Stewardship and Value Creation

In a recent contribution to the Harvard Business Review blog, Paul Druckman, CEO of the International Integrated Reporting Council (IIRC), made the following observation:

“The system has lost sight of reporting: to give companies access to financial capital by communicating their value to investors.”

He went on to say that as a result of a systemic failure “companies focus on short-term financial performance – because that is what they believe investors are interested in – to the detriment of long-term value creation.” He claims that integrated reporting is a better way to communicate about the sources of value creation.  Moreover, he suggests that it supports investor decision-making by providing a more complete basis for dialogue with the company’s board and an assessment of present and future value.

At the heart of the on-going pursuit of a new, more integrated form of corporate reporting is the acknowledgement that “financial capital is not the only asset in a business that drives value creation”. Paul Druckman lists six different types of capital: financial, manufactured, intellectual, human, social, and natural all of which are somehow involved in creating “value”.

These are strong and clear arguments for a new approach to company reporting. It is certainly true that a sustainable form of capitalism must achieve a more efficient allocation of capital consistent with some criteria of ‘sustainability’. But it is not necessarily the case that the purpose of reporting is to communicate value to investors only. This may be necessary but not entirely sufficient, especially if the claims made for an extended view of 'capital' (I call this the "extended capital model" or ECM) and value creation are to be upheld.

I propose in conclusion that an alternative framework that focuses on the accountability and ownership relationships implicit in ECM might shed more light on the role of reporting. It might clarify what we mean by ‘value’, how it is ‘created’, and establish more precisely the basis for the wider responsibilities corporations (and investors) have, if any, to society. I shall call this a “Stewardship Approach”. It is for now a rough sketch of what a new sustainable capitalism might look like. 

The traditional model of Shareholder Value

The shareholder value model is regarded by many proponents of sustainable capitalism as too narrow and incapable of guiding free enterprise towards sustainability. It is grounded in the notion of fiduciary duty established by legal contract. Owners of ‘capital’ (which in ECM is viewed in its initial form as financial capital) establish an obligation on its recipient through the terms of a legal instrument. In the case of joint stock company this includes a property right (ownership) which imposes a conditional duty on the company to return the financial rewards from capital provided by shareholders in the form of dividends. Thus, shareholders have a contractual and legally enforceable interest in the fortunes of the business, defined in purely financial terms.

These institutional arrangements also establish a separate obligation of accountability to the owners of capital which is fulfilled through legally enforced corporate reporting. Thus, in the shareholder model, the reporting isn't done for its own sake, or even to communicate ‘value’ as such. Rather, it is to satisfy the requirements of answerability. It is presumably intended to reassure the owners of capital that its recipients are using it wisely and in their interests. It is to answer the question: have those to which I have entrusted been good stewards of what they have received on my account? In so doing it may cement the contractual relation established through legal contract with something less tangible - trust. 

   

What a corporation does with the financial capital entrusted to it determines whether ‘value’ is created for the shareholder. In a simple uni-directional linear model of value creation, financial capital is transformed into productive capacity (capital goods or ‘manufactured capital’) which generates an economic surplus. This is reflected in the (market’s) present valuation of the future flow of financial benefits in the share price. Shareholder value is created by increasing the return on the capital employed.  

The Extended Capital Model

In our expanded view there are many more productive assets involved in value creation. Labour is recast as ‘human capital' in which a corporation may invest through the training and development of its workforce, thereby increasing their productive potential. The accumulated stock of knowledge resident in a business can be appropriately managed as an intangible asset; while the value of a portfolio of patents and trade-marks lies in an often substantial prior investment in intellectual capital. Corporations can contribute to and draw on a stock of social resources: the rule of law, community cohesion, social norms, trust etc. They can create or alter the pattern of social ties: the bonding, bridging and linking forms of social capital. They can 'invest' in building and strengthen intra- and extra-organisational relationships, fostering a culture of solidarity in a common purpose rooted in shared values. Finally, the stock of natural resources on which business success may crucially depend is now viewed as 'natural capital' with both use and non-use value derived from the range of ‘ecosystem services’ it provides.

Value creation according to ECM is an extension of that proposed by the simple shareholder value model. Companies create value by increasing the return on total capital employed and hence the economic value of its total asset base. However, there are however a number of related difficulties and limitations associated with the extended capital view of value creation:

1. It stretches the economic metaphor too far.
2. It doesn't fit easily into a linear view of value creation; and.
3. It perceives 'value' in narrow terms.

