Welcome to the new investor wasteland

This article appears in the February 2021 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

The end of days for clarity has arrived. The hazy world of accounting rules is slamming headlong into the murky disclosures for environmental, social and governance (ESG) reporting to create a new wasteland for investors to navigate.

French multinational dairy operator Danone S.A. last year unveiled carbon-adjusted earnings, the company’s recurring earnings measure that adjusts for the estimated financial cost of carbon. The kicker: carbon-adjusted earnings grew 12% in 2019 versus just 8.3% growth in recurring earnings per share (EPS). This favourable variance was attributed to the company’s 9.4% gain in “carbon productivity” delivered during the year.

This is not the first time that a company has spun an obvious cost like carbon into a seeming win, but the practice requires an explanation at the very least. Danone’s financial cost for carbon is based on the estimated metric tons of emissions from its direct operations as well as the indirect emissions from its value chain, both upstream and downstream (known as full-scope emissions). The emissions are then valued at a constant cost of €35 per ton. (We won’t get into who measures the amounts, or how.)

Key to the perceived gain in Danone’s carbon-adjusted earnings is the company’s claim of having reached peak full-scope carbon emissions in 2019, and that its greenhouse gas (GHG) emissions are therefore set to decline on an absolute basis. But that’s at odds with the claim that the company’s carbon intensity actually declined in 2019, which would imply emissions had peaked earlier.

Danone’s headline 9.4% gain in emissions intensity is tricky to reconcile. Halfway through the company’s 300-page annual report, Danone disclosed in excellent detail that full-scope emissions actually increased by 4.1% during 2019 on an absolute basis. What’s not explained is the throwaway line that on a “like-for-like” basis, those emissions declined by 9.4%, which is what led to the original claim that carbon-adjusted earnings improved.

The company also stated that it “completely updated its carbon accounting referential” during the year — using the type of eye-glazing gobbledygook that we’ve become attuned to over the years as a financial reporting red flag.

The point: the supposed advancement in carbon intensity is never explained in numbers, nor is the calculation of the restated costs or how they translate to better carbon-adjusted earnings.

A change in the value of avoided costs is not the same as actual cost savings and therefore shouldn’t be confused with the already tenuous construct that companies use to report financial earnings. It’s like adding apples to oranges. Indeed, because of this, Danone doesn’t actually report a euro-denominated figure for its carbon-adjusted EPS — and this omission is probably the biggest testament to the metric’s usefulness.

Years ago most companies got on board with the notion that reporting an adjusted earnings measure needed to be done in a reasonable manner, which includes providing a tabular reconciliation of the amounts involved. Danone reconciles its International Financial Reporting Standards–based earnings and its recurring earnings measures — but not its carbon-adjusted earnings.

Further, in the same year the company changed its “carbon accounting referential” and realized its “like-for-like” GHG emissions had decreased using the new measuring stick, it quickly ushered in a carbon-adjusted earnings “evolution.”

These changes represent an unfortunate overreach for a company that’s a strong leader in its actual efforts to reduce its environmental impact, and does an otherwise decent job in quantifying its goals and achievements of the same.

Our advice for advisors is to take a hard pass on carbon-adjusted earnings and anything similar for the time being. Separate ESG ratings for companies, while not without their own problems, are useful enough when screening portfolios for an environmental mandate. If history teaches us anything when it comes to financial statement reporting, it’s to not let individual companies decide the way forward. They have an almost perfect record of only choosing to “evolve” when circumstances paint them in a better light.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.