Boards, Incentives, and CSR

Citation preview

BOARDS, INCENTIVES AND CORPORATE SOCIAL RESPONSIBILITY

935

Boards, Incentives and Corporate Social Responsibility: the case for a change of emphasis Craig Mackenzie* Boards of large UK companies are devoting more time to the governance of corporate social responsibility (CSR). This is in line with the Combined Code on Corporate Governance’s requirement that boards set standards and values for companies and ensure they meet their social obligations. But is board activity in this area as effective as it could be at achieving corporate compliance with CSR standards? This paper draws on the economic literature to offer an analysis of the primary causes of breaches of corporate responsibility standards. Based on a small survey of the board CSR activities of 20 of Britain’s largest companies, it assesses whether boards are addressing these causes effectively. The tentative conclusion is that board activity might usefully be reoriented to do more to address the fundamental incentives problems that often cause corporate responsibility failures, namely market failure and misaligned performance management systems. Keywords: Board, corporate social responsibility, United Kingdom, internal controls, evaluation of the board

Introduction

T

here is a growing interest in the notion of corporate social responsibility (CSR) from companies, investors and regulators.1 One does not have to embrace radical “stakeholder” agendas (Letza et al., 2004) to see why this is so. Companies see non-compliance with corporate responsibility standards as a significant source of risk to their reputations with customers, employees and other stakeholders. Recent examples include: perceptions of software companies’ complicity with human rights abuses in China; breaches of ethical expectations about sourcing in supply chains with labour problems; failures by oil companies to take due care to safeguard health and safety in refineries; exploitative marketing of financial services products; not to mention the numerous dishonest and fraudulent practices associated with the wave of scandals following Enron. In all these examples, valuable reputational assets have been destroyed because of © 2007 The Author Journal compilation © 2007 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA

breaches of accepted standards of corporate responsibility. Corporate responsibility is not just perceived to be about avoiding risk. Companies also see strong performance in this area as a source of opportunity to strengthen trust in their brands and to enhance employee motivation. Advocates of investment in intangible assets such as customer loyalty see responsible behaviour as key driver (Reichheld, 2001). In addition to any business benefits, there is a view that many of the most basic CSR obligations are also legal requirements. As one company chairman has explained to me: CSR for him is about fulfilling both the letter and the spirit of the law. And you don’t have to look far in legislation to find ethical concepts requiring companies to, among other things, treat people fairly, be honest about their products, and take due care of the safety of staff.2 Compliance with many of the most basic CSR standards is therefore a requirement for companies that wish to be in full compliance with the law.

*Address for correspondence: Centre for Ethics in Public Policy and Corporate Governance, Glasgow Caledonian University, 70 Cowcaddens Road, Glasgow G4 0BA, UK. E-mail: craig.mackenzie@ gcal.ac.uk

Volume 15 Number 5 September 2007

CORPORATE GOVERNANCE

936

There are continuing questions about just what responsibilities companies have and to whom, but few if any companies reject the idea that they have some corporate social responsibilities. As a result more and more companies are establishing programmes and publishing CSR reports. As of early 2006, 73 of the UK’s largest 100 listed companies have issued a public statement indicating the CSR principles that they accept (Ethical Investment Research Service, 2006). Company boards are key participants in ensuring companies meet CSR standards. The UK Companies Act 2006 makes explicit a requirement for board directors to have regard (amongst other matters) to the impact of the company’s operations on the community and the environment and to the desirability of the company maintaining a reputation for high standards of business conduct (s 172). And Britain’s Combined Code on Corporate Governance recommends that “directors should set the values and standards of the company and ensure that it meets its obligations to shareholders and others” (Financial Reporting Council, 2003). More and more boards in the UK seem to be explicitly accepting this role by creating special board committees on CSR. Half of Britain’s largest 20 listed companies now have committees on this topic (or related topics such as “sustainability” or “health, safety and environment”), while none did 20 years ago. But are UK boards taking the necessary steps to ensure companies comply with accepted corporate responsibility standards? Are these new board committees concentrating on the governance activities that would be most effective at achieving compliance? This paper draws on the economic literature to offer an analysis of the primary causes of breaches of corporate responsibility standards. Then, using data gathered from a modest empirical study of the board activities of 20 large UK FTSE 100 listed companies, it offers a preliminary indication of whether board CSR committees are addressing these causes effectively. The tentative conclusion is that board activity might usefully be reoriented to do more to address the fundamental incentives problems that often cause corporate responsibility failures, namely market failure and misaligned performance management systems.

