Sustainability in business has become a vital selling point, but companies remain value-maximising entities, writes Audencia Business School’s Iordanis Kalaitzoglou
In response to spiralling scientific evidence for climate change, increasing numbers of countries are introducing environmental legislation. Global political will in this area appears higher than ever, as evidenced by the 2015 UN Climate Change Conference (COP21), 2016’s Article 173 of the French Energy Transition Law, and the European Commission’s action plan on sustainable finance. There has also been 2019’s election of Ursula von der Leyen, who put environmental action high on her agenda as President of the European Commission and successor to Jean-Claude Juncker.
However, empirical evidence suggests that much environmental legislation is either overly ambitious or inadequate, meaning that the vast majority of countries do not meet their environmental targets. The usual explanation for this is that environmental action is not cost effective. Yet this is inconsistent with the fact that, over the long term, energy generation from renewable sources will become stable and economically viable. For example, around 75% of coal production in the US is now more costly in generating energy than solar panels and wind turbines, according to a study for Energy Innovation, a San Francisco-based firm that analyses clean energy and climate policies.
Wish lists rather than concrete plans
Unfortunately, the political will to disengage from fossil fuels does not seem to be strong in the US, while other countries, such as Brazil and Turkey, prioritise economic objectives over environmental goals.
This leaves global energy summits seeming more like an exercise in creating wish lists than opportunities to formulate concrete action plans. In fact, evidence shows that very few countries address their environmental impact adequately, with the result that global greenhouse gas emissions are reaching ever-increasing heights. Several reports stress that we are the last generation that can act on preventing climate change. They also suggest that unless significant action is taken now, the ensuing crisis will lead to worldwide social, political and financial turmoil on a level not seen since the Second World War. Even so, the setting of high targets while carrying on with ‘business as usual’ seems to be rooted in some strong macroeconomic trends.
Environmental corporate incentives
The warning signs are already here. July 2019 was the hottest month ever recorded on Earth. Even if we put this fact aside and look at the issue from a simple business standpoint, the growing sense of urgency around climate change is creating a strong demand for more ethical entrepreneurship and for products that address environmental concerns. In other words, sustainability has become a selling point as well as being necessary for human survival. Companies therefore have a strong incentive to show that they are in line with their stakeholders’ environmental concerns.
A significant number of companies are beginning to cater more overtly to the ever-increasing demands of their stakeholders, to present a greener profile to their customers and suppliers, and to society in general. This shift in public demand means environmentally friendly activities have become commercially valuable. An environmentally friendly social profile has become so popular that there are now agencies that evaluate firms’ environmental performance and financial entities that focus exclusively on green firms.
But if environmental friendliness is so high on so many companies’ agendas, why are so many companies, and countries as a whole, still not aligned with officially recommended environmental targets? Are these companies’ actions simply inefficient, or are there other factors holding things back?
Most likely, it is both.
Financial corporate incentives
Companies are value-maximising entities. The primary objective of management is to increase the wealth of shareholders because they are hired by, and answerable, to them. Over the past few decades, it has become generally understood that value maximisation is an holistic approach that doesn’t just include financial objectives, but encompasses anything that can affect the profile of a company. In that spirit, companies are inclined to offer what their stakeholders request in the best possible way. If an environmental profile is in demand, it is advantageous for a company to adopt it.
Yet, sacrificing consumption power in favour of the environment does not resonate unconditionally with consumers. As the ‘gilets jaunes’ protests in France, or US coal and oil protectionism measures designed to save jobs, have shown, this tends to influence government actions.
A sharp shift towards a zero-carbon economy would require a drastic shift in consumption habits. For example, energy generation from renewable sources, although abundant at times, is not stable and might result in periods of low energy generation. This might require electricity consumption (industrial and retail) to be adjusted, but current demand for electricity is completely inflexible at a global level.
Similarly, green products might require higher production costs, which would make them more expensive. Energy-intensive industries and price-sensitive consumers are then more likely to prioritise financial needs over environmental ones.
Companies therefore often face a trade-off between being environmentally friendly and price competitive. These two things are not necessarily aligned, so companies choose to optimise, rather than specialise. The criterion they optimise is their value-maximisation objective. This is somewhat sensible from an economic point of view, since it is more realistic to adopt new measures gradually, rather than to induce a shock. It is also the spirit of EU policies, in which promoted incentives focus on becoming smarter rather than better. This equates to a period of transition, during which individual firms and national economies are expected to move gradually towards a zero-carbon state.
Companies’ incremental adjustments are looking to find the right balance between environmental friendliness and value maximisation. This is why their current actions might seem inefficient: the macroeconomic trends driving these actions do not yet support a full environmental engagement.
Window dressing vs. lobbying
The economics of energy transition create both financial and environmental incentives, so different firms should be expected to pursue different strategies, according to their energy profiles.
For example, it would be much more difficult for an energy-intensive firm, or a fossil fuel company, to change its business model drastically in order to be more environmentally friendly, because this would involve significant investment and cost.
However, since a company’s profile is often improved if it makes this change, or at least gives the impression that it is doing so, businesses might take less conventional actions to preserve or increase their value in this way. There are two types of corporate activity that are observed frequently in this arena: ‘window dressing’ and lobbying.
The private sector is well known for trying to bend political will towards its financial incentives by lobbying decision makers. But, when it comes to environmentally sensitive issues, these actions are often met with firm public opposition. The consumer base, especially in mature economies, is becoming more environmentally sensitive and lobbying activities that are perceived to have a negative environmental impact can also have a negative impact on the companies involved.
Companies have been very active in trying to improve their public profile with respect to their environmental impact, but most continue to lobby at the same rate.
In some cases, as in the examples of the big five fossil fuel companies (BP, Shell, ExxonMobil, Chevron and Total), PR campaigns are designed to show that attempts to reduce environmental impact are being made, while spending continues out of the public eye on current – and not so environmentally friendly – activities and/or lobbying.
Again, a drastic shift in stakeholders’ consumer behaviour would help reduce the impact of lobbying, either by supplying a financial objective for these firms, or through changes to the political agenda and reforms to the relevant legislation.
Is it all that bad?
Greater environmental awareness and a demand for more sustainable products create the foundations for a potential shift in corporate actions.
Although the demand for environmental friendliness among stakeholders may be best described as ‘lukewarm’, with an electoral base that leads governments to pursue a very slow shift of resources and priorities towards environmental policies, there is significant progress that partially mitigates the impact of the rigid demand for energy.
The most encouraging progress has perhaps come with the realisation, among stakeholders, that to promote more environmentally responsible policies, they must mobilise the aggregated demand towards more responsible consumption. This can be done by quantifying their arguments so that people can understand and compare the relative costs – while also making use of social media platforms to nudge people to amend their spending habits.
Shifts in aggregated demand would force companies to innovate and offer
more environmentally friendly products, with the support of governments. While current levels of change are insufficient, there have been notable developments. In the finance industry, for example, terms such as ‘climate change risk’, ‘social cost of carbon’, and ‘carbon price’ have entered the vocabulary, and green financial products have emerged. As little as 10 years ago, this would have sounded far-fetched.
The public and private sectors both serve a social purpose and are supposed to meet the needs of their stakeholders in the best possible way. Consequently, if the social groups they serve amend their attitudes at an aggregated level, it is in the best interests of both the public and private sectors to follow. In other words, if everyone played the same game, everyone would win. However, considering the demographic composition of the electoral basis, this should not be expected to happen any time soon.
Iordanis Kalaitzoglou is a Finance Professor at Audencia Business School, France.