IIRC & KIRCHHOFF INVESTOR RESEARCH REPORT

Closing the gap: The role of integrated reporting in communicating a company’s ­value creation to investors 2 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Contents

Contents

3 Foreword 4 Executive summary

6 The imperative 8 Methodology 9 What is non-financial information? 10 What types of non-financial information do investors value? 12 Uses of non-financial information 16 Sources of non-financial information 19 How integrated reporting could help to improve non-financial disclosures 23 Levers for encouraging the integrated reporting of non-financial information 26 Summary and outlook

27 Appendix 1: Interview questions 28 Appendix 2: A brief overview of corporate reporting requirements in Germany 29 References | Acknowledgements

30 Imprint/Contact 3 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Foreword

Foreword

Integrated reporting is an important In Germany, uptake of integrated reporting Therefore, the foundations for enhanced development in the evolution of corporate to date has been relatively limited. A few high- reporting under the Framework are reporting. Its roots can be traced back to the profile companies have blazed a trail, but ­already in place. We encourage companies first King Report on Corporate Governance, the majority have failed to follow. However, not only in Germany but around the world to published in South Africa in 1994, the year an important feature of the reporting explore the potential benefits of integrated that Nelson Mandela was elected President. landscape in Germany is the Lagebericht reporting, if they are not already doing so. The King Report responded to the need to – the management report that medium- rebuild trust with investors, as well as other sized and large companies are required to Corporate reporting continues to evolve. key stakeholders, after mass disinvestment prepare. This management report provides ­Future developments are likely, given the had helped to bring an end to the apartheid era. an appropriate view of the course of business cooperation now taking place between five and the position of the company. Alongside global organizations involved in corporate Building and maintaining trust with investors the financial statements, it is an important reporting and sustainability standards, remains a key goal of corporate reporting. element of most companies’ annual reports. including the International Integrated In today’s world, this cannot be achieved Reporting Council (IIRC). These organizations by disclosing financial performance alone. Given the existing requirements for the are coming together with a shared goal to ­Investors increasingly appreciate the linkage ­Lagebericht, for many German companies achieve global consistency in reporting. between company performance on a range the step up to producing an integrated As one of the first steps in this regards, of environmental, social and governance report would not be too great. The the IIRC and the Sustainability Accounting factors and their ability to deliver profits management report must, for example, Standards Board (SASB) recently announced over the longer term. Integrated reporting contain certain content elements, including their intention to merge in 2021 into a provides a framework that companies can the most important financial and (for large unified organization, the Value Reporting use to provide investors with the information companies) non-financial performance Foundation. The Value Reporting Foundation they need to make better investment indicators, an explanation of the company’s will maintain the Integrated Reporting decisions. By reporting consistently under the expected development and significant risks Framework, advocate integrated thinking, International Framework over successive and opportunities. These could equally and set sustainability disclosure standards years, companies can help investors to be contained in an integrated report that for enterprise value creation. Both companies understand the risks and opportunities encourages the integration of financial and and investors stand to benefit. they face and generate greater trust in their non-­financial information in a clear and potential performance. coherent way. By Charles Tilley and Klaus Kirchhoff 4 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Executive summary

Executive summary

This report explores the extent to which Integrated reporting focuses not only on MULTIPLE USES AND SOURCES investors and analysts value non-financial financial, environmental and social value ­information, the various ways they use it drivers but also the key areas of intangible Investors and analysts use non-financial and the benefits they see from integrated value, such as intellectual capital and information in many ways – from screening reporting. It also considers how to stimulate human capital, and tangible value, such as companies in or out of portfolios, through increased reporting of non-financial manufactured capital and the growing need to to estimating company valuations. In doing information in an integrated way. Although address global infrastructure gaps. so, they make judgements about future cash based on interviews with members of the flows and the risks companies face, for investment community in Germany, the This research focuses on a subset of the ­example by adjusting the classic discounted research has insights relevant to companies six broad value drivers included in the cash flow DCF( ) model accordingly. and investors internationally. Framework: natural, human, and social and relationship capital. These three capitals Third-party databases and company While the IIRC and Kirchhoff Consult AG can be directly linked to the commonly used reports, as well as a direct dialogue with the share the view that the term “non-financial” language of ESG (environmental, social and companies, are all considered useful sources is misleading, we have used the term in governance) reporting, which is a focus of of non-financial information, particularly this report as it remains the prevailing this research given recent progress and on core aspects of environmental, social and terminology currently used by many investors developments in this space. governance (ESG) performance. However, globally. Our research finds that investors ­managers of large portfolios inevitably rely and analysts of all types value non-financial more on databases and ratings agencies information that ultimately translates into due to time constraints. More targeted financial impacts and metrics. They see investors are willing to take the time to read this non-financial information as covering material that companies produce themselves, many areas of interest, including companies’ particularly annual reports, but also additional governance frame­works, their relationships sustaina­bility and other relevant reports. with employees and wider society, and Other sources, including sector reports and their environmental impacts. Investors and websites, are also often used to gain a more analysts also want to know about business complete picture of a company and the market models, strategy and market trends. in which it operates. 5 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Executive summary

CHALLENGES AND REQUIREMENTS LEVERS FOR ENHANCED REPORTING Integrated reporting is a well-established mechanism for linking the financial and non-­ Non-financial information can have some If investors would like to see more reporting financial information that companies report weaknesses. The data companies report can of this nature, how could it be encouraged? across the six capitals identified in the IR< > be subjective and is not always comparable. ­Investor pressure is essential. Regulation Framework. Although many entities around There is often a lack of linkage between the could also play a part, although some inter­ the world are now applying the principles of non-financial and financial content of company viewees have concerns that mandatory integrated reporting, take-up in Germany has reports. reporting requirements can result in less been relatively limited – hence the focus on relevant disclosures. Quantity may increase, Germany in this research report. Our findings What investors and analysts want is non- while quality decreases. Similarly, if encourage us to assume that, if embraced financial information that is material, relevant, regulations require funds identified as “green” by more companies across the world, reliable, comparable and consistent over time. or “sustainable” to meet certain criteria, integrated reporting could make a significant They also look for connectivity between all the some providers may be deterred from offering contribution towards closing the current different elements of a corporate report – a ESG-focused products. Further development information gap and meeting the needs of a coherence in the story companies tell. Most of of global standards might also stimulate wide range of investors. all, investors look for connectivity of the non- increased reporting, but again some investors financial information with the financials. fear that standardization can result in some loss of richness and the unique nature of the For this reason, integrated reporting can information companies disclose. Although help to provide investors with the information current regulations in Germany have improved they need, in a useful format that links non- corporate reporting, there is still much financial and financial impacts and outcomes. opportunity for further development. They appreciate the centrality of the business model and multiple capitals in the On the international stage, progress is being Framework, which allows them to fully made towards a reformed corporate reporting understand the company’s value creation. system that gives equal weight to financial Investors and analysts also value the and non-financial information. Such work connectivity, long-term focus and integrated recognizes the need to fill the information gap thinking that results from adopting integrated created by traditional financial statements reporting. that place relatively little emphasis on the intangible assets that now underpin market values. 6 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT The imperative

The imperative

For many years, the relationship between a AN EVOLVING LANDSCAPE COMPONENTS OF S&P 500 MARKET VALUE company’s book value and market value has IN % TANGIBLE ASSETS INTANGIBLE ASSETS been weakening. The gap between the two is At the same time, the social and regulatory now extreme. According to research by Ocean environment in which companies operate Tomo in July 2020, intangible assets account keeps evolving. Society, governments and 100 10 for over 90% of market value among S&P 500 regulators see the need to encourage or 20 16 32 companies. [1] This compares to 17% in 1975. enforce behavior that minimizes harm to both 80 people and planet, while still encouraging 68 The increasing dominance of intangible profitable businesses. 60 assets is also seen in the European arena. 83 84 90 Based on companies in the S&P Europe From a global perspective, the United ­Nation’s 40 80 350 Index, intangible assets now account for Sustainable Development Goals (SDGs), 68 74% of market value (up three percentage agreed in 2015, provide a blueprint to achieve a 20 points in the last five years). better and more sustainable future for all. 32 17 0 As a result, although traditional financial Regional initiatives are also having an impact. and accounting metrics are still vital, they In the US, for example, President-Elect Joe 1975 1985 1995 2005 2015 2020* do not provide a sufficient explanation of Biden has outlined a plan for a Clean Energy the ­company’s value as determined by the Revolution and believes the Green New Deal Source: Ocean Tomo, LLC intangible asset market value study, 2020 ­market – and how it could change in future. is a crucial framework for meeting climate *Interim study update as of 1 July 2020. challenges. The Biden Plan includes ensuring This creates particular challenges for the US achieves a 100% clean energy economy investors and analysts. How can they and reaches net-zero emissions no later than estimate a company’s future value? How can 2050. Climate change will be fully integrated they understand the risks that could erode into national, foreign and trade policies. the intangible assets underpinning that value? 7 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT The imperative