Market failure and corporate irresponsibility I suggest that the most substantial literature on the causes of corporate irresponsibility is in economics, and specifically the economics of

Volume 15 Number 5 September 2007

market failure. The business ethics literature tends not to address explanatory questions about the causes of CSR breaches – instead it focuses on either normative questions (e.g. what responsibilities should companies have) or on descriptive questions (e.g. how many companies have adopted formal ethics codes) (Collins, 2000). There is also some practitioneroriented management literature on this topic (Zadek, 2001), but this tends to describe the current view of “best practice” management rather than offer an account of causes of problems. The welfare economics literature on the other hand has provided a rich account of the conditions under which markets serve the public interest and under what conditions they fail to do so. The literature on market failure provides useful insights about why companies act in ways that breach CSR standards. In a sense this branch of economics does for CSR what agency theory does for corporate governance (Eisenhardt, 1989). In both cases, economics provides an account of the incentives facing economic actors, and indicates how this might motivate their behaviour. The basic picture provided by welfare economics is that, under favourable conditions – where information flows freely, where there is strong competition, and where costs are “internal” to the market transactions – markets provide incentives for profit-seeking companies to act in ways that serve the public interest (Akerlof, 1970; Arrow, 1971; Cornes and Sandler, 1986). However, when these conditions are absent, these incentives go into reverse. It is as if as there is an “invisible foot” (Hunt and D’Arge, 1973) to accompany the “invisible hand”, that drives companies to undertake harmful activities even when doing harm is no part of their intention. It is this incentives problem – rather than malice or wickedness – that leads companies to breach accepted standards of CSR. Let me start by providing an example to illustrate this problem. In summer 2005 I held a discussion with a divisional director of a large UK bank about his division’s apparent non-compliance with the bank’s CSR policy. The division concerned sells, among other things, payment protection insurance (PPI) to customers who take out loans from the bank. The market for this product does not operate under the favourable conditions mentioned above. Specifically, information does not flow freely and there is a significant asymmetry of information between providers and customers. The problem is that customers do not in practice have very good information about the product and so are not able to make effective choices. There are various reasons for this,

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

BOARDS, INCENTIVES AND CORPORATE SOCIAL RESPONSIBILITY

including the fact that much of the key information about the product is buried in small print. The difficulty customers have in understanding what they are buying means that suppliers can charge high prices (adding as much as 40 per cent to the cost of the loan) and impose restrictive conditions on the insurance policy that limit payouts when customers attempt to make claims. This makes PPI very profitable for banks (on some estimates it accounts for 10 per cent of the profits of some UK banks). But it also means that large numbers of customers buy products that are far more expensive than they realise, that could be bought much more cheaply elsewhere, and that often fail to meet their needs (Financial Services Authority, 2005b). In the face of this problem, government regulators, public interest pressure groups and others have called on companies to adhere to standards of corporate responsibility – to treat customers fairly (Financial Services Authority, 2005a). But the enormous rewards available to companies who breach these standards create a strong incentive for them to do so. I suggest that this example is not an isolated case, but an example of a general problem where structural problems with markets create incentives for companies to breach corporate responsibility standards. These incentives problems are not confined to PPI, but have been a regular source of “mis-selling” problems in the UK financial services marketplace for over a decade (Financial Services Authority, 2004). Nor are they confined to financial services markets, but to a wide range of markets where information asymmetry problems apply, including, in perhaps the most cited article on this topic, the market for second-hand cars (Akerlof, 1970). Nor is asymmetric information the only market failure that gives rise to incentives for companies to breach corporate responsibility standards. A second kind of market failure is the absence of competition (Arrow, 1971). When markets are not competitive because of barriers to entry, companies will be able to sell poor value products for high prices. They will not face the usual incentives to offer good value for the simple reason that their customers cannot go elsewhere. This does not much matter if the uncompetitive market is for luxury handbags, but it is crucial if the market is for, say, AIDS drugs in developing countries. Until recently, the monopoly conferred by patents enabled pharmaceutical companies to charge $10,000 for an annual course of antiretroviral therapies in Mozambique, even though generic drugs companies could have provided the same course for a few hundred

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

937

dollars, had they been allowed to compete (Oxfam, 2001). Similarly, the third and perhaps most significant cause of market failure occurs when some of the costs of a transaction are external to it (Cornes and Sandler, 1986). When costs are external to companies, markets can create very damaging incentives. For example, climate change arises because the costs of emitting carbon are external to market participants. It is, as Nicholas Stern recently put it “the greatest example of market failure we have ever seen” (2006, p. 1). Externalities are also at the root of problems associated with toxic chemical emissions, deforestation, over-fishing, the collapse of biodiversity, and some health and safety failures. Common to all these cases of market failure is the problem that in the absence of favourable conditions, markets can create incentives for companies to act in ways that are against the public interest and, often, in breach of corporate responsibility standards. This, I want to suggest, is the fundamental cause that boards must address if they are to be effective at ensuring companies comply with many corporate responsibility standards.

