The Case for a Sustainability Statement

Abstract:

The most beneficial improvement to current GAAP financial reporting will be the creation and preparation of a standardized sustainability statement; to be filed alongside the balance sheet, statement of cash flows, and other SEC-required financial statements. This statement will comprehensively quantify and value the environmental impacts and contributions of each publicly-traded company. It’s no secret on Wall Street that knowledge is power, and this proposed expansion to reporting will provide indispensable information to investors. Making available this type of reliable information will enable the powers of free market capitalism to innovate the solutions we need for the environmental and humanitarian catastrophes we currently face. The positive effects will be felt by all stakeholders, to include our entire global economy and ecosystem. To test the validity of this proposal, I have conducted research on the precedent set by current sustainability reporting frameworks and GAAP requirements. I provide evidence of demand for such regulation, demonstrate the positive and negative consequences for investors, and the free market economy as a whole. I conclude with a mock-up example sustainability statement highlighting significant KPI and the other findings of my research.


The Case for a Sustainability Statement

Improving traditional financial reporting under U.S. GAAP from the perspective of investors

Our culture and our government recognize that the environment has value and that its degradation, by intent or by neglect, must be avoided and punished. But under our current system, or lack thereof, environmental assets are too often valued in reverse, and only after they have been despoiled. Unless a firm proactively accounts for its ecosystem services, it will only learn their value by destroying it. Fines for Environmental Protection Agency violations are used as a retroactive pricing system for natural resources, but they prove to be an ineffective attempt to internalize environmental damage when current GAAP rules permit negligent companies to unshoulder the burden of their fines. British Petroleum was fined over $20 billion for the 2010 Deepwater Horizon disaster, but the vast majority of this Justice Department settlement will be written off as a tax-exempt cost of doing business, except for a $5.5 billion Clean Water Act violation (NMPIRG, 2015). This sort of haphazard valuation of our most economically vital resources will inevitably lead to their exhaustion. The business community and regulatory agencies must agree that these resources have value, and then we must find a way to establish a true market price before our most precious common goods are ruined.

Voluntary and discretionary disclosures do not currently meet the needs of investors and other stakeholders. Most companies who report on their sustainability impact and initiatives use some form of a Corporate Social Responsibility (CSR) report. There are a number of reporting frameworks designed to help guide the reporting of economic, environmental, and social impacts. These frameworks, such as the most widely-used Global Reporting Initiative (GRI), are published by different organizations internationally, and have been adopted at differing rates (Brockett, 2012, p. 278). In 2012, 53% of S&P 500 companies published a sustainability report (Schooley, 2015, p. 24). These toothless and often unassured attempts at green-washing are usually too opaque or shallow to reveal anything of material use to investors. One study of reporting practices by GRI and A4S found that “nearly two-thirds (61%) of investors and analysts find social information difficult to compare,” (The Value of Extra-financial Disclosure, 2012, p. 5). Many so-called industry leaders in sustainability use the opportunity to issue a glossy and colorful report, the same length or longer than their 10-K filings. They highlight a few philanthropic donations and sustainability initiatives, while completely ignoring the negative impacts and externalities created by the firm. Since the costs of reporting can be assumed to almost always outweigh the benefits, we cannot realistically expect most companies to self-report faithfully. When Price Waterhouse surveyed a sample of securities issuers in 1993, 62% of “issuers knew they were exposed to environmental liabilities but did not mention the liabilities in financial statements” (Roberts, 1993, p. 1). Although these frameworks are a good start towards addressing this issue, until there is an enforceable GAAP standard for environmental accounting, we rely on the goodwill of firms to outweigh their business acumen. From Exxon, to Enron, to BP, to Ford’s exploding Pinto, the examples of massive corporate irresponsibility dominate the examples of their ethics without strict regulation. It is time that investors and all other stakeholders demand that we move beyond CSR, to comprehensive and integrated sustainability accounting.

Investors are primarily interested in capital expenditures and operational efficiency, measured and reported as numerical KPI. Quantitative information is more persuasive and informative to the financial community than a colorful waste reduction infographic on a CSR. When sustainability KPI are non-standardized, important data is easier to obfuscate and omit. Absent any regulation to compel truthful reporting, many companies use technocratic language or distorted statistics to shield the intricacies of their internal operations from prying eyes. If “accounting is the language of business,” then sustainability is barely a part of the conversation, and there is insufficient information relevant to investors.

There is a burgeoning investment trend towards companies with leadership in sustainability efforts. “Socially responsible investments (SRIs)- mutual funds that screen companies for their contributions to society- rose 258 percent in the last ten years, a return on investment that beats the market by more than 15 percent.” (Sanders, 2008, p. 5) In 2011, over 35% of shareholder proposals to the Conference Board related to matters of social and environmental policy (Brockett, 2012, p. 286). Countless groups, funds, and coalitions, representing trillions of dollars, have been formed to support sustainable investment, e.g. Ceres, Investor Network on Climate Risk, Fossil Free Fund, and the Dow Jones Sustainability Index.

