Last month, "The Economics and Politics of Corporate Social Performance" won the 2009 Moskowitz Prize. The Haas School of Business at UC-Berkeley and the Social Investment Forum (SIF) award the annual Prize to research relevant to socially responsible investing (SRI).
Prize-winning Stanford Professor David P. Baron and his team found that the "social pressure market," through its interplay with the markets for products and equities, can reward companies for their corporate social responsibility (CSR) practices. In doing so, Baron confronts a canard that the SRI sector has disputed since its inception: "The Social Responsibility of Business is to Increase its Profits."
Most Executives Sleeping With the Enemy
SRI and CSR skeptics have perennially repeated this assertion, which is the title of a 1970 New York Times op-ed by Milton Friedman. In that piece, Friedman wrote that an executive, as "an employee of the owners of the business," must run a company in its shareholders' interest. He defined this interest in entirely financial terms, and called any belief to the contrary a "fundamentally subversive doctrine in a free society."
Such "subversion" was rampant in 1970, and as Prof. Baron details, it's even more so today. In his paper's introduction, he cites a 2008 Economist poll that found a majority of firms believe CSR "is a necessary part of doing business," while under 4 percent called it "a waste of time and money." This commitment is not cheap:
"The amount business spends on CSP ['corporate social performance'] dwarfs the amount it spends on campaign contributions and lobbying expenditures. Milyo, Primo, and Groseclose (2000) estimated that corporate campaign contributions and lobbying expenditures were $300 million and $3 billion, respectively, whereas charitable contributions alone were $35 billion."
Why do executives give away so much of their shareholders' money? Do such expenditures help corporate profitability? Prof. Baron reviews past research into the impact of CSR efforts on financial performance, and finds a "positive but weak correlation" between good CSP and corporate financial performance (CFP).
If responsible behavior doesn't always lead to increased profits, then why do most executives believe it's necessary? To answer this, Prof. Baron and his team propose "a theory of the underlying economics and politics of CSP."
A Summary of the CSP Theory
Prof. Baron explains:
"The theory and empirical analysis view CFP and CSP as jointly determined by firms operating in three markets: a product market, a capital market, and a market for social pressure as generated by government, NGOs, and social activists. The theory provides the empirical specification and is also used as a framework to interpret the estimates as an equilibrium in the three markets."
Customers form the product market, and the capital market consists of investors. Prof. Baron on the third market:
"Social pressure could come from government in the form of regulation and enforcement or from NGOs and social activists in the form of boycotts, media campaigns, and harm to a firm's reputation or brand equity. …
"To investigate the relations among CFP, CSP, and social performance in more detail, social pressure is disaggregated into a component judged to be due to public politics (government) and a component due to private politics (NGOs and social activists)."
What the Theory Means for SRI
Two of the study's core findings are especially relevant to SRI, which can be defined as investment that considers extra-financial metrics of corporate environmental, social and governance (ESG) performance.
" …[The] paper finds support for three hypotheses–consumers, employees, or investors penalize firms for incurring social pressure, social activists and NGOs choose soft targets to which to direct social pressure, and CSP is responsive to social pressure. …
"[Also,] disaggregating CSP and social pressure shows that the relations among CFP, CSP, and social pressure are due to social pressure from private rather than public politics."
Here is a clarification of this private political process:
1) A corporation's business practices may attract social pressure from activists.
2) Activists pressure some companies more than others – the "soft targets."
3) When consumers, employees or investors penalize targeted companies – financially or otherwise – companies act to improve their corporate social performance.
In a private-politics-driven market, penalties and rewards are unevenly granted. Prof. Baron writes:
"Dividing the dataset into consumer and industrial industries reveals that the slope of the social market line for consumer industries is positive (i.e., CFP is increasing in CSP), whereas it is negative for firms in the industrial dataset….
"This may be due to rewards that are available to firms that sell to consumers and the absence of those rewards for firms that sell to other firms."
In other words, a consumer-facing firm can profit from its better ESG performance, thereby rewarding its shareholders for its CSP efforts. A firm that sells capital goods has, historically, less market incentive to improve its CSP.
SRI Helps Correct a Market Failure
Why did "The Economics and Politics of Corporate Social Performance" win the Moskowitz Prize? It is a study of CSR, not SRI, and it found only weak financial rewards for good corporate social performance. Why, then, is it of "practical significance to practitioners of socially responsible investing," according to the Prize judges?
The answer, perhaps, is revealed by the discrepancy between CSP's impact on consumer and industrial firms' profitability. In Prof. Baron's tripartite market structure, firms that respond to social pressure will be more profitable – if product market and capital market actors are aware of private political action.
The inability of non-consumer-facing firms to profit from CSP is a market failure. Individuals signal to consumer firms that they will pay for responsible corporate behavior, but for wholesalers, this signal – and its corresponding impact on profitability and investment returns – is muffled.
ESG investors amplify this signal – this willingness of individuals to reward ethical business practices – through the capital markets. By considering the CSP of consumer and industrial firms alike, SRI investors' feedback can help capital markets price the potential value of responsible business practices.
This form of private politics – or "lobbying the corporation," in the words of another 1970s critic – upends the belief that CSR is "subversive" in a market economy.
A follow-up to this KLD Blog article will suggest that social responsibility is a legitimate concern of corporate management, even in Milton Friedman's world. As Prof. Baron's research shows, economic actors in a free society are willing to pay for better corporate ethics.
To understand why, we need only dispense with the "faith and speculation" that, in David P. Baron's words, obscure "the relations between social performance, financial performance, and social pressure."