Internal incentives Though market failure provides an account of the fundamental cause of corporate breaches of corporate responsibility standards, this account is incomplete. Welfare economics tends to represent companies as unitary agents and glosses over their internal structure (Simon, 1991). It seems likely that this internal structure has a part to play in completing an account of how market failure causes breaches of corporate responsibility problems. Let me return to the Payment Protection Insurance example. The board of the company concerned had recently issued a corporate responsibility policy requiring that the company’s staff should comply with corporate responsibility standards, including requirements to be fully transparent about products and to treat customers fairly. I suggested to the divisional manager that his division’s marketing of PPI appeared to breach this policy. He accepted that this was probably true, at least in some respects. So I asked him, why was he doing it? His answer was that while the board had issued a new CSR policy prohibiting certain behaviours, it had also issued him with objectives and performance targets relating to the sale of insurance products, including PPI. These performance objectives, he said, were not consistent with complying with the company’s CSR policy. And given the choice

Volume 15 Number 5 September 2007

CORPORATE GOVERNANCE

938

between meeting the objectives he had been given and complying with a CSR policy, he argued that he should meet the former because they specified his role at the company, and were the basis on which his performance was appraised and rewarded. Furthermore, he suggested that the board’s failure to change his performance objectives led him to doubt that they meant the CSR policy to be taken entirely seriously. After all, he pointed out, PPI is very profitable for the bank and the board needs to avoid disappointing the shareholders. However, he also said that if the board were to give him new objectives and performance targets that were aligned with the CSR policy, he would be quite happy to comply. Indeed, he said he would prefer this to the current conflicted situation the board had created for him. In this example, breaches to corporate responsibility standards arise not solely because of market failures, but because the organisation’s internal incentives structure rewards rather than penalises managers for exploiting them. There is a substantial literature on this broad topic (see, for example, Fisse and Braithwaite, 1993; and for a recent applied example, see US Chemical Safety and Hazard Investigation Board, 2007) which I will not attempt to summarise here. I merely wish to suggest that if boards are to ensure compliance with corporate responsibility standards, they should address two kinds of incentive problems: those arising from market failure and those arising from their own incentives or performance management systems.

Board responses From an economics perspective, for boards to be effective at avoiding breaches of corporate responsibility standards, they must address the fundamental incentives that motivate noncompliance. If we accept the arguments above, this requires them to respond to market failure and adjust the incentives arising from their performance management systems. Boards have limited ability to resolve market failures by themselves. The economics literature suggests that market failures require government action for their solution, either through regulation or the use of economic instruments such as taxes. While there has been some debate about the appropriate balance between government and marketbased solutions and the type of solution to be preferred (Aslanbergi and Medema, 1998), there is a consensus that some kind of government activity will be necessary, particularly in situations where large numbers of people are involved and transaction costs are high.

Volume 15 Number 5 September 2007

If government action is the solution, then boards may feel that the matter is out of their hands. This is far from the truth; companies and their trade associations often play a highly influential role in the development or nondevelopment of regulation (Ayres and Braithwaite, 1992; McRae, 2005). If companies choose to be obstructive, they can sometimes derail or subvert regulatory action so that market failures persist or are exacerbated. If, on the other hand, companies choose to be constructive, it is more likely that effective regulation will result, reducing or removing the pressures that lead to breaches of accepted corporate responsibility standards. The message for boards is clear: if boards wish to avoid breaching accepted standards of corporate responsibility on issues ranging from climate change, access to medicines in poor countries and financial services mis-selling, they should seek to ensure that their companies play a constructive role in the public policy process to encourage appropriate regulatory solutions for market failure. In practice this might mean issuing company policies that support regulation on key public policy issues; tightly overseeing implementation of these policies through the company’s lobbying and government relations activities; and even reviewing lobbying undertaken on the company’s behalf by its trade associations. While correcting market failures may ultimately be the way to remove the causes of many breaches of corporate responsibility standards, it is also important for boards to address the incentives arising from performance management systems. In the PPI example, above, the divisional manager was explicit about his willingness to meet CSR standards if the board adjusted his objectives and performance incentives accordingly. The challenge of aligning incentives is familiar in the corporate governance literature, because it involves the same kinds of consideration required to tackle agency problems. Except that here the challenge is not to align managers’ interests with shareholders, but to align them with the company’s corporate responsibility policies. So, if boards wish to avoid CSR failures, they need to ensure that the company’s performance management systems are appropriately designed. In practice this might mean taking special care to review the objectives and performance targets of managers responsible for areas of business exposed to substantial market failures, and seeking to develop modified objectives and performance targets. In some cases this may involve making awkward trade offs between encouraging CSR and encouraging short-term profit-

