Ideas for Leaders #181

How Best Behaviour Boosts the Bottom Line

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Key Concept

Businesses can see beneficial financial effects if they implement policies based on corporate social responsibility. These effects are evident in both the equity and corporate bond markets where they lead to reduced market risk and default risk, lower cost of equity and debt and increased credit quality.

Idea Summary

Do you want your business to operate sustainable, socially and environmentally friendly practices? Almost every business leader will answer with a “yes”. But if they are allowed to elaborate, most will talk about certain conditions that have to be met: “Yes, as long as these practices do not destroy firm value”, “Yes, as long as the firm can afford it”, “Yes, if that is what the law dictates”, “Yes, if that is what shareholders want”.

But what if we turn the underlying argument on its head? Is it possible that applying socially and environmentally responsible practices can actually generate advantages, such as enhanced operational performance, reduced exposure to relational and reputational risks and consequently to improved financial performance and easier access to capital?

The business case for CSR is establishing itself as one of the crucial business issues of the 21st century. According to recent surveys, 88% of consumers believe that companies should try to accomplish their business goals while still trying to improve society and the environment. At the same time, from a global sample of 750 CEOs, 93% see sustainability as a factor that can materially influence their firm’s future success.

Empirical research in the area has also brought forward convincing evidence that corporate social performance is priced in financial markets. The incorporation of social and environmental considerations in a firm’s operation can lead to the creation of significant improvements in the long-lasting business relationships of the firm with a variety of different important stakeholders (customers, employees, suppliers, non-governmental organisations and pressure groups, local communities) and through them to improved profitability and overall stronger financial performance. Similarly, there are indications that CSR is associated with lower operational risks through lower probabilities of suffering legal prosecutions and fines, less stringent regulatory controls, more stable relations with the government and the financial community, customer loyalty and fewer occurrences of employees going on strike or withholding best efforts.

Now, new research shows that the financial effects of corporate social performance are evident in both the equity and corporate bond markets where they lead to reduced market risk and default risk, lower cost of equity and debt and increased credit quality.

This award-winning paper is one of the very first to examine, extensively and rigorously, the association between corporate social performance and financial risk. Previous research has examined the effect of corporate social performance on firm profitability and stock returns, using risk only as an adjustment factor, if at all. In contrast, this research investigates whether corporate social performance has wealth-protective, as opposed to wealth-enhancing, effects.

Firm-value protection may be achieved by, for example: preserving a company’s ‘relational wealth’ (that is, the value inherent in maintaining good relations with its stakeholders) and reputational capital in times of crisis; reduced likelihood of boycotts by consumers, strikes by employees, targeting by environmental activists, and fines, penalties or more stringent regulation by local or central government.

The study finds convincing evidence that firms that are involved in a variety of different transgressions and display indications of being socially irresponsible (especially when it comes to environmental and employee issues) have stocks that are characterised by higher levels of overall volatility and financial risk. Conversely, it finds indications that being socially responsible and proactively contributing to the benefit of stakeholders can also decrease financial risks – although these results are less conclusive.

What is perhaps even more interesting is that in times of overall financial turmoil, the value-destroying effects of corporate social irresponsibility become more pronounced, whereas during times of economic strength it is the value-protective effects of corporate social responsibility that are strengthened.

Methodology: The research examined an extensive sample of S&P 500 firms between the years 1992 and 2009. It used ratings by KLD, an independent agency, to assess companies’ social responsibility and irresponsibility in a number of areas including: relationships with local communities, protection of the natural environment, recycling and use of alternative energy sources, employee safety, diversity issues and product safety and quality.

Business Application

These findings are of considerable importance for business leaders making strategic business decisions, implementing effective risk management practices and attempting to forecast the future cost of equity of their firms.

They are also highly relevant for investors who are trying to identify optimal asset allocations. Such findings have spurred a huge interest in socially responsible investing (SRI), which refers to the principles applied by professional asset managers that incorporate environmental, social and corporate governance (ESG) considerations in the security selection process. The goal is to maximise risk-adjusted returns while respecting the social concerns of the investor.

Lastly, they are of interest for a variety of different stakeholders including discerning consumers, environmentalists and other concerned citizens.
A pragmatic incentive for ethical corporate behaviour may be the best way of leading towards better business and a better society. Firms can outsource their operations but they cannot outsource their values, especially when they do not want their value to drop.

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Authors

Institutions

Source

Idea conceived

  • July 2013

Idea posted

  • July 2013

DOI number

10.13007/181

Subject

Real Time Analytics