How Can Statements of Long-Term Risk and Opportunity Help Shift Mindsets to Long-Termism?
By Cornis Van Der Lugt, Bill Baue and Ralph Thurm
During a recent investor call, Wall Street analysts repeatedly asked Tesla CEO Elon Musk about future “capital requirements” as well as “continuing production issues and high cash-burn rate,” according to The New York Times; Musk responded: “Boring bonehead questions are not cool… Sorry, these questions are so dry. They’re killing me.”
The exchange illustrated the obsession among financial analysts with the coming 12 months, versus the vision of an industry leader on what can or should be in the coming years and decades. The challenge of market short-termism is well known. Various studies in recent years have pointed to the risk of earnings manipulation by managers to meet quarterly earnings targets. Institutions such as the Chartered Financial Analysts Institute have recommended that companies stop publishing quarterly earnings guidance.
What’s the issue?
This raises issues such as the frequency of disclosures made by companies, incentives tied to the performance targets included in these, the type of investors involved, as well as the types of investment involved. Presumably institutional investors like pension funds are focused on long-term investments, taking care of the pensions of generations of people. Investment in assets with long lives also highlights the need for a long-term perspective when dealing with things such as infrastructure and public resources.
Yet there remains a surprising disconnect between, on the one hand, the assessment of short-term business (and financial) performance, and on the other hand, business decision-making on capital expenditures that often needs planning ahead for decades. For extractive industry companies or public utilities such as energy or water services companies, planning and capital investment for the coming 50–100 years is not uncommon. Why this disconnect between decision-makers or two types of decision-making that may very well sit within the same company?
Why it’s important?
No issue demands future, long-term focused decision-making and disclosure more than that of climate change. Zooming in on forward-looking disclosures by heavy industries and financial institutions, for example, the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has recommended the use of scenario analysis for better understanding of the potential financial implications of climate change for business. Encouraging 2 degrees or lower scenarios, it notes that the implications of climate change are without historical precedent.
There are also other historically unprecedented challenges for business today, for example global population growth, resource needs and planetary boundaries. Are the implications of these for large businesses reflected on the representation of assets, liabilities and capital as found on current-day balance sheets?
Think stranded assets. These may be resources that a company either purchased or paid for, including shared ones that it may be very dependent upon but don’t have full control over. How can these be adequately reflected on the balance sheet and its accompanying reporting narrative? How can we help managers and investors take well-informed decisions based on available stocks today and the likely health of available stocks (and their ongoing flows) two or three or more decades from now?
How can you tackle it?
Our Reporting 3.0 Blueprint on New Accounting proposes a Statement of Long-Term Risks and Estimated Non-Current Asset / Liability Value. You can call it a balance sheet of the future if you like. Partially a Future Balance Sheet addressing future value, the statement presents a combination of quantitative, financial and qualitative, explanatory information.
This proposed forward-looking statement provides the opportunity for a company to provide estimations of what may be the value of its long-term assets and liabilities twenty years from now. For the purposes of facilitating a discussion on long-term risks and opportunities across industries, a period of twenty years should be a good yardstick — mindful that “long-term” has different meanings in different industry sectors. Significant societal, economic and ecological change at systems level plays out over decades. This context is a given.
The statement proposed builds on the recommendations of the TCFD, but links it more closely to the key elements and structure of the balance sheet. And most importantly, it takes the focus beyond just climate change. It means that when a company is asked to disclose a description of key long-term risks and opportunities, valuation, assumptions, and future implications for investment, it is a comprehensive scenario that is involved. Similar to stress tests applied to banks, this may consider various significant developments (climate and other). It will also be mindful, as the World Economic Forum (WEF) has pointed out, that global risks are becoming increasingly systemic.
The above will be applied not only to different assets like land, reserves, buildings and equipment, but also liabilities in the form of long-term debt and leverage.
What will you have achieved?
Sitting inside a large company, would you be ready to take on the proposed Statement of Long-Term Risks and Estimated Non-Current Asset / Liability Value? You may well have numbers inhouse to work with. If you complete the experiment you may feel uncomfortable going public with the findings. Even if initially only conducting the experiment internally, it will certainly make for a more informed and strategic discussion inhouse. Furthermore, it will enable you to have a more productive discussion with responsible investors.
The Reporting Blueprint starts off with the premise that there is no sustainable business in an unsustainable world. Its recommended Integral Thinking and Integral Materiality Process (as also described at length in the Reporting Blueprint) advance the idea of an organization serving a ‘bigger whole’. This includes business decision-making that more effectively addresses transition risk and systemic risk, as well as transformation risk and root-cause opportunities.
The flip-side of any risk is an opportunity. Looking twenty years and decades ahead leaves a sense of nervousness and excitement. The ability to look far ahead in an intelligent manner requires not only gut feeling but also education, among others of Main Street analysts.
What question will we discuss next time?
Why do we need Narrative Reporting? Please read part 19 here.
[Context of this series: This is part 18 of the Reporting 3.0 series that forms the basis of an Implementation Guide that summarizes the total value of Reporting 3.0 in implementing a future-ready sustainability strategy and disclosure approach, in line with the idea of a Green, Inclusive and Open Economy. By posting these articles here Reporting 3.0 seeks feedback in the writing process of the final document, to be released as Blueprint 5 at the 5th International Reporting 3.0 Conference in Amsterdam, The Netherlands, on June 12/13, hosted by KPMG, see www.2018.reporting.org]