New Bottle, Old Wine? Six Capitals Framework Will Require Trade-offs

Nick A. Shepherd | April 8, 2016 | 1

Integrated reporting offers a great opportunity to think differently about the decisions that organizations make. It can help companies make decisions based on more than financial criteria and the bottom line to consider socio-economic impacts, governance and accountability, sustainability, and more.

The International Integrated Reporting Council (IIRC)’s six capitals framework seems to require recognition that for any entity to create value it must call on not just financial capital but others forms of external capital—some of which impact its local, regional, or even global community. Conceptually this is significant progress but the challenge will be in how organizations approach, adopt, and apply the framework. It also remains to be seen to whether the results of decision making using the framework will translate into full transparency and accountability to society as a whole.

One of the ways to start thinking about the application of integrated reporting is to consider the societal issues and concerns that have brought us to this point. What’s the problem that we are trying to solve? In what way is the existing approach to decision making not serving society? These questions and type of thinking opens up a considerable discussion that can include possible changes that might make capitalism as we know it work better, provided the discussion is open and honest.

The reality is that the larger and more global a corporate entity becomes, the greater the risk to both its home society as well as those it operates in. Entities also face trade-off decisions between the capitals. For example, manufacturing has seen a global shift to low labor-cost countries with the resultant loss of jobs in more developed, higher-cost nations (this can also be true within larger nations, such as in parts of the US). A positive impact on one capital arguably at the cost of a negative impact on another.

Government priorities and the application of all the Sustainable Development Goals (SDGs) is no less challenging. International agreement on these goals is wonderful but the reality is that there is not a level playing field in the international market. As a result, different countries are in different places when it comes to attaining these goals—and it is hard to convince any nation to cut back in one area to see progress in another. For example, it is politically very challenging to convince a population to cut back on economic opportunity, which can provide the taxes necessary to create social systems to provide for basic safety needs, when scaling back might result in fewer emissions. Thus, implementing the SDGs remains a challenge even though everyone may agree philosophical that these are honorable goals.

Using the IIRC model, it could be demonstrated that a decision to enhance financial capital would result in significant depletion in both human and social capital. Where costs are reduced through outsourcing or downsizing, shareholders benefit from sustained or increased profits and users of the product or service receive competitive products at a sustainable or decreased price. The impact on society as a whole from a loss of jobs is a limited cost to the employer who, in most countries, has to pay some level of separation pay. After this charge, all further costs are to society—unemployment, decline in housing prices, reduction in local services as a result of lower tax revenue, costs of increases in stress and mental illness, etc. These costs deplete social capital but the impact on the business is minimal. Arguably, the brand value and reputation may be harmed but the impact is typically local and the enterprise global.

On the other hand, the trade-off might be managed differently through different choices. Instead of fully depleting human capital, the organization invests in manufactured capital and reduces high-labor costs through automation and robotics. This way the financial capital would be depleted but manufactured capital increased and human and social capital sustained or even grown. For example, manufacturing unions around the world talk about “the race to the bottom” but in reality organizations that chase low-cost labor are playing a zero sum game as eventually everyone will have the same cost base. Certain industries, such as the garment industry, already face this type of challenge where outsourcing no longer provides a competitive advantage. Meanwhile, societies everywhere are paying the price as the organization pulls up stakes and moves on, leaving behind desolation, unemployment, empty factories, and crumbling infrastructure. For politicians in a developing country, this would not be a good political outcome—and some may, therefore, opt to allowed continued pollution instead of working toward the SDGs, for example.

Another area where decisions might be different is in outsourcing IT, which has grown significantly as countries develop their capability to offer services at lower costs, in India for example. Typically, the decision to outsource IT is made either to lower costs or because IT is a “non-core” activity. Again, human capital is depleted to increase financial, relationship, and social capital through sustained or lower costs and, ultimately, lower prices. A recent article in the New York Times recalled that the late Andy Grove, one of the founders of Intel, warned Silicon Valley that the US was “squandering its competitive edge” by exporting jobs to lower cost environments resulting in a decline of intellectual and human capital for the US. It can also be argued that if lower environmental standards exist in the outsourcing destination for areas like power generation, outsourcing IT would also deplete natural capital at a greater rate.

Strategically the decision on outsourcing is much more critical. To what degree is current intellectual capital being depleted by no longer having IT capability in-house? In today’s competitive environment, increasing numbers of organizations are turning to analytics to rapidly understand their business activity. To what degree can the provision of IT services be separated from the knowledge of the business that can only be maintained by those who are actually engaged IN the business? The alternative is to look at IT as a key source of intellectual capital—the loss of which would deplete the value of the business strategically if not in the short term operationally.

Actions during economic downturns provide additional examples, as they are different than those made during times of prosperity and reflect different belief systems affecting the six capitals. The company where I was a financial officer was faced with a business downturn. We had approximately 60 semi-skilled staff members who manually wired customized electronic equipment. When the downturn came, there was no work for these staff members and laying them off would have minimized the financial impact. However, our leadership successfully argued that our staff members represented an investment we had already made in training that would be hard to recoup if we let them go. As a result, we took on some low-revenue generating business that barely covered our costs. Our bottom line suffered more than if we had made the layoffs but the longer-term strategic value allowed us to retain the skill sets. We recognized and valued our staff’s experience as part of the human capital we generated. We decided to forego financial capital for the sake of retaining human capital.

Populating the pilot IIRC models needs to demonstrate transparency on these types of decisions if organizations are to change decision making and retain investor support. Providing insights into the investments that organizations are making in the six capitals and how they employ them to add value is a step in the right direction. But it remains to be seen whether the full disclosure will allow users of the information to determine whether they are dealing with a “good corporate citizen” at the strategic and sustainable level or whether the disclosures are just skin deep, especially when global organizations have both political and shareholder needs to address. It also remains to be seen whether investors are able to shift decision making for the good of society as a whole or remain focused on purely financial performance. Thus, effective adoption of integrated reporting is as much—if not more—a corporate governance issue as an operational and reporting issue.

Nick A. Shepherd

President, EduVision

Nick A. Shepherd FCPA, FCGA, FCCA, FCMC, is the President at EduVision, Inc. Mr. Shepherd has more than 40 years of business experience and since 1989 has been running his own management consulting and professional development company, EduVision Inc. that provides professional facilitation and management consulting and development services to public and private sector organizations. See more by Nick A. Shepherd

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Ian Jenkins May 13, 2016

The aim of integrated reporting seems to be to highlight the extent to which the performance of political organisations around the world compare with a goal decided at the United Nations. But as the essay points out, "it is politically very challenging [even for a transient national government] to convince a population to cut back on economic opportunity, which can provide the taxes necessary to create social systems to provide for basic safety needs". It has been suggested elsewhere that, arguably, a more important comparison of basic financial statistics should be carried out. However it may be difficult getting Washington, for example, on board. The US accounting rules so far ignore accruals; if just accruals are included, it is said that the public debt is $72 trillion, not $19 trillion as at present. Will the G20 ever be in a position to insist on, and vet, disclosures of national finances? Bearing in mind that the unchecked 2008 financial crisis started in the US.

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