The European Green Deal, which aims to THE VALUE OF INTEGRATED REPORTING However, although more than two thousand make the EU’s economy sustainable, provides entities around the world are now applying an action plan to boost the efficient use of One solution lies with the adoption of the principles of integrated reporting, take-up resources by moving to a clean, circular integrated reporting as developed by in Germany has been relatively limited. Only a economy, while also restoring biodiversity the International Integrated Reporting handful of companies explicitly report under and cutting pollution. Council (IIRC). The IIRC’s International the Framework. On a positive note, while Framework, released in 2013, with minor the number of integrated reports produced High-level ambitions are gradually being revisions to the Framework being published in Germany is relatively low, the quality is translated into frameworks that companies in January 2021, identifies six capitals that “­excellent”, according to recent research. [2] can apply. Work is ongoing to develop the organizations depend on to varying degrees EU Taxonomy – a tool to help investors for their success: financial, manufactured, JOINT RESEARCH and companies navigate the transition to a intellectual, human, social and relationship, low-carbon, resilient and resource-efficient and natural. It identifies guiding principles Inspired by the desire to understand the extent economy. The goal is to create a common that underpin the preparation of an integrated to which investors and analysts in Germany framework to enable investors to assess report and its content, such as strategic do value and use non-financial information, how effectively companies are delivering focus and future orientation, connectivity the IIRC and Kirchhoff decided to undertake against environmental and social criteria in of information, materiality, consistency a joint research project. Its goals included particular. and comparability. The Framework exploring whether investors would welcome also identifies the expected content of an the wider adoption of integrated reporting and Such initiatives and frameworks are integrated report, including information what levers could be pulled to achieve it. important for stimulating additional reporting on governance, the business model, risks by companies on a range of sustainability and opportunities, strategy and resource Although this research is based primarily on issues. However, companies still face the allocation. German investors, the findings are relevant to challenge of presenting this information in a both companies and investors across Europe coherent and connected way. How can they In essence, an integrated report is intended to and the world. They focus attention on the convey the link between their investment in communicate how an organization’s strategy, information gap that currently exists in terms low-carbon assets and their income potential? governance, performance and prospects, of explaining and understanding companies’ How can they explain how investing in their in the context of its external environment, market value. They also give insights into how workforce feeds through into increased lead to the creation of value over the short, companies can provide investors and analysts revenues? medium and long term. Its approach can with information they value, in a form they therefore help to connect financial and non- can use most easily. financial information.

8 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Methodology

Methodology

We interviewed 12 individuals in German-speaking countries (11 based in Germany and one in Switzerland). These interviewees have a range of roles. They include sell-side and buy-side investors and analysts and risk management specialists. We interviewed representatives from large financial institutions with a global reach, family offices, and investment and valuation consultancies. Some interviewees have a mainstream investment focus, while others have a particular ­interest in ESG areas or a focus on impact investing.

All interviews followed a similar structure, covering issues such as:

IITypes of non-financial information investors and analysts use IIHow they use non-financial information IISources of non-financial information IIDesirable qualities of non-financial information IIFeatures of integrated reporting that investors find useful IILevers that could encourage increased reporting of non-financial information in an integrated way IIThe impact of regulation so far on reporting practices.

The core questions used to guide these discussions are included in Appendix 1. However, we allowed conversations to flow freely, guided by individuals’ experience and interests. 9 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT What is non-financial information

What is non-financial information?

Non-financial information is information that Non-financial information may be purely have investment goals that place as much does not currently appear in a company’s qualitative, expressed in text, such as emphasis on tackling climate change as financial statements – its profit and loss a description of the qualifications and on delivering profits. However, for typical account (P&L), balance sheet or cash flow experience of a management team. It may mainstream investors, the value of non- statement. However, it provides insight into also be subjective, e.g. when companies financial infor­mation does not depend on any the potential future financial performance report on how they are positioned in a market. ethical or moral viewpoint but on the extent or value of a company. However, it can also be quantitative and that it increases insight into a company’s objective, e.g. the number of insurance claims risks, future performance potential and Alternative terms include “extra-financial”, received by an insurer year on year, or market current valuation. referring to the fact the information is not share statistics. included in conventional financial statements, One business valuation expert uses the or “pre-financial”, emphasizing the fact that Some investors have moral or ethical example of environmental pollution, whereby these factors ultimately have an impact on standards that guide their investment polluters run the risk of financial penalties. the financial performance of the company – activity. For example, they may not want to He says: “Irrespective of whether we think its cash flows, P&L and balance sheet. invest in defence companies because they this [pollution] is good or bad, it is a question have a ­moral objection to the ultimate uses of valuation and financial risk alone.” of their products. Impact investors may

BUSINESS VALUATION CONSULTANT HEAD OF MUTUAL FUNDS EQUITY ANALYST “Relevant non-financial information “With non-financial KPIs, you always “In the end it is only the financials is that which may not be financial have a purpose or goal that you are that are ­interesting – or the future at the moment, but which may become pursuing. In addition, it is interesting ­financials… the profit or turnover in financial in the future.” to determine a financial reference value ten years, 15 years, 20 years or in from the non-financial information. one year. But in order to ­estimate that, It can be an enabler for determining a the non-financial figures are the financial figure.” decisive factor.” 10 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT What types of non-financial information do investors value?

What types of non-financial information­ do investors value?

Investors and analysts use many different GOVERNANCE A change of management could be an Assessing corporate culture is not types of non-financial information in their indicator not only of future earnings potential straightforward. For example, as one daily activities. Some investors have been considering but also future ESG performance potential. investor notes, employee surveys may give governance issues as an important part of As a senior analyst says: “You will not only some insight into corporate culture, but BUSINESS MODEL, STRATEGY AND their fiduciary responsibility since the 1990s. have an earnings momentum in the classic can be distorted, depending on participation MARKET TRENDS Aspects of governance considered important sense, but also an ESG momentum.” rates and whether staff of all levels of forms of non-financial information include: satisfaction take part. Information related to a company’s business Company ownership structures are also model and strategy, as well as market IIThe quality of the board and its independence of interest, for example, whether there is trends that could affect the organization, IIRemuneration systems – including whether a dominant major shareholder who is also are considered useful forms of non-financial these take account of ESG factors and have a represented in the management team or information. When considering market short-term or long-term focus on the supervisory board. Such a dominant factors, key non-financial performance IIRelated-party transactions shareholder may restrict the ability of other ­indicators are established for each sector, IIAuditors and audit-related issues shareholders to influence management with individual company performance IIShareholder voting rights decisions. The incentives driving decisions assessed against those KPIs over time. IICourt cases against the company may also differ from those in a company IIAny indications of bribery or corruption owned by “anonymous investors” with One equity investor comments: “We spent a IIAny indication of reliance on illegal migrants relatively little connection to it, one equity very, very long time on the business model… IIHuman rights violations in the supply chain. analyst notes. The business model, the environment, the products and services were crucial for us.” In terms of the quality of the management Some investors and analysts include If the story did not add up, there would be no and supervisory boards, investors will look at corporate culture under the governance IMPACT INVESTOR investment. the board members’ backgrounds, what they heading. “Corporate culture is an extremely have done in the past, what they stand for and strong governance mechanism,” says a “80% of the risk in early stage From a strategic perspective, investors any indicators to measure past performance. business valuation consultant. Companies investing or entrepreneurship want to understand how a business is with strong corporate cultures are better positioning itself, e.g. as a niche player, cost Understanding what motivates the able to address problems quickly. “This is lies with the founders’ team.” leader or whether it has some other form of management team is seen as valuable. One a form of risk management, because we as differentiation. The competitive environment early stage impact investor says: “Nobody company valuers, as investors, must look to and market trends are also of great works around the clock for money only. the future… Even if the question of corporate interest e.g. what impact might be felt from After three decades of investment and culture does not make our point forecast technological developments and digitization. entrepreneurship experience, I know that any better, it makes it more stable in a sense only your passion and purpose will pull because it represents a certain downside you through tough times, not the financial protection.” incentive.” 11 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT What types of non-financial information do investors value?

