Barbara Frey
The Globalization of Environmental Crisis
Capstone Paper 2012
The Convergence of Sustainability, Corporations
and the Financial Sector
Who Benefits?
ABSTRACT
Environmental and social responsibility concerns are receiving their just due in general discourse as more attention is paid to sources of environmental degradation and recovery. Individuals who previously had no direct connection to large scale environmental or world issues today are apt to be in positions to influence, reward and punish companies that are seen as contributors or degraders of the environment and civil justice. Many studies have been performed to investigate the financial performance versus the costs involved to companies that act and voluntarily disclose their activities in this area. For just over a decade, financial investment vehicles have become available in the marketplace for individual and institutional investors. The Dow Jones Sustainability Index is one such instrument. The questions posed in this paper are: 1) Do companies benefit from participating in environmental issues and being listed on such indices; 2) Do investors benefit financially from investing in such indices?; and 3) Does the environment and society benefit from the attention given by the funds’ direction or are these funds merely another package for the financial market?
The paper is divided into three sections. First, aside from regulatory compliance, what are the implications and costs for corporations that voluntarily participate in sustainability disclosure? Second, what do investors and stakeholders expect from the corporation and their investments in corporations that voluntarily disclose sustainability? And third, I provide an analysis of sustainability indices performance. Note: the nomenclature of environmental and social concerns generally reflect the terms used by authors of the respective studies. Also, the terms Corporate Social Responsibility (CSR, CR), Corporate Social Initiative (CSI), Corporate Social Performance (CSP) and Environmental, Social and Governance (ESG) all refer to the same type of information and are used interchangeably.
Although it seems a recent notion because of the wider globalization discussion, the issue of corporate responsibility and its relation to economic performance has been around for many decades. Ullmann (1985) cites a number of CSR and corporate externality studies from 1950 to 1978. More recent studies have confirmed the same results he found: the results are mixed regarding associated economic performance. Some authors mentioned by Ullmann, including Vance (1975) and Alexander and Buchholz (1978) found no correlations or negative correlations between social and economic performance; however, Moskowitz (1975) did find a positive correlation. Ullmann’s explanation for the disparity in results was partially related to “key terminology, conflicting hypotheses, differences in the models, methods, measurements and time periods” (Ullmann, 1985). More recent studies performed within the past decade also suffer from the same kinds of paralysis of definition. Ullmann’s original contention still seems to hold nearly three decades later: The lack of a solid theoretical foundation is repeatedly quoted as the reason why the empirical studies have not resulted in the “convergence of knowledge” (Lankoski, 2008). The subject is complex with many variables which are not as well defined as would be available in a typical corporate financial report. As there are no auditable standards and no official standards body as compared to financial accountability and audit standards which have existed for many years in both country and globally acceptable formats to define things like corporate governance and social responsibility, the contributions and achievements as well as the costs can be difficult to measure.
STANDARDS
Yet as investors, especially institutional ones are increasingly seeking CSR information as determinants to decision-making in fund building and advising, the need for standardization in the field is growing. Additionally, because of the very large and ever-increasing number of corporations and fund vehicles reporting CSR information, the investment community must rely on a wide variety of reporting formats, including corporations’ self-reporting through company websites, governance reports and annual reports.
Among the current, though limited, standards formats in social issues are the ISO 14001 Environmental Management Standards related to corporate environmental impact and compliance; SA 8000, a voluntary compliance certification program related to working conditions administered by Social Accountability International (SAI) a non-governmental organization; and the UN Global Compact.
Briefly stated, UN Global Compact, while not providing an official standards model, does provide a framework for corporate and other organizations with practical and policy guidelines. Its Ten Principles cover human rights, labor, environment and anti-corruption. The basis for each of The Ten Principles are from established and well-accepted UN organizations’ tenets, such as The Universal Declaration of Human Rights, The International Labor Organization's Declaration on Fundamental Principles and Rights at Work, The Rio Declaration on Environment and Development, and The United Nations Convention Against Corruption.
While the UN Compact does not enforce or measure the behavior of participating corporations, the signatories are required to report annually on their implementation of the ten principles thereby creating accountability (Rasche, 2009). The Compact is global in scope with participants from over 115 countries, including developed and developing. Interestingly, North American companies represent only a small percentage of participants presumably because of the fear of “blue-washing” accusations and the litigiousness of American society (Rasche, 2009).
