Industrials

Evolution Of Value Creation- Tangibles Vs Intangibles

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<p>The first Industrial Revolution in the 18th century focused on the mechanization of industrial processes with the use of steam instead of human or animal labour. Although there had been pollution prior to this time, the emissions from mechanized factories was the beginning of the dangerous anthropogenic emissions as we know them today.</p><p>One of the consequences of wealthy families providing equity capital and several of their members becoming directors of the company was that other stakeholders, particularly employees, saw these shareholders as the owners of the company. Shareholders were given the primacy of place in regard to all the other stakeholders involved in the business of the company; suppliers, creditors, financers, employees, advisers, etc.</p><p>During the 19th and 20th centuries, the second Industrial Revolution was characterized by mass production leading to huge profits. One if the companies benefitting from this mass production was the Ford Motor Company, which wanted to increase the wages of its employees for working long hours for meeting the extra production demands. This was contented by Dodge Brothers, a minority shareholder of the company, that the company had a duty to pay the excess profits as a special dividend to shareholders before increasing the wages of employees because of the primacy of the shareholder. This was disputed by Ford. The Dodge Brothers instituted an action in 1919 for a declaratory order that the Ford Motor Company was obliged to declare that excessive profit as a special dividend to shareholders before considering increasing the wages of employees. The Court upheld this contention and consequently the concept of the primacy of the shareholder and that directors should steer a company to ensure the maximisation of shareholder wealth, became entrenched. The concept of shareholder primacy was reinforced by the Nobel Laureate economist Milton Friedman, who in the 70&rsquo;s wrote: &ldquo;The sole purpose of the corporation is to make profit without deception or fraud.&rdquo;</p><p>Tacit in that statement was that the company was not integral to society and environment and that as long as the company was increasing its profits, without deception or fraud, it could do so at any cost to society or the environment. The consequence was that the governance of companies, right towards the end of the 20th&nbsp;century, was focused on increasing the monetary bottom line even if it was at a cost to society and the environment. The response of governments was to treat such adverse impacts or actions of companies with regulations, for example environmental impact laws instead of tackling the source of the adversity.</p><p>During the second Industrial Revolution was also the Second World War, during which concerns about the violation of human rights being carried out by the Nazis emerged. International law experts and questioned the international legal principle that the State has control over its citizens. Lawyers in the United Kingdom said that international law had to change to give universal rights to individuals. The theories of &ldquo;crimes against humanity&rdquo; and &ldquo;genocide&rdquo; were coined in this period. President Roosevelt, in January 1941, said the world should have four essential human rights: freedom of speech and expression, freedom of worship, freedom from want, and freedom from fear.</p><p>While international law was starting to oblige governments to act or to refrain from acting in certain ways, companies continued to lawfully carry on business as usual, namely maximizing profit even if it was at a cost to society and the environment. The anthropogenic emissions from factories, plant, machinery and vehicles started exacerbating the polluted world which had started as a result of the first industrial revolution. At the same time in the second half of the 20th century, single use plastics, in or with manufactured goods became the norm. Millions of tons of plastic were being manufactured each year and finding their way into landfills or rivers and subsequently into the oceans. Plastic has started polluting life below oceans and an island of plastic waste twice the size of Texas has formed in the middle of the Pacific Ocean. Cheaper child labor started getting deployed in in supply chains. Industrial farmers started fertilizing their lands with chemicals and the rain washed these chemical fertilizers into streams and rivers which eventually found their way into the ocean. There are now dead zones in the oceans of the world where there is less oxygen in water and marine life either dies or flees the area. These habitats which had been teeming with life have become biological deserts.&nbsp;</p><p>Society&rsquo;s reaction during the 20th&nbsp;century to these adverse impacts from companies&rsquo; business models was to ask its governments to regulate against them and expect NGO&rsquo;s to deal with them instead of advocating that they should have been dealt with at source &ndash; the primacy of the shareholders and how the company made its money at any cost.</p><p>During the latter part of the 20th century, the third Industrial Revolution started with electronics and information technology automating production. Globalization and information technology led to trade in a borderless and electronic world. Input costs such as labour were reduced which led to a growth of economies that could provide labour at a much lower cost than developed economies. These developing economies grew without regard to the adverse impacts on society and the environment. This is evidenced by the explosive growth of the Chinese economy during this period and the consequent present dangerous pollution levels in its industrial cities.