Sunday, April 19, 2015

Sustainability - Environment, Social and Governace Issues

What should be the objective function of a  firm? My answer is 'creating shareholder value'. A business firm creates shareholder value while complying with applicable laws and regulations and social norms. When we discuss business sustainability, we often, argue that 'creating shareholder value' is a 'dumb idea'. It is unfortunate. A business is sustainable only if is able to earn return on invested capital (ROIC) that is higher than the cost of capital. We have to apply the traditional accounting and financial measures to calculate value created by a  firm. A  firm that creates 'social value', but fails to create 'shareholder value' is not sustainable. One may argue that a firm that creates social value, necessarily creates shareholder value. This is not correct. For example, a  firm that is manufacturing cigarettes might be destroying social value but creating shareholder value. So long the government does not ban the cigarette business a firm may see opportunity in cigarette business and invest in the same to create shareholder value. Similarly, a firm that creates negative externalities with the permitted level might be destroying social value but creating shareholder value.

Is sustainability a fad? No, it is not a fad. Enlightened firms integrate sustainability in their business model and strategic decisions. Sustainability initiatives of business firms are driven by the regulations or likely future regulations, government priorities, community and consumers. Firms are pushed to focus on sustainability by global concerns (e.g., climate change), government priorities (e.g., solar energy),  regulations (e.g., environmental laws) and  consumers (who demand sustainable products or products produced using sustainable process) and community (which demand reduced negative externalities and increased positive externalities).  Sustainability is pushed through advocacy by voluntary organisations and other institutions, as that creates awareness among consumers and community. Firms' sustainability initiatives aims at managing risks  (managing threats arising from sustainability concerns), building reputation, taking advantage of opportunities arising from sustainability concerns and reducing wastes and costs.

Business sustainability should not be confused with corporate social responsibility (CSR). There is no social responsibility of business. It should engage only in those activities that are required to implement firm's business strategy. For example, it should develop only those skills that will be useful in doing business, directly or indirectly, may be, in the long-term. It cannot and should not take the position of a central planner, assess skill requirements in the country and invest in building those skills. Similarly, it invests in social projects to build social and relationship capital (including reputation) that it will leverage in doing business more efficiently in future. It cannot and should not take the position of a central planner, assess the priorities of the country and invest in community development in priority areas.

Therefore, both the sustainability strategy and CSR strategy should aim at creating shareholder value. Value-driven firms balance short-term, medium-term and long-term.

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