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

BOARDS, INCENTIVES AND CORPORATE SOCIAL RESPONSIBILITY

maximisation. If PPI is responsible for 10 per cent of a bank’s profits, and a significant proportion of these profits result from exploiting a market failure, then shareholders may well be displeased with the negative earnings consequences of a board’s decision to voluntarily forgo these profits. But responsible companies cannot duck this dilemma, and addressing it is an important aspect of the board’s role and cannot be delegated entirely to management (Carver, 2002). The conflicts of interest will often, however, be more apparent than real. Frequently the kind of short-term profit-seeking described in the PPI example will be at the expense of longterm value-drivers such as reputation, customer satisfaction and good relations with the regulator. Boards that modify the PMS so that it is more long-term focused may well deliver better CSR performance as well as shareholder value (Deckop et al., 2006), though this is by no means a foregone conclusion.

Board activity in practice If boards wish to ensure compliance with corporate responsibility standards, the economics literature suggests that they should focus on addressing the fundamental incentives problems that cause breaches of these standards. Is this what they are in fact doing? While there is a growing literature on board effectiveness (Nicholson and Kiel, 2004), this specific aspect does not appear to have been addressed in any detail. So, in order to answer this question the author has conducted a modest empirical survey of board practice of 20 of the largest UK listed companies.3 This survey involved three roundtable discussions attended by some 30 FTSE-100 board directors.4 It also included 20 interviews with board directors, company secretaries and CSR managers about aspects of board practice on corporate responsibility. I would have liked to also include observations at a number of actual company board meetings, but this proved impossible to arrange given the sensitivities involved. The roundtable discussions and interviews were held under the auspices of a project initiated by Insight Investment, Business in the Community and FTSE Group.5 The author has also reviewed the terms of reference for the relevant board committees of FTSE top 20 companies (where such committees exist),6 as well as the CSR reports and published policy documentation. UK boards are unitary and comprised of a mix of executive and non-executive directors (for a comparison of UK vs US boards see Aguilera et al. (2006)). Most UK companies delegate some of their work to a small number of

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

939

board subcommittees. The Combined Code recommends that these should include an audit committee and a remuneration committee, and should be chaired by, and be largely comprised of, independent non-executive directors. Some companies have also created additional committees to address a range of topics including governance, corporate responsibility, risk and external affairs. Helpfully, the Combined Code recommends that companies publish the terms of reference of board committees; and many have done so. This, in addition to my interviews and discussions, provides the basis for my assessment of board activity. A review of the terms of reference of board CSR committees indicates that they tend to focus on the following activities: • Reviewing CSR issues. The first objective specified in the GlaxoSmithKline (GSK) terms of reference is: “To review GSK’s policies and practices in anticipating and managing external issues that have the potential to seriously impact upon the Company’s business and reputation” (GlaxoSmithKline plc, 2004). Six out of 11 committees include this topic in the terms of reference. • Identifying non-financial risks and monitoring risk management. BAT’s committee is tasked with this objective: “to identify, in conjunction with management, significant social and environmental risk areas and to evaluate management’s handling of such areas” (British American Tobacco plc, 2003). Five out of 11 committees include this topic. • Establishing policies and standards. “The purpose of the committee is to ensure that Rio Tinto management has in place the policies, standards, systems and people required to meet Group social and environmental commitments” (Rio Tinto plc, 2004). Ten out of 11 committees include this topic. • Monitoring compliance with and performance against companies CSR policies. BP’s Ethics and Environment committee “monitors the observance of the executive limitations relating to non-financial risks to the group” (BP plc, 2006). Eight of 11 committees include this topic. • Reviewing company reporting on CSR. “[K]eep under review the extent and effectiveness of the Company’s external reporting of CSR performance, and its participation in relevant external benchmarking indices” (National Grid plc, 2005). Four out of 11 companies include this. • Overseeing philanthropic activity. GSK’s committee is tasked with reviewing “on an annual basis the expenditure and other commitments by the Group on corporate