</p><p>&nbsp;</p><p>Research showed that towards the end of the 20th century, major companies listed on some of the great stock exchanges in the world had only about 30% of their market capitalization represented by additives in a balance sheet according to financial reporting standards. The focus right through the 19th and 20th centuries on financial capital had changed because of a realization that natural assets were finite and that ecological overshoot had been reached, namely companies and individuals were using natural assets faster than nature was regenerating them. Further, landfills had started toxifying underground water systems and the earth was running out of suitable space for landfills.</p><p>The other 70% of market capitalisation was made up of what became known as intangible assets. Asset owners and asset managers had realised that a company which had a long term strategy of value creation in a sustainable manner would probably survive and thrive in the changed world whereas a company that focused only on improving the bottom line at any cost would eventually fail. Further, society was starting to turn its face against companies that were having a negative impact on society or the environment. Wireless and mobile communication started galvanizing civil society against poor corporate citizenry.</p><p>According to an Ocean Tomo study on Intangible Asset Market Value in 2015, Intangible assets are now responsible for 80% of all business value.&nbsp;The study examines the component of market value, specifically the role of intangible assets across a range of global indexes. Comparing the 39 companies appearing on both the S&amp;P 500 and the Interbrand list suggests brand value may represent roughly one quarter or more of average IAMV. (4) See Figure 1</p><div class="slate-resizable-image-embed slate-image-embed__resize-full-width"><img style="display: block; margin-left: auto; margin-right: auto;" src="https://media-exp1.licdn.com/dms/image/C5612AQEG4jVkCNb_sA/article-inline_image-shrink_1000_1488/0/1590985904976?e=1643241600&amp;v=beta&amp;t=5rpRvBV8rxtoVoRQpf-A5SgGuvlQwy94W7rCvJv6jH0" alt="No alt text provided for this image" data-media-urn="" data-li-src="https://media-exp1.licdn.com/dms/image/C5612AQEG4jVkCNb_sA/article-inline_image-shrink_1000_1488/0/1590985904976?e=1643241600&amp;v=beta&amp;t=5rpRvBV8rxtoVoRQpf-A5SgGuvlQwy94W7rCvJv6jH0" /></div><p>Figure 1</p><p>The second half of the 20th Century is unique in the history of human existence. Many human activites reached take-off points sometime in the 20th Century and sharply accelerated towards the end of the century.</p><p>This period, without doubt has seen the most profound transformation of the human relationship with the natural world in the history of humankind. The effects of the accelerating human changes are now clearly discernible at the Earth system level. Many key indicators of the functioning of the Earth system are now showing responses that are, at least in part, driven by the changing human imprint on the planet. The human imprint influences all components of the global environment - oceans, coastal zone, atmosphere, and land.&nbsp;(2) (See figure 2 below).</p><div class="slate-resizable-image-embed slate-image-embed__resize-full-width"><img src="https://media-exp1.licdn.com/dms/image/C5612AQE37kihnMLhyA/article-inline_image-shrink_1000_1488/0/1590985953021?e=1643241600&amp;v=beta&amp;t=jNHh9BkRAOW5Lw70ei-F1J2_Bbx0AyoXhJUkz5gopSQ" alt="No alt text provided for this image" data-media-urn="" data-li-src="https://media-exp1.licdn.com/dms/image/C5612AQE37kihnMLhyA/article-inline_image-shrink_1000_1488/0/1590985953021?e=1643241600&amp;v=beta&amp;t=jNHh9BkRAOW5Lw70ei-F1J2_Bbx0AyoXhJUkz5gopSQ" /></div><p><em>&nbsp;Figure 2 : The updated Great Accelaration graphs</em></p><p>This influence has manifested in the form of more frequent and more severe climate-related events in the 20th and 21st century such as flash floods, cyclones, and wildfires, which were earlier freakish. The biggest user of natural assets and the biggest polluters are private and public companies. Companies had been acting lawfully because of a shareholder-centric governance model but committing wrongs against society and the environment. Lawful wrong is an oxymoron but directors were lawfully directing companies to maximize profit instead of focusing on both the tangible and intangible assets of the company as well as its adverse impacts on society and the environment.</p><p>At the start of the 21st century, thought leaders in Boston tried to work out how the boards of companies could measure and report on the 70% of value on which there was no accountability in an annual report which consisted only of the balance sheet, profit and loss statement and related notes according to financial reporting standards. They started drawing guidelines for sustainability reporting which led to the founding of the Global Reporting Initiative (GRI).&nbsp;Companies now started reporting in two silos &ndash; the annual financial statement and a sustainability report according to the then GRI Guidelines, and now GRI Standards.</p><p>&nbsp;The corporate responsibility stream had its origins in the mid-to-late 1800s, with industrialists like John D. Rockefeller and Dale Carnegie setting a precedent for community philanthropy, while others like John Cadbury and John H. Patterson seeded the employee welfare movement (Carroll, 2008).