Radical Old Idea

The Global Ethical Finance Initiative’s inaugural Radical Old Idea virtual event took place on 23rd June 2020. Professor Alex Edmans of London Business School discussed how to be a responsible business in a time of crisis in a session chaired by Eva Cairns, ESG Investment Analyst – Climate Change at Aberdeen Standard Investments.

The COVID-19 pandemic has seen some inspired corporate responses, such as Unilever donating €100 million of food and sanitizer, and guaranteeing the jobs of all 150,000 workers including contractors. But what if you’re a small business without millions to donate? Or in an unrelated industry without relevant products to give? Professor Edmans discussed what it means to be a responsible business, for companies of all sizes and in all industries. He also explain the business case for responsibility in normal times as well as crisis times, and how companies can ensure that responsibility is consistent with long-term shareholder value. Professor Edmans drew on rigorous academic research, real-world examples, and his new book, “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”.

Professor Edmans was introduced by the session chair Eva Cairns and he started his presentation with an interesting example as to the role the media plays in informing the public’s perception of responsible business. In 2007, Vodafone created the innovative M-Pesa mobile money service that, through a mobile phone, provides access to financial services to over 37 million people who previously had only limited access to bank accounts, while in 2012, they were the first telecoms company to release a tax transparency report highlighting its contributions to the public finances in the countries of operation. Professor Edmans posed two questions:

1. Which of these decisions created most value for society?
2. Which of these decisions, if not taken, would have led to most public outrage, or worsened Vodafone’s CSR rating / reputation?

Public and media anger was focused on the issue of tax – relating to the fair division of the pie. Whilst this is important, Professor Edmans proposes that it is time to change the thinking about responsible business and move from a “doing no harm” approach to “actively doing good” by growing the pie with socially beneficial projects like M-Pesa.

Professor Edmans then introduced the concept of “pieconomics” where companies seek to create profits only through creating value for society, rather than simply extracting value from other members of society such as employees.

What is the evidence for this? Employee satisfaction studies have shown that over 1984-2011 the “100 Best Companies to Work For in America” beat their peers by 2.3-3.8% / year. Professor Edmans suggested that qualitative factors (such as trust in management, camaraderie etc) are as important as quantitative factors (such as pay and benefits) in successful companies.

For companies, creating stakeholder value is therefore an issue for CEOs, not CSR departments, and for investors, a company’s stakeholder capital is a financial issue for all investors, not a non-financial issue for “socially responsible” investors.

To make decisions under ‘pieconomics’ Professor Edmans cited three principles:

• Multiplication
• Comparative advantage
• Materiality

He focused on materiality. To introduce the topic, he discussed the meaning of purpose. The common perception is that purpose is about altruism and serving society. Some companies have a purpose that aims “to serve customers, workers, suppliers, the environment, and communities while generating a returns to investors.” However, Professor Edmans contends that purpose is about being targeted, focused and deliberate – focusing on the most material stakeholders rather than trying to be all things to all people. Purpose is the answer to the question: “how the world is made a better place by my company being here?”.

The importance of materiality was demonstrated through the work of Khan, Serafeim, and Yoon (2016) who found, through analysing ESG data, that firms that score high on all issues outperform by 1.5% / year, which is statistically insignificant. However, firms that score high on material issues and low on immaterial issues outperform by 4.83% / year. This research highlights the importance of having clarity in purpose.

Professor Edmans then applied the insights to the pandemic. Some companies have responded by splitting the pie differently – giving up profits to pay furloughed workers and or donate products to customers. These actions are laudable, but not every company can split the pie – they may be small companies that don’t have millions to donate, or large companies in unrelated industries. This highlights the importance of viewing responsibility as growing the pie through innovation – for example, a perfume company pivoting to make sanitizer.

To conclude the formal presentation Professor Edmans made a passionate call for to support companies that do no harm AND do good. There is a lot of energy around responsible business and to grow the pie, rather than being viewed as the enemy, investors and profit have the greatest role to play in repurposing businesses and creating a sustainable economy.

