Stakeholders do not merely challenge the business model; they identify opportunities for value creation.
By Dinah A. Koehler, Deloitte Services LP, and Chris Park, Deloitte Consulting LLP
Part of the Business Trends series
In 1962, Nobel laureate Milton Friedman declared that “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”
Two decades later, Edward Freeman laid out his stakeholder theory of corporate management: stakeholders include any group or individual that can affect or is affected by the achievement of an organization's objectives, which should ultimately be to augment the greater good for the many.
When Freeman first proposed his stakeholder theory in 1984, the concept of corporate social responsibility was not well formulated, nor was there much talk of sustainability in the private sector. Scientific understanding of and ability to measure the impacts of industrial activity on the planet and public health was nascent. Furthermore, without the Internet, our global society was much less transparent.
Today the situation could not be more different.
We are tracking the rise in greenhouse gas (GHG) concentrations in the atmosphere, we can measure toxic chemicals in human blood and in the foods we consume, and we are counting the demise of many species. A wide range of stakeholders are keeping score of corporate impacts on society and the environment, and by seizing the megaphone of the Internet, challenge corporate leaders to reframe their objectives and beliefs. In many cases, this can impact market value. What is good for many is increasingly also good for the company.
In a series of blog posts this summer we explored themes from our article The Responsible Enterprise, a chapter from Deloitte’s 2013 Business Trends, including the increasing importance of ESG as a strategic issue, and an examination of the drivers fueling the trend. Today, we take a look at strategic considerations and lessons learned, particularly related to stakeholders.
Strategic Consideration 1: Know Your Stakeholders
As strong ESG performance increasingly becomes the norm, it becomes harder to impress even the average shareholder, who has also become more risk averse to negative environment news. The crucial tipping point is when their response begins to pose material risk to the company. This usually occurs somewhere between nascent discussions and outright media campaigns, boycotts, or shareholder resolutions. For guidance we refer to the policy life cycle set forth by Maxwell, which identifies various phases of an ESG issue, starting with issue identification and limited awareness (see below). As the ESG issue infiltrates various segments of our society, goes viral on social media, and flashes across traditional news media, the financial impact for an affected company tends to increase.
What is interesting about this figure is the difference in costs to the company between the traditional policy life cycle – where activists and NGOs push regulators and legislators to govern company actions – and the private policy life cycle, which is driven by stakeholders who engage directly with companies and can force change and impose costs – via protests, media campaigns, and boycotts – more dramatically than regulations. However, figuring when and why stakeholders will escalate an ESG issue is not well understood.
When & Why do Stakeholders Escalate an ESG Issue?
Based on the empirical record, various factors appear to influence stakeholder behavior and impacts on the business:
- Common stakeholder targets tend to be large companies in consumer products that are financially sound and heavy polluters. Activists also tend to target companies with a strong brand or that are considered leaders within their industry.
- Stakeholder protests targeting labor (e.g., fair labor practices) or consumer issues (e.g., product safety or performance) with more media coverage tend to have a greater negative effect on stock returns than boycotts alone.
- Companies with an already tainted reputation are even more susceptible to the negative effects of media attention.
- Activists prefer to target firms that have signaled a desire to change and often confront them with greater demands. Once a company has signaled a willingness to act, the bar can rise even more.
- Companies that have been targeted by a shareholder campaign, or whose industry peers have been targeted, will likely be targeted again. Similarly, boycotts are often repeatedly targeted at companies in the same industry, particularly large companies with a strong reputation. In fact, the impact on sales is less than the impact on a targeted company’s reputation.
Strategic Consideration 2: Adapt
One challenge for a company is how to show that its stakeholders no longer perceive it as destroying value on a particular ESG issue. The long-term goal should be greater consensus between the business and its stakeholders around an ESG issue, because it creates value for both.