SOCIAL FACTORS any changes in regulation that may have an impact on a company’s business model and Social information of interest to investors and competitive position. Health and safety is also ESG INTEGRATION SPECIALIST analysts includes insights linked to internal a topic covered in the “social” category. AND FORMER ANALYST stakeholders. For example, investors look at information on employees, such as ­numbers ENVIRONMENT “On the environmental side, we look at large of employee fatalities and accidents, and blocks of topics such as the efficiency of the rates of employee absenteeism. Staff Interest in environmental non-financial turnover rates are widely considered. This information is strong, reflecting factors such company in the use of raw materials. How clean could be particularly relevant in consulting as increasing regulation to tackle climate is the company? Are there emissions? What is businesses, where employees build up change and concerns about water shortages. valuable knowledge and experience over time These are topics that many mainstream done with wastewater? Are there spills? Then and where high staff churn could indicate investors consider, as well as impact there are topics on the energy side and the a risk to the business model. If it becomes investors with a particular focus on climate harder to recruit replacements, the business change. company’s exposure to green innovation.­ What model could again be at risk. products or services does the company sell? Analysts and investors are interested in

One equity analyst explains the importance details such as CO2 emissions and water Does it help other industries to reduce their of considering social factors when evaluating consumption, although they interpret them in impact on the environment?” a mining company. Gaining the buy-in of a sector context. For example, they see little the local population (through employment point in an internet company disclosing water and local­ investment) may incur costs, but consumption. could reduce the risks of opposition and riots, including attempts to appropriate the VALUE CHAIN mine. He is therefore interested in various factors: “How many employees are local? One mainstream mutual funds investor notes Are schools or infrastructure being built? that rather than individually, companies How long term is the approach or is as much are analyzed in the context of their market as possible ­taken out quickly? In my opinion, environment and value chain. For example, behavior beyond the financial ratios naturally one investor knows to the nearest ton the has an immense influence on the value of the CO2 footprint (using the equity ownership company.” methodology) for all his funds. However, he believes it important to not only consider the External stakeholders such as customers are footprint (where the company can be held also of interest, for example, whether there accountable for it), but also the impact of the have been any issues with product safety footprint elsewhere in the value chain. or the need for product recalls. So too are 12 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Uses of non-financial information

Uses of non-financial information

Investors and analysts use non-financial in- SCREENING ESG funds in particular have specific rules. In principle, there are minimum formation extensively and in a variety of ways standards that need to be met. These could thresholds that companies must achieve when making investment decisions, from Non-financial information is used to be linked to global standards and initiatives, in order to qualify for such an investment pre-selecting a range of potential invest- determine the “investment universe” from such as the UN Global Compact. If there vehicle. We’re talking about the potential ments to estimating company values. which companies will be selected for an is a violation, the company will simply be investment universe from which individual individual client’s portfolio or a mutual fund. excluded. A senior analyst at a leading asset securities can then be selected.” Investors can screen out companies that do manager says: “There is simply no money not meet certain criteria or clearly defined then, neither on the equity nor on the fixed Screening can be highly focused. One hurdles related to ESG topics. They also income side. Not from us and not from many organization creates a “materiality matrix” raise “red flags” relating to existing investee others.” by sector or subsector – identifying the companies if some new issue occurs. Equally, ESG issues that are most relevant. Another some investors may be looking for “best- Similarly, a head of sustainability and interviewee maintains a form of KPI score in-class” investments as assessed against corporate governance at a major investment sheet, which defines specific financial and various ESG benchmarks. firm says: “Every portfolio has a dedicated non-financial KPIs for each company. sustainability policy, a set of sustainable The criteria used may relate to simple facts, e.g. that an investee company must not be involved in arms trading, the betting industry HOW INVESTORS USE NON-FINANCIAL ­INFORMATION IN PORTFOLIO DECISION MAKING or online gaming. There could be a threshold (ILLUSTRATIVE TABLE) for the frequency of workplace accidents. There may be human rights requirements. Excluding Including SUPERVISORY BOARD Sin stocks High performing ESG companies ­MEMBER OF A LEADING e.g. tobacco, defence e.g. ESG industry leaders, best-in-class Stranded assets Sustainability indices ­ASSET MANAGER e.g. oil, fisheries e.g. MSCI ESG Indexes/MSCI Climate Change Indexes, DJSI index family “If companies behave badly when High carbon industries Particular sectors it comes to ‘E’ and ‘S’, especially e.g. cement, transportation e.g. renewable energy when it comes to the environment, Special focus areas e.g. SDGs, impact investing then they drop out right away or are only kept in portfolios if they make visible efforts to improve their ­carbon footprint.“ 13 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Uses of non-financial information

One interviewee explains that in order to no longer considered externalities, but and beautiful planet, then it is sustainable. VALUATIONS be considered for a fund, a company must become an integral part of what I call Integral And if they do not, it is not sustainable.” In achieve a certain composite rating indicative Investing.” For impact investors, investee this investor’s view, ESG reports, although a In addition to serving as pre-selection criteria of its ESG performance. The investment companies must meet stringent criteria, step in the right direction, do not do enough for the investment universe, non-financial organization maintains its own proprietary including requirements for a corporate to ensure there will be a habitable planet for information can also influence investment database containing relevant information culture that embraces the idea of the future generations. With reference to the decisions with regard to the valuation of on companies. This includes a specially integration of people, planet and profit. The warnings of the Intergovernmental Panel on particular companies. The example of a calculated uniform ESG rating, created by decision-making process for any investment Climate Change (IPCC) that carbon emissions classic discounted cash flow DCF( ) model applying algorithms to ESG data from leading is intensive, involving direct interaction need to be cut by 45% by 2030 (from 2010 shows that non-financials can go into the information providers. It also takes account of with companies and extending far beyond levels) to restrict global warming to 1.5°C she valuation in various ways. the ex-ante view of internal analysts i.e. those information provided by databases or any calls for more ambitious goals to measure analysts’ views of ESG issues in relation to corporate reports. [3] the companies’ performance against, rather individual companies. The database helps than for a compliance exercise. analysts and portfolio managers to identify However, even for impact investors, financial whether a company is high risk due to sustainability and profit generation is a controversy e.g. in relation to the UN Global requirement. One investor aims to invest Compact principles or in relation to climate capital in longer-term infrastructure projects risk, including whether its performance is to protect the climate by reducing 1% of BASIC DCF MODEL (SIMPLIFIED) worse than its peers. global CO2 emissions. Thus, all potential investments need to contribute to this goal Impact investing by bringing “significant added value in terms ∞ Although mainstream investors increasingly of CO reduction”. The investor notes that CF 2 t use non-financial information for screening fund managers’ bonuses are dependent Equity = ∑ – Debt purposes, impact investors have particular on achieving both financial and climate- MV t MV needs in this respect. One impact investor related hurdles. An “impact measurement t=1 (1+WACC) explains: “In traditional investing, the management system” is currently being only measurement for success is profit developed, which will include ESG and SDG maximization, which is legally dictated criteria. through fiduciary responsibility. Since the 1980s, impact investors have begun adding For impact investors, however, current ESG their values to traditional for-profit metrics. reporting can seem like simply “ticking the They are trying to integrate metrics for box” rather than a “serious, deep integrated where, people and the planet with profit criteria, measurement”. One provides her definition EquityMV = market value of equity unfortunately without much success. of sustainability, as follows: “If a company CFt = cash flow in period t This will change only through appropriate works in such a way that our grandchildren WACC = weighted average cost of capital legislation when people and the planet are and great-grandchildren find a habitable DebtMV = market value of debt 14 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Uses of non-financial information

