The importance of horizons in shaping a responsible future
A speech by Paul Druckman, Chief Executive Officer, International Integrated Reporting Council, given in October 2015:
The title of this speech is, “The importance of horizons in shaping a responsible future”. I want to begin with a quotation from an investment banker which I think frames the challenge I am going to set before you over the next few minutes.
A challenge to short-termism
This quote is included in a new book by the economist Professor John Kay and is from the then head of global structured products at Royal Bank of Scotland in February 2004: “We are investment bankers. We don’t care what happens in five years”. The date – February 2004 – becomes important when you consider that Royal Bank of Scotland was bailed out by the UK taxpayer precisely four years and eight months later.
It is a quote that makes you angrier the more you think about it. And it reveals a mind-set that is as unacceptable as it is pervasive in certain parts of our economy. It is a mind-set that destroys confidence and trust in our businesses, capital markets and the economic system which we take for granted. It is a mind-set that must be challenged and I want to explain how.
The truth is that, for much of my adult and business life, we have been living through an age of irresponsibility. It is an era of irresponsibility that has consequences for all of us: high levels of personal and government debt, low business investment, stagnant wages, stock market volatility, climate change, growing levels of inequality and a global migration and refugee crisis.
It is a situation that has attracted calls for change by political, business – and even religious and spiritual – leaders. Speaking in June 2014, Pope Francis said, “It is increasingly intolerable that financial markets are shaping the destiny of peoples rather than serving their needs, or that the few derive immense wealth from financial speculation while the many are deeply burdened by the consequences”.
What I fear we are witnessing today is an end of the “American Dream”, the automatic upward social and economic mobility from one generation to the next, which had become the entrenched right and expectation of developed societies. Certainly in environmental matters, mine will be the first generation knowingly to leave our planet in a worse state than that which we found it. And the key word in that sentence is, of course, knowingly.
All of these problems are with us today. They are global and structural, and none of them – not one – shows any sign of abating any time soon. What unites them further is that they all have their root cause in human behaviour – in the choices we make; the actions and omissions of human beings, often collectively as Governments or global corporations, in the name of taking a short-term advantage.
The case for system change
The case I want to put to you is that the pace of change in our economy and society is putting pressure on the structure of the system we have created to manage it. It is bringing about a level of disruption to business models and entire industries that many companies and investors are finding hard to assimilate. The Theory of Accelerating Change suggests that the increase in the rate of technological progress through history points to faster and more profound change in the future. In his 1999 book, The Age of Spiritual Machines, Google’s futurist Ray Kurzweil argues that this rate of change is increasing exponentially rather than in linear fashion. And in a 2001 essay, Law of Accelerating Returns, Kurzweil predicts that, “technological change will be so rapid and profound it represents a rupture in the fabric of human society”.
Rather more prosaically, former chairman of the International Organization of Securities Commissions (IOSCO) and IIRC Board member Jane Diplock, recently revealed her surprise at the slump in Weight Watchers’ share price. She observed, “You would think that, Weight Watchers would be a great stock to push in the midst of an obesity crisis. What has eaten its lunch? The Fitbit. The Fitbit provides a community where you can share your progress, you can factor in all of your calories, you can do everything that Weight Watchers did, but you don’t have to get out of your house and go in the car, on a wet night, to a sort of ‘AA for fatties’. It’s transformed and undercut that business model”.
If we thought hard enough, we could all identify examples of companies that have suffered a similar fate.
I would argue that these developments increase the need for boards and management to focus on strategy and on creating and building resilient business models capable of withstanding short-term pressures over the medium and long-term. Yet too often the system itself promotes rigidity, compliance and conformity – the opposite of what business and investors need.
As Andy Haldane, Chief Economist of the Bank of England argued earlier this year, “Ultimately, if we can change the structure of the system, the structure of incentives in banks and non-banks, that’s got to be better for everyone”.