&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p><p>&nbsp;</p><p>The sustainability stream, also, started early with air pollution regulation in the UK and land conservation in the USA in the 1870s (Visser, 2011). Fast forward by a century, and we got the first Earth Day, Greenpeace and the UN Stockholm Conference on Environment and Development. By the 1980s and 1990s, we had the Brundtland definition of "sustainable development" (World Commission on Environment and Development, 1987), the Valdez Principles in 1989 (later called the CERES Principles), and the Rio Earth Summit in 1992.&nbsp;</p><p>As these two movements of responsibility and sustainability gathered momentum, they naturally began to see their interconnectedness. Labor rights are connected with human rights, quality is connected with health and safety, the community is connected with supply chain, environment is connected with productivity, and so on. The coining of the "triple bottom line" of economic, social, and environmental performance by John Elkington (1994), and the introduction of the 10 principles of the UN Global Compact in 1999 reflected this trend.</p><p>Integration started to happen at a more practical level. The ISO 9001 quality standard became the design template for ISO 14001 on environmental management and OHSAS 18001 on occupational health and safety. The Global Reporting Initiative and the Dow Jones Sustainability Index adopted the triple bottom line lens. Fair Trade certification incorporated economic, social, and environmental concerns, and even social responsibility evolved into a more holistic concept, now encapsulated in the 7 core subjects of ISO 26000.</p><p>The start of the 1900s also saw the adoption of the 8 Millennium Development Goals (MDGs) which ranged from halving extreme poverty rates to halting the spread of HIV/AIDS and providing universal primary education, all by the target date of 2015 &ndash; formed a blueprint agreed to by all the world&rsquo;s countries and all the world&rsquo;s leading development institutions. The MDGs galvanized unprecedented efforts to meet the needs of the world&rsquo;s poorest.</p><p>In July 2000, the United Nations launched the 10 principles of its Global Compact. It was based on the unprecedented rise in partnerships between business, civil society, governments and the United Nations leading to the Sustainable Development Goals of April 2015.&nbsp;The UN stated that business has to be a part of a solution to the global challenges of people, planet and profit.</p><p>The Global Compact contains 10 principles for a company to exhibit good corporate citizenship. The 10 principles are derived from the Universal Declaration of Human Rights, the international labour organizations Declaration on Fundamental Principles and Rights, the RIO Declaration on Environment and Development and the UN Convention against Corruption.</p><p>At the beginning of 2010 the International Federation of Accountants (IFAC) and the UN Community on Trade and Development called a meeting at the UN headquarters in Geneva. The invitees included, inter alia, the World Chairmen of the Big Four, the World Bank, the Institute of Internal Auditors, major asset owners, asset managers and regulators.&nbsp;At that meeting, the IFAC stated that it was clear that annual financial statements, were critical but on their own not sufficient to discharge a board&rsquo;s duty of being accountable. A sustainability report, without the numbers, was meaningless and reporting in two silos did not reflect the complete reality of a company. No company has ever operated on a basis that financial capital was in one building, human capital in another, natural capital in yet another, intellectual capital somewhere else, as with social and manufactured capital. There has always been a symphony of these sources of value creation because of their interconnection and interdependency together with the relationships between the company and its stakeholders, such as its employees, suppliers, investors, service providers, shareholders, etc. These sources of value creation and relationships have always been integrated.</p><p>His Royal Highness, Prince Charles, had in 2006 started the Accounting for Sustainability Trust (A4S) because he argued that the annual reports of companies in which the Royal Family invested had not reported on how their business models had impacted the society and the environment. This led to the historic meeting at St James&rsquo; Palace, called by his Royal Highness Prince Charles, in which significant institutions and regulators of the world, the Big 4 auditing firms, asset owners and asset managers were invited and the discussion was if the companies were operating on an integrated basis and if their Boards were accountable for the same? The outcome was the formation of the International Integrated Reporting Council (IIRC).