Cash flow estimates On a more general level, encouraging non- since the introduction of the EU Emissions child workers. Adidas customers reacted Starting with the numerator, non-financial financial indicators can also enable analysts Trading System. However, companies could negatively and the company took measures KPIs can be used to estimate future cash to forecast cash flows with more confidence do harm to the environment in other ways, regarding its supply chain behavior. “It’s not flows. The use ofCO 2 is one example that is and make judgements about the potential through pollution, excessive use of water that Adidas has morally or ethically better reflected in this approach. With the existing growth rate of cash flows. One equity analyst or damaging rainforests. As the valuation management; it’s simply they understood

EU Emission Trading System and its CO2 explains: “If one believes that companies act expert says: “They build up some sort of it has consequences for their revenues,” pricing, carbon use is often already included in a socially responsible manner towards environmental liability that does not show up comments one interviewee. in financial figures. However, one interviewee their employees and stakeholders, then one in a financial accounting balance sheet, but gives the example of a hypothetical CO2 price can assume that a certain excess return can which might be a liability from an ESG point In contrast, most customers of fast fashion that can be considered for airlines, even be sustained over a longer period of time. of view.” do not appear concerned about supply chain if they are not connected to the European So you gain more confidence in future cash issues such as low pay or poor conditions trading system. Given the possibility of a flows.” The same goes for social issues, such as of workers. “But that’s also a social debt,” future internalization of such effects – e.g. poor treatment of suppliers. For example, says a business valuation expert. “It might be through future regulation or taxes or through Balance sheet extensions squeezing down on supplier prices and that one day awareness in society changes a potential decrease in revenues – there Instead of going into the projection of future failing to monitor quality resulted in the and customers say they do not want to buy might be an effect on future cash flows. cash flows, non-financial information can in a horsemeat scandal of 2013. Food producers these clothes any more if they are not fairly similar vein also be used to recognize certain and supermarkets, including Tesco, were produced. It could be regulated or a tax put on Investors will consider whether ESG factors additional balance sheet positions, “an ESG badly affected by the loss of reputation and it. That’s some sort of social debt that could will require a company to invest in order to balance sheet extension” as one business customer confidence in their meat products. occur. But it’s tricky to properly take this into adapt and survive. One interviewee gives the valuation expert calls it. For example, this As one interviewee says: “It was a big social account.” example of a company affected by climate could take account of some form of social liability… It would be interesting to know such change, where capital expenditure may well debt or social burden. (In the valuation model, things in advance. From an investor point of be needed to change its business model: “If this would be reflected in the calculation of view, if you think there are some externalities a company is very much affected by climate the company’s equity value – by subtracting like this which might get internalized later, change and does not invest money, it will not the value of debt from the value of the entity). either by the reaction of society or taxes or be able to change its business model in the other regulations from the government – then future. This is why these capital expenditures A range of potential adjustments can be it’s worth taking it into account.” are extremely important – the extent to made to consider the sensitivities of various which ESG developments require future ­issues – indicating the range of impacts As another example, Adidas suffered investment.” Such assessments also affect certain non-financial information could have. when allegations were raised that some forecast future cash flows. Adjusting for CO2 emissions is relatively easy of its football production had involved 15 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Uses of non-financial information

Discount rate adjustments An investor’s assessment of strategic Moreover, non-financial information can risks can also be incorporated into the also impact the assessment of risks, which denominator. One interviewee gives the are reflected in the denominator in the DCF example of an oil company that increases its model, through an adjusted discount rate. activity in deep-sea wells, Arctic wells and oil sands, with the result that its reserves Investors identify a range of risks that could portfolio and operations become riskier. affect the discount rate, including risks linked This would be recognized in the DCF model to governance weaknesses, potential future by increasing the discount factor in the regulation and strategic positioning. denominator, resulting in a smaller net present value – and ultimately a lower fair As one investor identifies, one “classic value of the company’s shares. risk” that would affect the discount rate is poor corporate governance. There might, Investors may consider such issues from a for example, be concerns about a weak sector perspective (where there are similar supervisory board. This does not necessarily drivers and non-financial performance mean that the company will generate worse indicators) and from an asset class approach cash flows than expected, but causes some e.g. equity or bonds. uncertainty about its ability to cope with unexpected problems. “Anything that touches on the subject of uncertainty, or that reduces visibility so that I simply cannot make the forecast so accurately, these are topics that are more likely to be reflected in the interest rate,” says a business valuation expert. The DCF model allows the uncertainty to be “mapped”. EQUITY ANALYST “If the non-financial indicators are pointing in the right direction, a lower interest rate can be justified than for a business where it is more difficult to ­assess or where you see problems and risks. I would compensate for this with a higher interest rate.” 16 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Sources of non-financial ­information

Sources of non-financial information­

Investors and analysts draw on many different One interviewee found the introduction of Ratings or scores by different agencies In addition, bare metrics or ratings do not sources of non-financial information. What ratings that cover topics related to the annual are not necessarily comparable, however. indicate threats to the business model they use and how many sources they draw on general meeting (AGM) helpful for assessing One interviewee, referring to the company or company strategy. As one interviewee is inevitably affected by their role e.g. whether administrative and legal issues across scores generated by some specialist ratings explains, database metrics “help us to get a a manager of a large investment portfolio multiple countries: “I cannot judge the quality agencies, added: “We did a study and feel for where the company stands today… containing hundreds of companies, a sell-side of the rating, whether it was right or bad. But found that these scores sometimes run in But depending on the issue at hand, we analyst focusing on a highly targeted sector, it has at least given me the opportunity to completely different directions depending also need to look at the companies’ annual an ESG specialist or an early-stage investor. compare and understand­ what the company on which criteria are weighted more heavily. reports or corporate responsibility reports… is doing or what has just been criticized in In the extreme case there was a stock that So we cannot completely ignore corporate DATABASES the rating, so that I can discuss and debate has 80 on one score and 20 on another. reporting.” it with the company. So agencies could This showed quite drastically that no real Investors make extensive use of information have an important role to play in assessing consensus had yet been found in the financial streams, databases and ratings from [information] and making it useful and world.” third party information providers such as readable, digestible for the financial-driven Bloomberg, Reuters, MSCI, Vigeo Eiris, imug, investor.” One interviewee, working in sell-side research,­ Sustainalytics, ISS, Trucost, Arabesque and “hardly ever” uses databases. He prefers to ecoinvent (a life cycle inventory database) – Technology has made data providers’ services use material produced by companies to name a few. even more useful. One equity analyst says: ­directly – particularly annual reports, but “Data quality has improved massively, and so also other documents and material produced The advantage of data from such providers has access to the data. With just one click, “on demand”. is that it is generally standardized and you can pull it into Excel or have a general comparable. It also needs to be objective. overview without having to download the Database information is not generally “I only rely on the information that someone figures.” sufficient to meet all investor needs. For HEAD OF has really measured, where there is no example, if a database indicates that an issue MUTUAL FUNDS great subjective evaluation,” says a business is still pending, investors can go directly to valuation expert. If a database identifies some the company for further information on the “It’s a bit like a mosaic. aspect of a company as “subjectively good”, current situation, any provisions relating to We turn over [a great] the analyst will want to check back to original this issue and financial impacts. sources if there is time, which is highly many mosaic pieces dependent on the number of shares that he to get the whole picture. or she analyzes. And this is based on a variety of sources of information.” 17 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Sources of non-financial ­information

