According to George Serafeim, the big global problems could be solved if the industry’s competitors worked more together. Is it even possible in a market economy?
by Sean Silverthorne
George Serafeim has come up with a surprising proposal to tackle the world’s biggest environmental, social and governance (ESG) issues such as water pollution, deforestation and wealth inequality: boosting businesses in the region
For example, competitors in the fashion industry could join forces to jointly manage resources to reduce water pollution through their manufacturing processes. The beef industry may agree to work together in livestock to reduce deforestation. These partnerships would take place before the competition, which means that everyone would start at the same level by eventually competing in the marketplace.
Would not such cooperation throw a key into the capitalist competition of the free market? Serafeim says no, this collaboration is different from collusion. In this case, companies will explicitly talk about their cooperation and under the control of investors, regulators and their own legal experts. “Like airlines that work together by buying jets together to cut costs together, collaboration is mutually beneficial, but it does not affect competitors’ core relationships,” he adds.
Serafeim, associate professor of the Jakurski family at Harvard Business School, talks about his theory in an e-mail interview. His article is called Investors as Shop Stewards?
Sean Silverthorne: Why is your proposal necessary? Are the current ESG efforts not sufficiently used by the companies?
George Serafeim: Consider the following: Over the last two decades, most companies have created sustainable development departments, hired more people for their social impact, invested more resources and published many more wonderful articles. In some cases, these efforts have borne fruit. For example, many companies have increased the diversity of their workforce. But all these efforts have not been enough to stop or reverse the serious challenges we face. Environmental degradation and the challenges of social inclusion and equality are persistent problems that have in many cases become more acute.
“THESE QUESTIONS ARE RESPONSIBLE FOR THE FUTURE COMPETITIVENESS OF THESE INDUSTRIES”
In our competitive environment, ESG efforts are driven by economic incentives. In fact, my research with colleagues has shown that improving business development on ESG issues that are relevant to enterprise-based companies is positively related to future financial performance. A company’s efforts to improve its social impact could result in cost savings, increased brand value, innovation, employee productivity, and lower financing costs. A large number of studies and researchers have documented these effects. Prof. Geoffrey Jones’ new book, Profits and Sustainability: A Green Entrepreneurship Story systematically documents some of the early CEOs who have seen opportunities in this area.
Although these studies suggest that positive social impact and financial performance complement each other, it is not clear that companies will solve many problems over time for three reasons. First, while a company that improves its ESG performance could be financially better in the future than other companies, this does not mean that the measure is sufficient to make a significant contribution to the problem. For example, it might be better for a company to increase the wages of low-level employees by $ 1 an hour, but it might not be cost-effective to raise wages by $ 2 an hour. However, the wage increase of $ 1 could lead to these people working below the subsistence level.
Second, there are cases where improving a company’s social impact does not help financially. In some cases, consumers are unwilling to pay more for “green” products, and in most cases, only certain customer groups for certain products are willing to choose more environmentally friendly products. Companies that take costly measures for sustainable procurement can therefore have a higher cost structure, lower profit margins and thus a competitive disadvantage.
Third, raising wages or selecting suppliers with better environmental practices could bring long-term financial benefits; However, short-term pressure on the company can encourage corporate owners to make such investments. The market for corporate governance, the design of executive compensation programs, and the board’s valuation horizon may be obstacles to such decisions.
My previous work has focused on ESG issues, where company-level action really has business benefits and positive social impact. With this paper, I try to integrate ESG issues where this may not be the case. I wonder what role investors play in enabling companies to increase their social impact.
“IT IS INDISPENSABLE THAT MANY PROGRESSES ARE IN THE PROBLEMS OF THE INDUSTRY IN WHICH INVESTORS ARE NOT SOME OF THE MOST IMPORTANT COMPETITORS IN THE INDUSTRY”
Silverthorne: What are the conditions in an industry for this plan to work? Are there industries that you think are the most successful?
Serafeim: The first requirement associated with this article is that the problem must be a value added opportunity for the entire industry. It is unlikely that progress will be made in cases where cooperation would be unprofitable in the short and long term.
Second, large institutional investors must hold a significant stake in a significant portion of the industry’s major players. Significant progress is unlikely to be made in areas where investors are not among the major competitors in the industry. If so, it would be more difficult to co-operate with a significant part of the industry and effectively reduce the temptation to break free.
Silverthorne: What would be the incentives for competing companies in the same industry to work together?
Serafeim: Most of the leaders I’ve worked with over the years really want to do good. They acknowledge that many issues need to be addressed, either in terms of environmental practices or inclusion and equity. Solving these issues is crucial for the future competitiveness of these industries.