What saddens me is that my generation has been asleep at the wheel. And the chronic challenges we now face as an economy and society are part of my legacy, my story – not personally of course – but I am not proud that on my watch in business the scales have tilted towards such an unsustainable imbalance in so many aspects of economic decision-making, with its impact on climate change, inequality and financial stability. And there comes a time in life when it isn’t “someone else’s problem”, but something you have to take a personal responsibility for. Isn’t that the essence of leadership in action?
It is why I get up every morning to lead the International Integrated Reporting Council after many years running my own businesses in the accountancy software industry, then as a regulator and non-executive director. And in our small way, which I will explain, we are starting to tilt the scales in favour of a more inclusive, stable and durable economic system.
And so it is my mission this evening not just to talk to you. I want to recruit you as officers in the global army of people around the world who say “today’s operating system is simply not delivering the goods” and we need to break the cycle of short-termism which is doing so much harm. We need to act today in ways that secure our future, not put it at risk.
To break the cycle of short-term behaviour, where the future is someone else’s problem, will take activists and champions and leaders – frankly that means you. Because it is you, and people like you in the business schools, global corporations and investment houses who need to pick up the baton and make the changes to systems, processes and incentives that will re-orient our economic decision-making in favour of the long-term.
Now everything that I have said to you so far this evening about the risks threatening the wellbeing and security of our economy, society and environment is well-known and documented.
The questions you might be asking are, first, what has this got to do with me? And, second, what can I do practically to reverse these trends?
The power shift
I want to persuade you that the legacy my generation passes on to yours is not part of an inevitable trajectory – quite the opposite. I believe that some of the unfortunate trends that I have described above can be reversed. I would actually argue that they must be reversed. The problem is that we have been looking in the wrong places for the solutions – to governments rather than ourselves.
Should you choose to do so, I believe the solutions lay as much in your hands today as any government or regulator. The reason you have the power is that the private sector holds the key to unlocking the solutions to all these major problems. From the United Nations, to the Financial Stability Board and the G20, it is to the private sector that these intergovernmental institutions look to implement major policy initiatives – and finance them.
For businesses have the influence, human capital, global reach and investment capability to make the change to a new system:
- A system that encourages inclusive capitalism as the fastest and most secure route to achieving sustainable development.
- A system that embeds a broad understanding of value creation so that future risks and opportunities can be incorporated into today’s business and investment decisions.
- And a system that rewards patient financial capital – capital that, if released, has the potential to transform entire economies through infrastructure investment, unlock productivity gains and boost future economic growth and employment.
The point about the power vested in today’s multinational corporations is illustrated in a new book, No Ordinary Disruption: The Four Global Forces Breaking All the Trends, by McKinsey directors Richard Dobbs, James Manyika and Jonathan Woetzel. In the book, they explain the extraordinary economic power of the world’s largest companies, due to their global networks of customers, suppliers and talent. They reveal that, “prior to the 2008 recession, multinationals made up less than one per cent of all US companies, but they generated 25 percent of gross profits, 41 percent of productivity gains, and nearly 75 percent of the nation’s private-sector research and development spending”.
It is a point reinforced by Harvard Professor, Michael Porter, who argues that businesses have the financial resources to build the “infinite scalability” of a new system where business profits from solving social problems, rather than the conventional wisdom – which he challenges anyway – that businesses profit by causing social problems.
When you consider the total revenue by stakeholder in the US economy, it is hard to argue with his analysis. In 2013 US corporations received revenue of $20.1 trillion, compared to just $3.1 trillion for the government and $1.2 trillion for non-profit organisations.
Porter calls his approach “shared value” and many businesses such as Nestlé and Unilever, that are also adopting Integrated Reporting, incorporate shared value principles into their business models and strategy. Porter argues that there is no trade-off between social progress and economic progress, except in the very short-term, again highlighting the importance of long-term thinking.
Now, the theory and evidence are important. But so too is how they relate to the practical challenges I outlined at the beginning of this talk. I want to take two of the most profound issues facing the world today – inequality and climate change – and talk with a little more granularity about how we can bring about change and reverse the current troubling trends.