COMPANY REPORTS According to one equity analyst annual reports now give more attention to non-­ Investors refer to a wide range of company financial information, includingESG topics. reporting, including annual reports, He says: “It is quite clear that the non- integrated reports and sustainability reports. financial focus has massively improved and Those using company reports in preference that the focus is now very prominently on to databases are typically individuals what happens outside the financial figures – ESG INTEGRATION SPECIALIST working in a consultancy role or focused on which is desirable… These are important AND FORMER ANALYST small numbers of investments, rather than factors that deserve to be presented more managers of large portfolios. “My preferred prominently in a report, and they really do add “Metrics and information from data source is clearly what the company produces value for shareholders or the addressees of ­providers are only a starting point. itself. I look less at databases,” says one financial reporting in general.” equity analyst. As well as current and past But in order to really­ develop an opinion annual reports, other material such as One sell-side research analyst considers on what impact it can have on the business company ­statutes (e.g. to determine the rights companies’ sustainability reports to be of minority shareholders) and remuneration less relevant than their annual reports: model, competitive ­position and value of reports can give useful insights. For example, “Everything that is really relevant is also companies over the next three, four, five a remuneration report gives insight into included in the annual report – and also in the incentive structures in place and what the form that the analyst needs it in the end.” years, we must ­sometimes rely on company KPIs influence management remuneration. Standardized tables simply stating emissions reporting or talk ­directly to the companies­ or electricity usage are “not very interesting”. Company reports can also help to show what and ask direct questions.” targets a company has set itself, whether Investors and analysts are also interested these targets make sense and ultimately in what companies do not disclose in their whether they have been achieved. various reports. The omission of disclosures raises a red flag, particularly if a company One equity analyst says: “My aim is to get as stops providing previously reported KPIs. good an understanding of the company as As a business valuation expert says: possible… and to read widely, read the annual “Corporate disclosures are central sources reports from start to finish, maybe even read of information in every respect – whether it is the footnotes to understand accounting.” in the integrated report or the sustainability Such detailed reading might give the investor report or the normal annual report, or some competitive advantage when making whether it is on the website. Especially for investment decisions. larger companies, one always knows what it means if disclosure is missing.” 18 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Sources of non-financial ­information

DIRECT DIALOGUE One mainstream mutual funds investor says: “I can get… market or transaction data from Investors will go directly to companies one sector and try to break it down to a single to check their understanding of reported company. For example, I can look at aircraft information or gain updates on ongoing movements and see what this data tells me issues. This is particularly likely when there about Airbus. We use a lot of such data for is a lack of standardization around reported investment decisions.” information. However, industry reports can sometimes One equity investor would seek information be “rather journalistic texts that provide directly from a company “to make sure that background information. They are not very what is written there [in a report] is what we quantitative or analytical”, says one sell-side understand it to be and not otherwise. This research analyst. standardization is missing at the moment. And the (partial) lack of quantification is a Targeted internet searches are also problem where one would simply like to have undertaken to look for statistical material on more information, especially on risk aspects.” a topic of interest. One mainstream investor says: “There are techniques where we look OTHER SOURCES at the pricing of individual products via web scraping and ask: is the pricing adequate for Investors and analysts will use any sources the expected margins, or better or worse?” of information that help them form a view on a company, including reports from directly In addition, websites such as Glassdoor comparable competitors. They also draw and kununu can give insights into corporate on industry and sector reports, including culture, which investors can find hard to do reports from trade associations and sell-side from the outside. research. 19 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT How integrated reporting could help to improve non-financial ­disclosures

How integrated reporting could help to improve non-financial disclosures­

The non-financial information that companies One interviewee says that less can be more Companies applying the Framework One interviewee thinks it is good to provide often suffers from certain weaknesses, if information is relevant and presented in also provide information on the various “sensitize” people to the concepts of compared with what the investors are looking an integrated way. Companies should focus capitals that their businesses use, different capitals, including natural for. Integrated reporting can help to address on the ESG issues that are most important transform and create through their capital, because these do have an these weaknesses, through the content for them, in their sector and in the countries activities. One interviewee finds it hard impact on financial value. Society is included and the principles that reporting where they operate. This is far more useful to to imagine life without a multi-capital increasingly punishing companies that entities apply. investors than reporting on a wide range of approach to company analysis. The damage the rainforests, for example, issues that have no great importance to the stakeholder-based approach to integrated through consumers no longer buying their RELEVANCE AND MATERIALITY company. reporting supports the provision of useful products. “That’s where the companies information to investors – but the content feel it,” he says. “That’s where the link As the disclosures required of companies For example, water consumption may be of integrated reports needs to be relevant between the natural capital or natural increase, annual reports can become highly relevant in some sectors, such as and sufficiently precise. value and the financial value is.” increasingly lengthy. Investors want oil and gas, but not for internet-based companies to focus on material issues to businesses, where electricity use would be of Human capital is increasingly important help them form the big picture in terms greater interest. The relevance of disclosures in a today’s world, as one equity analyst of its performance and potential. This can is therefore on a case-by-case basis. points out: “The business world is be obscured by inclusion of matters that changing massively into a service are not material and provided in excessive How integrated reporting helps industry. We are producing less with detail. As a sell-side research analyst Integrated reporting involves clear classic machines and more with says: “Sometimes companies overload the explanations of a company’s business intellectual know-how… That makes the annual report with details: a lot of trees, model. Investors value information on the employee much more relevant.” The but little forest. This is often seen instead business model, as one sell-side research “creative output” and ideas of employees of clearly explaining the strategy… or what analyst explains. Some companies only are increasingly important for companies’ is the business model. Large companies make limited statements about what success. Assessing human capital is in particular get carried away with details, they make or sell. “That’s where the therefore immensely important: “That’s but sometimes forget to present the whole good and the bad annual reports differ. what ultimately determines financial picture.” There are companies that really do try success.” to explain to the layman what they do. And that is important, especially when it is not necessarily obvious or in need of explanation.” 20 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT How integrated reporting could help to improve non-financial ­disclosures

CONSISTENCY OVER TIME This is why investors also want to rely on not only quantitative but also qualitative the complexity associated with the many auditors in checking the non-financial elements play a role,” says one mainstream sustainability standards and frameworks, can Information that is comparable and presented information and giving at least some form investor. For example, the results of be challenging for mainstream investors. over time is also valued. “I would definitely of assurance. One interviewee thinks that employee surveys and customer surveys may look at everything that is standardized and a regulatory requirement for reasonable not be readily comparable. “Many people have How integrated reporting helps comparable and is presented over time,” assurance on non-financial information would good approaches. There is also no right or The Framework identifies content says one equity investor. A basic data point be helpful, including a qualitative assessment wrong. But sometimes it is simply difficult to elements that companies should include on tons of CO2 generated, for example, is not of the reporting systems underpinning the compare the data.” in their integrated reports, including necessarily useful in itself. production of non-financial information. the business model, resource outlook One interviewee refers to polymer materials and performance. With reporting on the How integrated reporting helps Where possible, metrics are desired. producer Covestro, which co-founded the business model, for example, details will When companies apply the Qualitative explanations are valued too, but Carbon Productivity Consortium, an initiative be specific to the company. Comparability Framework over successive years, they may need to be treated with care. With a to track the use of carbon employed as will be a subjective issue in the sense that provide a track record of performance description “you always run the risk that a resource throughout the life cycle of a investors and analysts can compare how that users of their integrated reports the company presents itself too beautifully product with the goal to increase the return clearly companies explain their model, value. Investors appreciate the fact and this often raises a suspicion that it has on carbon employed (ROCE). He sees this as and other factors such as the risks and that companies such as BASF and SAP been portrayed in a too positive light”, says “interesting, but it is not really comparable”. opportunities they face. have been applying integrated reporting one investor. For example, climate risks may principles for some time, with the result be discussed, but rarely in a quantitative Because the information that companies Over time, greater standardization in that detailed information over successive way. Metrics help to make the information report is not standardized, “automated reporting may develop, particularly given years is available. One senior analyst provided more verifiable and at the same time evaluation” of ESG performance is not the cooperation between organizations comments: “You can see what objectives more comparable across companies. possible. Investors cannot automatically involved in corporate reporting and the companies have set themselves. How compare the accident frequency rates of two sustainability standards, such as the has that worked on the timescale? Did Presenting non-financial information in a companies, for example. IIRC and the Sustainability Accounting they follow up on it, or were there reasons comparable way is key for investors. They Standards Board (SASB), which why they deviated linearly from it? This is want to be able to compare companies within Different ESG frameworks also have different announced their intention in November very, very informative.” their sectors or peer groups, rather than just approaches, which may allow for some 2020 to merge into a unified organization, looking at basic performance data. As one different interpretations. For example, under the Value Reporting Foundation. RELIABILITY AND COMPARABILITY analyst notes, RWE will never perform as the GHG Protocol, companies may have

well as SAP in terms of CO2 emissions. “But different approaches to calculating their Some investors would appreciate the Investors want non-financial information to they can be very transparent within their peer Scope 3 indirect emissions. “There is a lot of development of accounting standards be reliable. However, some information tends group – the utilities.” data available, but they all still have corridors that address sustainability. As one says: to be subjective. One interviewee refers to the of interpretation,” says one impact investor. “The IASB [International Accounting difficulty in assessing management quality: However, non-financial information as Standards Board] must define a set of “It’s difficult to compare or standardize currently reported is not always comparable The Global Impact Investing Network (GIIN) rules on sustainability in the long term so everything; that’s a very subjective between companies. “Comparability is not provides another example. One investor that the topic can be included in normal perception.” always guaranteed, especially since we are queries the meaning of “fair working accounting – then via IFRS accounting.” now talking about sustainability issues, where conditions”. This lack of clarity, as well as 21 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT How integrated reporting could help to improve non-financial ­disclosures