</p><p>In the International Framework it was pointed out that in a value creation situation, the major inputs can be listed under six capitals, viz. financial, manufactured, human, intellectual, natural and social, which would include the relationship between the company and all its stakeholders. A company should build these six capitals into its business strategy in the resource constrained world of the 21st century, and not merely focus on financial capital. The sustainability issues critical to the business of the company, should be part of the company&rsquo;s long term sustainable value creation strategy. Now the board was dealing with the outcomes of a company&rsquo;s business model rather than leaving them to regulators and NGO&rsquo;s. The outcomes based approach of IIRC is to look at the value creation chain from inputs into the company&rsquo;s business model, its output, being its product or service and the effects that the product or service has when it goes out into society on the three critical dimensions of sustainable development, the economy, society and the environment. This outcomes based approach is also recognised in the 17 Sustainable Development Goals of the UN adopted in 2015 in which the UN states that in order to achieve sustainable development by 2030, account has to be taken of the indivisible and integrated dimensions of the economy, society and the environment.</p><p>We have now entered the fourth Industrial Revolution based on digitisation, artificial intelligence, the internet of things, nano-technology, bio-technology and 3D printing but with diminishing natural assets and continuing population growth. It is clear that it is no longer an option to carry on business as usual. Society, with radical transparency at its fingertips through social media, no longer accepts these lawful wrongs against humanity committed by a company.</p><p>According to a report on global trends by SustainAbility, the top global sustainability issues and trends that will shape the business agenda beyond 2020 are Climate Mitigation, Changed Climate, Circular Solutions, Plastics Sustainable Consumption, Supply Chain, Protecting Biodiversity, Technology for the SDGs, Human Capital and Sustainable Finance. The 15th edition of the Global Risks Report 2020, published by the World Economic Forum says that if stakeholders concentrate on immediate geostrategic advantages and fail to reimagine or adapt mechanisms for coordination during this unsettled period, opportunities for action on key priorities may slip away. The downward pressures on global economy, from macroeconomic fragilities and financial inequality continue to intensify, increasing the risk of economic stagnation. Low trade barriers, fiscal prudence and strong global investment&mdash;once seen as fundamentals for economic growth are fraying as leaders advance nationalist policies. The margins for monetary and fiscal stimuli are also narrower than what they were prior to the 2008&ndash;2009 financial crisis, creating uncertainty about how well countercyclical policies will work. According to the Global Risks Perception Survey, members of the multistakeholder community see &ldquo;economic confrontations&rdquo; and &ldquo;domestic political polarization&rdquo; as the top risks in 2020. Citizens&rsquo; discontent has hardened with systems that have failed to promote advancement. Disapproval of how governments are addressing profound economic and social issues has sparked protests throughout the world, potentially weakening the ability of governments to take decisive action should a downturn occur. Without economic and social stability, countries could lack the financial resources, fiscal margin, political capital or social support needed to confront key global risks. Climate change is striking harder and more rapidly than many expected. The last five years are on track to be the warmest on record, natural disasters are becoming more intense and more frequent, and 2019 witnessed unprecedented extreme weather throughout the world. Alarmingly, global temperatures are on track to increase by at least 3&deg;C towards the end of the century&mdash;twice what climate experts have warned is the limit to avoid the most severe economic, social and environmental consequences. The near term impacts of climate change add up to a planetary emergency that will include loss of life, social and geopolitical tensions and negative economic impacts. Health systems around the world are at risk of becoming unfit for purpose. New vulnerabilities resulting from changing societal, environmental, demographic and technological patterns threaten to undo the dramatic gains in wellness and prosperity that health systems have supported over the last century. More than 50% of the world&rsquo;s population is now online, approximately one million people go online for their first time each day, and two-thirds of the global population own a mobile device.</p><p>While digital technology is bringing tremendous economic and societal benefits to much of the global population, issues such as unequal access to the internet, the lack of a global technology governance framework and cyber insecurity all pose significant risk. Geopolitical and geo-economic uncertainty&mdash; including the possibility of fragmented cyberspace&mdash;also threaten to prevent the full potential of next generation technologies from being realized.&nbsp;</p><p>&nbsp;</p><p>Now corporate leaders are rethinking the role of business in society. Investors are increasingly focusing on companies&rsquo; social and environmental practices as evidence mounts that performance in those areas affects returns over the long term. Standards are being developed for which environmental, social, and governance (commonly referred to as ESG) topics are financially material by industry, and data on company performance in these areas is becoming more available and reliable, increasing transparency and drawing more scrutiny from investors and others. The large-scale and long-term nature of the problem makes it uniquely challenging, especially in the context of economic decision-making.