Volume 15 Number 5 September 2007

CORPORATE GOVERNANCE

940

donations, product donations, community programmes and charitable support of any kind” (GlaxoSmithKline plc, 2004). Three out of 11 companies include this topic. In addition, one committee also reviews the company’s adoption of external codes and inclusion in CSR indices (e.g. FTSE4Good); and two companies look at management implementation plans and targets. In summary, these terms of reference documents indicate a focus of board CSR activity on: discussing issues and risks, setting standards, reviewing implementation and disclosure, and philanthropy. With two partial exceptions, the terms of reference documents do not include an explicit remit relating to market failure, the oversight of government affairs activity, or to the design of performance management systems in as far as they relate to questions of corporate responsibility. The partial exceptions are Rio Tinto and Unilever. Rio Tinto’s terms of reference document does give its committee a remit to review the company’s “political involvement” (Rio Tinto plc, 2004). However, its scope is limited to reviewing involvement in party politics and payments to politicians, rather than oversight of government lobbying activity. Unilever is a more interesting exception. Unlike the other 10 companies, its committee does not focus on corporate responsibility per se but on “External Affairs and Corporate Relations”. While it covers questions of corporate responsibility and compliance with the company’s ethics code, it also reviews “developments” relating to “government relations” and the “effectiveness” of this function (Unilever plc, 2005). However, the terms of reference do not give the committee an explicit remit to assess the implications of government relations activity with regard to corporate responsibility issues. So it is not clear that even this case is a real exception to the general observation that board committees do not review the implications of lobbying activity or performance incentive systems for corporate responsibility. My discussions with several of the board committee members and the company officers that report to and serve as secretaries to these committees broadly confirmed this observation. These interviews revealed a basic model of operation: the board committee discusses an issue or a risk. This is often driven by stakeholder concerns or issues emerging in the media related to the sector. The committee then considers proposals for management initiatives to address the issues concerned. Typically these involve adopting policies specifying various voluntary company actions to seek improved performance on the issue

Volume 15 Number 5 September 2007

concerned. Finally, the committee reviews the company’s performance against its policies, often as part of an annual CSR reporting cycle. (In many cases, the part of the responsibility for reviewing those aspects of corporate responsibility performance most closely associated with legal compliance is retained by the company’s audit committee). Perhaps this model oversimplifies things, and masks the variation between companies’ committees, but I think it contains the core elements of UK board CSR committee processes. And this model is similar in some respects to the recommendations of the limited governance literature that has addressed this topic (Bonn and Fisher, 2005; Cadbury, 2002). The interviews revealed that many of the issues and risks that board committees discuss are those that the economics literature might view as arising from market failures. However, board committees do not tend to characterise them as such, nor do they tend to see government action as the obvious solution. One interview emphasised that CSR was about voluntary action by companies, not regulatory action. There were a couple of notable exceptions to this. In two cases examples were given where the board had issued public statements calling for more government regulation. In both cases, these related to climate change and made clear the company’s acceptance of the need for government intervention to provide market mechanisms to reduce carbon emissions. But these were exceptions rather than the rule. Similarly, while there was an acceptance (when prompted) that the incentives generated by company performance management systems could be a part of the problem, board CSR committees do not tend to interfere with these systems, or review the risks they pose systematically. And this is not part of their terms of reference.

Discussion The overall picture that emerges from this empirical work is that board CSR committees are aware of the symptoms of market failure problems, but do not seem to have a clear diagnosis of their underlying economic causes, and so their activities are not targeted at addressing them, at least not systematically. There is therefore some scope for boards to redirect their activities in this area. Before we accept this conclusion, there are some objections to consider. The first is that the economics literature may not provide an accurate analysis of the causes of CSR problems. I concede that market failure

