Burgess COMMENTARY

Peter Burgess

Beyond corporate reporting: are integrated ratings next? Ratings and reports have to consider new forms of sustainable and credit capital, writes Allen White

IMAGE moody's credit rating agency ... Will Moody's move to integrated ratings? Photograph: Brendan Mcdermid/Reuters

Integrated reporting is on the horizon. After months of consultation with organizations around the world, the International Integrated Reporting Council (IIRC) is scheduled to publish its international framework in December. After that, companies participating in the pilot program will begin testing the framework.

IIRC is a response to what investors and other stakeholders have long recognized: financial reporting's usefulness is steadily diminishing in an increasingly interconnected, complex world in which intangible assets are a primary driver of value creation. Integrated reporting heralds a new vision for corporate reporting.

By meshing financial and sustainability information into a holistic framework, IIRC seeks to design a vehicle for communicating how a company creates value over the short, medium and long term.

The backward-looking and myopic focus of financial reporting provides inadequate insight into the mind, business model and strategy of the organization. It fails to capture long-term opportunities and risks in a world in which knowledge, technology and supply chains are increasingly borderless. Further, financial reporting's short-term focus and omission of intangible assets that underlie some 75% of market value beg for remedy.

The foundation of the IIRC framework rests on the pillars of the 'multiple capitals' that an organization uses and affects: financial, manufactured, intellectual, human, social and natural.

The interplay of these multiple capitals, viewed through the lenses of a business model and strategy, illuminates what conventional financial reporting fails to provide: an understanding of the value creation process wherein financial performance is the outcome, not the cause of, wealth generation.

If integrated reporting becomes the norm, it will provide users with a portrait of a company in relation to its capacity, commitment and performance in preserving and enriching all forms of capital. It will, in other words, portray the organization's prospects of becoming a truly generative enterprise.

If corporate reporting evolves in this fashion, why shouldn't corporate ratings – both company ratings and credit ratings? Logically, reports that provide an integrated portrait of a company's capacity to create value, now and in the future, should serve as the foundation for rating its performance and the debt it floats in financial markets.

Sustainability ratings

Consider first the case of sustainability ratings, the work of some 100 organizations worldwide that assess companies' sustainability performance from both an integrated and topic-specific perspective.

Using a wide array of methodologies and data sources – such as sustainability reports, questionnaires and media coverage – raters apply a wide range of methodologies to assess the environmental, social and governance performance of thousands of mostly publicly traded companies worldwide.

The evolution and proliferation of these ratings since the early 1990s have brought valuable insights into performance that were previously unavailable to financial market players and to companies themselves.

While opacity, inconsistency and volatility have hampered uptake by mainstream markets, the ratings are gradually making some inroads into financial markets. Fueling such progress is mounting evidence that sustainability performance correlates with long-term share price performance, reduced share price volatility, greater resilience in the wake of controversies and incidences, and reduced cost of capital.

Notwithstanding this progress, however, mainstream finance overall remains unconvinced that sustainability matters. Would integrated ratings that blend sustainability and conventional financial performance into a singular, multiple capitals framework help surmount such skepticism? We believe it would.

Credit ratings

Next, consider credit ratings, which are performed by Moody's, Fitch, Standard & Poor's and a handful of others certified by the U.S. Securities and Exchange Commission as 'Nationally Recognized Statistical Ratings Organizations'. Credit ratings are a big business. Moody's 2013 revenues totaled $2.7bn. S&P in 2011 rated nearly $3.2tn in new debt alone. In any year, the total rated debt (corporate, sovereign and otherwise) amounts to tens of trillions of dollars.

To some extent, credit raters address sustainability in their methodologies without explicit reference to the 's' word. 'Social risk', 'political risk' and 'governance factors' are frequently embedded in creditworthiness analyses.

If, for example, an oil company floats a bond to fund new drilling operations in Nigeria, a creditworthiness assessment of that bond may incorporate risks associated with regional human-rights controversies, environmental litigation, political strife and social unrest leading to facility sabotage or shutdown. Under the rubric of human rights, anti-corruption or environmental impacts, the same or similar issues are also found in sustainability ratings.

Analogous to the case of company-level integrated ratings, a future of integrated credit ratings would embrace the full spectrum of such risks, but at a deeper level than is the case today. In this scenario, investors would benefit from added confidence that credit analysis accurately characterizes the prospects for repayment, especially for long-term debt obligations.

New tools needed

Moving markets toward sustainability requires the deployment of different instruments and analytics – ones that are equipped to measure the multiple capitals at the heart of long-term value creation.Company ratings and credit ratings play vital roles in capital allocation worldwide.

Just as IIRC's framework is built on a multiple-capitals foundation, so too can integrated ratings reframe measurement to embrace a more holistic view of an organization's long-term performance and prospects.

The pathway toward integrated ratings awaits articulation. New paradigms take time to achieve widespread acceptance. Integrated reporting captures and communicates the complexities and synergies of multiple capitals in value creation.

As integrated reporting emerges in the coming years, integrated ratings will benefit from a new generation of information ready to populate a new generation of ratings methodologies.

This evolution cannot materialize too soon. A transformation of ratings can play a vital role in creating the 'new operating system' for capitalism that Peter Bakker, president of the World Business Council on Sustainable Development, advocates:

'The mistake currently lies in only expecting (and managing) a return on financial capital. Capitalism requires a new operating system and needs to be rebooted so that we expect and manage the return on financial, natural and social capital. … Business as usual is not an option for a future-proofed economy in which nine billion people live well with the limits of the planet by mid-century.'

Companies, investors and society at large stand to benefit from such a sea change. It is a future the ratings community should not only anticipate, but champion as well.