Each of these three standards organizations are rigorous and influential, but none are as complete in themselves or in combination comparable to the level of standardized expectations in financial reporting by organizations such as the International Accounting Standards Board’s (IASB) International Financial Reporting Standards (IFRS). These are principles-based standards, interpretations and a framework founded upon input from stakeholders/trustees of global accountancy, regulation, investment, and business, based on accepted practices, governance, jurisdictional adoption and transparency (www.ifrs.org).
Therefore, aside from regulatory compliance, no such international body exists today to define a fully accepted set of common metrics related to Social Responsibility or voluntary environmental activities. The nearest official organization is the United Nations Environmental Program Financial Initiative, which works with financial institutions “to identify, promote, and realize the adoption of best environmental and sustainability practice at all levels of financial institution operations” (UNEPFI). Its 200 plus institutional signatories represent global institutional investors and other concerned organizations of the UN Principles for Responsible Investment.
CORPORATE PARTICIPATION
Clearly, there are costs to the corporation for Corporate Responsibility activities. Businesses are not altruistic; they function as profit producing entities. Capitalist theorists as supported by Milton Friedman reject the idea of companies incurring costs that do not directly promote the economic functions of the business. Ullmann mentions “Friedman-style investors’” who would not favor companies’ involvement in “wasteful voluntary social responsibility activites” yet at the same time, he recognizes that “‘ethical’ investors may be willing to pay a premium.” (Ullmann, 1985). Further, “CR issues are holistic: they relate to the whole life cycle of the product of the firm, involve all functions of the firm” (Lankoski, 2008).
A study of manufacturing firms describes a “Win-Win” paradigm between Corporate Responsibility activities accompanied by financial rewards, particularly when the firms’ managers “believed” in environmental performance. This study also found that environmental activities are profitable in the long run because they offer a “competitive advantage, enhance relationships with stakeholders and alleviate regulatory burdens” (Plaza-Ubeda, et al., 2009). Corporate Responsibility activities may indeed increase a company’s costs, but may lead to cost savings through increased efficiency, reduced risks and waste (Lankoski, 2008). Lankoski describes an inverted curve relationship between the customer value and the costs of CR activities. See Figure 1.
Callan and Thomas posit that despite the fact that costs run counter to the objective of maximum profit, a negative relationship between CSP and CFP (Corporate Social Performance and Corporate Financial Performance) does not necessarily exist. Their thorough statistical analysis of large U.S. firms did find a “positive relationship between CSP and CFP,” but not for all industries (Callan, 2009). On the contrary, another study found that the trade-offs and conflicts in corporate social responsibility and economics was “the rule rather than the exception” (Lutz Preuss, et al.)
STAKEHOLDERS
Without a definitive set of performance standards and mixed voluntary disclosures, why do companies bother participating in Corporate Responsibility? While it may seem obvious that aside from market position, corporate reputation and regulation,at least one study shows that corporations’ ethical behavior is driven by its stakeholders’ and by certain kinds of stakeholders in particular. Corporate Stakeholders represent not only its stockholders, but communities, employees, suppliers, government and customers (Prado-Lorenzo, 2009).
The financial market is also now seen as an important stakeholder which “should screen industry from an environmental point of view to judge and evaluate environmental risks and thus price companies more realistically depending on their liabilities” (Dobers, 2000).
Ullmann designed a three-dimensional framework around levels of corporate social and economic performance based on the stakeholder involvement (later known as Stakeholder Theory) and strategy of the corporation In it, Ullmann maps the correlation of high or low stakeholder involvement, active or passive corporate strategy, economic performance and mandatory or voluntary social disclosure. His stated purpose was to provide a framework for future research. (Ullmann, 1985)
Prado-Lorenzo, Jose-Manuel, Isabel Gallego-Alvarez, and Isabel M. Garcia in 2009 expounded on Ullmann’s framework in describing dominant shareholders who “imply a context of concentrated ownership” and who are “more likely to adopt decisions that maximize the firm’s economic, social and environmental behavior” (Prado-Lorenzo, 2009). They find that indeed, in support of Ullman’s findings shareholders, particularly dominant ones with a large financial stake in the corporation, “foster” the disclosure of social information more so than lesser shareholders who are more interested In the financial performance of the company (Prado-Lorenzo, 2009).