By applying an economic metaphor to a wider range of goods as 'capital', the ECM approach builds-in certain assumptions about their character. ECM is an appeal to 'donor-type' values preferred by ecological economists. But the various forms of capital envisaged all find their counterpart in 'assets' which deliver a flow of benefits over time: i.e. in receiver-type values. Therefore 'social capital' conceives of the social goods to which it refers as long-lived assets, the value of which can be affected by business decisions. Similarly, the ecosystem services concept bestow an asset value upon 'nature' which can be increase or - more likely - decrease as a result of business activities. The changes in asset values contribute to the full or social cost of business expressed in strict economic terms.

Applying the ECM approach to all social and environmental goods risks stretching the metaphor to breaking point. It requires that their social benefits can be quantified, preferably in monetary amounts as financial benefits. Values that are not amenable to monetisation in economic valuation are hence described as 'non-economic' or intangible. Yet these are likely to be pervasive in certain forms of capital even if a corresponding receiver-type value is difficult to discover from market prices or estimation of willingness to pay (WTP). What price a happy, fulfilled and committed workforce in social capital valuation? Or the difficult-to-price 'cultural value' of a tract of rain forest to indigenous people that have inhabited it for centuries? Since the capital approach cannot easily accommodate these values, they are more likely to be ignored by decision-makers concerned only with maximising tangible total capital.

A little further reflection on the 'new' forms of capital envisaged reveals that they don't fit very easily into a simple linear model of value creation. Private, internal, benefits to the business are produced jointly with costs to society, so-called 'externalities'. The latter may be revealed by ECM approaches in economic valuation of social and natural capital. But the opposite is also true of human and intellectual capital. Internal costs to the business of investing in these assets generates a corresponding external benefit to society. These wider benefits establish a positive feedback loop to all businesses. Most adherents of sustainable business argue that internal and external costs and benefits converge in the long-run. As such, the ECM approach favours the valuation of total capital from the perspective of society irrespective of the divergence of internal and external costs and benefits in the short term. In so doing it sets up a potential conflict with the narrower interests of shareholders and companies' fiduciary duty, at least in the short term.

Finally, ECM commits decision-makers to a narrow or restricted 'theory of value'. As alluded to above, in the economic 'resource' perspective adopted, all values are strictly 'instrumental'. It locates ultimate value in consumer preferences revealed in prices or WTP, treated equally and impartially in markets and market-based methods. The only good of intrinsic value is some measure of utility or welfare to be maximised. The great strength of the ECM approach is its direct link to a welfare optimising goal. The obvious downside is that it requires that all values are revealed in prices by markets, rather than discovered. That is to say that what is a 'good' for society is whatever its 'consumers' prefer. Many would argue that this is completely the wrong way around! They argue for a far richer account of the things to which humans attach meaning and significance. That is to recognise a wider range of intrinsically valuable goods than economic theory admits. A more pluralistic theory of value suggests that economic values need to be supplemented with other values discovered through other 'value-articulating' or deliberative institutions. In these individual stakeholders are cast in the role of citizens, rather than self-interested consumers, concerned with some notion of a common good.

Goodwill Hunting

In short, the extended capital approach widens the goods but restricts the values considered in its model of value creation. The problem of intangible values is not new to the accounting profession. 'Goodwill' is the difference between the market valuation of a company and the book value of its assets. It is assumed to represent the 'hidden' value in the business: brand value, intellectual assets, quality of management and so on. The economic valuation of capital assumed by ECM does not deny that non-economic or intangible assets exist. We can therefore conceptualise the Total True Capital (TTC) employed by a company as inclusive of these values even if they are not estimated or fungible with monetary values. Furthermore, a True Capital Employed cannot be imputed from a companies' market value since non-economic values cannot - by definition - be reflected in market prices.

Interestingly, 'good will' is also the term that Kant gave to one's motivation to do one's duty and in his moral philosophy it is the only thing of intrinsic value. The ECM concerns itself with economic goods, not moral goods. Social and natural capital, as we have seen, are conceived in this framework as economic goods. Moral goods are the domain of ethics, not economics. In this sense, economic approaches may be said to be 'value-free'. Moral goods, on the other hand, are another source of intangible - perhaps intrinsic - value to society. Society applauds good behaviour or conduct by moral agents in a wider moral community according to some ethical standard or set of principles. If corporations are also moral agents in this sense then their ethically praiseworthy behaviour is of some 'value' to society. If so, values in this moral sense may qualify as another hidden 'asset' which isn't captured in measured total capital. Can a corporation 'invest' in moral assets? Certainly, to the extent that its reputation can have economic consequences. But even if morality can't be described in narrow economic terms, society surely values 'good' or 'right' behaviour by its corporate citizens nonetheless.

Thus, the moral values upheld and promoted in the corporate culture and in its business practices are important. Some may say the erosion of moral values from business and economic life lie at the heart heart of a crisis of confidence in capitalism. Economics is a powerful decision-making tool and free markets are still the best way of allocating scarce resources when they exist and work well. But, by definition, markets do indeed have moral limits. If markets and market approaches can't help with ethics, how can moral values be restored and rewarded in the marketplace?