Lifting the small boats
In an important speech in June this year called “Lifting the Small Boats”, Christine Lagarde, Managing Director of the International Monetary Fund, said that, “reducing excessive inequality – by lifting the “small boats”, the lower and middle classes – is not just morally and politically correct, but it is good economics”. She revealed research by the IMF which shows that, if you lift the income share of the poor and middle class by one percentage point, then GDP growth increases by as much as 0.38 percentage points in a country over five years. By contrast, if you increase the income share of the rich by one percentage point, GDP growth decreases by 0.08 percentage points.
So finding ways to reduce inequality is an economic imperative.
Yet research by the OECD shows that the living standards of poorer and middle class households in advanced economies have been falling relative to the rest of the population. As Madame Lagarde said, “This kind of inequality holds back growth because it discourages investment in skills and human capital – which leads to lower productivity in a large part of the economy”.
This brings me to one of the causes of excessive inequality, and there has been a lot of research in this area conducted by the World Bank, IMF and the Bank of International Settlements, all pointing to the same conclusion, that, in the words of Christine Lagarde, an over-reliance “on finance can distort the distribution of income, corrode the political process, and undermine economic stability and growth”.
A 2013 book published by the OECD entitled, “All on Board: Making Inclusive Growth Happen”, states, “The recent global financial crisis underlines the importance of regulatory frameworks that discourage financial market operators from risky activities, often divorced from the core business of financing real investment, that bring them exceptionally high rewards in good times, but greatly harm the real economy when risks materialise. The exceptionally high rewards themselves exacerbate inequality of earnings and also attract a higher share of the highly skilled, so that productivity suffers in other sectors that depend of skilled human capital”.
Last week in New York, world leaders took an unprecedented coordinated step by agreeing a plan for eradicating global poverty by 2030. The 17 Sustainable Development Goals announced at the United Nations are universal, applying to all UN countries, and require the public and private sectors to collaborate to make them happen. We support this action and believe Integrated Reporting can be an important ally both in terms of the financing and implementation of the Goals.
I also share Christine Lagarde’s analysis that an over-reliance on finance is exacerbating the crisis of inequality affecting the world.
It is why I am proud of the International Integrated Reporting Framework, released by the IIRC in December 2013, which puts “financial capital” in its proper context as a key strategic resource alongside human, intellectual, social and relationship, manufactured and natural capitals. By introducing a “six capitals” approach to economic and business management, we are giving parity to the indicators of future value that cannot be understood or communicated through the lens of financial transactions alone. It is an approach now being implemented by the World Bank Group as a development bank and financial institution in its own right.
I believe that by embedding this inclusive management tool into the operations of businesses, boards and company executives will have the ability to manage long-term risks and opportunities, and help to rebalance the focus of decision-making away from an isolated focus on financial management and onto the strategic issues that determine future performance.
It is in this spirit that the IIRC supports the powerful Coalition for Inclusive Capitalism, spearheaded by Lady Rothschild that is convening global leaders such as Bill Clinton, Mark Carney and Christine Lagarde herself, around a set of principles intended to change behaviour and incentive systems that favour a long-term approach. It is that shift from financial to inclusive capitalism that I believe Integrated Reporting embodies with its multi-faceted approach to understanding and articulating value creation, lifting the sights of the board and management to leading indicators that are on the horizon rather than in the immediate gaze.
Tragedy of the horizon – tackling climate change
Now I want to confess that the inspiration for the title of this speech originated in a forum led by Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board, the organisation that provides the secretariat to the G20 process. Mr Carney was speaking at the World Bank in October 2014 at a meeting to discuss the implementation of Integrated Reporting across the major capital markets. In his remarks, Carney coined a new phrase: the tragedy of horizons, defined as the market failure that arises from not taking into account today known future risks – in this case, he was talking about climate change.
Carney’s argument, which he set out in detail in a lecture at Lloyds of London on 29 September 2015, entitled, “Breaking the tragedy of the horizon – climate change and financial stability” – is that “the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors – imposing a cost on future generations that the current generation has no incentive to fix”.
