well-known and very pertinent cinematic reference from Ian Fleming’s James Bond: “Shaken, not stirred.” This should continue to be the true motto of integrated reporting.
It appears decisive that ‘’financial’’ and sustainability-related financial disclosures are not presented as “mixed” or only ‘‘connected’’. Perhaps the most relevant and essential reason for this is that to this day, incorporating a business’s sustainability into its valuation remains unresolved. This elementary and obvious issue, but almost always forgotten, is the “elephant” in the room.
Taking a traditional view of valuation, a business’s value depends exclusively on 3 factors: the CF generated, the expected growth, and the cost of capital (WACC). Nothing more.
This is why integrated reporting (multi-capital value creation over time) must not lose sight of this methodological restriction to be useful. It appears key to respect 5 red lines:
- Allow the user of the information to know clearly whether the information given corresponds to the “financial” or “sustainability ” world, preventing both “realities” from being misinterpreted. A company with weak financial metrics is no better financially just because its ESG rating is excellent. And vice versa.
- Allow the reader to determine clearly the level or CF that the company generates today (independent of its ESG situation).
- Allow the reader to incorporate into the future growth of the CF those ESG elements that may condition it (CAPEX intended for ESG objectives, additional costs to be assumed to improve the sustainability of a business, etc.).
- Allow the information user to judge the company’s ESG reality based on the user’s own (and subjective) standards. These can be very different between investors: since in some cases one factor may take precedence (environmental issues, for example) or in another (investors are more concerned about governance). The integrated grade (E+S+G) that each investor gives to a company is always different.
And this is key since it conditions the way each investor (subjectively) incorporates sustainability into the valuation. That is, the price you are willing to pay for a business. As “hard” as it may be to accept, today this issue remains unresolved. And each investor incorporates sustainability into “their” assessment in a different way, and, obviously, they do so through the risk premium used in the WACC, which implies that the most important thing is that each investor finds each company’s ESG KPIs perfectly identified. You can then form your own opinion about the integrated risk premium (and integration is key here) to apply to a company. The integrated risk premium adds together the financial and non-financial risk of each company.
- Have full confidence in the reliability of the ESG data presented. This trust pivots on two pillars: 1) offering the source of the data and ensuring its veracity, and 2) guaranteeing that the KPIs are presented based on the most reliable and recognized standards. And in the ESG issue we always end up running into the same wall: there is no single method to judge the sustainability of a business, but rather there are as many methods as there are investors.
While this limitation lasts (and it seems that it will be for a long time) the reporting must guarantee, at least, that the data is perfect (in quality and quantity) so that each investor can “cook” it to their liking.
At no time should this point be forgotten: today there is no single, academically (not even regulatory) accepted criterion to “grade” the sustainability of a company. The absence of standardization in ESG is a great weakness, something that ESMA has repeatedly warned about. And reporting must aim to make this weakness more bearable and not aggravate it through an arbitrary “mix” of information.
The objective is integrated reporting (connected or related, but not mixed) of information that allows each user to quantify (based on their own standards) the price to pay for a business. Knowing that this price will be “integral”: because when you buy a company you do not buy the financial and the sustainability separately, but the integration of both realities.
To end, let me say that EFFAS welcomes all the progress made by the IASB to define and improve the financial accounting standards and the work done by the ISSB to issue the new sustainability standards. Both are a major contribution to the improvement, efficiency and transparency of capital markets.
EFFAS has been collaborating for many years with the IFRS, and we will be very glad to continue working closely to face the new corporate reporting challenges, including when it comes to demonstrating the value of integrated reporting to investors.
Thank you very much.
The European Federation of Financial Analysts Societies (EFFAS is a Not-for-profit organisation set up in 1962 with 14 national member associations in Europe, representing more than 16,000 Financial analysts, Asset managers, pension fund managers, corporate finance specialists, risk managers, treasurers among many other professional profiles from the investment profession. EFFAS is a certification body for finance with over 24,400 certificate holders worldwide.
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