Slide 1

How Can Businesses Be Rewarded For Ethical Behaviour
Professor Michael Mainelli, Executive Chairman, The Z/Yen Group

[An edited version of this article first appeared as “The Ethical Dilemma” (CSR and Volatility), Accountancy Age, VNU Publications (30 March 2006) pages 20-21.]

While many people regard their own morals as a private matter, businesses are expected to be more public than ever about their ethics.  In the modern world, corporate social responsibility (CSR) is a real business issue. Intellectually at least, the concept of corporate social responsibility and its drive for sustainability is difficult to argue against, but CSR is not without its issues – whether its too many initiatives, disagreement over the best responses, and the triumph of form over substance – after all, even Enron had a code of ethics.  ‘Business ethics’ still sounds like an oxymoron. Former OECD chief economist David Henderson goes further, arguing that the burden of CSR is actually harming organisations and society.  CSR objectives are, he says, neither well defined nor free from controversy, and many corporations are unconsciously and irresponsibly endorsing anti-business hostility to the market economy.

The real problem is achieving proportionate CSR, and how to establish the cost-benefit of sustainability.  It’s not a new argument.  Economists such as Keynes, Hayek and Hicks have long struggled with definitions of sustainability. The problem is, if we can’t define what sustainable levels of income, consumption or resource depletion are, then how can we hope to evaluate a business’s actions? But unless we can reward organisations appropriately for sustainable behaviours, they will not change.

‘Carrots’ might include good public relations, brand enhancement, access to contracts with CSR requirements, positive relations with NGOs, attracting higher-quality staff at lower rates and preferential access to capital.  Freedom from ‘sticks’ could mean not being subject to NGO attacks, not suffering from government impositions, not being boycotted from regions or markets, and not losing key employees with different ethical values.

Of course, the ideal reward for a business pursuing CSR would be a demonstrable increase in shareholder value.  This would allow CSR decisions to fit better into existing financial decision-making models and be subject to cost-benefit approaches.  Without this, businesses run the risk of making poor investment decisions and investing too heavily or too little in CSR. Attempts to measure CSR benefits are numerous, yet the jury is still out on whether there is indeed a link between CSR and investment success.  People pay more attention to larger companies, so they tend to invest in CSR to improve their PR.  But because organisations that invest in CSR tend to be larger, stable and more successful in the first place, there is a danger of confusing cause and effect.

A review of global investment banks by the United Nations environment programme finance initiative back in 2004 found that it was too early to conclude that the pursuit of CSR leads to superior performance.  The study reported that comparative analysis was made more difficult by the wide range of reporting practices for environmental, social and corporate governance risks and opportunities. Still, companies that adhere to CSR should reduce their earnings volatility (see box), be less vulnerable to actions against them (from NGOs, government inquiries, or shareholders), have fewer staff qualms and problems and be able to work in longer-term, more stable partnerships.

One large telecommunications firm began measuring external stakeholder perceptions.  It calculated that although locating transmission masts away from schools cost more, it reduced the risk of possible future public concerns about the safety of schoolchildren. A model was devised to allow the company’s managers to estimate the effects of risk reduction by CSR using option pricing and give some basic shareholder value estimates.  By knowing the value of CSR, the company was able to increase its pursuit of ‘safer’ network provision at higher cost knowing that it was adding to net shareholder worth and protecting brand value. Despite misgivings, CSR initiatives seem to be here for the medium-term at least.  And if research proves that CSR can be measured, that CSR investment can be quantified and that CSR returns are superior, where are the ethical problems in doing the obvious? Does a choice have ethical issues when a proper financial process will arrive at the same decision?

Companies may not be using the right tools to gauge the value of their CSR activities, and that itself may be an ethical lapse. Moreover, some decisions must be made under great uncertainty, other decisions are made in markets that are not competitive or free, and some decisions involve external factors that are not properly priced. But if you invest in CSR activity that does pay back, have you made an ethical decision or simply a normal business investment choice?

Do the maths

Reduced earnings volatility should increase value, and we know investors favour low profit volatility.  A two year study of 1,000 UK companies over a 33-year period shows that the difference between the top and bottom quintiles of profit stability is a 25% to 30% share price premium for the most stable quintile.

Managers can use option theory to evaluate their plans for reducing future profit volatility.  They can also estimate how reducing profit volatility might help their share price, either by looking at the sensitivity of share premiums from moving to a lower quintile of volatility, or by estimating the transfer of value from option holders to shareholders from reduced volatility of share prices using Black-Scholes or other algorithms. Naturally, as CSR plans involve spending money, expenditure needs to be contrasted with price/earnings ratios.

For example, a company with a £10bn market capitalisation might like to reduce perceptions of future profit volatility from 50% to 20%.  The company may estimate a gain of 15% on the share price from profit volatility reduction, and a 10% share price gain from a reduction in share price volatility. As the company has a price/earnings ratio of eight, if it cuts costs by £125m, the share price would also rise by £1bn.  Thus, the managers are justified in investing up to £125m in CSR expenditure that reduces profit and share price volatility.

This over-simplified example ignores a number of complexities such as reduced volatility on larger market capitalisation, liquidity issues and asset allocation motives, but nevertheless illustrates how such measures work.

Michael Mainelli is a director of risk/reward consultancy Z/Yen and Mercers’ School Memorial Professor of Commerce at Gresham College.