From mariner's compass to spaceship dashboard
Rethinking performance assessments for businesses
Why measuring Tomorrow’s Value needs a new valuation framework
A year ago in London, the Natural Capital Coalition1 launched a universal protocol2 for businesses to measure and value their impacts and dependencies on nature. Why is the ‘Natural Capital Protocol’ such a vital step in transforming business for tomorrow’s world? Indeed, in a market-based, trade-deregulated, technology-empowered, globalized, constantly innovating economy, such as we have today, why should having such a Protocol matter at all?
Why measure impacts and dependencies on nature?
Last year, in India, severe drought inflicted huge costs to the nation’s economy3 with agriculture and hydropower sectors being particularly badly hit4. One of the worst affected states was Maharashtra (Mumbai is its capital city) which had to cut water supply to industry by up to a half, forcing many manufacturing businesses large and small to shut down. Business dependency on nature’s freshwater cycle, now disrupted by a changing climate, could not have been more painfully felt.
Mainstream scientific opinion is that climate change is driven largely by anthropogenic greenhouse gas (GHG) emissions, of which the lion’s share is emitted by the private sector. Thus the cumulative impacts of dominant business models in major sectors such as fossil-fuelled energy, transportation, construction, conventional agriculture and animal husbandry are now being felt in the form of costly disruptions of the otherwise benign environmental conditions that have enabled development across many sectors and countries, including manufacturing in India. This development is now seriously at risk.
The example mentioned above was just one of many that have been hitting headlines with increasing frequency. Impacts on natural capital, so-called ‘externalities’ of business-as-usual, are disrupting supply chains and creating price volatility in many commodities. Narrowing margins in still fragile economies with weak demand are reducing business profitability. This combination of higher risks and lower returns in the private sector feeds into bank balance sheet quality and adds to financial system risks, economic instability and sometimes recessions, which in turn exacerbate poverty, damage political stability, and feed back to weakening demand and further vulnerability in business value chains. To use Winston Churchill’s words, “the era of procrastination, of half measures, of soothing and baffling expedience of delays, is coming to its close. In its place we are entering a period of consequences.”
Arming business managers to tackle these challenges in and from the arena of ‘natural capital’, and providing investors with a clearer picture of ‘future-readiness’ of their investee companies needs the introduction and widespread use of a universal measurement framework such as the Natural Capital Protocol. It can ensure that we identify, measure, value and thus better manage business impacts and dependencies on natural capital that so far have mostly been ignored.
Are our challenges limited to natural capital?
As business leaders increasingly face up to the reality that stakeholders other than shareholders do matter for the long-term success of a corporation and are indeed vested in and committed to a corporation, they need to measure performance across all major capital classes...
Environmental risks and ecological scarcities have direct impacts on key sectors such as agriculture; resulting in crop losses, and losses of incomes and livelihoods, large scale rural migration5 and a breakdown of resilience in rural communities. Other serious outcomes can include political and social failures and disruptions, which exacerbate inequality and poverty. And given the direct dependency of the poor on natural resources, increasing poverty can start a vicious cycle of environmental degradation and persistent poverty. Thus a problem in the natural capital domain can quickly migrate to the realms of human capital and social capital, denying viable incomes and livelihood security to many of the billion-plus smallholder farmers and their families.
Conventional capitalism usually responds to such complex challenges on the lines of “innovation and the markets will take care of this”. Unfortunately, since damages to natural capital and social capital are problems of mis-managed public and community wealth (sometimes referred to as “shared value”), there is little point in hoping that markets alone will solve these problems. Markets discover prices for and allocate capital to private goods, but they can only trade private claims. We are besieged instead by public goods challenges, and unlike private goods, public goods belong to everyone and to no-one, and cannot be traded in markets. To make matters worse, when governments attempt policy solutions, perverse outcomes might ensue. A case in point is the subsidization of wheat, rice and sugar (rich in carbohydrates) in an effort to meet daily caloric intakes for poor people. It has been argued6 that such policies are driving serious changes in diets, making them less diverse and nutritious, leading to physical and mental stunting in children in developing countries, and at the same time, increasing the risks and costs of lifestyle diseases. Agri-businesses and food and beverage businesses in value chains that are involved in such solutions could be depleting, rather than adding to human and social capitals, thereby increasing reputational risks and regulatory costs.
