#Capitalism

Institutions matter: The importance of institutional quality when embedding sustainability within the capitalistic realm

By Lisa Bernt Elboth, Adrian Rudolf Doppler, & Dr. Kristjan Jespersen

◦ 5 min read ◦

Institutions not only structure any sort of social interaction [1], but are also essential in solving societal problems [2], such as climate change and the associated threat towards a fair and just future. It is not without reason that the United Nations particularly emphasized institutional progress within SDG 16 [3] to advance to a more effective, inclusive, and accountable society. In a recent study, it was found that institutions matter to a great extent when scrutinizing the relationship between corporate financial performance (CFP) and ESG performance. More specifically, the institutional environment a company finds itself in determines whether sustainable business practices get transformed into financial returns.

The claim that more sustainable companies are outperforming their not so sustainable peers is not new [4] and the consequent shift of investors’ preferences towards more sustainable companies has been taking place with increasing speed over the last decade [5]. Associated wake-up calls and the urge to take ESG into consideration are not surprising either. Besides the alleged desire of investors for a just and sustainable future, this shift is more likely based on the theory that sustainable finance delivers abnormal returns [6]. But is the relationship between sustainable behavior and financial performance as straightforward as it is disseminated? Are more sustainable corporations indeed more likely to achieve better financial results regardless of where they are and what they do?

In fact, when utilizing ESG scores, rankings, and performance as a proxy for sustainable behavior, two meta-analyses [7] [8] concluded that in most empirical studies the resulting relationship was not as simplistic, universal or linear as it is often propagated. In a corresponding literature review, the researchers also identified a large number of discrepancies among scholars in how to statistically model the relationship, what control variables to use and how to even quantify the dependent and independent variables of focus. Following these insights, the researchers uncovered a determining factor in establishing and shaping the emphasized relationship – institutional quality.

Key Findings

The final sample consisted of datapoints from 6,976 corporations, situated in 75 different countries over a period of eleven years or, specifically, from 2009 to 2020. Subsequently, these were analyzed applying fixed effects panel regression models. Both an accounting- and a market-based measure were used to quantify corporate financial performance, respectively, Return on Assets (ROA) and Tobin’s Q. Meanwhile, ESG performance was proxied by ESG scores from Refinitiv (former Thomson Reuters). The variables associated with institutional environment were split into

Institutional Quality, calculated through a factor analysis and based on the World Governance Indicators from the World Bank and
Industry Sensitivity, a dummy variable equal to 1 if the GICS industry of a firm was deemed sensitive towards ESG.

Institutions are among the determinantal factors for the link

Interestingly, the general statistical analysis of ESG and CFP did not yield any significant results, however, when moderating effects stemming from the institutional environment were introduced, this changed. Under high institutional quality, the researchers found a positive relationship between ESG scores and financial performance. Contrarily, the relationship was negative under low institutional quality. Exemplified below by the case of Finland 2012, Argentina 2018 and Zimbabwe 2012, institutions can be seen as the determining factor for direction of the focal link. Furthermore, the industrial environment a corporation finds itself in was found to affect the relationship ambiguously. Generally, sensitive firms seem to receive relatively less financial gain for improved ESG performance, and it may even be negative.

Possible explanations for such dynamics

Legal institutions, such as environmental regulations, labor laws or health and safety requirements, can serve as the means of reflecting sustainable behavior inside a company’s balance sheet. Finland was for instance the first country to introduce a carbon tax capturing corporate pollution by giving it a price and hence affecting accounting profits.
In highly corruptive settings, where the trust of the general public is lacking, the likelihood of sustainable activities being perceived as greenwashing and thus not rewarded by investors, could be another reason for an inverse relationship in low institutionally developed regions.
In line with the previous, when accountability is low, and corporate entities can disclose information without third party verification, it could be relatively easy to stay focused on short-term profits through unsustainable practices but still receive a better ESG rating.
In environments with low institutional quality, banks tend to only give out short-term loans in order to reduce their own risks. This can lead to a vicious cycle of corporate lenders also only focusing on short-term profit maximization which then again decreases their access to capital, constraining their ability to engage in long-term sustainable practices.

