We’ve started pricing for carbon. It’s time to price for inequality too
Amid reports of rising inequality – the world’s 26 richest billionaires now own as much as half the entire population – the former CEO of Social Value International takes a stand against one overlooked factor: our financial accounting system
Financial accounting is a significant, but ignored, driver of wealth inequality. This may seem surprising, especially for those who – if they think about accounting at all – view it as a dull technical exercise. An exercise that allows investors to invest in, and government to tax, the businesses that provide us with the goods and services we desire. A set of numbers that shows how much money we earned, minus however much we spent to earn it.
But until we challenge this, everything else we do to reduce inequality will be limited. We’re pushing a boulder up a downwards-moving escalator.
We have a problem
Inequality is getting worse. Oxfam warned recently of a “broken” economy, in which hundreds of millions live in extreme poverty while huge rewards go to those at the very top. The number of billionaires has doubled since the financial crisis.
Rising inequality is a threat to us all. This is increasingly recognised: at the United Nations; among academics, from Thomas Piketty to Joseph Stiglitz; among organisations like the OECD and the International Monetary Fund. Yet in all the international policy proposals, measures and reports, and among all the businesses and communities working towards the UN’s Sustainable Development Goals, you won’t find many references to accounting. Finance perhaps, but not accounting.
Why should this matter? Because we need a real shift in how resources are allocated to activities. If the way in which resources are allocated increases inequality, even raising the US$30trn supposedly needed to achieve the SDGs won’t have changed the fundamentals. We will continue to allocate resources in ways that drive inequality and we’ll be back to square one in the blink of an eye.
We will continue to allocate resources in ways that drive inequality and we’ll be back to square one
In our neoliberal world, Adam Smith still holds sway. “By pursuing his own interest,” the economist wrote, “he frequently promotes that of the society more effectually.”
This principle still informs so much of our economics and how we think about economies, despite the growing numbers of those who want – and are working on – alternatives. Worse still, this early belief that efficient markets and self-interest will produce the best results is being undermined by the reality: increasing inequality. As Stiglitz set out so well in The Price of Inequality, the very rich can undermine ‘efficient’ markets by influencing the legal systems that underpin those markets, further skewing the ways in which resources are allocated.
All so depressing.
Enormous flows of resources
The scale and rate at which resources flow is almost impossible to conceive. Foreign direct investment was around $1.3 trillion in 2017 which excludes national internal investment. Trading volumes for UK equities on the London Stock Exchange averaged $3.7 billion per day in July 2017.
All this wealth is busy moving around, searching for the highest possible positive returns. And the key driver that measures those returns is financial accounting. It is financial accounting that determines how much a business can pay in dividends, whether this is to private investors or to taxpayers, via government ownership of nationalised corporations.
If these decisions contribute to increasing inequality there is very little we can do that will offset this. It’s remorseless.
Surely it’s at least worth considering whether financial accounting has a neutral, positive or negative effect on inequality?
A system based on a flawed assumption
Financial accounting originated in the 14th century, when universities in Italy needed to assess the performance of the stewards of their lands. The concept was later picked up by the finance industry.
However, its current form owes much more to a combination of limited liability and government interest. Limited liability – meaning individuals involved are not personally liable – provided new opportunities for people to invest, while financial accounting provided the basis for new investors to hold businesses to account. Governments, especially following the first World War, needed more transparency over levels of profit in arms contracts. Cost accounting and developments in standards, for example matching income to related expenditure, provided that transparency.
All countries legally require companies to produce accounts. In the UK, the Companies Act requires firms to produce accounts that are ‘true and fair’. But the legislation didn’t specify how to do this, so the accounting profession has been working this out. The starting point was that the accounts were primarily for investors, not for the business, though of course the information would also be critical for managers. The next consideration was what decisions investors wanted to make. Investors’ decisions, it was concluded, came down to whether to invest, sell or hold investments to maximise financial returns.
There are a couple of important issues here. Firstly, this is an assumption about investor motivations. It has become widely accepted but is still just an assumption.
Secondly, accounting must be based on a single generalised motivation. If we allowed for every investor to have different interests, the information included in the accounts would need to be adapted to those interests. Yet the current assumption of maximising financial returns with zero interest in other outcomes is probably not what motivates us as individual investors (though it may be what motivates the asset managers looking after our money).