None of these significant dependencies and impacts on natural, human and social capitals figure in the statutory reports filed by corporations. This convention is reinforced by the mistaken idea that such reports are really for shareholders, who are the only legitimate “owners” of a corporation, a notion that has been debunked in recent times7. As business leaders increasingly face up to the reality that stakeholders other than shareholders do matter for the long-term success of a corporation and are indeed vested in and committed to a corporation, they need to measure performance across all major capital classes and ownership categories, in essence to provide effective stakeholder reporting.
Stakeholder reporting includes measuring externalities (both positive and negative), across ALL four important dimensions of society’s wealth (i.e. physical, natural, human and social capital), across all categories of ownership (i.e. private, community, and public ownership). Measuring performance through the wider and more sophisticated lens of stakeholder reporting can help businesses to evolve into responsible corporations, which compete on the basis of innovation, resource conservation and the satisfaction of multiple stakeholder demands. The information in a stakeholder report is needed and used by corporate managers, investors, governments, civil society and customers to differentiate their responses to different corporations on the basis of their real performance.
Addressing the needs of managers, investors, regulators and civil society
...tomorrow’s sustainable business will need a comprehensive performance assessment that measures all the value it has created/eroded and estimates its ability to erode/create more into the future.
It is a basic management tenet that one cannot manage what one does not measure. To start managing its most significant externalities, tomorrow’s sustainable business (I call this “Corporation 2020” to remind us that “tomorrow” is just around the corner) will need a comprehensive performance assessment that measures all the value it has created/eroded and estimates its ability to erode/create more into the future.
From an internal perspective, such multi-capital assessments are a superior way to present business performance, using metrics that can be easily integrated and benchmarked, allowing managers to balance the short-term and long-term creation of value; and enabling board members and investors to determine whether management's policies and the company's share price are on target.
For governments and other regulators, such assessments help regulations to be drafted to incentivize/penalize the creation of positive/negative externalities, in an effort to improve overall societal wellbeing. For example, to oblige the externalities of GHG emitters to be internalized, regulators might implement market-based mechanisms such as Pigouvian taxes, subsidies, market caps, tradable permits, etc; but to do so the underlying requirement is that regulators have complete information of a corporation's emissions and the ability to regulate such emissions in a cost-effective manner.
Regulators today are also beginning to shift policy towards directing companies to be more transparent in reporting their social and environmental issues. The 2014 European Commission (EC) directive on disclosure of non-financial information is an example of such legislation. This EC directive requires companies (starting with large companies having more than 500 employees) in member states to begin public reporting of their environmental and social strategies, actions, policies and programs by 20178. The objective behind such regulation was to ensure cost-effective availability of information, which can enable market-based mechanisms to be effectively implemented for preserving the quality of the environment, protecting human health, and ensuring rational use of natural resources.
Belatedly but rapidly, investors are questioning the prudence of investing in traditional sectors that are susceptible to higher degrees of regulatory, operational and brand-value risks. As of 2016, global sustainable investment grew to an estimated US$ 22.89 trillion9, almost a tenth of all financial assets. This is a 25 per cent increase from 2014, and 73 per cent increase from 2012. This reflects a new trend amongst investors in general (not just specialist sustainability portfolios) of actively checking, filtering, and finding businesses that are both sustainable and profitable. It has far-reaching consequences for successful transition to a green and equitable economy of permanence.
One popular lens through which investors are looking at corporations is the ability to integrate environmental, social and governance (ESG) considerations into their business practices and communications. ‘ESG integration’ as a visible strategy for driving sustainable investment has almost doubled from US$ 5,935 billion in 2012 to US$ 10,369 billion in 201610. These figures are evidence that holistic or ‘stakeholder’ performance focus and credible metrics for measuring such performance are becoming important for business to attract new capital going forward.
Dashboard for navigating a complex, changing, multi-capital world
In order to achieve so many purposes for a wide range of stakeholders, performance management and reporting must evolve considerably. The image that springs to mind is of trying to navigate a multi-dimensional space at spaceship speed using a mere mariner’s compass. GDP (at the macro level) and Profit & Loss (at the micro or corporate level) are outdated metrics, to the point of being dangerous. Figuratively speaking, we need a system as far removed from these old metrics as a spaceship’s dashboard is from a mariner’s compass. It needs to be multi-dimensional, not one-dimensional when considering capital impacts. The figure below illustrates one pioneering presentation of multi-dimensional value, as developed by AkzoNobel to cover natural, human, social and financial capital, focusing on both positive and negative aspects of its activities on each dimension of value.