Putting the SO WHAT into practice

When setting out for systemic change, it is important to ensure the necessary institutional environment in order to encourage individuals, as well as corporate entities to act in the best interest of the entire society and the planet. Thereby, a bottom-up approach focusing on incentivizing every individual and a top-down approach, fostering legal macro-level change can be synthesized, leading to the best possible outcome. These institutions should seek to maximize accountability, transparency, and mechanisms to internalize negative externalities. Corporations within such environments should fully leverage opportunities associated with sustainable practices, such as cheaper access to capital, in order to incrementally advance the progress towards a just space for humankind. Corporations, which are especially sensitive towards ESG related elements irrespective of their ESG scores, should aspire to enhance their own credibility, as this might award them with a competitive advantage. Lastly, societies with high institutional quality should strive for teaching about their institutions and the associated benefits to everyone else, as a global problem can only be solved on a global level.

References

Doppler, A.R., & Elboth, L.B. (2022). Institutional Quality, Industry Sensitivity and ESG: An Empirical Study of the Moderating Effects onto the Relationship between ESG Performance and Corporate Financial Performance (Unpublished master’s thesis). 22098. Copenhagen Business School, Denmark.

About the Authors

Lisa Bernt Elboth recently graduated with an M.Sc. in Applied Economics and Finance as well as a CEMS Master’s in International Management from Copenhagen Business School and Bocconi University. Her interest in global matters and sustainability has flourished during her studies impacting the choice of master thesis topic and this subsequent blog contribution.

Adrian Rudolf Doppler works as a research assistant for the Department of International Economics, Government and Business at Copenhagen Business School and had just graduated with a Master’s in Applied Economics & Finance and the CEMS Master’s in International Management after a two-year journey. He had always been passionate about ESG, Sustainability and the existing links with the capital markets, as well as the complex system dynamics arising form it.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo credit: Galeanu Mihai on iStock

Making the case for and against and beyond Friedman in 2020

On the anniversary of Friedman’s “The Social Responsibility of Business Is to Increase Its Profits”

By Steen Vallentin

September 13th marked the 50th anniversary of the publication of Milton Friedman’s famous New York Time Magazine essay entitled “The Social Responsibility of Business Is to Increase Its Profits”. This has occasioned a slew of testimonials and opinion pieces on Friedman’s legacy in general and the legacy of this free market manifesto in particular.

Not surprisingly, the tone of testimonials have differed. From those lamenting Friedman’s enormous influence on the discipline of economics, economic policy, modern business and finance over the last three to four decades in particular, to those celebrating these very same developments. One commentator, in The New York Times, speaks of how a generation of C.E.O.s have been brainwashed to believe that the only businesses of business is business. That the sole responsibility of business is to make money.

Dwindling relevance

Anti-Friedman sentiment, and this is nothing new, takes aim at the single-mindedness and moral blind spots of free market capitalism, market fundamentalism, the shareholder paradigm, finance capitalism, you name it.

Indeed, ‘Friedman was wrong’ was for many years a recurrent theme in arguments made in support of CSR and stakeholder capitalism. But Friedman is not as relevant as he used to be.

In recent years, as far as specialized discussions of CSR go, the Friedman doctrine has increasingly been displaced by ‘the Porter doctrine’, that is, the strategic view of business responsibilities promoted by renowned, now retired, Harvard Business School professor Michael Porter along with Mark Kramer.

Porter & Kramer’s more accommodating brand of economic instrumentalism – encapsulated in the influential notion of Creating Shared Value (CSV) – has turned out to be much better attuned to present circumstances than the message of Friedman’s antagonistic and polarizing opinion piece.

The critique of free market capitalism has arguably gained urgency and currency with the climate crisis and calls for sustainable development and green transition. This is not to say that the Friedman doctrine has been abandoned by all those who used to support it.

However, given the opportunity to reflect, supporters of Friedman tend not to dwell much on the minutiae of the 1970 essay.

The devil is in the detail, and few seem to be willing to argue that what Friedman wrote 50 years ago is a proper representation of how the problem of corporate social responsibility is constituted in the year 2020.

The strength of Friedman’s wonkish essay was always its crude simplicity. For many years it seemed to encapsulate everything that needed to be said about CSR – according to mainstream economists and ideologues of a similar persuasion and the discipline of neoclassical economics. In other words, very little needed to be said. 3000 words were enough.

However, with the rise of ESG and sustainable finance it seems to be dawning even on the disciplines of economics and finance that more indeed needs to be said – and that the crudeness of Friedman falls terribly short in capturing the challenges, risks and opportunities ahead.