Our economic system is rooted in neoclassical neoliberal individualism. This doesn’t reflect many countries’ cultures when it comes to balancing individual and community needs. Yet it’s the one the that informs our global accounting practice, supported by the International Financial Reporting Standards (IFRS) Foundation and the new Conceptual Framework for increasing consistency in accounting practice. Globalisation, in this case, has meant standardisation of the interests of wealth-maximising individuals.
The average time a stock is held is less than a minute – and just 22 seconds for US stocks in 2011
Assumptions about investor interests mean that accounts include the information they need to assess potential financial returns. Initially, this was assumed to refer to long-term returns. Nowadays, quarterly reporting heavily influences investment decisions. The average time a stock is held is less than a minute – and just 22 seconds for US stocks in 2011.
Financial accounting makes things worse
If something is in the accounts, it is financial. By definition the social and environmental consequences of rising inequality are not relevant to the generalised investor.
Of course, some investors are becoming more interested in how social and environmental consequences may affect a firm’s ability to create long-term value. And consumers now expect to know more about how businesses are affecting society more broadly. One of the potential effects of a firm’s actions is a change in wealth equality, something that hasn’t been an issue for investors so far.
Of course, a business’s operations could either lead to a rise or fall in wealth equality. In practice, we see that business operations will drive inequality up. And this will continue. Why? Imagine a fixed number of people are trading with each other. Each trade has a potential benefit, but this is not equally shared. One party does better than the other. With each trade, by chance, some of those who did better the first time will do better again. Over time, wealth inequality is inevitable. Factor in all the possibilities for traders to protect their position or increase the chance that they do better in a trade and this will reinforce rising inequality (and reduce social mobility). Financial accounting isn’t interested in this, so our current approach actively supports increasing wealth inequality.
Whatever initiatives we set up to address inequality, the rest of the market – at a substantively larger scale – will still be producing financial accounts. These accounts will continue to give price signals to investors and so effect resource allocation decisions. Investment will continue to flow to activities that increase inequality.
But there are solutions
It doesn’t have to be like this. Change the basic motivation of the average investor for whom accounts are produced and everything else changes. What if we, as society, said: produce accounts that are true and fair, for an investor who is interested in maximising financial returns subject to no increase in wealth inequality? Accounts would have to measure and value changes in inequality. The price signal to investment managers would be to move resources away from those activities that increase inequality, to those which either reduce it or at least are distribution neutral. We’ve started pricing for carbon. It’s time to price for inequality as well.
The price signal to investment managers would be to move resources away from those activities that increase inequality
Accounting has two core aspects: deciding what to include in accounts, and then valuing what has been included.
There is increasing international convergence on how the first of these tasks should be done. Social Value International’s Principles for Social Value aredesigned to do this; the Impact Management Project has developed a convention for managing impact; the Natural and Social and Human Capital Protocols do similar things.
There are also standards emerging for how impact should be valued, using financial proxies to reveal the relative importance of these impacts to those that experience changes in their lives. There’s a growing body of practice using valuation techniques, for example in the Impact Valuation Roundtable, across Social Value International’s membership, and within governments.
Recent research carried out by Social Value UK suggests investors are interested in more than simply financial returns and would expect accounts to include wider consequences of business. Changing our understanding of what motivates an investor would integrate these practices for identifying and valuing impact into mainstream accounts. There are many ways this could be done: an additional statement, a social and environmental profit and loss as part of the financial accounts, or even a full integration, making a provision on the balance sheet for, say, negative environmental impact. This negative impact would reduce the company’s reserves, resulting in reduced dividends, providing a price signal to investment managers.
There is work to be done – but there’s also enough practice to show that it is possible. A change in legislation would help us jump from a few good examples, to thousands of sets of accounts. That would quickly drive consistency. It wouldn’t be perfect, but it would be far better than what we currently use, and would be good enough to drive investment decisions that reduce inequality. The investor who wants a financial return subject to not increasing inequality will probably be comfortable with a lower level of accuracy around measures of inequality, and a lower level of confidence will be good enough. Let’s not wait for unachievable levels of accuracy to start creating an accounting system that reflects our hopes and needs. Accountancy has been an incredible social innovation – but it’s time for accountants to bring accountancy into the 21st century.