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

BOARDS, INCENTIVES AND CORPORATE SOCIAL RESPONSIBILITY

is not the whole story here. Some CSR problems, such as gender or racial discrimination in the workplace, do not obviously arise from market failure. The racial or gender related prejudice of some managers may provide a better explanation. Similarly, I suspect that quite a number of CSR breaches arise because of management ignorance and incompetence, which suggests economics arguments about bounded rationality may provide a useful supplement to those from welfare economics (Simon, 1982). However, the argument that boards should devote systematic attention to market failure and related PMS incentive problems does not require market failure to be the only cause of problems, merely a significant cause. And the examples given above seem to indicate that many important CSR problems arise from the kinds of marketfailure-related reasons described above. Another kind of objection is that while board CSR committees may not address market failure and PMS incentives problems, boards may do so in other ways. There is probably some truth in this. The board directors I spoke to about this subject acknowledged that regulatory issues were discussed by the full board from time to time. This is no surprise: where companies operate in situations of significant market failure, it is highly likely that boards will consider their attitude to regulation for the simple reason that in such situations the market failure is likely to raise important strategic dilemmas. However, a board discussion of market failure and regulation from a strategic perspective is not the same as a board discussion of the topic from a CSR perspective. After all, the central point of the economics arguments about market failure is that exploiting market failure is a strategic opportunity for business. So a board discussion motivated solely by strategic considerations may very well lead a company to exploit market failures and resist regulatory interventions, rather than to exercise selfrestraint. Given the strong dysfunctional incentives that market failures can create for businesses, a special board discussion focused on their implications for CSR would seem to be necessary, undertaken in full awareness of the potential conflicts of interest, with short-term profit maximisation considerations placed firmly to one side. Whether this should take place at the CSR committee or at a main board meeting is a secondary consideration. Having said this, as my interviews with company management indicated, the one important exception here seems to be climate change, where several constructive public policy positions have emerged from several companies (including BP and Rio Tinto) in recent years. However, this kind of activity

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

941

appears to be the exception rather than the rule. Given the prominence of climate change in the public policy arena, and the growing fears of its devastating long-term effects, the pressure for boards of high-emission companies to consider it has been substantial. For more routine kinds of market failure, these pressures are more attenuated. There is also a case for saying that incentives problems associated with the PMS may be addressed elsewhere by boards. After all, one of the basic jobs of boards is to consider the objectives and performance incentives for the executive directors. And all UK boards have remuneration committees that consider the latter in great detail. However, boards primarily consider these incentive structures with a view to encouraging value creation for shareholders, rather than discouraging breaches of corporate responsibility standards. But some boards have been starting to take a wider view of the issues. In some cases there has been an explicit attempt to balance financial incentives with incentives to support responsible behaviour. As one board director told me, “More balanced incentives reduce conflicts and enable better focus on what creates long-term value.”7 For example, several oil and mining companies have introduced occupational health and safety targets into executive incentives (Henderson Global Investors/USS, 2005) to balance financial targets. Other companies have adopted a more systematic balanced scorecard approach (Kaplan and Norton, 1996) to executive remuneration, which as one director told me, has significantly shifted focus away from shortterm financial goals to long-term value creation, which he argued made more space for CSR. So some progress on this topic is being made. However, many of the board directors I have spoken to confirmed that their executive compensation system was based exclusively on financial metrics. One board director I talked to rejected the idea that incentives systems should be tampered with for CSR purposes. As he put it, “Conflicts of interest should be managed by good executive directors. It is up to [the] board to appoint people who have the leadership and skills and integrity to manage those conflicts.”8 And even those who include some reference to CSR factors in the design of incentives tend to take the view that they play a minor role. Moreover, very few boards seem to systematically review the risks associated with their PMS much below the level of the board. (The divisional manager I referred to in my example above operated one level below the board). Given that the risks often arise at this level, this would seem to be a missed opportunity for boards.