Friedman’s article has served as a moral cornerstone for the shareholder value paradigm. Its moral shortcomings are increasingly showing, though.

The Friedman doctrine nonetheless

What supporters of the Friedman doctrine nevertheless argue, is that he was (and is) right about fundamentals: that the shareholder value paradigm is a superior economic principle and form of governance. The argumentative support structure for this paradigm does, however, need adjustment in order to achieve better alignment with changing historical conditions, opinion climates, societal norms and expectations.

In other words, supporters of shareholder capitalism need to fight for their cause. They need to renew their engagement in the ongoing ‘battle of ideas’ over business and society.

Their main opponent in this battle is well-known, but has been gaining new and more widespread support as of late. The opponent is stakeholder capitalism, the virtues of which have found high-level affirmation recently in the Davos Manifesto of 2020 and in the Business Roundtable statement on the purpose of business from 2019.

Importantly, the American brands of stakeholder and shareholder capitalism have a common denominator. Both Friedman and R. Edward Freeman (the great popularizer of stakeholder thinking) have described themselves as libertarians. Stakeholder capitalism, US-style, begins and ends with voluntary initiatives and stakeholder engagement by business. Government and regulation are not supposed to have central roles to play in such endeavors. They are supposed to work better, more smoothly and efficiently without government interference.

Thus, the first line of battle – for Friedman supporters – has to do with regulatory failure. Sure, there are market failures that we need to take account of when assessing the responsibilities of business. But regulatory failure should be no less of a concern.

The second line of battle has to do with principles and practices of governance. According to its supporters:

Stakeholder capitalism is supposed to be more open, democratic, responsive and responsible than its counterpart. But what does stakeholder governance mean in practice, at the corporate level, unchecked by government regulation and without agreed upon rules of engagement? It is far from clear.

Will it ultimately be good for business and society if companies are governed in accordance with the diffuse model and principles of ‘stakeholderism’? It is equally well imaginable that stakeholder capitalism can turn out to create less value for the stakeholders whose interests it is supposed to reflect and serve, and that stakeholders will ultimately be worse off if this is the direction the development of the economy takes. And it may be that shareholder capitalism, with its more clearly defined purpose and governance principles, is ultimately better equipped to keep business leaders on their toes and create value not only for shareholders but for stakeholders at large. So the argument goes in conservative circles.

Ideology and the ongoing ‘battle of ideas’ over business and society

While many of these arguments seem to fly in the face of public opinion of the more progressive kind, we must acknowledge how, in a polarized opinion climate, public opinion is divided on many political topics. Andrew Hoffman (2012) speaks of how the climate change debate in the US has become enmeshed in the so-called ‘culture wars’. Acceptance of the scientific consensus regarding climate change is now seen as an alignment with liberal views consistent with other cultural issues that divide the country (i.e., abortion, gun control, health care, and evolution). This tendency has only worsened under the Trump presidency.

On top of this we can observe how sustainable development and green transition are evolving as government-driven agendas, involving a high level of social and economic planning – not to mention the COVID-19 crisis and how the pandemic, for better or worse, has provided a large-scale affirmation of the primacy of government intervention in dealing with grand societal issues.

Under these conditions it has once again become relevant to speak not only of broader socialist tendencies in politics and society, but also of how CSR/corporate sustainability can be a Trojan horse or slippery slope leading from market capitalism into a new socialist order. In other words, the ideological underpinnings of the CSR debate are once again becoming more apparent.

This calls for more in-depth studies of the ideological commitments sustaining the theory and practice of CSR. It does not necessarily call for rejuvenation and regurgitation of Friedman’s short essay, though. Friedman is not as relevant as he used to be in discussions of CSR. The anniversary has done nothing to change this.

We need to look beyond Friedman and see him (only) as one part of the larger ideological tapestry. We need contextualized, updated engagements, not more flogging of a somewhat dead horse.

References

Hoffman, A.J. (2012). Climate science as Culture War. Ross School of Business Working Paper No. 1361, June 2012 / Stanford Social Innovation Review, 10 (4).

About the Author

Steen Vallentin is Director of the CBS Sustainability Centre and Associate Professor in the Department of Management, Society and Communication at Copenhagen Business School. His research is centred on CSR (corporate social responsibility) and sustainable development in a broad sense.

