More Than a Numbers Game

Frederick Alexander, CEO of The Shareholder Commons, explains how the IFRS might fix disclosure and save the planet in the process.

A decade ago, Jane Gleeson-White’s remarkable book title asked, ‘Can Accountants Save the Planet?’

So far, they haven’t, as a voracious global economy continues to deplete resources at a dangerously unsustainable pace. But the following (admittedly eye-glazing) sentence in a research plan prepared by the staff of the International Financial Reporting Standards (IFRS) Foundation could help to realise her vision by beginning to change the way we measure success in business:

“The research will aim to understand whether . . . financial implications arise from idiosyncratic versus systemic risks and opportunities and how they relate to investor portfolio versus entity-specific information.”

Allow me to explain.

The IFRS is an international standard-setter for company reporting of financial information to investors whose standards influence disclosure mandates from governments around the world and can also be used voluntarily by companies.

The research plan addresses two new standards to be created by the International Sustainability Standards Board (ISSB), an affiliated organisation that sets standards for corporate social and environmental disclosures. The sentence above suggests a potential departure from previous ISSB standards (and many other investor-oriented disclosure standards), which have been limited to disclosure of information that affects the financial prospects of the reporting company itself.

Specifically, it suggests that the standards should not only consider disclosure of social and environmental information that affects the reporting company’s idiosyncratic and entity-specific risks but should also consider information pertinent to the systemic risks that relate to investors’ portfolios. Conceptually, this is a considerable expansion of scope – the standards would not only mandate disclosure about social and environmental impacts that might affect the reporting company’s prospects, but also about the impacts of that company on the systems that undergird investors’ entire portfolios.

For example, under an expanded standard, a company might have to clearly report on how its greenhouse gas emissions contribute to climate change and thus weigh down the global economy, which in turn threatens most investment portfolios. The same idea applies to the treatment of workers, threats to biodiversity, and a host of other systemic concerns. That is very different from just reporting about how sustainability issues might impact the reporting company’s own cash flows.

Yesterday’s problem

To understand the potential significance of this change – why it could ‘save the planet’ – recall that our market economy largely relies on investor choices to allocate resources. For example, no bureaucrat is responsible for the items on sale at the grocery store. Instead, a complex chain of manufacturing and distribution brings these items to the shelves based on market signals: Are people buying vanilla almond milk? 12-grain bread? How much are they willing to pay? What is the cost of grain and fuel necessary to make and distribute these products? In theory, the companies make choices (i.e., allocate society’s resources) in a manner that maximises value for both investors and society, as measured by the margin between their costs and revenue – their profit.

But the markets that allocate resources do not occur naturally. We have created a financial system with institutions, norms, and rules intended to facilitate markets. These include courts that enforce investors’ rights and mandatory disclosures to make sure they have the information they need to effectively allocate and steward their capital.

However, this financial system is largely designed to address an early twentieth century concern that shareholders’ capital would be used by corporate executives for their own personal needs, rather than being applied to optimise production and investor returns. It was thought that the ‘separation of ownership from control’, would lead to an inefficient economy and discourage investment.

To counter this concern, we developed a system that closely measures and manages economic success at the individual company level (in the words of the paper, entity-specific information). For disclosure, this means that we require companies to tell investors everything they need to know about the company’s pursuit of profits. The initial belief was that this would be sufficient to allow investors to steer their capital in a direction that both optimises their returns and efficiently allocates society’s resources. Other entity-specific elements of the financial system include stock options that incentivise CEOs to make companies more valuable and richly rewarding asset managers who help investors find companies that outperform the market.

To date, entity specificity has been the principle upon which the IFRS and the ISSB have operated. All the disclosures they mandate expressly revolve around the prospects of the reporting company.

But this entity-specific focus leaves a critical gap: our financial system does not account for the true cost that companies impose on social and economic systems. The research paper quoted at the beginning of this article recognises the gap by contrasting “idiosyncratic versus systemic risks”. For example, a company might increase its profits by using a cheap, dirty fuel in its production processes. All of the cost savings accrue to the company, while the costs of using that fuel are paid by society as a whole, in the form of the physical costs of climate change. Nothing in our financial system is designed to allow markets to account for this cost, or the costs imposed when companies overuse antibiotics, ignore human rights violations, or engage in a myriad of practices that increase their profits, but burden the broader economy.

Tomorrow’s solution

This is not just a numbers game; the failure to address the true cost of corporate activity means that the current disclosure system protects neither investors nor economic efficiency. Indeed, it encourages dangerous and inefficient resource allocation because investors are not informed when companies externalise social and environmental costs that undermine the economy.

These external costs threaten to overwhelm the economy and the very investors the system is supposed to protect. Since most investors own many companies in their diversified portfolios, their investment success is determined by the performance of the economy in which they are embedded. Returning to the climate example, one recent paper estimated that the current trajectory of greenhouse gas emissions will cost the average investment portfolio 30% of its returns over the next 40 years. But the diversified investor who owns stock in a high-emitting company is never informed about this devastating impact of those emissions on their portfolio, even though they could certainly use that information to protect their investments and the economy in which they are embedded.

This failure of accounting encourages unsustainable behaviour and is a root cause of the climate crisis, biodiversity loss, growth-sapping inequality, and a myriad of other global threats generated by business practices that prioritise company profits over the critical systems that support the portfolios of investors (and our way of life).

The IFRS paper signals that the international group most identified with financial disclosure is (finally) thinking about closing that gap. This could serve as a critical step in recalibrating the financial system to account for the true cost of the goods and services produced in our economy. If social and environmental disclosures clearly call out the threats that companies are imposing on investors’ portfolios, investors will have the information they need to steward companies away from such conduct, and to address some of the other elements of the financial system that encourage irresponsible behaviour.

“Idiosyncratic versus systemic” may sound like hairsplitting from an alphabet soup bureaucracy in an obscure corner of the financial world. But the fact is, this change could signal the beginning of a new way to measure success in business, a change we desperately need if we are going to alter the unsustainable path of our economy and, yes, save the planet.

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