Volume 15 Number 5 September 2007

CORPORATE GOVERNANCE

942

Conclusion There is some mismatch between what boards are currently doing to avoid non-compliance with CSR standards and what the economics literature implies they should be doing in order to be effective in this respect. This conclusion draws on a study of the very largest UK companies. It seems reasonable to suppose that if these boards are not addressing market failure systematically, then few boards of smaller companies will be doing so. I am not suggesting that boards are entirely ignoring regulatory solutions to market failure and incentives problems associated with their PMS. But their approach to CSR does not seem to include a sufficiently theoretically informed diagnosis of the fundamental causes of CSR breaches, nor does it appear to employ an understanding of the fundamental conflicts of interest and incentive problems in the choice of solutions, at least not systematically. If this is accurate then there would appear to be opportunities for boards to reorientate their activities in order to more effectively avoid breaches of accepted CSR standards. Specifying these alternative actions in more detail is a task for another paper (see Mackenzie and Hodgson (2006) for a schematic attempt at this large project). However, to sketch an outline: my argument suggests that boards should constructively address market failure by establishing board policies supporting government action on relevant issues; they should oversee implementation of these policies by the company’s lobbying and government relations departments; and perhaps also keep a check on the lobbying activities of any relevant trade associations in which the company participates. They should also address PMS incentives problems by reviewing the risks created by the performance management system in those areas of the business where market failure is a problem, and by seeking to develop modified objectives and performance targets to mitigate these risks. One persistent feature of debates about CSR is a deep scepticism about the intentions of companies. There is a recurrent suggestion (e.g. Bakan, 2004) that CSR activity is just window-dressing aimed at distracting attention from the real problems. Most of the board directors I have spoken to reject this criticism. They claim to be sincere in their desire to ensure that their companies behave responsibly in addressing the major social and environmental impacts associated with their business activities. I suggest that scepticism about CSR initiatives arises in part because of a perception that the actions companies take on CSR are superficial and not well suited to dealing

Volume 15 Number 5 September 2007

with the deep-seated causal factors that drive breaches of corporate responsibility standards. If these fundamental causes arise from the kind of incentives problems described above, then this perception may be accurate. By changing the emphasis of board activity in the way recommended by this paper, directors may be better placed to meet their CSR objectives and restore trust in their sincerity.

Notes 1. See, for example, the discussion by Mackenzie (2006) and Aguilera et al. (2006) on investors; see www.csr.gov.uk for the UK government’s enthusiasm for CSR. 2. See for example Financial Services Authority (2005a), the 1975 Sex Discrimination Act and the 1973 Health and Safety at Work Act. 3. The companies included Boots Group plc, BP plc, British Land Company plc, BAT plc, BT Group plc, Centrica plc, EMI Group plc, GSK plc, GUS plc, HBOS plc, Holidaybreak plc, HSBC Holdings plc, Kingfisher plc, National Grid plc, Next plc, O2 plc, Rio Tinto plc, Shell Transport and Trading Co plc, Shire Pharmaceuticals Group plc, Unilever plc, Vodafone Group plc. 4. I am grateful to Sir Derek Higgs, Chairman of Alliance and Leicester plc; Lord Stevenson of Codenham, Chairman of HBOS plc; and Mark Makepeace, CEO of FTSE Group for chairing the series of board director roundtable discussions 5. Additional output from these discussions can be found in Mackenzie and Hodgson (2006) (www.bitc.org.uk). This report was published with support from Insight Investment, Business in the Community and FTSE Group. 6. Anglo American plc, BG Group plc, BP plc, BHP Billiton plc, British American Tobacco plc, GSK plc, HSBC Holdings plc, National Grid plc, Rio Tinto plc, Shell plc, Unilver plc. 7. This quote is from a FTSE 100 board director attending a roundtable discussion hosted jointly by Insight Investment, Business in the Community and FTSE Group. These discussions were held under the “Chatham House Rule” allowing contributions at the meeting to be quoted but not attributed to the individual concerned. 8. This quote is from a FTSE 100 board director attending a roundtable discussion (see note 5 above).

References Aguilera, R. V., Williams, C. A., Conley, J. M. and Rupp, D. E. (2006) Corporate Governance And Social Responsibility: A Comparative Analysis of the UK and the US, Corporate Governance – an International Review, 14(3), 147–158. Akerlof, G. A. (1970) The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, 84(3), 488– 500.