Consider the shift in Home Depot’s approach to sourcing wood products in response to stakeholder pressure, for example. In the early 1990s, Rainforest Action Network, together with Greenpeace and Natural Resources Defense Council, launched a campaign against the destruction of old-growth forests, targeting the Fortune 500 companies. They wanted the companies to cease using or buying pulp and paper products sourced from old-growth forests.
Starting in 1997, activists increased the pressure on Home Depot – at the time the world’s top seller of old-growth wood products – until the company committed to phasing out products using wood from endangered forests and environmentally sensitive areas in 1999. Home Depot, along with other major home improvement retailers, also committed to preferential purchasing of wood certified to the independent FSC standard.
As of 2000, Home Depot adopted a proactive approach to how it sources wood products. Between 2000 and 2003, the company pulled out of $90 million in purchases from vendors in Indonesia and other Southeast Asian countries whose supply chains could not be validated. From 2000 to 2002, VP of Merchandising and Sustainability Ron Jarvis traveled the world to understand Home Depot’s suppliers and their forestry practices. Upon his return, he convened a meeting of key stakeholders and shared his findings on where Home Depot sourced its wood (of which 95 percent comes from North American forests).
With that examination, Home Depot proved that it knew more than many stakeholders about the issue, and has since become a valuable resource of knowledge of forestry practices around the world.
Strategic Consideration 3: Disclose Strategically and Cultivate Your ESG Halo
Information is money, a relationship that applies quite often when it comes to ESG disclosure. Research shows that voluntary disclosure on sustainability and corporate responsibility may lower the cost of equity capital for companies with stronger ESG performance who invest in employee relations, environmental policies and product strategies.
ESG disclosure also tends to attract institutional investors with a long investment horizon. Those companies with strong ESG performance have increased analyst coverage and improved forecast accuracy. Conversely, companies with poor ESG performance are less likely to maintain profitability due to regulatory, customer and investor pressure.
Furthermore, issuing a steady stream of positive and credible ESG performance news can create a halo effect and insulate the company somewhat from future activist pressures and possible drop in stock price, moving the company from risk management to creating value both for its stakeholders and its investors.
However, it can pay to watch the company you keep.
If a competitor in your industry falters, then it is likely that activists and shareholders will monitor your company more closely and even drive down your company’s market value. Thus, investing in industry policies, industry associations and benchmarking with your industry peers can be effective in maintaining a solid level of ESG performance and protecting against the negative events that inevitably arise.
Stakeholders and a Path to Long-term Business Value
Not long ago, business operations were grounded in the assumption that ESG issues are not financially material, because the impacts are in the future and of relatively little consequence to current business success. This assumption is no longer supported by statistical evidence for a growing set of ESG issues and companies. There is value in these numbers, as evidenced by growing shareholder interest and market value effects. Stakeholders are keeping score, and companies are expected to increasingly demonstrate a positive impact on financial performance.
More corporate leaders are also broadening their understanding of business risks—some more proactively than others. However, many managers have yet to shift their frame of reference in terms of ESG performance evaluation and disclosure. Much of the information disclosed in today’s corporate sustainability reports, for example, continues to be self-referencing and difficult to interpret.
An assessment of what level of ESG performance is better or worse cannot be judged relative to the company’s own internal standard or its past performance, because it does not include value creation for multiple stakeholders. The stakeholder’s reference point is as, if not more, important than that espoused by managers.
A sound strategy then requires an understanding of human nature and the biases that we bring to all decisions. Success is built, in part, upon a more holistic approach to an ESG issue, such as recognizing that child labor management is tied to educational opportunity. Finally, as more managers realize that the management of ESG issues is an input factor to production and not an ad hoc undertaking, and become more transparent on performance, we can expect risk reduction and lower cost of capital. Stakeholders do not merely challenge the business model; they identify opportunities for value creation.
Although the issue of materiality is not new, it is not well understood. In our next and final article in this series, we will look at the future of ESG in particular the issue of materiality. Coming up next!