Leading the change
These examples of corporate leadership show that in today’s changing world, it is no longer enough for business to merely rely on its current financial performance. To drive tomorrow’s value, it is imperative that they discover, measure and value and the full range of their business’ impacts.
Every year, more and more leading corporations are shifting their reporting focus to incorporate their impacts across multiple capitals and measuring performance with respect to stakeholder value creation. The concept of “Integrated Reporting” introduced by the International Integrated Reporting Council (IRRC) is being implemented in practical and quantified terms, addressing diverse stakeholder needs and quantifying impacts in order to express their materiality.
In 2014, AkzoNobel released their 4D P&L Report based on a pilot study of their Pulp and Performance Chemicals business in Brazil, which specifically looked at the company’s environmental, human, social and financial impact – making it the first company to truly present a quantified integrated report11.
Brazilian forestry company AMATA’s 2016 Integrated Report12, is a recent example of corporate leadership that emphasizes tools for dialogue with society and for learning from the challenges entrenched in operating in a highly scrutinized industry in one of the world’s most ecologically sensitive regions.
Similarly, the 2016 Integrated Profit & Loss (IP&L) report13 published by Australian public water utility company Yarra Valley Water, is driven by the company’s desire to understand fully the value it delivers to society and to answer the questions “what can Yarra Valley Water do as a business to add the greatest value?” and “how can Yarra Valley Water contribute towards improving the livability of its customers in a meaningful way?”.
These examples of corporate leadership show that in today’s changing world, it is no longer enough for business to merely rely on its current financial performance. To drive tomorrow’s value, it is imperative that they discover, measure and value and the full range of their business’ impacts. Moreover, they need to transparently disclose the results of such assessments in order to build collaborations that are effective in delivering complex solutions to the complex problems caused by our current business models.
Corporate leadership in this direction has begun, but what remains is to ensure that these leaders have followers, and that too in large numbers. To enable this we need urgent reforms in performance reporting, such as the Natural Capital Protocol. Further work is required to collaborate and evolve universal frameworks for human capital and for social capital. But in the meantime, there is no reason why businesses should wait. They can, and indeed they must, integrate stakeholder value creation across all capital dimensions and ownership categories as the objective of their corporate reporting, and not just shareholder financial reporting.
1 Earlier ‘TEEB for Business Coalition’ the Natural Capital Coalition (http://naturalcapitalcoalition.org/) is a global multi-stakeholder collaboration that brings together leading initiatives and organizations to harmonize approaches to natural capital. Its key document, the Natural Capital Protocol, is a framework designed to help generate credible and actionable information on impacts and dependencies to support business decision-making.
2 The Natural Capital Protocol (“NCP”) was launched on July 13th 2016, at the Institute of Chartered Accountants of England & Wales, London. See http://naturalcapitalcoalition.org/natural-capital-protocol-launched/
5 Increased large scale migration to urban centers is inevitable due to the global realities of ageing societies, slow and uneven economic growth among regions in a country and among nations, and environmental and climatic instability (International Migration Organisation, 2015, World Migration Report 2015: Migrants and Cities: New Partnerships to Manage Mobility. Accessible at http://publications.iom.int/system/files/wmr2015_en.pdf)
6 International Food Policy Research Institute. 2016. Global Nutrition Report 2016: From Promise to Impact: Ending Malnutrition by 2030. Washington, DC. p 5.
7 See Chapter 2, Legal History of the Corporation, in “Corporation 2020” by Pavan Sukhdev, Island Press (2012) and the Harvard Business Review (2017) https://hbr.org/2017/05/managing-for-the-long-term and also the web article “Firm of the Future” by Bain & Co., http://www.bain.com/publications/articles/firm-of-the-future.aspx
9 Review Report by Global Sustainable Investment Alliance, 2016
Realizing Tomorrow’s Value
How business can measure, manage and strategize value creation in the broadest sense
Managing the total impacts and value of business has reached a tipping point. To drive tomorrow’s value, it is essential for businesses to discover and value the full range of their business impacts across the range of capitals that sustains both business and society. Tomorrow’s value measurement helps leader’s future-proof decisions on risks and opportunities; it also helps companies to show how activities and value creation contribute to the Sustainable Development Goals.