       

The Sustainability Criterion

The real attraction of the ECM approach is found in its direct connection with the macroeconomic account of inter-generational justice - a non-declining welfare function with respect to time. Macro-economic indicators of sustainability may thus be 'flow-based' (e.g. 'green' national accounts) or 'stock-based'. The ECM belongs to the second class of approaches in which sustainability may be defined as a non-declining capital stock. This criteria may take a weak or strong form, depending on the assumed marginal rate of substitution between different types of capital. In the strong form, the natural capital stock must be non-declining in aggregate and in an even stronger form a certain level of 'critical natural capital' must be protected (for which thresholds, safe minimum standards and the precautionary principle may also hold sway). These conceptualisations of sustainability in economic terms chime with the more recent narrative of 'ecosystem services' (a flow measure). Thus, the ECM is seen as a vital link between corporate accounting and sustainability outcomes. If companies are able to measure changes in in total capital employed and show that either the total stock is non-declining (or its components) they will have a way of reporting sustainable value creation. This is the great hope of integrated accounting and sustainability reporting.

What can stakeholder theory add?

In many respects the ECM is simply a version of stakeholder theory grounded in economics (or at least appealing to economic concepts) rather than ethics, political theory or sociology. Stakeholder Theory’s close cousins, for example the ‘social licence’ or ‘corporate citizenship’ (both contractarian), find their justification and appeal from the other social sciences. It many respects ECM adds some practical analytical rigour but it does so at the cost of simplification.

One such simplification of ECM already mentioned is in its implicitly narrow theory of value. This raises a number of related problems but for now we may highlight the following:-

1. It blurs the obligations of corporations hitherto defined by fiduciary duty.
2. It multiplies the lines of accountability to the providers of capital.
3. It fails to establish any moral requirements in its account of ‘responsibility’.

Stakeholder theory, on the other hand, offers little by way of a practical or theoretical framework for measuring value creation. It does, however, attempt to clarify the lines of accountability and establish ethical grounds for doing so. This is achieved through its emphasis on weighing the ‘interests’ of multiple stakeholders, whose moral standing as such imposes duties on the corporation to have regard to those interests. Stakeholders have a commensurate ‘right’ to demand that their interests are upheld. This is a vastly extended conception of a corporation’s fiduciary duty, consistent what has been called the principle of corporate effects (PCE).

Who, then, are these interested ‘stakeholders’? They are none other than the providers of ‘capital’ in the ECM. This includes the different socio-economic roles played by actors in ‘society’ affected by corporate activity, including customers and local communities. If nature is cast as capital provider and has an ‘interest’, it relies on social institutions to protect them on its behalf. The stakeholder model imposes a moral obligation to do so only on the grounds that nature has a ‘good’ of its own – it has interest in its own flourishing. Some argue instead that it has only an instrumental value to human society and therefore society has a direct (rather than fiduciary) duty to safeguard the natural world. The stakeholder approach attempts to arbitrate between and balance these, potentially competing, interests. But it doesn’t provide a ready-made solution to how to do so.

Towards a Stewardship Model

Can an alternative model help overcome some of the drawbacks of the extended capital and stakeholder models of corporate responsibility? Stewardship in its secular and religious conceptions emphasises accountability and ownership relations from which moral and non-moral obligations extend. The extended fiduciary duty is indeed to grow ‘true total capital employed’ in a conceptual sense. It does so by looking after the interests, and hence values, of all capital providers that have a stake in value creation. These are in fact the duties performed by any good steward. Assurance that the corporate steward is in fact doing so relies on its full accountability to the ‘owners’ of capital in all its forms. An effective board can only safeguard these interests and values if they are all properly represented on it or by it. Further, these interests and values must define the purpose of a good and accountable corporate steward as a creator of true value.

 

By defining responsibilities in terms of accountability and ownership, a stewardship approach can establish a corporation’s instrumental and moral responsibility to all sources of 'capital' and to protect the full range of values they represent. In this sense it imposes an obligation on corporations to create economic value and moral value. That is, to preserve and grow the ‘moral goods’ that society values, as well as the non-moral goods it wants or needs. It is perhaps to envisage the corporation’s value-creating purpose in terms of a broader concept of human and non-human ‘flourishing’ than utility (welfare) maximization. 

Corporate reporting of the kind being pursued by IIRC is the content of the accountability relation; it is a means to an end but not an end in itself. An expanding toolkit for measuring and valuing ‘total capital’ serves the steward’s duty to be properly and fully accountable to all capital providers. It does not fulfill it. It is only through engagement and deliberation with stakeholders as capital owners that the true values missed by economic instrumentalism can be discovered and incorporated into a fuller account of truly sustainable value creation.