Sustainably-minded American investors are ill-served by the current selection of mandatory reporting, as the vast majority of SEC required filings relate to traditional financial data. Regulatory coverage of non-financial and sustainability reporting is piecemeal, and required disclosures are few and far between. The Environmental Protection Agency (EPA) is the most potent entity in this domain, with the power to regular emissions standards, and enforce legislation like the aforementioned Clean Water Act, and Clean Air Act. The SEC does require a climate risk disclosure, but evidence for compliance is limited (Hirji, 2013). There has long been talk of a “cap and trade” carbon control system here in America, but at the time of this writing, carbon goes unpriced and nearly unregulated. A smattering of industry specific disclosures compels the reporting of conflict minerals and other mine safety factors (SEC Adopts Dodd-Frank, 2011).

The US government has made some contributions to sustainability reporting. The Resource Conservation and Recovery Act of 1976 requires the EPA to control hazardous wastes from cradle to grave, or from the point of their origination to the point of their disposal (Solid Waste Disposal Act, 2002). The GRI Carrots and Sticks 2013 report specifically mentions “Presidential Executive Order 13514; issued by President Barack Obama, this Order requires all federal agencies to measure and report on their sustainability performance, which includes assessing their supply chain,” and the 2010 California Transparency in Supply Chains Act, which has the same effect for the manufacturers in the state of California (Carrot and Sticks, 2013, p. 77).

Many international companies adhere to the International Financial Reporting Standard set by the International Accounting Standards Board. This reporting standards is principles-based, as opposed to the more strictly binding, rules-based US GAAP. IFRS emphasizes an asset/liability or balance sheet approach over a revenues/expenses or income statement format. There is mixed evidence for the ability of IFRS to account for and control environmental degradation (Negash, 2012). There has been talk for many years of converging US GAAP with IFRS (Holzmann, 2015). Should this ever come to fruition, it would be an ideal time to fully integrate a sustainability statement as part of a comprehensive, principles-based, global financial reporting language.

The International Organization for Standardization (ISO) has released a number of guidelines for social responsibility and environmental management. Tamimi and Sebastianelli studied the shareholder impact of ISO 14000, which stipulates the requirements for an Environmental Management System. They found that all but one of the sectors they examined “experienced significantly better annualized returns than their corresponding S&P 500 indexes,” and that investors earn more from ISO 14000 compliant stocks, especially in the short term (Tamimi et. al., 2012, p. 7). ISO 26000 was developed in 2010 to provide standards for corporate social responsibility. It emphasizes stakeholder engagement to develop idiosyncratic CSR to suit each particular company. Unlike 14000, “ISO 26000 does not include requirements for a management system and is not intended for certification” (Moratis, 2014, p. 82).

The GRI Carrots and Sticks 2013 report details the mandatory and voluntary filing requirements implemented by different countries across the world, many of which are inspired by the GRI framework. For instance, Canada requires that “all facilities that emit the equivalent of 50 kilotons or more of greenhouse gases in carbon dioxide equivalent units per year are required to submit a GHG report,” and that firms in certain industries release a “National Pollutant Release Inventory” (Carrot and Sticks, 2013, p. 56). The Danish “Green Accounting Scheme” describes how to account for non-financial KPI, and is mandatory for more than 400 companies. The Danish government is currently in development of an “Environmental Profit and Loss” statement that may prove to be an excellent example of a sustainability statement (Carrot and Sticks, 2013, p. 29).

Numerous other organizations have taken aim at the development of sustainability reporting standards and KPI. It falls outside of the scope of this report to describe them all in detail, but there is a wealth of information from which to begin building a GAAP sustainability statement. The European Eco-Management and Audit Scheme recommends using common bird populations as “a proxy for wide-ranging pressures on ecosystems and the services they provide for the quality of life” (Management Plan 2015, p. 5). The United Nations Environment Programme Project for Ecosystem Services works to value ecosystem services in four economically developing pilot countries. They found that in Trinidad and Tobago, “coral reefs provide up to $49.6 million of shoreline protection services annually to the national economy” (New UN Report, 2015). Another UN project, the System of Environmental-Economic Accounting, provides progressive guidelines for linking environmental and economic statistics, and establishes principles for ecosystem accounting (System of Environmental-Economic Accounting, 2012).

To develop a sustainability statement, a company must use full-cost accounting techniques from managerial accounting to assess costs over a product’s complete life cycle, and evaluate all hidden and indirect costs. The double-entry debit and credit system will be upheld to ensure the continuity of the matching principle to apply to environmental or social inputs and economic outputs.  Sustainability KPI addressing each realm of triple bottom line accounting will be industry-specific as well as idiosyncratic and unique to each firm. Assurance will be universally required, as currently only 25% of environmental metrics are assured by a third party auditor (Brockett, 2012, p. 197).

