We Are Nowhere Near Stakeholder Capitalism
If you read the headlines coming from the 2020 World Economic Forum at Davos, you may start believing that public corporations have fundamentally changed their raison d’être: from creating value for shareholders to benefiting society-at-large. In our opinion, this conclusion is premature. We haven’t seen real change yet, and we won’t without first transforming firms’ performance measurement systems.
Let’s look at some recent news: A group of 200 influential CEOs declared that the main purpose of the corporation is to serve all Americans, not just capital providers. Blackrock announced that it will shift its investments toward firms that support sustainable growth. Goldman Sachs recently declared that it would stop supporting the IPOs of companies that have all-male board of directors.
It is unclear how these praiseworthy objectives would be achieved without a unified framework for evaluating a firm’s performance that combines financial and nonfinancial measures. No such framework yet exists, while a few have been proposed. Public companies continue to be organized as “for-profit” organizations and run as “nexus of contracts” whose principal objective remains to create wealth for shareholders. Almost every move, strategy, tactic, or intervention is evaluated based on its impact on revenues or profits, using metrics such as efficiency, return on capital, payback period, asset turnover, and margins. Some examples are dividend policy, marketing policy, corporate diversification, selection of board of directors, corporate governance, competitive strategy, and supply chain management.
CEOs continue to be hired, fired, and compensated based on metrics, such as revenues, profits, and share prices. Fund managers, who make investment decisions on behalf of dispersed investors, continue to be rewarded based on how their investments performed relative to the market. The board of directors continue to be selected by shareholders to protect their interests. So, how likely is it that a CEO would get up one day and suddenly change his or her focus from revenues, profits, and stock prices toward wider Environmental, Social, and Governance (ESG) goals? Some CEOs might, but for most, the predominant objective would continue to be to maximize shareholder value while keeping ESG objectives in mind, instead of the other way around.
Change also appears unlikely when you consider how businesses are funded and held accountable. Firms are funded by entrepreneurs by way of ideas and capital; these entrepreneurs are later joined by second-stage investors, public investors, and banks – all of whom expect to be rewarded with financial returns. Government-mandated accounting systems, audits, and financial disclosures are principally created with shareholders in mind.
Take the income statement, for example, whose top-line and bottom-line elements of revenues and profits, respectively, drive most decisions in a modern corporation. The bottom-line number is supposed to represent the amount that the firm can pay out in dividends to shareholders, while leaving the firm equally well off at the end of the reporting period. So, the summary net income during a financial year is calculated based on the increase in a firm’s potential to pay dividends to shareholders, not its contribution to society. As far as the balance sheet is concerned, shareholders’ net worth equals book value of assets minus the book value of liabilities, not the value of ESG investments.
Imagine what an altered reporting system from an ESG perspective might look like. It doesn’t take long to realize what a monumental task this would be. Let’s focus on a simple measure like Return on Investment. To calculate the value of total investment, an organization would first have to calculate the value of all resources used in its day-to-day operations. Those resources would not just be warehouse, factories, land, and inventory owned by the company, but also intellectual capital (intellectual property, systems, procedures, and protocols), natural capital (air, water, land, minerals, forests, biodiversity, eco-system health), social/relationship capital (shared norms, key relationships, brand and reputations), human capital (competencies, capabilities, experience, motivations), and strategic capital (purpose, business model, governance, culture).
Suffice it to say, calculating the value of all these capitals is practically impossible. The accounting standard setters have not even been able to provide a framework for calculating the value of in-house innovation, forget calculating the value of nebulous resources like shared norms and business purpose or the value of external resources like air and water.
Calculating the return part of ROI would require a calculation of not just accounting revenues and expenses, but also the value of creation and consumption of all of the ESG resources during the year. Again, the accounting standard setters have not even been able to provide a framework for calculating the increase in value of Facebook because of increase in subscribers, forget calculating the value of depletion of society’s air, water, or biodiversity.
While we admit that considerable progress has been made in developing theory, models, and disclosure norms for ESG objectives, we believe that we are nowhere close to achieving “integrated reporting,” as some people might claim.
Consider SASOL, a South African oil company, which purports to offer integrated reporting. It honestly discloses: “We impact negatively on natural capital by using nonrenewable resources, and through our emissions and wastes,” and “we also impact adversely on human and social and relationship capital through competition for resources such as water.” But then it also claims that “by converting natural capital into value-added products, we boost the stocks of all the other capitals,” which is an indirect way of saying “earning profits.”
In our view, these boiler-plate disclosures do not make financial reports “integrated,” and they make little or no difference to the decision of capital providers. Can ESG stakeholders force a firm to change its operational policies based on those disclosures as much as an activist shareholder can for missing an earnings target?
So while we admire and support the move toward a wider organizational purpose, we are reluctant to believe that, at the operational level, things have changed as significantly as claimed by the current news headlines. CEOs continue to be fired for missing earnings targets. The Fortune 500 list continues to be based on revenues, profits, and assets. Society continues to eulogize people based on their amassed wealth. As we praise the efforts of the CEO round table and the WEF in Davos, let’s not ignore just how much more needs to be done.
About the Authors:
Anup Srivastava holds Canada Research Chair in Accounting, Decision Making, and Capital Markets and is an Associate Professor at Haskayne School of Business, University of Calgary. He examines the valuation and financial reporting challenges of digital companies.