ESG and Stakeholder Capitalism: Seeking Value for All

This article was first published in Outlook India on May 09, 2023. Co-authors: Moksh Garg, Sougata Ray; https://www.outlookindia.com/business/esg-and-stakeholder-capitalism-seeking-value-for-all-news-284879

Nobel Laureate Milton Friedman, in his famous essay "The Social Responsibility of Business is to Increase its Profits," published in the New York Times magazine in 1970, famously wrote, "There is one and only one social responsibility of business--to use its resources and engage in activities designed to increase its profits..."

Compare this with the Statement on the Purpose of a Corporation adopted by 181 CEOs of America's largest companies in 2019. The Statement declared, "…companies should deliver long-term value to all of their stakeholders – customers, employees, suppliers, the communities in which they operate, and shareholders."

Post the Covid19 pandemic, calls for "stakeholder capitalism" has further picked up the pace. Gone are the days when economic profits alone determined a firm's success. The for-profit entities are being held responsible not only for the bottom line but also for the activities through which they create shareholder value and the value they create for other stakeholders. As a result, it is no longer surprising to see them getting mired in controversies or even attacked by their shareholders over broad-ranging social issues. This has led shareholders and the wider investor community to take stock of businesses beyond traditional metrics.

Measure accurately and improve

The method to measure economic profits has been established and standardised for long. However, measuring stakeholders' value creation is still in its infancy. And, what cannot be measured, cannot be improved, managed, or controlled. Therefore, combined with changing social dynamics and the issue's salience, many rating agencies and data providers started providing ESG ratings for companies.

At the most basic level, ESG ratings aid investors in comprehensively evaluating a firm by analysing it across its three major dimensions: environmental, social, and governance actions and impact. While ESG, in spirit, is a step in the right direction, it has been wrestling to drive a commensurate impact worldwide. There are significant roadblocks impairing its overall uptake and effectiveness. Two major hurdles are the lack of standardized disclosures by corporate and inconsistent measurement criteria employed by the ESG rating providers (ERPs).

Disclosure: Our research at the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, suggests that less than 4% of the total publicly listed Indian firms have been assigned ESG ratings between 2014 to 2021. We arrived at this figure by consolidating three different ERPs, i.e., WRDS Sustainalytics, Thomson Reuters, and CRISIL. The reason for the low coverage of companies by ERPs is that ERPs rely on publicly available data to make assessments. However, most companies – especially the medium and small-sized ones – do not track their ESG activities, let alone disclose them publicly. Even companies that make complete disclosures do not follow any standard procedure, making their interpretation subjective and comparisons across companies challenging.

Measurement: While comparisons across companies are difficult due to a lack of standardised disclosures, how information for the same company is compiled, measured, and converted into an aggregate score differs quite a bit from ERP to ERP. A study conducted by researchers from MIT, published in the Review of Finance, reported steep inconsistencies in the ESG ratings assigned to a business by different agencies (Berg, Koelbel, & Rigobon, 2022). In many cases, firms are assigned highly inconsistent ratings by different ERPs owing to differences in methodology, scope, or weights (importance) assigned to attributes. The divergent estimates about the same underlying entity add to the confusion and defeat the very purpose of these ratings.

Sample: The number of firms assigned an ESG rating in India (by the three ERPs cumulatively) is a minuscule percent of all listed firms (4%). Further, because we cannot compare the ratings across ERPs, research must be done using the data from just one ERP, reducing the number of companies that can be studied even further. Additionally, the number of years of data available for each ERP varies. In such a scenario, the reliability and generalization of research become questionable.

ESG ratings and their effectiveness are subject to substantial political debate in the West. The opposition has openly attacked ESG for its overly ambitious vision but deeply flawed implementation. Some critics have even questioned the morality of ESG by calling it a fabricated tool to legitimize greenwashing. However, in our opinion, although ESG is undoubtedly far from perfect, it remains one of the most potent ways to reimagine businesses in a society fraught with grand challenges.

