Do-gooder FDs do better

As recently as two years ago, Monsanto was the toast of management gurus on account of its success in transforming itself from a chemicals and agricultural products business into a biotechnology powerhouse. Then disaster struck. Claims in a television programme that genetically modified potatoes could stunt the growth of rats focused public attention in the UK and elsewhere in Europe on the potential risks associated with GM crops. Never mind that scientific opinion was deeply divided on the issue. Technology that had been seen as providing an answer to the world’s food shortages suddenly became responsible for creating ‘Frankenstein foods’. And, as the standard bearer of this science, Monsanto saw its fortunes plummet, to the extent that US analysts recently calculated that the profitable $5bn-a-year agricultural-business arm of the company was effectively worthless.

This tale is a graphic representation of the effect that environmental and ethical issues can have on a company. And it is not an isolated example. Many will recall, for instance, how Railtrack saw its shares fall sharply in the wake of the safety concerns raised by last year’s Paddington rail crash. In addition, growing interest in the conditions under which clothes and other products are made in developing countries has resulted in substantial amounts of negative publicity for numerous multinational companies.

Such issues are not entirely new. For example, several years ago, the Anglo-Dutch oil giant Shell found itself in stormy seas when – despite famously investing heavily in scenario planning and having a strong reputation as a socially responsible company – it failed to anticipate public concern about the disposal of the redundant oil-drilling platform Brent Spar, and its activities in Nigeria.

What is new though, is the speed with which such problems can strike at the core of even the most apparently sound company. Just as the corporate collapses at the end of the 1980s and the beginning of the 1990s led to questions about how companies with clean audits could suddenly fail, now there is soul-searching about how to reflect potential ethical calamities in company accounts.

Part of the problem, of course, is that financial reports, by their very nature, look backwards when what is needed is some mechanism for looking forwards. Criticisms of traditional accounts as being about as helpful to investors and other users as driving looking in a rear-view mirror have been well rehearsed, and led to the arrival of the ‘balanced scorecard’ approach to company reporting and what later became known as the ‘stakeholder’ concept and the ‘triple bottom line’ of economic prosperity, environmental quality and social justice.

Well-meaning as such initiatives have been, they have tended to founder on the grounds that it is difficult to measure such notions as customer satisfaction, employee loyalty and social impact. The result is generally an either/or situation. Companies either tend to make all sorts of fine-sounding references to customers, suppliers, employees and the other stakeholders, but concentrate on what can be measured – shareholder returns. Or they concentrate on the so-called soft issues to the detriment of the financials.

However, several developments are conspiring to change this state of affairs. The Turnbull Report – the last piece in what has been termed the corporate governance jigsaw that also includes the Cadbury, Greenbury and Hampel reports – has introduced rules on how companies listed on the London Stock Exchange manage and report on business risks. As of the beginning of this year, such companies are required to have an ’embedded’ internal control system that monitors important threats, such as environmental, ethical and social risks.

There is even a Centre for the Analysis of Risk and Regulation, which has been established by the London School of Economics. Michael Power, professor at the centre, will be one of the speakers at the Institute of Risk Management’s annual conference in Cambridge in September, when the theme will be developing a language of risk. The idea is that, now there is what the institute calls ‘a diverse range of risk stakeholders’, there is a need to establish an effective means of communicating and establishing best practice.

Moreover, at a time when branding is becoming more important for all businesses, boards are realising that risk should encompass incidents or issues that need not have an immediate financial impact. For example, a survey published in March by the British Safety Council showed that the UK’s business leaders believe health and safety has a significant effect on corporate reputation.

Similarly, research published at the end of last year by Arthur Andersen and the London Business School found a rapid growth in ethics training as a means of managing reputation. Peter Newman, a partner in Arthur Andersen’s risk consulting practice, says there is no doubt that corporate guidance, such as Turnbull, is having an effect on companies’ attitudes to best practice in risk management. ‘In an increasingly competitive marketplace, the protection and enhancement of corporate reputation is vital to retaining competitive advantage,’ he says.

All this accords with research carried out in the US which indicates that winning an environmental award can lead to a rise of nearly 1% in a company’s share price, while being held responsible for an oil spill can have a dramatic effect in the opposite direction. Another US study in the mid-1990s found that public announcements about fraud, price-fixing or patent infringement tend to cost as much as 2.3% of share price.

Allied to the rules set out in the Turnbull Report is the clear message coming from the government that environmental reporting is an issue that British companies need to take seriously. Although about 40% of FTSE-100 companies publish environmental reports, environment minister Michael Meacher is keen to see much wider disclosure and is threatening to ‘name and shame’ those that do not provide this sort of information.

