The Power of the Multi-Capital Model for ESG Value Optimization

The increased attention on Environmental, Social and Governance (ESG) in business is testing common management assumptions and driving significant change across our economy.  The ultimate goal of ESG efforts is to improve how business works in order to address rising risks and capitalize on emerging opportunities. The drivers are a diverse set of challenges and opportunities around climate, energy use and social change to name just a few. This is a complex challenge because it requires businesses to think in three dimensions:

• What’s good for the company and its shareholders
• What’s good for the stakeholders upon whom the company relies (customers, suppliers, employees, communities)
• What’s good for the environment (to ensure a stable ecosystem and also because shareholders and stakeholders are watching)

All three elements are necessary to the successful, sustainable operation of a business. This balance is sometimes called the Triple Bottom Line of “People-Planet-Profit”. A more common description today is ESG, for Environmental, Social and Governance factors.  Underlying this three-part thinking is an understanding that a company is dependent on resources that it doesn’t own and often can’t see. But without these resources, the business itself cannot be sustainable. This kind of thinking challenges the traditional way we think about and account for corporate resources.

Accounting for Resources

The accounting we use today was designed and optimized for a tangible economy.  It was adopted centuries ago and then standardized in the early 20th century to provide consistent and comparable reporting to shareholders and stakeholders.  It was a well-designed system for the industrial era and showed a company’s operations from two perspectives:

• Income Statement: summarizes performance in the current period using revenue and cost data.
• Balance Sheet: summarizes the company’s fixed assets and liabilities. The assets demonstrated the level of continuing investment in the company’s capacity to generate future performance.

This system worked very well as an indicator of the health of a company and the sustainability of its value creation system until roughly 1975. Up until then, the value of a company’s tangible assets averaged roughly 83% of its corporate value. Financials were a good starting point for talking about sustainable value.  However, this model was not designed for the current post-industrial economy due to two big trends:

1. The rise of intangibles fueled by information technology – The development of electronic computing hit a pivot point with the introduction of the first PC in the business market in the early 1980’s. The existing accounting model was well suited to track the purchase of the computers themselves as hard assets but not to track the creation of value inside the computers in the form of data, systems, processes, knowledge and intellectual property.
2. The shift in responsibility around “externalities.”  The full social and environmental costs of the industrial model have become increasingly clear in recent years and companies are now being held more accountable for their impact on “externalities” such as employees, communities and the environment. None of these are company “owned” assets and, therefore, cannot be tracked within the existing accounting model.

Due to these trends, the value ratio has flipped. Today, tangible assets only explain 10% of the value of the average company. The rest is intangible and/or undefined.  It falls to financial and sustainability leaders to fill in that information gap.

Emerging Standards

Over the past few decades, there has been a surge of standards, approaches and rating systems to try to identify the material sustainability issues that are affecting individual businesses as well as the ecosystems in which they operate. There are literally dozens of specialized standards with a few, such as the GRI, EU standards and SASB, gaining prominence.  While far from the only and definitive solution, it is striking that this summer the IFRS Foundation, which has long been the overseer of the International Accounting Standards Board (IASB), created the International Sustainability Standards Board (ISSB).  The ISSB will have a very fast launch because it will use the SASB standards developed in the U.S. over the past decade.

But how do financial and sustainability standards talk to each other? How does it all fit together in an integrated value creation model?  This is where the critical work of the Integrated Reporting Framework and Integrated Thinking Principles comes in. Integration is the connective tissue, providing the context in which to begin to talk about the complex challenge of optimizing financial and ESG performance.  One of the core concepts underlying both integrated thinking and reporting is the multi-capital model.

A New Conception of Capital

The traditional concept of corporate capital can be seen in this definition:

Capital is a broad term that can describe anything that confers value or benefit to its owners, such as a factory and its machinery, intellectual property like patents, or the financial assets of a business or an individual.  – Investopia

This traditional definition falls short in the context of discussion above of the rising importance of tech-fueled intangibles and stakeholder/shareholder focus on externalities.

Enter the multi-capital model which endeavors to identify all the major resources a company relies on to fulfill its purpose and support its business model. The multi-capital model is essentially a classification tool that is very helpful for companies to identify the full set of resources it needs today and tomorrow. This model has been around for 20+ years in various forms. As mentioned above, this model is a core concept in both the integrated reporting and thinking efforts of the IFRS Foundation.

The exact definition of the capitals remains flexible in practice but there are common classifications you see in most systems. In the Insights7 platform, we give users the following list (including how the capitals are often grouped as portfolios that correspond to the Triple Bottom Line and ESG models):

Organization (P-Profit/G-Governance)

• • Financial Capital – cash, equity, loans
  • Structural/Intellectual Capital – the organization’s unique digital and analog knowledge such as systems, data, processes, designs, architectures, models, and intellectual property
  • Strategic Capital – the company’s vision, mission, purpose, value proposition, business operating model, corporate governance, culture and competitive differentiation

Environment (P-Planet/E-Environment)

• • Manufactured Capital – physical assets including plant and equipment
  • Natural Capital* – environmental footprint such as natural resource use, land and waste generation

Relationship (P-People/S-Social)

• • Relationship Capitals* – connection and willingness to engage with the company by key stakeholders:
    • Customers
    • Employees
    • Suppliers
    • Community

* Note that Natural and Relationship Capitals are not owned by the company using them. These capitals must be attracted by meeting the expectations of its partners and society. If you don’t meet your stakeholders’ expectations, you risk losing them as a partner and a source of resources.  In today’s highly connected world of greater transparency,  meeting stakeholder expectations is more important than ever.  It’s about doing things right and communicating what you do clearly.

Why use these classifications?  It’s about data, analysis and action.  Each kind of capital requires different management approaches and resource usage. Also, each capital is measured with countless metrics of the current and target performance.  Grouping these metrics by capital begins to paint a pattern that informs external reporting and internal integrated thinking and management. It can help you begin to see the forest for the trees.

How to Use the Multi-Capital Model to Fuel Sustainable Corporate Value

This classification approach helps clarify sources and uses of value in your company, and can help fuel the optimization of sustainable corporate value that balances both ESG and financial performance.

How can you implement a multi-capital model? We recommend these best practices:

• Create the right classification system for your company’s capitals
• Associate all key performance Indicators (KPIs) and controls to one or more capitals (if it can’t be mapped to a capital, it’s not a KPI)
• Identify where KPI’s are managed in your internal value chain and by whom
• Track performance by capital to get a sense of the performance and health of that class of resources today and the outlook for tomorrow
• Communicate with stakeholders about how you’re doing with respect to the capitals in order to continue to earn the right to attracted capitals
• Integrate the capitals into your corporate decisioning systems.  Key areas are resource allocation, innovation/improvement management and capital investments.  Require that investment analysis consider not only the direct effect on financial and operational performance—but also indirect effects on all the capitals.

Conclusion

This new approach is completely in the spirit of the definition of capital used above as long as you change the word owner to user:

Capital is a broad term that can describe anything that confers value or benefit to its user

Ensure that your company continues to have access to the capitals it needs. The multi-capital model is a way to understand, communicate, manage and optimize this broad group of resources upon which your company relies.  It helps frame thinking to ensure the key needs of shareholders, stakeholders and the environment are all considered in your external reporting and internal management practices.  Think holistically now to ensure better results tomorrow.

All of these multi-capital management best practices discussed here are available in our Insights7 platform.  Click here to create a free account today or click here to schedule a call.