First, attracting talent to the industry is one big reason why companies can work together. Many large organizations, such as those involved in carbon intensive companies, are worried about it. How will you attract the best graduates if your business destroys the environment?
Second, competitors want to avoid new regulations that could significantly impact the industry. The financial sector is a good example. In the past, banks were innovative, delivering real customer service and attracting the best talent. They become public services exposed to an unbelievable amount of regulations due to their own driving problems.
Third, they could reduce the risk of major scandals. The price of medicines is a good example. More and more business leaders in the healthcare sector are realizing that industry players demanding very high drug prices are causing all sorts of problems for the industry as a whole.
Silverthorne: You find that companies are unlikely to come alone on this issue. Investors have the power to bring them to the table. Which investors are the most likely to influence?
Serafeim: I identify two characteristics of investors who can interact with companies at the sector level in matters of environmental and social importance: their investment horizon is long and the co-ownership of companies that belong to the same or the same supply chain. Two types of investors meet both criteria. First, large, mostly passive asset managers like BlackRock, State Street and Vanguard. These investors hold significant equity stakes and as long as a company remains in the index, it will continue to hold shares. Second, large pension funds such as Norges Bank Investment Management, AP and the Common Retirement Fund of New York State. They also tend to hold a significant portion of the shares of many companies while matching assets with long-term commitments.
These investors are now officially recognizing the importance of ESG issues for investment performance and management. Large index investors have formed teams that interact with their portfolio companies, and large asset owners are among the leading companies in the business dialogue on environmental and social issues.
This does not mean that other investors do not play a role in this change theory. In fact, I suggest that two other types of investors, socially responsible investment funds and individual investors, play a key role in solving free will issues at the level of large institutional investors (the temptation of a manager) the efforts of other asset managers) and direct incentives to involve major institutional investors.
Silverthorne: Can you name one or two precompetitive collaborative actions that could motivate investors?
Serafeim: Many cases and everyone has their strengths and weaknesses.
Beef is one of the main reasons for deforestation worldwide. The transformation of forests into pastures, mainly in Latin America, destroys 2.7 million hectares of tropical forests each year (an area the size of Massachusetts). It is expensive for meat producers to solve the problem of deforestation alone. If they agree to slow down the process, they risk losing market share and income because they will not be able to find new pastures for cattle while other players in the sector carry on cutting down the trees. Consequently, the problem of deforestation requires coordinated action by key stakeholders. Ceres and the Principles for Responsible Investment (PRI) launched a partnership to tackle global deforestation in 2016, due to growing beef, soybean and wood production, with a focus initially on South America. Both organizations are helping global institutional investors put pressure on food and timber companies to eliminate deforestation and other related problems.
“I see this as a chance to increase the reach of corporate governance and create opportunities to earn more in the future”
In another example, the production of clothing is associated with water pollution at many stages of the value chain. Agricultural production (especially cotton) has been associated with inefficient use of agrochemicals, leading to overuse and excessive leaching of chemicals into water systems. The wet treatment also has a special effect. According to World Bank estimates, 17 to 20 percent of global industrial water pollution comes from textiles dyeing and processing. When it comes to water, fashion brands face the same risks in their supply chains. The geographic spread of the production sites is low and therefore different actors can benefit from cooperation on selected commitments in priority river basins.
Other examples include the fight against obesity and nutrition in the food and drink sector, corruption in the construction sector and access to affordable products, and inclusion in the food and drink sector. Education.
Silverthorne: Are there any examples of this kind of industry-internal collaboration that works elsewhere?
Serafeim: There are many collaborations around the world. The International Council for Mining and Metals has developed transparency principles for mining companies, and the Responsible Care Chemical Industry program has focused on results ranging from employee safety to environmental impact. Similarly, the Global Agribusiness Alliance is developing an agreement for companies operating in different parts of the agricultural value chain, including behavioral standards to improve farmers’ living conditions. Some collaborations are effective and others are not.
Research is inconsistent in its effectiveness because incentives (for companies) are sometimes important for defection. Commitment mechanisms are needed and investors can be one of these engagement mechanisms. Professor Michael Toffel has done important work on self-regulation and its effectiveness.
Silverthorne: If you have kissed, do you think that this idea would be very successful in correcting the pressing problems of the world?
Serafeim: The number of people who believe that this is the sole responsibility of governments is decreasing. I see this as an opportunity to increase the reach of corporate governance and create more win-win opportunities in the future. As these collaborations become more effective, an increasing number of companies will be able to engage in activities that have a more positive social impact. Professor Rebecca Henderson writes a fascinating book on the subject, inspired by the Reimagining Capitalism: Business and Big Problems course, which we teach in the optional MBA program.
While it is unlikely that investors can solve many pressing societal issues, progress can be made.