However, investors do welcome To explain the value of connectivity, one Linking actions with the financial results experimentation and initiatives such as interviewee takes the example of an IT is important to investors. It remains a the Value Balancing Alliance (VBA), whose company, for whom the workforce has a challenge for the companies, though. As goals include standardizing how to assess material impact on performance. If the one interviewee notes, when a company and monetize the value of a company company invests in healthcare for its reports that it uses renewable energy, and its financial and pre-financial value employees, it could achieve a lower rate has covered its roofs with photovoltaic contributions to society. The VBA seeks to of sick leave and absenteeism. There is modules or employs many trainees, this design a disclosure framework enabling therefore connectivity between healthcare may be good marketing and also good for stakeholders to compare natural, social, expenditure and performance. stakeholders such as the local community. human and financial capital performance However, these actions include additional across companies. How integrated reporting helps costs. This is why one equity investor Investors and analysts familiar with believes that companies avoid making a CONNECTIVITY integrated reports believe they are most “financial connection”. useful where there is a “comprehensive Simply adding non-financial information attempt to link the non-financial to to financial statements is an inadequate the financial in the reporting”, as one response to investor needs. Interviewees interviewee says. call for connectivity so that they can see the company has a clear strategy. Non- Integrated reports can combine comparable financial information needs to be integrated metrics with written explanations of issues into financial reporting in a way that is such as corporate strategy. Investors “transparent and consistent”, a senior analyst welcome integration of non-financial observes. Although both financial and non- information with the strategy and business financial information is provided, they are model. One interviewee says: “If you drill a “not yet put in relation to each other”, one bit deeper, the exciting thing is to see which impact investor says. indicators the company identifies that have materiality on the cost or revenue side.”

Similarly, an ESG integration specialist and For example, whether CO2 emissions have former analyst asks: “How am I supposed an impact on the P&L. to integrate this myself when I notice that the company is not integrating it at all? I can Assessing a company’s competitive make up my mind based on the data I get. But position is one thing. Converting that I do not know. The company itself does not assessment into financial numbers is know… so how can I do that sensibly?” “an extremely difficult step”. Integrated reporting is particularly good “if you can get this connection”, says a business valuation expert. 22 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT How integrated reporting could help to improve non-financial ­disclosures

AUTHENTICITY “The challenge is less in the data; the Investors and analysts would like to see challenge is that the sustainability more integrated thinking taking place One senior analyst wants to see “authenticity department and the accounting department within companies, as this would mean that in the transmission” of non-financial have to work together, which is like fire and relevant ESG issues would be reflected in information. Investors want to know water,” one interviewee says. CFOs may see the company strategy and the impact of what pieces of non-financial information integrated reporting and increased ESG such issues would be linked to financial management themselves think important. reporting as costing money, when their aim is performance. For one interviewee, to control expenditure. Sustainability teams integrated thinking is “the link between Another interviewee believes that some may lack power and authority to drive change, sustainability performance and the companies in the utilities sector have made sometimes having no board representation. financial impact of the company”. progress in explaining their way of thinking in their management presentations. For How integrated reporting helps A senior analyst expects in future there example, they explain why some ESG issues Companies can expect to benefit if they to be more scrutiny by capital markets of matter, what goals they have set and why. present their story clearly, in an authentic whether resources are being allocated This helps investors to understand why way through integrated reporting. “It in a way that aligns with the company’s the company is taking certain actions and helps companies because they can steer strategy, rather than just scrutiny of, for the impact on the business model and analysts and investors in the direction example, profits and cash flows. This competitive position. they want them to go,” one interviewee is because some vital resources will suggests. become increasingly scarce. There will be Lack of authenticity in transmission may heightened interest in whether companies be linked to the fact that companies are Integrated reporting encourages are able to achieve financial goals with not thought to be thinking and acting in an integrated thinking, which in turn fewer resources. The capital markets may integrated way. One ESG specialist and underpins better integrated reporting then value such companies more highly. former analyst says: “Many companies through a virtuous cycle of continuous disclose something about sustainability, but improvement. This supports the that is not an important part of the company’s authentic development and identification strategy. In these cases, what is missing is of companies’ strategies and business IMPACT INVESTOR ‘integrated thinking’.” models. The IIRC is publishing a series of case studies exploring the relationship “If sustainability is a satellite between integrated thinking and strategy function and is not considered across a range of businesses and institutions, which are available on the in an integrated­ way, then it IIRC’s website. does not have a really relevant effect on the company.” 23 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Levers for encouraging the integrated­ reporting of non-financial­ information

Levers for encouraging the ­integrated reporting of non-financial­ information

Gathering and reporting non-financial One mainstream mutual funds investor also has an impact in terms of inducing months later are also on the wrong track.” information requires resources and incurs says: “There are KPIs where we have companies to provide relevant non-financial costs. Companies will only undertake it if they made it our business to get them reported information. As a senior analyst says: “It’s Some investors will use their voting power see benefits from doing so or are required to as they are now. And that is also in the not so much a wish list anymore, it’s just in annual general meetings to try to drive do so by some mechanism, be it regulatory or long-term interest of the company… We what global investors are asking for… The improved reporting. One interviewee says: “It due to market forces. have an influence there and we use it very momentum is big enough to put pressure on could be that we do not grant discharge to a actively.” This lever is typically pulled through companies…” board of directors or supervisory board due to INVESTOR PRESSURE written correspondence, conversations and a lack of disclosure or because of qualitatively “constructive dialogue”. Many investors are becoming more incorrect, poor information.” Such voting Pressure for change lies to some extent with demanding in terms of the timing and activity will often relate to strategy issues, the investment community. Investors exert Investor involvement in various ESG initiatives format of the reporting of non-financial such as whether sustainability goals have pressure on companies individually when (such as CDP, the Climate Disclosure information. One interviewee from a leading been achieved or whether non-financial asking for specific non-financial information Standards Board (CDSB), the Task Force on asset manager says: “Everyone who does performance indicators form part of the or by excluding them from investments if they Climate-related Financial Disclosures (TCFD), not do it at all is increasingly no longer being remuneration system. fail to meet certain criteria or performance the Global Reporting Initiative (GRI) and the considered by us. Even those who do the non- hurdles. Principles for Responsible Investment (PRI)) financial report separately, but also three

BUSINESS ESG INTEGRATION SPECIALIST VALUATION EXPERT AND FORMER ANALYST “You can hardly expect “Not only do we demand that they [companies] make ESG infor­ companies to change their mation transparent, but we also say that it would be most helpful for reporting if they do not get ­investors if they did integrated reporting in accordance with the IIRC. the pressure from outside.” This is always a topic of discussion in our management meetings.” 24 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Levers for encouraging the integrated­ reporting of non-financial­ information