In line with the old saying "do not throw the baby out with the bathwater," we expect that in the Indian context, SEBI's mandate for BSE Top 1000 companies to report their ESG activities as part of the Business Responsibility and Sustainability Reporting (BRSR) shall alleviate some of these concerns. However, it is time that companies understand the spirit of ESG, and even those companies that do not fall under the purview of BRSR voluntarily disclose the steps taken toward a more sustainable future. Let us actively work towards addressing the pitfalls, bringing more standardisation to disclosures and objectivity to measurement.

Shareholder capitalism to stakeholder capitalism: Are Indian family firms prepared?

This article was first published in moneycontrol.com, April 18, 2022, Co-authors: Sougata Ray & Navneet Bhatnagar; https://www.moneycontrol.com/news/business/shareholder-capitalism-to-stakeholder-capitalism-are-indian-family-firms-prepared-8371801.html

The debate whether companies should be governed with the sole objective of maximising shareholder value (shareholder capitalism as reflected in the shareholder primacy model advocated by Prof. Milton Friedman) or balancing the interests of multiple stakeholders (stakeholder capitalism as reflected in stakeholder primacy model advocated by Prof. R. Edward Freeman), including shareholders, has been raging for several decades.

Climate disasters, rapidly rising inequalities and COVID-19 have perhaps put to rest the shareholder vs. stakeholder primacy debate and tilted the balance firmly in favour of the latter. Modern corporations, irrespective of ownership, have an obligation to act in the interests of multiple constituents -- viz., ecology, environment, society, and shareholders.

It has been argued in literature, with some empirical validation across country contexts, that family firms are generally more influenced by the ideals of stakeholder capitalism and less by the idea of shareholder capitalism.

Anecdotal evidence in India suggests so. Many times in the past, when there has been the need, family firms in India have risen to the occasion and swiftly aided government and people, be it during the Independence movement, wars, floods, famine or pandemics.

How family firms fare

To measure how family firms fare with various stakeholders, we analysed them on various parameters and found interesting results.

Using a sample of over 6,000 firms, over the last 30 years, we found that family firms underperformed non-family firms in terms of return on assets. This indicates that family firms are, in fact, not very focused on returns. This is congruent with the socio-emotional wealth theory of family firms which suggests that they, at times, compromise on economic gains for non-economic goals of the family. This may not be something non-family shareholders want.

Pledging of shares by family owners is an example. Here, the goals of the family and non-family shareholders may deviate. Pledging of shares enables the family to raise funds against shares as collateral. The funds can be used for the same firm whose shares are pledged or for personal use. This results in a limited downside risk for family shareholders as they have already got the funds, but the minority shareholders risk losing a significant amount of their investments, if margin calls are not met.

Such situations are detrimental to minority shareholders. The behaviour of the dominant shareholders may lead to loss of wealth for other shareholders, and ultimately loss of wealth and control of the firm for dominant shareholders, too.

In the recent past, there has been a significant loss of wealth for all shareholders due to the misguided ambitions and decisions, clubbed with the pledging of shares, by promoters of family firms.

Low scores on social, environment fronts

It is, therefore, not surprising that the governance scores of family firms in the ESG (Environment, Social and Governance) rating, as per Reuters and Sustainalytics data, were found to be lower than those of other firms.

Family firms were also found to have relatively low scores on environment and social categories as well as consolidated ESG parameters. The low social score is somewhat puzzling as family firms in India are known to care for the community in which they operate.

In fact, among a larger sample of firms from a different database, we observed that the CSR spends of family firms are higher than those of non-family firms, suggesting that family firms are more compliant to CSR regulations.

It is important to note that the debate around primacy to shareholders vs stakeholders is not about the reaction of corporations to exigencies or CSR spends. It is not the primacy of other stakeholders over shareholders, but about achieving balance on sustainability principles.

It is not about one heroic act catching media attention, but their every action, every day. It is also not about one bottom line – profit. It is about the triple bottom line – people, planet, profit -- and generating and sharing value for all constituents in a fair and equitable manner.

It is about being purposive without losing focus on profit in day-to-day activities. Therefore, to be a multi-stakeholder-friendly and sustainable organisation, family firms need to adopt the principles of triple bottom line and make ESG their strategic ally. It is no longer an option. It is needed for the long-term sustainability of the firms as well as the business families in order to create and pass on the wealth to the next generation and build and sustain the family legacy.

The authors are from the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business.