The Link Between Good Governance And Green Firms

Published: Oct 28, 2010

A look into any newspaper reveals a plethora of problems that vie for the distinction of ‘most pressing issue.’ One of these – currently outshone by concerns about global financial systems, recession, and currency wars – is that of how we, as society, managers, or firms, treat the natural environment.

In fact, this particular issue has made quite a career – 60 odd years ago, it was not really a topic at all, as we considered the environment a convenient dumping ground for waste or an essentially free source of raw materials like air or water. Quite frankly, in the wake of a devastating World War, people were understandably focused more on building a livelihood around themselves than considering the damage to their environment. Eventually, however, the build-up phase was over, the air was hazy and the water cloudy, triggering a wave of activism around environmental concerns (the WWF was founded in 1961, Greenpeace 10 years later). This activism was reflected in initial environmental government legislation (the US EPA, e.g., was founded in 1970) – an interference in business not appreciated – and vividly fought against – by firms and shareholders at the time. Legislation was considered to be a cost – and a firm that is forced to ‘add a filter’ clearly primarily incurs an expense without any compensating benefit.

Much more recently, however, a number of academics have suggested, and in many cases also persuasively shown, that taking better care of the environment could actually pay-off handsomely for firms. Yet, this happens only if firms are engaged in intensive, pro-active green strategies, not just reactively adding filters. In other words, firms need to go beyond what current legislation requires in order to create products that thrill an increasing number of green-minded customers, and to build internal firm capabilities that allow them to create more products with fewer inputs – and much less waste. To the extent that firms can distinguish from their competitors in such a way, they may earn a cost advantage or an ability to sell more products or charge higher margins as customers turn to them as their preferred supplier. These new insights into the benefits of being ‘green’ have coincided with a much stronger public awareness of environmental problems, an urge to counter environmental destruction, and work towards a more ‘sustainable’ economic model. The pressures that lead to the Kyoto Accord and the strong reactions to BP’s recent Gulf of Mexico oil spill (which not only outraged customers, but compelled shareholders to significantly bid down BP’s stock) are both evidence of how much this former non-issue has become an important concern for firms and society – it also suggests just how many ‘green-minded’ consumers there are.

It appears green strategies can, under certain conditions, be quite lucrative for companies. Accordingly, even if we do not appeal to a moral obligation of firms to protect the environment, there should still be a sizable number of green activities that are not only good for stakeholders (the environment, society), but  also in the ‘best interest’ of shareholders. As firms, however, differ dramatically in their green strategies, a natural question for my colleagues and me was what determines whether firms will execute such green activities that are in everybody’s ‘best interest’ – i.e., how does a firm choose to focus its energies, among all the other contenders for management and financial attention, on things like ISO14001 certification, the installation of environmental management systems, or, more generally, waste reduction?

To address this question, we have undertaken multiple studies on the systems of corporate governance that firms already have in place and that, in our opinion, strongly influence whether or not ‘profitable’ green strategies will be executed. Corporate governance, in this context, is the set of rules, regulations, and relationships that ensures correct managerial behavior. Managers, especially those at the very top, are the ones that make key decisions – and any substantive strategy shift towards a pro-active environmental stance surely counts as such. The crucial question then becomes, what makes the top of the firm go green – at least in the sense of executing all ‘profitable’ green activities?

The simple answer is that managers either believe these green strategies to be in their ‘own’ interest, or they are pressured to execute them. For example, the first case would occur if managers somehow partake in the financial value created by green strategies. This, in fact, is precisely what my IE colleagues Juan Santaló and Luis Diestre, and I have found: firms in which more of a manager’s pay is performance-based – think stock-options or bonuses – have significantly lower levels of pollution.

If, however, managers do not participate in the financial implications of their strategies then there is generally a risk that they will slack off and not undertake profitable actions, or, worse, work only for their own pockets. The problem – and opportunity – is simply that managers can rely on unique insights into their firms’ operations, which gives them a clear information advantage over outsiders like shareholders or directors to select either profitable strategies – or such that only benefit themselves. Mind you, this does not solely apply to green strategies – it is rather a basic tenet of corporate governance that we either have to incentivize managers or monitor them and exert pressure so that they perform well and pick strategies in the best interest of the firm – the classical ‘carrot and stick’.

On a basic level, monitoring and applying pressure – which can emanate from a variety of sources like boards, banks, the takeover market or shareholders – could just mean that managers are held accountable if firm performance suffers. The hope, which is broadly supported by the results of our studies, is that managers of well monitored firms avoid sanctions by using their inside information to pick the most profitable strategies – including green ones.

This approach, however, requires that boards and shareholders give managers the discretion to choose the best course of action. Yet, there could also be another monitoring approach, aimed at eliciting particular managerial behaviors.  Boards, for instance, could mandate specific green performance targets while shareholders could bid-up the shares of firms with strategies they ‘like’. That would imply, of course, that the monitors themselves pick the ‘right’ strategies and not exploit the information advantage of managers. This tactic would work if managers are opposed to profitable green strategies, but would backfire if the opposite were true.

Shareholders, for example, may not always lead right.  In another study, we found evidence that the value of green strategies becomes only apparent to shareholders over long periods of time and that share prices of green firms are correspondingly initially depressed. This may suggest that at least some shareholders are still caught in the thinking of an earlier period of environmental management, when green activities were unequivocally seen as a cost. In turn, as I have shown a few years ago, in an article entitled “When the Market misleads”, such negative signals may discourage managers from making the right investments.

Altogether, being green seems to pay-off if done pro-actively to carve out a competitive advantage. A great tool to make this happen is ‘good governance’ – incentivizing and monitoring managers who have inside knowledge and discretion to pick those green strategies that are in everybody’s best interest and to significantly help our environment.

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain]

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