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

BOARDS, INCENTIVES AND CORPORATE SOCIAL RESPONSIBILITY

Arrow, K. J. (1971) Essays in the Theory of Riskbearing. London: North Holland Publishing. Aslanbergi, N. and Medema, S. (1998) Beyond the Dark Clouds: Pigou and Coase on Social Cost, History of Political Economy, 20(4). Ayres, I. and Braithwaite, J. (1992) Responsive Regulation: Transcending the Deregulation Debate. Oxford: Oxford University Press. Bakan, J. (2004) The Corporation: the Pathological Pursuit of Profit and Power. London: Constable. Bonn, I. and Fisher, J. (2005) Corporate Governance and Business Ethics: insights from the strategic planning experience, Corporate Governance – an International Review, 13(6), 730–738. BP plc (2006) Making Energy More: Annual Report and Accounts, 2005. London: BP plc. British American Tobacco plc (2003) Corporate Social Responsibility Committee: Terms of Reference. London: British American Tobacco plc. Cadbury, A. (2002) Corporate Governance and Chairmanship. Oxford: Oxford University Press. Carver, J. (2002) Corporate Boards That Create Value: Governing Company Performance from the Boardroom. New York: Jossey Bass Wiley. Collins, D. (2000) The quest to improve the human condition: The first 1 500 articles published in Journal of Business Ethics, Journal of Business Ethics, 26(1), 1–73. Cornes, R. and Sandler, T. (1986) The Theory of Externalities, Public Goods and Club Goods. Cambridge: Cambridge University Press. Deckop, J. R., Merriman, K. K. and Gupta, S. (2006) The Effects of CEO Pay Structure on Corporate Social Performance, Journal of Management, 32(3), 329–342. Eisenhardt, K. M. (1989) Agency Theory: An Assessment and Review, Academy of Management Review, 14, 57–74. Ethical Investment Research Service (2006) Ethical Portfolio Manager Database. Financial Reporting Council (2003) The Combined Code on Corporate Governance. London: Financial Reporting Council. Financial Services Authority (2004) Treating Customers Fairly: Progress and Next Steps. London: Financial Services Authority. Financial Services Authority (2005a) Financial Services Authority Handbook. London: Financial Services Authority. Financial Services Authority (2005b) The Sale of Payment Protection Insurance: results of thematic work (http://www.fsa.gov.uk/pubs/other/ ppi_thematic_report.pdf). Fisse, B. and Braithwaite, J. (1993) Corporations, Crime, and Accountability. Cambridge: Cambridge University Press. GlaxoSmithKline plc (2004) Corporate Responsibility Committee: Terms of Reference. London: GlaxoSmithKline plc. Henderson Global Investors/USS (2005) Getting What You Pay For: Linking Executive Remuneration to Responsible Long-Term Corporate Success.

© 2007 The Author Journal compilation © Blackwell Publishing Ltd. 2007

943

Hunt, E. K. and D’Arge, R. C. (1973) On Lemmings and Other Acquisitive Animals: Propositions on Consumption, Journal of Economic Issues, 7, 337– 353. Kaplan, R. S. and Norton, D. P. (1996) The Balanced Scorecard: Translating Strategy into Action. Boston, MA: Harvard Business School Press. Letza, S., Sun, X. P. and Kirkbride, J. (2004) Shareholding versus Stakeholding: A Critical Review of Corporate Governance, Corporate Governance – an International Review, 12(3), 242–262. Mackenzie, C. (2006) The scope for investor action on corporate social and environmental impacts. In R. Sullivan and C. Mackenzie (eds) Responsible Investment (pp. 20–38). Sheffield: Greenleaf. Mackenzie, C. and Hodgson, S. (2006) Rewarding Virtue: Effective Board Action on Corporate Responsibility. London: Business in the Community. McRae, S. (2005) Hidden Voices: The CBI, Corporate Lobbying and Sustainability. London: Friends of the Earth. National Grid plc (2005) Risk and Responsibility Committee Terms of Reference. London: National Grid plc. Nicholson, G. J. and Kiel, G. C. (2004) A Framework for Diagnosing Board Effectiveness, Corporate Governance – an International Review, 12(4), 442– 460. Oxfam (2001) Dare to Lead: Public Health and Company Wealth. Oxford: Oxfam. Reichheld, F. F. (2001) Loyalty Rules! How Today’s Leaders Build Lasting Relationships. Boston, MA: Harvard Business School Press. Rio Tinto plc (2004) Committee on Environmental and Social Accountability: Terms of Reference. London: Rio Tinto plc. Simon, H. (1982) Models of Bounded Rationality. Cambridge, MA: MIT Press. Simon, H. (1991) Organizations and Markets, Journal of Economic Perspectives, 5(2), 25–44. Unilever plc (2005) External Affairs and Corporate Relations Committee: Constitution. London: Unilever plc. US Chemical Safety and Hazard Investigation Board (2007) Investigation Report: BP Texas City Refinery Explosion and Fire. Washington. Zadek, S. (2001) The Civil Corporation. London: Earthscan.

Craig Mackenzie is Director of the Centre for Ethics in Public Policy and Corporate Governance at Glasgow Caledonian University. Between 1997 and 2006 he directed the corporate governance and socially responsible investment functions at Insight Investment and Friends Provident. His research interests include responsible investment, corporate social responsibility and business action on climate change.

Volume 15 Number 5 September 2007