MARKET FORCES Research suggests demand for ESG Investors generally feel the CSR-RUG has However, one interviewee feels that investments will grow further. A survey had a positive impact on reporting, firstly regulation such as the CSR-RUG could result One interviewee believes that demand for of over 4,600 consumers in 14 countries by increasing the quantity of information in bloated company reports. Non-financial sustainable investments and products by Vontobel in 2019 found that 59% of available. One equity analyst says: “The and ESG issues could “dilute the report, but that perform well on an ESG basis is respondents did not know an ESG approach obligation to do more on the part of the are not really enlightening” unless they are now exceeding supply. Therefore, there to saving and investment was even possible; company has already massively improved the relevant to the company. is increasing justification for investors 47% would welcome greater support and information base.” requesting that companies produce ESG advice on ESG from their advisers; and 49% The CSR-RUG had little impact on smaller information, potentially in integrated reports, would like their advisers to provide more One interviewee welcomes the fact that the companies. Their responses to such which compile non-financial information in a information on ESG topics. In addition, 65% CSR-RUG has resulted in “greater openness”, regulation tends to depend on the attitude of “meaningful way”. believed ethical businesses would deliver but sees there is still “dark and light” – a wide management and their desire (or otherwise) better investment returns. [4] range of reporting. to present themselves like a DAX company. Voluntary adopters that want to stand out will Some interviewees suspect investors Overall, however, the quality of reported embrace changing requirements, even when have not pushed hard enough in Germany information is thought to have improved. not legally binding. Others will not. One equity for integrated reports and non-financial At the same time, the perception of the investor says: “Unfortunately companies see information. As a result, even German importance of this information internally – up it to a large extent more as a burden than as companies that initially embraced integrated to the supervisory board – has increased. a possibility to position themselves better or reporting may have lost some momentum. One interviewee says: “The audit committee differently. My impression is that many are However, as investors face new regulations usually has the non-financial statement not yet ready.” increasing their need for ESG, sustainability backed up with limited assurance.” This helps and non-financial information, their demands to ensure that reported information is robust Need for more regulation? of companies are expected to increase. and reliable. However, one investor even calls Some investors think that further regulation for a higher level of assurance: “We demand is needed to stimulate enhanced non- IMPACT INVESTOR REGULATION reasonable assurance. And we want to have financial reporting by companies and even an integration into the ICS [internal control integrated reporting. A senior individual at a “I believe that realizing­ German companies must meet certain system] and thus also into the compensation leading asset manager says: “You won’t get that the market is reporting requirements by law (see programmes.” it [more integrated reporting] through a pure Appendix 2 for a brief overview). One relatively market mechanism.” Barriers such as lack ­changing… and that there recent development is the requirement for As a result of the CSR-RUG, investors of resources and increased costs could limit is an economic necessity certain large public interest companies feel they can now more easily compare progress. One interviewee fears that, without to supplement their management report information. When companies within a sector regulatory pressure, many companies would has a different effect than with a non-financial statement for fiscal all report information such as CO2 emissions, lack the “courage or desire” to improve their when the legislator says: years from 2017 onwards. This requirement poor performers then come under pressure reporting. was introduced by the Corporate Social to explain why and ultimately to improve. The ‘You have to do it now.’” Responsibility Directive Implementation Act potential for improvement becomes more (CSR-RUG). transparent. 25 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Levers for encouraging the integrated­ reporting of non-financial­ information

However, regulations are likely simply to In addition, from March 2021, retail investors’ to look at things more globally or at least require increased disclosures, which in itself sustainability preferences must be checked regionally and get away from this territorial will not lead to more integrated reporting. by organizations such as asset managers or national view. That simply doesn’t help, One interviewee is concerned that companies and banks in Germany. A classification because the investor and the capital market may focus on providing the disclosures, system will be introduced, based on certain are not local.” without giving more thought to how specific criteria set by BaFin. Specific company issues interact and affect the business model, information will be needed in order to ensure Another investor would like to see a corporate strategy and performance. customers’ sustainability preferences “preferably global” approach to the reporting are met in the investments made on their of non-financial information. “But to get ESG INTEGRATION One interviewee working in sell-side research behalf. “Companies that do not provide ahead at all you start with the EU. And here in is also skeptical about the value of a report this information are not then eligible for Germany too.” SPECIALIST AND or integrated reporting that is regulatory investment,” one interviewee notes. FORMER ANALYST driven. In this case, companies may view One investor believes the EU Action Plan the regulated reporting as just extra work, However, one impact investor fears that puts Europe ahead of other parts of the world “Regulation – even if it does potentially resulting in disclosures that additional regulation could reverse progress and expects the rest of the world to have to not create a perfect world – investors see little value in reading. He says: already made in ESG investment activity. follow suit: “Because the investor is globally “If it [reporting] is not demand-driven, but For example, if the EU requires funds that oriented, the better standard always prevails.” at least helps to move in the imposed from above, then it is often no longer call themselves “green” or “sustainable” to right direction.” interesting or relevant.” meet certain criteria, some financial services However, there is some concern that providers may not issue such products unless standardization can reduce some of the Investor regulation there is market demand for them to do so. richness in reporting. Companies may stop As well as companies, investors are also They will not want the regulatory burden. reporting some information they previously facing new regulations that affect their Some existing fund managers could even had identified as relevant to their own demand for and use of non-financial withdraw from the arena. situation. “Standards always develop, and information. One interviewee refers to BaFin, with standardization, information is lost the German Federal Financial Supervisory Global standards again,” says one mainstream investor. Authority, which issued guidance in December German investors recognize the global nature 2019 on how supervised entities should deal of capital markets. Ideally, therefore, standards with sustainability risks. [5] This requires that for the reporting of non-financial information in entities include sustainability criteria in their an integrated way should be global. risk control systems. Aggregating this data will create “statistical noise”. As the investor One senior asset manager believes national says: “This is the spearhead, where this identity will become less important in non-financial information will have an impact terms of reporting – regardless of whether beyond portfolio management and beyond the the global standard embraces integrated research process.” reporting or any other approach. “You have 26 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Summary and outlook

Summary and outlook

It is clear that investors and analysts rely governed, structured and managed to support information relevant to enterprise value on non-financial information when making long-term value creation. creation, sustainable development and investment decisions and forming an opinion evolving stakeholder expectations. on a company’s value. Traditional financial Investors do not necessarily agree, however, reporting alone is no longer sufficient for on the best way to encourage increased Our research among German investors many investors. reporting of non-financial information in an and analysts suggests that companies integrated way – whether this can be achieved have improved their provision of relevant The range of non-financial information that by investor pressure and market forces, or non-financial information. The investment investors and analysts use is extensive, whether further regulation is required. community does now have access to a including both metrics and qualitative wide range of information on ESG topics descriptions. Third-party data providers Looking ahead, on the international stage, that supports their activities. However, the deliver important services to investors, progress is being made towards a reformed quantity and quality of disclosures could be helping them to access data quickly and corporate reporting system that gives equal improved, particularly when considering the in a relatively comparable way. However, weight, where appropriate, to financial needs of specialist ESG and impact investors. many investors and analysts still turn to and non-financial information. This is company reports to gain more insight into evidenced by the cooperation of five global Investors want to see greater integration the many and varied drivers of a company’s organizations involved in corporate reporting between the financial and non-financial performance and value. In doing so, they and sustainability standards: the IIRC, CDP, information that companies report. Integrated want to see what particular ESG aspects the Climate Disclosure Standards Board, reporting, if embraced by more companies – management teams and supervisory boards GRI and SASB. It is hoped that by sharing not only in Germany but across Europe consider important. They aim to build a more and collaborating, these organizations will and the world – could make a significant complete picture of the business, its risks and establish a global consistency in reporting contribution towards closing the current opportunities. that will reduce burdens on reporting entities information gap and meeting the needs while facilitating analysis, interpretation and of a wide range of investors. Investors and analysts appreciate the action by users of information. strengths of integrated reporting. These EQUITY ANALYST include the focus on the business model, Consideration is also being given to the coverage of a broader range of capitals and creation of a new sustainability accounting “In the end, integrated the importance placed on connectivity across standards board that would exist alongside ­reporting has to become the all areas of reporting and between financial the International Accounting Standards and non-financial elements. An integrated Board. This could help in the creation of a actual reporting.” report supports the needs of investors reporting system that delivers consistent, by helping to identify companies which are comparable, reliable and assurable 27 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Appendix 1: Interview questions