A third significant development is the long-awaited arrival of an international standard for social and ethical accounting, auditing and reporting. According to Simon Zadek, chairman of the Institute of Social and Ethical AccountAbility, the standard AA1000 is a contribution to the ‘clarification of what constitutes good practice in accountability and performance management’. Long a champion of such a development, he describes it as a ‘foundation standard’ that offers a common currency of principles and processes that underpins and provides reassurance about specialised standards.

For managers and accounting firms, the significance of this move is that it creates the starting point for a system of proper comparisons between companies. In the past, companies that were pioneering environmental, ethical and other non-financial reports were having to use specialist consultancies to verify their activities, and these would often be operated according to different models.

In recent months, though, the leading international accounting firms have set out their credentials in this area as part of the activity they now tend to term business assurance rather than audit. For example, KPMG sponsored the most recent annual environmental reporting awards organised by the Association of Chartered Certified Accountants and its UK senior partner, Gerry Acher, is part of a government body looking at business and the environment. Meanwhile, PricewaterhouseCoopers sees issues such as environmental reporting and reputation management as fitting into its recently launched ‘ValueReporting’ concept.

This notion is a response to what the firm calls the ‘shortcomings of the historic financial reporting model’ and is an attempt to ‘measure and report on newer and more progressive drivers of value’. Of course, such thinking fits in with the pressure to adapt valuation techniques to take account of the fact that Internet-related companies attract investors on the strength of prospects rather than records. But it also allows for the influence of other less traditional factors, such as environmental and ethical matters.

However, for all this willingness to accept non-traditional performance measures as means of valuing companies, there remains pressure for hard numbers. And one organisation that is going some way towards supplying them is the Safety and Environmental Risk Management Rating Agency, which was set up in 1996 in response to a paper published three years before by the Centre for the Study of Financial Innovation. This document, written by then Financial Times journalist David Lascelles, proposed a system of risk rating that would provide financial markets with a practical way of assessing the environmental liability of companies.

Since then, the Safety and Environmental Risk Management Rating Agency has developed a method that takes into account such matters as tarnished reputation as well as direct costs and has the support of companies that represent about 40% of the total value of the London stock market. The aim, says Jonathan Barber, who runs the organisation, is to create a universally applicable approach that stops people shying away from attempting to measure risk because it is too difficult.

One of its smaller clients is Bovince, an east London-based printing company that won the SME award in the recent ACCA environmental reporting awards. ‘We helped them to think about risk and turned all these fuzzy issues into hard cash,’ Barber says.

Similar thought processes have been going on at companies as diverse as BP Amoco, Shell, and the Cooperative Bank. The first two have realised that their long-term survival depends on turning themselves from oil companies into energy concerns where sustainable energy forms part of the portfolio; while the Cooperative Bank attributes a marked increase in customers over recent years to its clear ethical lending policy.

And yet scepticism and cynicism remain. In particular, although it is often noted that energy companies and utilities have been in the vanguard of the environmental reporting movement, the suggestion is often that such businesses are in some way seeking to make up for their past activities.

However, even if a company’s initial objective is to improve its image, it will quickly find the environmental reporting process so demanding that it will either have to commit itself or give up. As Maria Sillanpaa, who has joined KPMG’s burgeoning social accountability practice after managing the ethical auditing team at Body Shop, points out, one of the key principles is ’embeddedness’, or the extent to which the ethical approach is part of how the company does business.

‘You have to do this stuff in a way that actually adds value,’ she adds. ‘If it’s not embedded – if it’s a bolt-on thing – it remains whitewash.’ And, as such, does not amount to a management tool in the way that the Turnbull Report requires.

Another issue that companies have to bear in mind is that this is a field in which the goalposts keep moving. For a start, as Body Shop has found, just setting out to have high standards makes observers inclined to criticise. In addition, this area is constantly developing, so that what is cutting-edge one year is old hat the next. For example, it is no longer enough for a company itself to be environmentally or ethically sound; it must check on the activities of its suppliers and other business partners if it is to obtain a completely clean bill of health.

This is where reporting and communication come in. To see the influence of lobby groups just check out the websites of sporting goods company Nike and toy manufacturer Mattel, and the lengthy explanations of their activities in the developing world. In responding in this way, such companies appear to be acknowledging that – in an era when, due to the growing influence of the Internet, they can no longer control the flow of information – they need to establish a dialogue with the community.

These efforts bring Monsanto’s difficulties into fresh focus. It is widely reckoned that it was in its communications that Monsanto made trouble for itself, even though it had produced a sustainability report. The isolation of its scientists, says one observer, meant that it did not realise that perceptions had become more important than the science. In other words, Monsanto’s campaign for understanding was a failure.

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