These horizons include the business cycle, the political cycle and the horizon of authorities such as central banks, who are bound by their mandates.
This analysis strikes such a chord with Integrated Reporting – indeed Carney has expressed the hope that Integrated Reporting, with its focus on communicating future risks and opportunities, could be one of the tools to deal with the problem.
When we think about corporate reporting, it is not just the business cycle that is locked into a short-medium term mind-set. At a more basic level, disclosure horizons themselves are completely out of synch with the need to provide useful information about the future that can influence today’s strategy and business model. Many institutional investors observe that their own liability horizons may last many decades into the future, yet disclosure horizons tend to be narrowly focused on the very short-term and limited to mainly financial disclosures which are a poor predictor of future value.
So it is our call to align better the disclosure horizons of businesses with the liability horizons of investors. We support calls from U.S. Presidential candidate Hillary Clinton to abolish “the tyranny of quarterly reporting” as an urgent first step, and the adoption on a country-by-country basis of Stewardship Codes, which helps to drive a better quality dialogue between company boards and investors, focused on the factors that contribute towards long-term value.
An avoidable tragedy
As I conclude my remarks, I want to leave you in no doubt. I am a capitalist. Or perhaps I should say I am a “multi-capitalist”, because I believe governments and businesses should be held to account for more than their short-term financial performance.
And I believe that the ideas advanced by the inclusive capitalism movement should be implemented. This is because I believe profoundly that capitalism must have meaning and purpose, to create the conditions for “shared value” to flourish and unlock the incredibly positive and creative power of business. But I do believe that for Integrated Reporting and shared value to become the norm, changes to our economic and capital market systems are required. It is what we, at the IIRC, call the “three shifts” needed to anchor mainstream decision-making to the behavioural changes we all want to bring about. These are, first, the shift from a financially focused capital market system to inclusive capitalism; second, the shift from short-term horizons to long-term horizons; and third, the shift from silo reporting to Integrated Reporting. Together, they represent the broad policy changes we believe should be implemented.
Mark Carney spoke of the “tragedy of the horizon”. And I believe his analysis can be applied much more broadly to decisions beyond the focus of climate change, which was the subject of his speech. We have not only allowed ourselves to become caught in a trap of short-term horizons, we have created an entire economic and capital markets system devoted to its continuation.
But it is an avoidable tragedy for your generation because the approach you take as business leaders will determine whether we can chart a course to victory against any, or all, of the world’s most pressing challenges.
At the start, I painted a bleak picture of these challenges confronting all of us. Some may see them as insurmountable barriers, preventing progress and change. These people foresee doom and a never-ending spiral of decline. But I do see things differently. And I hope you do too. For the challenges we face are epic in scale, but the job of today’s leaders is to dismantle the barriers, and instead treat them as hurdles to be overcome, not a permanent obstruction to the progress from one generation to another.
Let’s make change happen
I began this talk with a quote from an investment banker which neatly summed up the attitude of a generation. I want to conclude with one that is more optimistic and frames the challenge and opportunity to you, future leaders in business. It comes from Warren B. Bennis, the American professor in leadership and adviser to four U.S. Presidents. He said, “Leaders keep their eyes on the horizon, not just the bottom line”.
I have attempted this evening to give you the argument, the analysis and evidence to show why Bennis was right. By focusing on two issues – inequality and climate change – I have given you the argument that it is in all our interests to bring about change, and that the power to do so is in our hands.
Drawing on my experience in business and my current role in driving change in the system of corporate reporting, I have laid out policy suggestions and how you can act. It is now up to you. Do you repeat the cycle of the last thirty years and hand an even dirtier, unequal and less economically productive world to your children? Or do you vow, here and now, to break the cycle, and become a champion for change? For those of you who want to act, I can bring the convening power of the Integrated Reporting movement and, I believe, too, the power to convince business leaders, investors and governments to act.
Thank you for this opportunity to contribute to your thinking and I hope, too, your development as tomorrow’s business leaders. With your inspiration and intellect, we can not only make a difference, we can make change happen.