But does stakeholder pressure alone influence a company in social disclosure? No, according to at least two studies, including Gonzales-Benito, et al., who found all of the variables of environmental management, including company size, internationalization, location, position in supply chain, industrial sector and managerial values put environmental pressure on managers, but that the
perceived” stakeholder pressure has a very large effect on environmental strategies and behaviors (Gonzales-Benito, 2010).
OTHER REASONS
Heikkurin (2010) studies how corporations, which increasingly must participate in Corporate Responsible reporting, can use Corporate Responsibility disclosures as a differentiator, creating a favorable image and therefore contributing to a favorable reputation. However, First and Khetriwal’s study found that “environmental embeddness” (environmental values incorporated in brand identity), policies and practices are not conclusively supported as a brand advantage. By measuring 18 companies identified as Environmental Performers, Leaders, Laggards and Advocates they found that most companies do not reap the benefits of their efforts because they do not communicate their positions well to their stakeholders (First, et al, 2010). See Figure 2.
INVESTOR PARTICIPATION
Investors want long-term financial relationships and they want stability in their investment choices. What motivates investors more ̶ a desire to invest in socially responsible companies or to ensure a higher return on financial investment? One Australian survey study evaluated this question and found that as the level of an investor’s environmental concern increased, their financial criteria decreased relative to their “non-environmentalist peers” (Vyvyan, 2007).
According to Kruse, long-term investment goals are “leading to the integration of environmental, social and governance (ESG)” (Kruse, 2010). Investors, especially institutional ones increasingly are seeking this information recognizing that companies that practice good governance are likely to be sound long-term investments. In considering institutional investors as drivers of corporate social responsibility (CSR), Vivo and Franch comparing the U.S. and European investors note that in 2006 nearly $1 of every $10 invested in a managed portfolio was subject to social responsibility with assets of $179 billion. The European counterpart, led by the United Kingdom, France, Switzerland and Belgium amounted to €34 million (Vivo, 2009).
The Forum for Sustainable and Responsible Investment’s “Sustainability Trends in Alternative Investments in the United States,” states that $80.9 billion was invested in 375 alternative investment funds incorporating environmental, social and governance (ESG) criteria at the outset of 2011, reflecting a 15.9-percent growth in combined assets since the beginning of 2010 when 346 alternative funds managed a combined total of $69.8 billion. (USSIF.org, 2011)
Interestingly, investors seem to have short memories when it comes to non-financial aspects of companies. For example, despite the high costs in terms of resource allocations and hard dollars of implementing processes needed to win a prestigious quality award, such as the Malcolm Baldrige National Quality Award, investors historically do not reward the recipient companies. Though such awards are not intended to be “inducements” to investors per se, they are perceived as important to corporations, education and healthcare institutions and nonprofits who strive for them as very few are given annually and they are presented personally by the President of the United States. A recent study on the Baldrige Award in particular and similar awards found that investors do not have “long-term memories” and there is “no sustained increase in the shareholder wealth” of such an award (Cheah, 2007).
This is confirmed by the Vyvyan study which states that “in spite of one’s attitudes to investment, the key factor when allocating resources is performance.” Concluding, the authors state that despite “green attitudes” investors were not more likely to invest in SRI, rather that financial performance was the primary motivator (Vyvyan, 2007). Further evidence will be see in the discussion which follows on the Dow Jones Sustainability Index.
SUSTAINABLE FINANCIAL INVESTMENTS
With the growing attention and discourse of environmental issues the capitalist desire to make money is ever present. Rather than regarding this as an intrusive juxtaposition of the issue, I see it as a benefit. Using the “follow the money” model, people who have no genuine awareness of environmental or social issues will invest in sustainability funds vehicles if they can earn from them.
Today there are hundreds, if not thousands of environmental, social and sustainability funds vehicles in financial markets worldwide. Results on investment returns are mixed across the plethora of funds, but generally hold their own compared to benchmark traditional indices and exchanges. Figure 3 illustrates the worlds’ major exchanges compared to some of the major sustainability funds. Figure 4 is a sampling of returns of Socially Responsible Investing from the Forum for Sustainable and Responsible Investment.
