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THE ABCs OF HYBRID METRICS

In simplistic terms, the true measurement of success for any business today is whether a company is adding value to society. Hybrid metrics make that connection visible and introduces simplicity into the investor equation.

By Mariette du Plessis, Shift Impact Africa

25 JANUARY 2021 – Connecting Shared Value to shareholder value is a challenge faced by many organisations. It is also the central theme of a new reporting concept called hybrid metrics, which attempts to make the connection between doing good and doing enough good far more explicit, particularly for consideration by investors.

On the African continent, hybrid metrics came under the spotlight at an SVAI webinar on 3 December 2020, when we had the privilege of hosting Professor Mark Kramer1, lead author of the Hybrid Metrics report2 and integrated reporting champion, Professor Mervyn King3, as guest speakers in a live discussion chaired by Jon Duncan, head of responsible investment at Old Mutual.

According to Kramer, the ultimate goal of the hybrid metrics concept is that long-term strategies, which companies are pursuing around positive social and environmental outcomes, will be rewarded by a more direct and immediate increase in their stock price. Furthermore, implementing hybrid metrics internally represent another important dimension that can also have a very powerful effect – if it provides management with the right tools to use when making capital allocation decisions. Ideally, it should enable managers to not only look at the internal rate of return, but also factor in the social and environmental impacts.

Says Kramer: “Unless you bring sustainability and investor relations and finance and strategy together internally in the company, you are not actually going to be able to report hybrid metrics and, more importantly, you’re not going to be able to make the decisions as a company that enable you to perform better on the hybrid metrics.”

“We believe that every company has an opportunity to build social and environmental impact into their strategy, in a way that confers a greater competitive advantage and leaves a path to greater profitability.” – Mark Kramer

 

The sustainability imperative

In part, the challenge for many organisations is about deciding where sustainability fits in the corporation. Too many still sees sustainability as only something to do with a company’s reputation, brand or image and completely miss the significance of these issues for their bottom line performance and competitive position. There needs to be a shift in how companies begin to factor sustainability into their strategy, their operations and their financial reporting.

At the same time, what sets the hybrid metrics concept apart from the 125+ different sustainability-rating agencies available today is the fact that it solely focuses on impacts that are truly material to the financial performance of a company. Sustainability metrics, on the other hand, hold companies accountable for their negative impact on the world and has to report on just about every conceivable social and environmental impact in existence today.

Similarly, creating Shared Value is also not about holding companies accountable for all their social and environmental impacts, since accountability encompasses operational effectiveness, regulatory compliance, adopting industry best practices, ESG reporting, integrated reporting and so much more.

Impact-linked investment decisions

However, within the larger set of measurements and integrated reporting, relatively few indicators clearly demonstrate how a company’s social environmental actions are having a significant impact on their competitive position and future profitability. The ability to provide this direct correlation is of real significance and importance to investors from a financial point of view and frankly, from a fiduciary duty responsibility.

Enters the hybrid metrics concept, which identifies selective social and environmental indicators to measure and track a company’s actions, which are having a direct and significant impact on the company’s competitive position and future profitability.

For investors, this means a way to tell the difference between a company that is simply doing something that it is deemed good practice, versus one that is doing something to deliver shareholders a better return in the future, because of the positive social and environmental contribution this company has made.

In addition, by reporting hybrid metrics, companies can clarify for investors how key actions, which they are taking today to improve their social-environmental footprint, are in fact improving the future economics and financial health of the company. In this way, shareholders should be able to price that in today and create an immediate reward for the management team, which will incentivise them to invest more fully in social and environmental innovation.

Simplifying the investor equation

It is important to point out that, as a concept, hybrid metrics do not replace Environmental, Social, and Corporate Governance (ESG) Reporting or Integrated Reporting, which has been around for 10 years or more. Companies still need to be held accountable for all of their impacts on the planet and on people, which is a matter of public policy and accountability.

In fact, hybrid metrics build on the idea of integrated reporting. The main difference is that it introduces simplicity into the investor equation – one number to compare companies within an industry and that an external accounting firm can independently verify.

A case in point is Enel, one of the sponsors of the study, which understands the direct relationship between renewable energy and profitability. Renewable energy is more profitable for fossil fuel. It lowers the cost of capital associated with fossil fuel power plants and it reduces volatility. As such, there is a direct causal relationship between Enel’s shift to renewables and its financial performance.

In this scenario, a new hybrid metric can be identified that is earnings relative to decarbonisation (ratio of EBITDA to CO2 intensity) and, by using this metric, various utility companies can be compared to see who is decarbonising most profitably over time.

Essentially, hybrid metrics use the traditional financial measures of performance, pairs them with the relevant social or environmental impact, and enables one to create a simple number that you can then verify externally and compare across different companies within an industry on comparable terms. Potentially then, it also presents a quantitative way of assessing the social or environmental impact, which algorithm driven trading can handle.

In Conclusion

Unfortunately, examples like Enel are not in abundance, despite research in recent years showing that companies, which are doing a better job of managing the material impacts, perform 3-6% better over extended periods.

That is exactly where the idea of hybrid metrics comes into play. It looks at where a direct causal relationship exists between the social or environmental impact and the financial performance of a company.

In reality, the hybrid metrics concept is in the very early stages of development, but the benefits and potential it holds are promising.  It will require experimentation on the part of investors and organisations to identify the correct and most meaningful metrics, in any given industry. Ultimately, bringing us closer to demonstrating the causal link between social/ environmental and financial performance – underscoring the importance of creating shared value.

Kramer concludes: “I’m not naive to believe that everybody is going to jump on this new metric immediately. But I do think that there is a way of thinking here, a different kind of approach to this analysis that can be very powerful.”

1-Professor Mark Kramer is the co-founder and managing director of FSG and senior lecturer at Harvard Business School, where he teaches creating Shared Value.

2-The report “Hybrid Metrics: Connecting Shared Value to Shareholder Value,” introduced a new approach that combines companies’ social and environmental impact with standard measures of financial performance, making the connection between the two explicit. The project was borne out of an ongoing conversation among the Enel Group, a Shared Value global energy company, social impact consultants at FSG, faculty at Harvard Business School, and members of the Shared Value Initiative.

3-Professor Mervyn King is Chair Emeritus, International Integrated Reporting Council (IIRC) and Global Reporting Initiative