Group President and CEO
By: Anne Louise Koefoed, Thomas Barnett and Erik A. Hektor
Earlier this year, DNV released a position paper titled, Realizing Tomorrow's Value: The emergence of a new business practice. In this article we highlight key aspects of the paper, not least why business need a more holistic approach to measuring their performance, and how they should think about doing do.
Companies have strategizing and decision making at the heart of their activities. But how can leaders make solid strategy and decisions that safeguard value creation in a rapidly changing business environment that faces historic sustainability challenges, and a market place undergoing shifts in policy agendas, consumer and investor preferences?
Driving forwards, looking backwards
The future will look nothing like the past as the conditions underpinning value creation are rapidly changing. In his article above, Pavan Sukhdev discusses evident sustainability pressures, and how they are disrupting business operations. Since a company's performance depends on sustainable natural resources and healthy societies in which it operates, a solid understanding of mega-trends and how environmental and societal issues interlink with company value creation are key to protecting and managing value. Such an understanding can help to mitigate risks, avoid business costs and to leverage new opportunities.
The rear-view mirror of past performance is not a good indicator of future performance when the business environment is rapidly changing. Nor does it satisfy the expectations of regulators, consumers and investors wanting companies to demonstrate their value and contributions to society – shareholders and stakeholders alike – and their management of current and future risks. In addition to meeting such external expectations, companies need to connect the dots between their financial, social and environmental performance to make robust decisions.
Since environmental and societal objectives are indicators/proxies for long-term financial performance and success, companies will increasingly compete on their ability to respond profitably to diverse economic, environmental and societal needs and objectives. As such, realizing tomorrow’s value translates into measuring, valuing and managing all capitals – financial, environmental, social, human - and externalities, today. Strategy and decision making need to be informed by an understanding of the company’s total impact, risks and opportunities, meaning deep embedding of sustainability insights and related performance into these processes.
Bridging the gap between strategic ambitions and operations
In a recent survey, we asked companies around the world a question: what do you believe to be the key factor involved in seizing change and integrating sustainability into the core business? The dominant response was that measuring social, environmental and economic impacts of business is key.
For this to happen, new practical approaches are needed for a broader assessment of business impacts, performance and value creation across the range of capitals that sustains both business, economy and society. In addition, such approaches need to close the gap between company level sustainability ambitions and the operational level of decisions and management through integration with existing organisational frameworks, systems and processes.
Based on DNV’s experience in the risk management area, and extensive review of existing initiatives and leading practices, we have developed guidance to managers for the establishment of the new business practice that we in DNV call: Tomorrow’s Value Practice.
Guidance for action
A step-by-step approach enables the process from multi-capital assessment to interpretation and implementation in the core business- and operational model where insights become an integral part of how objectives are set, strategies are developed, and decisions are made – the latter with a broadening of cost and benefit considerations and decision criteria.
The key action points for company leaders are:
- Set the context, goal and scope: choose a relevant issue where the results will genuinely add value and where your stakeholders internal and external will thank you for bringing real actionable insight into a genuine business problem – for example acute water shortages hitting your sourcing or operations.
- Get started with best available data: rather than await perfection, take the pragmatic business approach of getting a handle on the new data sets that help decision making in day to day practice.
- Pilot with real business decisions: whether it is product design, a project or responsible sourcing, use the new insights developed to drive real decisions and create real long term value.
- Embed the business practice: once a proof of concept is established that has been shown to add value, prioritise company-wide adoption and provide tools to make it possible in the transformed version of ‘business as usual’.
- Leverage knowledge: others have been down this road. Experience, tools and techniques exist. Get access to that experience so you don’t have to reinvent the wheel or fall into well-known traps.
We believe that companies which embrace these actions will perform more robustly through ever-faster change cycles and gain significant competitive advantage. The new practice will also enable companies to communicate contributions to key social and environmental objectives, such as the Sustainable Development Goals.
As stated above, this article is based on the position paper “Realizing Tomorrow’s Value – The Emergence of a New Business Practice” (2017), and is the result of a strategic research and innovation project in the Climate Action programme, DNV Group Technology and Research. Please follow this link to access our position paper. If you are interested in finding out more about DNV’s experience in this arena, please contact us.