A Green and Fair COVID-19 Recovery Plan

By Stefano Ponte

This article is based on his previously written piece for the Centre for Business and Development Studies.

The COVID-19 crisis has made evident the limitations of existing thinking, preparedness and policy in relation not only to health pandemics but also to the sustainability challenges we face, locally and globally. Contemporary capitalism, with its hyper-individualistic culture and just-in-time – instead of just-in-case – approach to infrastructure and essential equipment, is not geared towards solving global problems that require coordination, cooperation and solidarity. As some activists, scholars and medical personnel have stated recently, ‘We don’t need heroes if we have preparation’.

Clear examples that have emerged with particular force in the past few months include the political inability to coordinate emergency responses within the EU and the US, cut-throat competition among countries seeking to procure essential medical gear, and the realization that we have been undermining the working conditions for ‘essential workers’ for decades. Therefore, an expansive economic stimulus to restart the economy during/post-covid-19 cannot be based on the first-line response of capitalism – restoring production and consumption back to ‘usual’.

This is the time to expand and rethink our socio-economic models to stimulate a more sustainable approach to consumption – not limited to consuming more sustainable goods and services (such as organic milk, ecotourism holiday or FSC certified timber), but also on consuming less.

We need to rethink the current organization of the global economy, reform the national economic and political institutions that govern it and devise new forms of governance and collective action within states and across borders. Contemporary hyper-capitalism, rather than humanity per se, is the root cause of the global sustainability crisis and the spread of pandemics – and thus should be the focus of action.

To achieve this, we need a different kind of ‘green entrepreneurial state’ that de-couples sustainability from growth, and that does not intervene to bail out carbon-intensive industries tout court. Oil markets have tanked in recent weeks, and $0 (or even negative) oil prices are devaluing oil industry assets dramatically. A green and just recovery in the oil industry transition means focusing on helping workers first and foremost, rather than executives or shareholders. This could entail partial nationalization of assets to essentially shut the oil industry down in the mid-term and open the way for further investment in renewables, which would otherwise be dampened by competition from cheap oil.

Second, what we need is more community involvement in the economy, changes in labour law to make unionization easier, tax reforms to make municipal and cooperative forms of organization more attractive, corporate regulation to facilitate employee ownership, and stimuli to expand the radical and democratic ecological experiments that are already in place – such as the shared living communities that have been active in Denmark since the 1970s.

Third, important insights for a recovery plan can be offered by the idea of ‘just sustainability’, which incorporates ‘the need to ensure a better quality of life for all, now and into the future, in a just and equitable manner, whilst living within the limits of supporting ecosystems’. Therefore, a path towards recovery during-and-post COVID-19 needs to address inequality – as it drives competitive consumption and leads to lower levels of trust in societies, making public action (including under a pandemic) more difficult. Excluding companies from recovery funds which have made use of tax avoidance tools is one of the necessary steps. But broader and collective actions to stamp out tax heavens are needed more than ever.

About the author

Stefano Ponte is Professor of International Political Economy at Copenhagen Business School and Director of the Centre for Business and Development Studies. His latest book Business, power and sustainability in a world of global value chains was published by Zed Books in 2019.

More about coronavirus pandemic:

The Coronavirus Pandemic – and the Consequentiality of Metaphors

Sustainable Development, Interrupted?

The Political Economy of the Olympics – Misconceptions about Sustainability

Supply Chain Responsibilities in a Global Pandemic

Photo by Edwin Hooper on Unsplash

The Decline of Neoliberalism – Implications for CSR?

By Steen Vallentin.

“May you live in interesting times” – so the apocryphal English-language expression goes that people often refer to as ‘the Chinese curse’. Times are certainly interesting. Taken for granted notions of what is up and down and left and right in politics are, if not turned on their head then knocked about in confusing and sometimes frightening ways.

The strange (non-)death of neoliberalism … again?

One of the interesting developments in world politics right now is the crisis of neoliberalism as ideology. A development that some will indeed see as a curse, others as a blessing. It is not the first time that neoliberalism has been declared dead or seen to be in its death throes. Many obituaries of finance capitalism and global free trade were written in the wake of the financial crisis. Nevertheless, neoliberalism has shown itself to be remarkably resilient and has continued – in spite of public criticism – to be a dominant force in public policy around the world. Colin Crouch has referred to this recurring trajectory as ‘the strange non-death of neoliberalism”.