</p><p>For many investors, climate change and other ESG aspects pose significant financial challenges and opportunities, now and in the future. The expected transition to a lower-carbon economy is estimated to require around $1 trillion of investments a year for the foreseeable future, generating new investment opportunities. At the same time, the risk-return profile of organizations exposed to climate-related risks may change significantly as such organizations may be more affected by physical impacts of climate change, climate policy, and new technologies. In fact, a 2015 study estimated the value at risk, as a result of climate change, to the total global stock of manageable assets as ranging from $4.2 trillion to&nbsp;$43 trillion by the end of the century. The study highlights that &ldquo;much of the impact on future assets will come through weaker growth and lower asset returns across the board.&rdquo;</p><p>Given such concerns and the potential impact on financial intermediaries and investors, the G20 Finance Ministers and Central Bank Governors asked the Financial Stability Board to review how the financial sector can take account of climate-related issues. To help identify the information needed by investors, lenders, and insurance underwriters to appropriately assess and price climate-related risks and opportunities, the Financial Stability Board established an industry-led task force: the Task Force on Climate-related Financial Disclosures (TCFD) which was asked to develop voluntary and consistent climate-related financial disclosures that would be useful to investors, lenders, and insurance underwriters in understanding, assessing and pricing climate-related risks and opportunities. The Task Force developed four widely adoptable recommendations on climate-related financial disclosures that are applicable to organizations across sectors and jurisdictions, known as the TCFD recommendations. These recommendations are structured around the four thematic areas that organizations operate around - governance, strategy, risk management, and metrics and targets.(8)</p><p>The American Consultancy, Arabesque, and the University of Oxford have reviewed 200 academic literature on sustainability and corporate performance. 90% of the studies on the cost of capital show that sound sustainability standards lower the cost of capital of companies. 88% of the research shows that solid ESG practices result in better operational performance of firms. 80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices. (5)</p><p>In short it has become good, hard-nosed business to ensure that a company&rsquo;s business model does not have adverse impacts on humanity. There is still scope for stakeholders to address these risks, but the window of opportunity is closing. Coordinated, multistakeholder action is needed quickly to mitigate against the worst outcomes and build resilience across communities and businesses. Companies that will survive and thrive into the 21st&nbsp;century are those which have their boards applying their collective minds to the fact that the corporate tools of yesterday can no longer be used today.</p><p>Stakeholder theory has been widely offered as a corrective to the perceived defects of business and business ethics, and as an alternative model of corporate governance. Indeed, it is now advocated so commonly as to have become a new orthodoxy. According to R. Edward Freeman's history of the term, the actual word `stakeholder' first appeared in the management literature in an internal memorandum at the Stanford Research Institute (now SRI International, Inc.), in 1963. The term was meant to generalize the notion of stockholder as the only group to whom management need be responsive. Thus, the stakeholder concept was originally defined as &lsquo;those groups without whose support the organization would cease to exist.&rsquo;'</p><p>&nbsp;</p><p>Now, however, `stakeholder' often means something quite different: according to Freeman, `A stakeholder in an organisation is (by definition) any group or individual who can affect or is affected by the achievement of the organization's objectives.' This, more inclusive sense of stakeholder has been widely adopted, as has the view that organisations should be conducted for the benefit of all their stakeholders. Stakeholder doctrines have become a staple of management theory and conventional business ethics, and the subject of extensive academic examination. They have been adopted by prominent management groups and used to inform official policy on directors' duties, takeovers and public pension fund investments; in the US, stakeholder interests have been recognized by law in 29 states. In Britain, the stakeholder concept was endorsed as early as 1973 by the Watkinson Report on The responsibilities of the British public company. Laws requiring its adoption have been advocated by the Confederation of British Industry&nbsp;as well as by the Trades Union Congress.</p><p>&nbsp;</p><p>`Stakeholder Theory' is the doctrine that businesses should be run not only for the financial benefit of their owners but for the benefit of all their stakeholders. It is an essential tenet of stakeholder theory that organizations are accountable to all their stakeholders, and that the proper objective of management is to balance stakeholders' competing interests. As a result of this, the number of stakeholders and their issues that the organization needs to discuss and incorporate into its vision and Strategy becomes quite endless. It is then required that we approach the stakeholder theory in conjuction with the materiality and prioritisation of stakeholders with respect to their legitimacy, saliency and urgency.</p><p>&nbsp;</p><p>&nbsp;</p><p>&nbsp;</p>
KR Expert - Priya Ranjan