The sustainability statement empowers investors with increased information about a firm’s operational impact, supply chain control, and resource management. When companies disclose the extent of their externalities, and their efforts at containment, investors gain a greater understanding of the risks faced and created by each firm (Gray, 2008, p. 2). Because it accounts for all resources relevant to a company’s value chain, the sustainability statement will be a better predictor of long-term sustainability, growth, and profitability. It is vital that the statement allow for a reliable comparison between firms to empower confident investment and divestment decisions. KPI should be designed and combined to support complex analysis like SWOT analysis, or financial and environmental health indicator ratios, like P/E ratios or the z-score. As more and more shareholders move towards the high return rates of sustainable investments, companies will compete and innovate to attract them.

The consequences of a sustainability statement requirement are hard to anticipate, as they will be extremely diverse and far-reaching. Unfettered access to accurate information of this magnitude will cause a shockwave to reverberate up and down the value chains of each industry, and quickly reach every stakeholder in the global economy. Without shrewd management, the early consequences of implementation could prove extremely dire. The economic engine of creative destruction is sure to run on overdrive for a number of business cycles, and scores of firms, both old and young, will implode.

A side effect of the sustainability statement will be increased market efficiency. An improved flow of information will help overcome the “invisible foot” of bounded rationality to let the invisible hand move freely and alleviate the market’s failure to address sustainability issues (Meadows, 2008, p. 106). Prices will reflect the true cost of goods sold, and act as much more reliable economic indicators. Stock prices will also become more meaningful. Ideally, there will be fewer bubbles and crashes as businesses learn to generate profits in a way that is truly sustainable for the long-term. This solution removes the need for intrusive instruments or taxation schemes, such as Pigouvian taxes, that result from market inefficiencies like externalities. Sustainably-minded investors will become the most sought-after and empowered influence on business. In turn, their increasing level of scrutiny will encourage businesses to be proactive with response to the new regulations and market pressures. Companies will be rewarded with increased efficiency as they learn to be parsimonious with environmentally or socially expensive resources. The report may even inspire extreme innovations; such as an increase in companies using as primary input materials what was previously considered waste, or even innovation beyond terrestrial resources. A standardized system of integrated sustainability reporting will lead to a cascade of new incentives and opportunities for all capitalists. Ideally it will lead to the inclusion of new members to the financial community, such as environmental experts, scientists, and new investors.

Appendix:

Sustainability Statement, Year Ended Dec 31, 2015

Picture1Picture2Fig. 1. Mock-up Sustainability Statement for anonymous fictional manufacturing company

References:

Brockett, A., & Rezaee, Z. (2012). Corporate sustainability: Integrating performance and reporting. Hoboken, N.J.: Wiley.

CARROTS AND STICKS: Sustainability reporting policies worldwide – today’s best practice, tomorrow’s trends. (2013). Retrieved December 12, 2015, from https://www.globalreporting.org/resourcelibrary/Carrots-and-Sticks.pdf

Gray, R. (2008). Social and Environmental Accounting and Reporting: From Ridicule to Revolution? From Hope to Hubris? – A Personal Review of the Field. Centre for Social and Environmental Accounting Research. Retrieved August 25, 2015, from https://www.st-andrews.ac.uk/media/csear/discussion-papers/CSEAR_dps-socenv-hopehubris.pdf

Hirji, Z. (2013, September 13). Most U.S. Companies Ignoring SEC Rule to Disclose Climate Risks. Retrieved December 12, 2015, from http://insideclimatenews.org/news/20130919/most-us-companies-ignoring-sec-rule-disclose-climate-risks

Holzmann O, Munter P. Challenges in Achieving Convergence Between U.S. GAAP and IFRS-The Case of the Revenue Recognition Standard. Journal Of Corporate Accounting & Finance (Wiley) [serial online]. September 2015;26(6):101-106. Available from: Business Source Premier, Ipswich, MA. Accessed December 12, 2015.

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Moratis, L. (2014). ISO 26000. Journal Of Corporate Citizenship, (53), 77-90.

Negash, M. (2012). IFRS and environmental accounting. Management Research Review, 35(7), 577-601. doi:http://dx.doi.org/10.1108/01409171211238811

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NMPIRG. (2015, October 5). NMPIRG: Deepwater Horizon Settlement Comes with $5.35 Billion Tax Deduction. Retrieved December 12, 2015, from http://krwg.org/post/nmpirg-deepwater-horizon-settlement-comes-535-billion-tax-deduction

Roberts, R. (1993, June 10). Remarks Of Richard Y. Roberts, Commissioner, U.S. Securities and Exchange Commission Washington, D.C. Lecture presented at Environmental Liability Accounting Developments, New Orleans, Louisiana.

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SOLID WASTE DISPOSAL ACT. (2002, December 31). Retrieved December 12, 2015, from http://www.epw.senate.gov/rcra.pdf

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Tamimi, N., & Sebastianelli, R. (2012). EXAMINING THE IMPACT OF ISO 14000 CERTIFICATION ON SHAREHOLDER VALUE BY INDUSTRY SECTOR. Proceedings For The Northeast Region Decision Sciences Institute (NEDSI), 109-116.

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