Yet, Fowler concludes that “the returns of socially responsible investment vehicles have either underperformed, or failed to perform comparable market indices” (Fowler, 2007). In his critical review of the indices he takes on the studies, focusing on the performance of the funds compared to their benchmark indices, the methodologies used and the impact of the indices on the investment community. He criticizes the sustainability indices and finds them to be biased for 1) “the need for analyst interpretation” introducing subjectivity in the ratings (which goes back to the earlier discussion of lack of standards in social responsibility performance) and 2) the indices’ over-emphasis on economic factors “(30.6% of the weighing).” However, these points may not be accurate. Fowler’s footnotes indicate that his criteria from SAM, the Sustainable Asset Manager for the DJSI is “based on the basis of publicly available information only.” For this research, I requested a funds index from SAM for academic purposes and was told that only PhD level requests were accepted. The DJSI Guide Book describes its methodology as a sustainability score based on four sources: 1) a questionnaire (see Figure 5 for sample pages), 2) company documentation (public and internal), 3) a media and stakeholder analysis (public), and 4) personal contact with the company. A fifth component of sector risk analysis and sustainability trends is also used. The Guide Book describes its scoring methodology as such: TS=∑ (ANS*CRW*QUW) for all criteria. Where TS=Total Score, CRW=Criteria Weight, QUW=Question Weight, ANS=Answer Score. One cannot discern from this publically available information what the true weight of the criteria is enough to form a criticism of it.
There is some evidence of investors’ “short-term memory” as noted above regarding a company’s stock performance after winning a quality award. Recognition for non-economic events do not necessarily have a direct positive influence on a company’s stock price. Each quarter the DJSI announces its top 10 company additions and deletions. Hypothesizing that a company’s status on these lists would have an effect on its stock’s performance if it was on the Additions list and a negative effect if it was placed on the Deletions list, I analyzed each stock’s daily price a week before and a week after the day of the announcement for this year (always September 8). The evidence in Figures 6 and 7 show that for the twenty companies listed the announcement on September 8 had a mostly negative response. On the Additions list, only two company’s stock prices rose, six were flat and two dropped in price. On the Deletions list, eight company’s prices dropped and two show no change at all. Caveats abound: this small sample size is not enough to draw any real conclusions, there is no statistical analysis performed and there is no way of knowing from this simple methodology of other influencers on the company’s stock or the markets in general.
CONCLUSION
BENEFITS TO CORPORATIONS
I conclude that corporations benefit from participating in responsible practices and reporting. I also conclude that a company’s costs involved are well spent in terms of their brand and reputation paybacks. I refute Friedman arguments that costs should only go into direct economically beneficial directions. I argue that such costs create a classic market-oriented situation (capitalist market) because aside from government intervention, individual companies will seek the appropriate balance toward environmental care, governance and profitability and that the macro-economic capitalist market, i.e., financial arm will continually seek and reward those company’s funds through investment choices.
BENEFITS TO INVESTORS
I conclude that investors will benefit from capitalizing on index funds dedicated to sustainability. This research has shown that the funds’ returns are comparable to those of general funds. Further, I predict as more attention is placed by the financial investment arena of sustainability funding and the financial sector participates at global levels that a standards process will occur that will be on par with the accepted financial accounting and auditing standards thereby increasing the attractiveness of sustainable indices investment.
BENEFITS TO THE ENVIRONMENT
I conclude that the environment and other social concerns benefit greatly by the attention being focused on its numerous related issues. Further, the very nature of financial investments through corporate expenditure and the financial sector will go much farther to benefit social and environmental causes than government regulation, NGO actions or piecemeal activist efforts combined.
REFERENCES
APPENDIX
FIGURE 1. The relationship between corporate responsibility activities and economic performance. The numbered arrows illustrate how undertaking different CR activities would affect the economic performance of Firm A. (Lankoski, 2008).
FIGURE 2. Environmental Embeddedness and Environmental Performance (First, 2010).
FIGURE 3. Sustainability Funds compared to major stock indices (Corporate Knights, 2010).
