PDI: The Imperative to Account for Externalities: Why We Must Bridge the Gap Between Non-Financial and Financial

As the world emerges from the pandemic with high inflation, vast inequalities, and rising oil and gas prices, it seems timely to ask how much we can expect of investors and businesses in our current system. While individual investors — people and firms — are taking on climate change and other systemic risks like inequality and biodiversity loss, they are doing so in a system where the odds are stacked against them. The very nature of the system resists change in ways that non-financial disclosure and policy and regulation alone cannot solve.

Financial decisions are based on financial analysis, and the current system lacks a mode for accounting for externalities in the calculation of returns. In our current economic system, companies and asset managers are expected to maximize their financial return to investors. Any negative impacts to nature and society that do not erode a company’s (or in certain situations, a fund’s) own financial performance are still generally not accounted for given current accounting standards. Even where there is some limited reporting on these issues, it is primarily focused on the effect of these impacts on future corporate financial returns, or on stakeholders separate from those financial returns. There is no risk that they might actually have to be accounted for in the calculation of current profits.

There is no future for us all if we continue with this approach. Investors are making asset allocation and portfolio construction decisions based on outdated modes of financial analysis that do not account for externalities. We must investigate how externalities could be discounted into prices today to shift behaviour.

Fortunately, investors are beginning to realize this. In the new paradigm of system-level investing, asset owners and allocators recognize that the long-term financial success of their portfolios depends on the health of the natural and human systems upon which the market depends. Advocates and practitioners of “Universal Ownership” contend that these owners have interests beyond the performance of any one company or sector — as they are long-term investors, and their portfolios encompass the majority of sectors, markets and asset classes. They cannot diversify away problems or risks caused by the private sector, including climate change, biodiversity loss, and inequality. As such, these investors must work with their investees to reduce their negative impacts on the system, or externalities.

This can change the perspective of investors when assessing corporate performance and corporate policies. For example, more focused or short-term investors may see corporate investment in the workforce or conservation of biodiversity as a competitive disadvantage to their holdings because of the associated costs incurred. Yet Universal Owners may see these investments as potentially benefiting the long-term health of the specific company (for instance by enhancing a company’s reputation), as well as the broader sector or economy (by reducing systematic risks), so are more likely to support these types of investments.

This might be seen as increasing the relevance of non-financial information or ESG considerations. Frameworks like the Global Reporting Initiative (GRI) and the European Union Taxonomy are useful tools for investors to understand risks (as well as the Value Reporting Foundation (VRF) and the emerging recommendations from the International Sustainability Standards Board (ISSB) regarding idiosyncratic risks). However, across these frameworks, the information presented is non-financial — information that someone else will have to turn into financial information to assess the effect of systemic interactions on financial returns. Guidance requires financial accounts to be prepared considering the need to mitigate asset values resulting from ESG issues, but the scope for recognising liabilities that relate to an enterprise’s share of systematic risk is much harder, though not perhaps impossible.[1]

Investors are beginning to understand how to treat climate risk as not only a non-financial risk, but also a financial one, for instance by integrating the cost of carbon into financial models. Yet other dynamics are harder to measure and manage. For instance, some private equity and private credit firms may overburden their portfolio companies with too much debt. This may be incentivized by asset owners and allocators who are seeking higher yielding investment products, particularly in a low interest rate environment. Investor appetite for leveraged buyout private equity, high yield bonds, leveraged loans, and collateralized loan obligations (CLOs) send signals to companies and asset managers to produce more of these products, and take on more risk. Yet this risk is not only borne by the investors and their investees. Companies’ highly leveraged capital structures may prevent them from offering quality jobs, or quality and affordable goods and services. Uncompensated risk is then shifted to workers and communities. And eventually, high debt burdens across many firms in the market can lead to credit crises or a “debt trap” where the potential to raise interest rates is inhibited. These dynamics close the loop between financial and non-financial factors and negatively impact both society and markets, but tools to measure and manage such risks are lacking.

This may all seem too hard, but potentially a significant part of the solution lies in our existing financial reporting standards. One of the main international standards is overseen by the International Finance Reporting Standards Foundation (IFRS) and managed by the International Accounting Standards Board (IASB). The IFRS trustees state in their conceptual framework that they seek to meet the information needs of the maximum number of users, where users are defined as existing and potential investors, providers of loan finance, and suppliers. The information will be used to make decisions to provide resources in the expectation of financial returns.

With the rise of Universal Ownership, the information needs of the maximum number of users can only be met if there is information on these systematic risks included in the financial reports, perhaps not initially in the balance sheet, but at least in the notes.[2] This would mean addressing the need for transparent quantification or valuation of trade-offs.

Although valuation has the tendency to generate strong views, these trade-offs are being made by managers all the time, and investors need some insight to how these trade-offs may affect their portfolios in the long term. It would also mean accepting a higher level of uncertainty than may currently be the case, but uncertainty is not new to financial accounting. The conceptual framework is built on existence, outcome, and measurement uncertainty around economic phenomena. Uncertainty is also recognised in the audit standards that provide those users with the assurance they need.

As paragraph 1.11 of the Conceptual Framework for Financial Reporting points out:

To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions. The Conceptual Framework establishes the concepts that underlie those estimates, judgements and models. The concepts are the goal towards which the Board and preparers of financial reports strive. As with most goals, the Conceptual Framework’s vision of ideal financial reporting is unlikely to be achieved in full, at least not in the short term, because it takes time to understand, accept and implement new ways of analysing transactions and other events. Nevertheless, establishing a goal towards which to strive is essential if financial reporting is to evolve so as to improve its usefulness.

Yes is does take time — but we are running out of it.

Delilah Rothenberg is a Co-Founder and the Executive Director of the Predistribution Initiative, which is currently curating programming for asset owners and allocators to consider integration of systemic risks into their financial analyses.

Jeremy Nicholls is the Assurance Framework lead for the UNDP SDG Impact Standards and an Ambassador to the Capitals Coalition and writes on financial accounting.

[1] https://capitalscoalition.org/publication/disclosing-impacts-on-natural-social-human-capital-in-financial-statements/

[2] This approach could also be more relevant to funds when reporting on risks, given their reporting formats differ from corporate financial statements.