The formal presentation was followed by a question and answer session that was moderated by Eva Cairns. Topics covered included:

Professor Edmans motivation for the writing “Grow the Pie”

• Huge movement against business and view that business not serving wider society
• Business can be a big force for good so important to work with and not against business
• Much of the research had already been done so it was timely to write it up

Challenges of change mindsets

• The pie splitting mentally is engrained in us from childhood (win / lose games). Indeed, one of the most successful manufacturing innovations is Ford’s assembly line, which aimed to extract as much effort as possible from workers
• Whilst investing in employees reduces short term profit we need to extend the horizon to consider the long term benefits of growing the pie

Role of climate change in responsible business

• Environmental factors have a weaker link to long-term profit than Social and Governance factors
• However, investors (such as pension funds) may have goals other than pure profit. Thus, even if combating climate change does not improve profit, even in the long-run, doing so can still be in shareholders’ interest

Surprising results from the book

• As the book was based on research conducted over the last 13-15 years there were no major surprises
• The popularity of responsible business means that lots of talking heads now want to write about it, even if they have not conducted rigorous research on this topic. In contrast, the book is based on decades of rigorous research by Professor Edmans and others

Approach to remuneration

• We need to be careful about linking pay to measuring things like climate impact, gender diversity etc as by focusing on specific outcomes may come at the expense of others
• It is better to align pay over the long term (5-7 years) to allow companies to best serve society (this can include investing in intangible assets)

Assessing stakeholder value

• SASB recognises metrics around stakeholder values and launched a Materiality Map that identifies sustainability issues that are likely to affect the financial condition or operating performance of companies within an industry
• It is important to have boots on the ground as this provides greater context to the measures
• The Blueprint for Better Business provides 8 questions that should be asked to get beneath the skin of whether a company is genuinely pursuing a purpose beyond profit

Role of Government

• Requirement to address three sources of market failure:

1. Lack of competition (employees / customers are locked into purposeless companies)
2. Lack of information (investors and stakeholders cannot hold firms accountable, e.g. for environmental impact)
3. Externalities (companies’ impact on society that does not affect profits, even in the long term).

The Friedman Doctrine

• Friedman’s article, “The Social Responsibility of Business is to Increase Its Profits” is widely misportrayed. It does not advocate exploiting stakeholders; instead, it stresses that investing in stakeholders can increase long-term profit
• However, Friedman’s approach to investing in stakeholders is instrumental – you do so only if you can calculate the impact on profits. Pieconomics’ approach is intrinsic – you do so in order to create social value; profits are a by-product

Purpose driving performance mechanism

• Human capital is the most important asset of the modern firm an a critical success factor to motivate, reward and retain
• Google provide intrinsic motivation by encouraging employees to spend 20% of their time working on what they think will most benefit Google
• The profits of responsible businesses systematically beat analyst expectations as they do not incorporate culture measures

Data

• The 100 Best Companies to Work For was initially published in a book in 1984. In 1998 it was published in Fortune Magazine. If markets were efficient, then the returns to investing in the Best Companies should be lower after 1998, as the information is more public
• Instead, the returns increased after 1998, suggesting that markets are not efficient – they ignore intangible information. Instead, the increase could be because the world is changing, with human capital particularly important in the 21st century firm

Good media attention

• There is a tendency to focus on failures, which are commonplace when innovating, and the media thrive on negative stories
• Instead of “naming and shaming” companies that make mistakes, the media should “name and fame” companies that innovate courageously

Shareholder primacy

• Many writers on responsible business (e.g. Bower and Paine in the Harvard Business Review) pit businesses against investors. They argue that companies focus too much on shareholder value and that we need to radically reform business away from shareholder primacy. These views are often accepted uncritically given “confirmation bias” – people often like to think that shareholders are greedy terrorists, and pundits who suggest radical changes are seen as revolutionary.
• However, these views are often not backed up by rigorous research. It is critical to focus on the highest-quality evidence, rather than articles that confirm what we think to be true. Harvard Business Review is a media outlet rather than a research publication; it is not peer-reviewed.
• A decade of evidence, published in the most stringent academic journals, finds that hedge fund activism increases stock prices in the short AND long term. This was not down to tax savings or cutting wages, but instead increases in productivity and innovation.