APPENDIX 1 Interview questions

Our interviews with investors and analysts 3) What types of corporate reporting would 6) Turning now to integrated reporting, how 7) What are your views on the future of were structured on the basis of the following you use to access relevant non-financial familiar are you with the framework? ­integrated reporting in Germany? questions, although we encouraged free- information for investment decisions? flowing discussions reflective of participants’ E.g. corporate annual report, sustainability IIWhat in particular makes you consider IIDo you expect more German firms to interests and experience. report, GRI indicators, SASB indicators, integrated reports useful for investment publish integrated reports in the future separate indices such as MSCI, DJSI etc. decisions (compared with traditional (and would you welcome that)? 1) To what extent do you currently use non- corporate reports): e.g., the business IIWhat would be the three most effective financial information to inform investment 4) To what extent has the increase in non- model, description of an organization’s levers to increase adoption of integrated decisions? Would you routinely review financial disclosure in recent years helped strategy, the wider definition of a firm’s reporting in Germany? an investment portfolio against ESG improve your decision making? value through the concept of the six IIWhat should the IIRC be focusing on to (Environmental, Social and Governance) capitals, the process of value creation, encourage market adoption of integrated criteria? Do you do so only some of the time IIDo you find this information easy to find? the way that information is presented reporting in Germany? or never? IIIs it presented in a way that is easily (connectivity, conciseness etc.), particular comparable between companies? content? 8) Are there any other observations you would 2) What non-financial information do you IIDo you consider it to be robust? IIAre you aware of which German firms like to share with us? consider useful when making investment IIIs it relevant and decision-useful for you? currently produce an integrated report? decisions? IIIs there clear linkage with financial IIWhat are your experiences of firms that do information? so – especially regarding how they support IICan you give some examples of the kinds your decision-making? of non-financial information you consider 5) Has the introduction of mandatory IIIs an integrated report more useful or less useful and how far this information has non-financial reporting for the largest useful than a traditional corporate report supported your decision-making? companies helped improve corporate for investment decisions? Why? IIHow would you characterize your use of reporting in Germany? non-financial information: as a constraint/ secondary condition to the financials, IIHas the quality of non-financial information as a potential opportunity or risk, as a improved since the introduction of the CSR contribution to the firm’s long-term value Directive Implementation Act? creation, as an indicator of future cash- IIIs the information presented more flows etc.? consistently by mandated companies? IIOf the main reporting methods under the Act (Management Report, Sustainability Report, Integrated Report) is there an approach you favor? If so why? 28 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Appendix 2: A brief overview of corporate­ reporting­ requirements in Germany

APPENDIX 2 A brief overview of corporate­ ­reporting requirements in Germany

In Germany, medium-sized and large non-financial KPIs, such as information on methodology) from the prior year must also in Germany until the implementation of the corporations are required to prepare a environmental or employment matters when be presented and discussed. European Corporate Social Responsibility management report (Lagebericht) providing an they are relevant to an understanding of the (CSR) Directive. However, since the appropriate view of the course of business and entity’s business performance. These KPIs are subject to assurance, since implementation of the CSR Directive the position of the company. The management the auditor in Germany is required to express Implementation Act (CSR-RUG), certain public report and financial statements typically form These requirements are specified in the a reasonable assurance opinion specifically interest entities with over 500 employees the basis of a company’s annual report. German Accounting Standard governing on the management report as a whole. The on average throughout the year have had to the group management report (GAS 20). German Assurance Standard (IDW AsS 350) on supplement their management report with The management report must satisfy certain The most important financialKPI s are the management report specifically mentions a non-financial statement for fiscal years principles of proper management reporting required disclosures in connection with the KPIs and stipulates the auditor’s procedures. from 2017 onwards. They must describe (GAS 20.12-35), including, amongst others, reporting entity’s report on its economic their business model and address specified completeness, reliability and freedom from position in the group management report. In a separate section, for some companies, the non-financial aspects: environmental issues, bias, clarity and transparency as well Since GAS 20 came into force in 2013, non- management report also needs to include the employee and social matters, respect for as materiality. It must also contain certain financial KPIs would supplement these if Corporate Governance Statement, which may human rights and the prevention of bribery content elements, including the most they are material for an understanding of alternatively be published on the company’s and corruption. Where neccessary for a important financial and (for large entities the course of business and position of the website. The statement includes a number proper understanding, additional disclosures also) non-financial performance indicators, group. Thus, their inclusion is subject to the of corporate governance disclosures like the are required. and an explanation of the company’s expected entity’s discretion, as applied in the individual declaration of compliance (on a comply-or- development and significant risks and circumstances (GAS 20.54). In either case explain basis) with the German Corporate The non-financial information can be opportunities. these should be KPIs used for internal Governance Code, information on corporate integrated throughout the management management purposes for managing the governance practices and the diversity report, presented as a separate section or, The German law – the Commercial Code group. GAS 20.101 et seq. and GAS 20.284 concept. In connection with this statement, the alternatively, presented in a non-financial (Handelsgesetzbuch (HGB)) – contains give further details and provide examples. German Corporate Governance Code requires report. A fourth option would be to publish the specific requirements. According to companies to publish a separate Corporate the non-financial information on the entity’s Article 289 (1) the management report has to GAS 20.26 requires consistency in the Governance Report. However, following a website later (up to 4 months after the end include an analysis of the entity’s economic content and format of the management revision to the Code, this additional report will of the reporting period). Companies are performance, which must include financial report. As the KPIs reported are specific no longer be required. able to apply integrated reporting and to use KPIs together with their relation to the to the individual company, there is no frameworks such as those of the GRI and IIRC. amounts and disclosures in the financial standardized calculation method in place, With the exception of the aforementioned statements. According to Article 289 (3), so consistency in methodology is important. requirement to report the most important for larger entities (according to size criteria According to GAS 20.113, significant changes non-financial KPIs, there were no legal also defined inHGB ) this also applies for (in the outcome – i.e., not in calculation requirements for 29 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT References | Acknowledgements

References Acknowledgements

1 Ocean Tomo, Intangible Asset Market Value 4 Vontobel Asset Management, Act ESG: Charles Tilley OBE Klaus Kirchhoff Study, 2020 Closing the ESG knowledge gap, – An Dr. Jeremy Osborn Dr. Stefan Hannen https://www.oceantomo.com/ opportunity for product providers and intangible-asset-market-value-study/ advisers to engage with end clients Thank you to all our interviewees from, https://am.vontobel.com/document/ amongst others, the following companies* for 2 Robert G. Eccles, Michael P. Krzus and f72cc5f3-7cf5-4b7d-9b26-056ec4cf3d60/ generously sharing their time and insights: Carlos Solano, A Comparative Analysis Act-ESG_-Closing-the-ESG-knowledge- of ­Integrated Reporting in Ten Countries gap_20190901_EN.pdf IIAllianz Global Investors GmbH (2 March 2019) IIAQAL Capital GmbH https://ssrn.com/abstract=3345590 5 BaFin Guidance Notice on Dealing with IICFA Society Germany Sustainability Risks IIClimate Endowment Group 3 Mariana Bozesan, Integral Investing – From https://www.bafin.de/SharedDocs/ IIDeka Investment GmbH Profit to Prosperity (Cham, Switzerland Downloads/EN/Merkblatt/dl_mb_ IIDWS Investment GmbH 2020), pp. 167–209 Nachhaltigkeitsrisiken_en.pdf?__ IIIndependent investors blob=publicationFile&v=5 IIRisk management specialist IISelf-employed consultant IISell-side analyst in equity research IIVALUESQUE

Moreover, thank you to Sarah Perrin and all IIRC and Kirchhoff employees who helped to conduct this study and prepare this report, as well as to Gillian Waldbauer (IDW) for her support on regulatory matters.

* Please note that the interviewees spoke in a personal capacity and the views expressed in this report do not necessarily reflect those of the companies in this list. 30 IIRC & KIRCHHOFF | INVESTOR RESEARCH REPORT Imprint/Contact

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IIRC IIRC The Helicon, Dr. Jeremy Osborn The International Integrated Report- At Kirchhoff, we design sustainable value for 1 South Place, FCMA, CGMA, ing Council (IIRC) is a global coalition of both our customers and their stakeholders. London, EC2M 2RB Director of Business and ­regulators, investors, companies, standard Kirchhoff is a team of specialists focusing on [email protected] T +44 207 504 2574 setters, the accounting profession and capital markets, corporate communications, Kirchhoff Consult AG NGOs. The coalition is promoting commu- and sustainability. Experience, creativity and [email protected] Dr. Stefan Hannen nication about value creation as the next holistic thinking distinguish us. We lead the www.integratedreporting.org Senior Consultant, Head of Sustainable Finance [email protected] step in the evolution of corporate report- way in annual and sustainability reporting, ing. The International Framework has support of IPOs, investor relations, as well as Kirchhoff Consult AG been developed to meet this need. For more in strategy development and communication Borselstraße 20 22765 Hamburg ­information about the IIRC, or to download of corporate responsibility. Learn more at the International Framework, please kirchhoff.de. T +49 40 609186-0 visit https://integratedreporting.org/ F +49 40 609186-16

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