However, Brexit (and the election of Jeremy Corbyn as head of Labour) and the movements surrounding Bernie Sanders and Donald Trump in the United States are each in their own way symptomatic of a turning of the political tide against hyper-globalization and free market capitalism. The benefits of free trade – of goods, services and capital – and outsourcing of labor to low-cost destinations are now being challenged across the political spectrum. Even the Republic candidate for the presidency is questioning, supposedly (who knows with Trump), fundamental tenets of economic liberalism. The crisis of neoliberalism is both an intellectual and a popular one. Leading economists like Joseph Stiglitz, Paul Krugman, Jeffrey Sachs and Thomas Piketty are among its vocal adversaries, and a public/populist movement is revolting against the crises and rising inequality that are associated with it. Even top economist from the IMF have recently acknowledged that neoliberalism has been “oversold”.

CSR as an embodiment of neoliberal ideology?

These developments, seen in isolation, would seem to pave the way for a political climate more attuned to the wants and needs of working people and to social values and democratic inclusion (as opposed to solutions based on the supposed workings of the sacrosanct market mechanism). How does it relate to CSR, then? What is the relationship between CSR and neoliberalism?

Arguably, the CSR literature has suffered from a lack of political-ideological self-reflection (and -criticism). Ideological reflection is often left to scholars and others who position themselves as outsiders to the field. As a result, rough and sweeping generalizations tend to prevail. As when critical sociologists and political science scholars suggest that CSR is simply an embodiment or reflection of neoliberalism (because it supports voluntary corporate self-regulation as opposed to government regulation etc.). Critical scholarship of the CMS (critical management studies) variety tend to strongly emphasize the hegemony of neoliberal capitalism as an all-pervasive and suppressive ideology and to stereotype/debunk the CSR literature as a supporter of this ideology.

Locating neoliberalism within CSR: Porter & Kramer on shared value

It is ultimately misleading, though, to think of the CSR literature in total as a reflection of a neoliberal mindset and of CSR promoters as suffering from false consciousness if they fail to realize this. A more nuanced and less stereotypical view of CSR allows us to distinguish between different forms of liberal thinking in CSR and to single out those instrumental streams of thought that more accurately deserves the label ‘neoliberal’. Here, pride of place goes to the strategic CSR/creating shared value approach promoted by Michael Porter & Mark Kramer in their series of influential Harvard Business Review papers. Porter & Kramer effectively subject all social action to the tribunal of cost-benefit analysis and economic value creation. Their approach is supposed to ensure that it is economic rationality and economic measures of worth, and not personal values or fleeting ethical, social or environmental sentiments (as promoted by more or less knowledgeable and qualified stakeholders), that hold sway over proceedings. In their view, shared value represents an internally driven and innovative way for businesses to address social problems and needs in ways that are also beneficial for themselves.

Collective impact – shared value as collaboration

However, a new paper on shared value by Mark Kramer and Marc Pfitzer suggests a softening of the neoliberal rhetoric and an opening toward a more inclusive and democratic approach to responsibility. The core concept here is ‘collective impact’ and the case is made for companies to engage in trust-building and mutually reinforcing partnerships with NGOs, governments and competing businesses as this will provide the strongest basis for dealing effectively with social problems and create shared value. The authors even concede that companies cannot be the backbone of such projects as they are not neutral players; instead, a separate and independently funded staff is called for. Indeed, collective impact calls for a new brand of leadership, ‘system leadership’ that involves multiple individuals from different constituencies leading together.

The new paper has already been accused of intellectual piracy on social media, and it certainly does not excel in terms of originality. Its significance rather lies in its ceding of ground to democratic adversaries in the CSR debate. The paper may be read as a reflection of the diminished self-confidence of purely neoliberal thinking about business and society. Whether or how this ceding of ground will make a real difference in the real world of business remains to be seen. At this time, we can see that a concept (shared value) that is rooted in neoclassical economics and has otherwise been associated with a clear corporate bias is now being presented as a collective, democratic endeavor. It is certainly interesting.

Steen Vallentin is Director of the CBS Centre for Corporate Social Responsibility (cbsCSR) and Associate Professor in the Department of Management, Politics and Philosophy at Copenhagen Business School.

Pic by bNation of Change