Kenan Study: Stakeholder Capitalism Cannot Jettison Profit Maximization

A year-long analysis of Stakeholder Capitalism by a think tank dedicated to finding “market-based solutions to vital economic issues” finds that “non-pecuniary” investor interests can put a “premium” on the valuation of organizations focused on ESG (Environmental, Social, Governance).

The Need to Focus on the Bottom Line
A New Model for Stakeholder Capitalism
Accounting for the Premium on “Greenium”

Demonstrating the increasing attention on the concept of Stakeholder Capitalism, the Frank Hawkins Kenin Institute of Private Enterprise has issued a report and model based on a year-long analysis of the growing movement.

The Frank Hawkins Kenan Institute of Private Enterprise “develops and promotes innovative, market-based solutions to vital economic issues. With the belief that private enterprise is the cornerstone of a prosperous and free society, the institute fosters the entrepreneurial spirit to stimulate economic prosperity and improve the lives of people in North Carolina, across the country and around the world.”

Noting the potential conflicts and confusion of a stakeholder approach to management or of businesses seeking to address societal issues, the report argues for a Stakeholder Capitalism model that retains the focus on profitability, but which accounts for the enhanced long-term value due to the “non-pecuniary” preference of many shareholders who place a premium on ESG-oriented companies.

“The broadening of a business’s mandate beyond maximizing profits to account for its impact on customers, suppliers, employees, and societal issues (such as climate change and income inequality) is not only controversial, but complex. And as an increasing number of businesses grapple with the adoption of environmental, social and governance frameworks and stakeholder capitalism’s tenets – along with the inevitable trade-offs between competing stakeholder groups such adoption brings – public and private sector leaders alike need guidance,” the report states.

The Need to Focus on the Bottom Line

“Based on our yearlong study of this topic, we believe that jettisoning profit maximization is not a sustainable solution. Rather, incorporating the nonpecuniary preferences of change agents such as shareholders while acknowledging their limited impact will provide the best outcome. Along with this approach comes a renewed appreciation for the role of government policy actions in achieving broad societal goals that we cannot realistically expect private market forces alone to address. Consequently, our approach is to provide a framework that allows for a clear understanding of the optimization problem facing corporate decision-makers in an economy with investors who value more than just financial returns. We also evaluate what can be expected from private sector adoption of the optimal solution. In short, we find that investor preferences toward ESG factors that are reflected in corporate actions will lead to better societal outcomes. However, the staunchest advocates of Stakeholder Capitalism and ESG investing will likely be disappointed by what private sector market forces alone will be able to achieve. It is important to note that our analysis is consistent with – and, in fact, determined by – the fiduciary responsibilities of corporate directors and officers.”

The report is critical of the Business Roundtable 2019 updated charter of the organization to address the interests of all stakeholders. “The Business Roundtable statement is largely vacuous and could mean almost anything to anyone depending on how it is read – perhaps deliberately. The Business Roundtable’s vision is not unique in this way. To date, there are not any rigorous models of Stakeholder Capitalism that provide specific methods for how trade-offs between stakeholders should be evaluated. Furthermore, there appears to be little consideration in the discussion around Stakeholder Capitalism about the fiduciary responsibilities of management and the corporate board of directors. Unless we believe that there will be significant modifications to the legal framework defining fiduciary responsibilities of for-profit companies, any viable model of Stakeholder Capitalism must be constrained by considering only actions that maximize shareholder wealth.

A New Model for Stakeholder Capitalism

The report recommends a model that does not need to deviate from traditional shareholder supremacy, but rather “harnesses the power of shareholders and their nonpecuniary preferences. This is a new, rigorous, and precise model of Stakeholder Capitalism that deviates from traditional Stakeholder Capitalism by demonstrating how certain corporate actions that benefit other stakeholders can decrease profitability and yet increase shareholder value. While this may seem counterintuitive, this model is quite straightforward and rests only on an intuitive extension to the traditional model of profit maximization by allowing investors to value more than just financial profits. In particular, if some investors care about a business’s stakeholders, and these preferences are reflected in their valuations of corporate equity, then it is possible for a wedge to open up between corporate profits and shareholder wealth.”

For example, the report states, “Consider a manufacturing company that needs to build a new production facility and has two options: it can build a traditional facility for $100 million, or a more environmentally friendly facility for $115 million. For simplicity, assume there is no difference in the other cash flows (e.g., efficiency) of the environmentally friendly facility – perhaps the only distinction is that it was constructed with more sustainable (and expensive) building materials that are otherwise identical in specifications. In the traditional model of shareholder supremacy, building the environmentally friendly building would cost the company another $15 million with no cash flow benefits and thus would decrease shareholder wealth by $15 million. Depending on one’s interpretation of the law, this could even be considered a violation of fiduciary responsibility by the company’s management and board.”

Accounting for the Premium on “Greenium”

The report continues, “But perhaps the issue is not so simple. What if some of the company’s shareholders have a preference for the company building the environmentally friendly factory instead of the traditional factory? Suppose, on average, shareholders would be willing to pay 2% more for the stock of the company if it owns and operates the green factory. (This equity price premium is often referred to as a “greenium”. Now, let’s assume that the market cap of the company is $1 billion. If the company builds the green factory, the market value of the company’s equity will increase by $5 million (2% of $1 billion is $20 million minus the $15 million in higher construction costs). This happens even though the company’s profits will decline by $15 million. If the company’s management seeks to maximize shareholder value, clearly they should build the green factory despite the lower profits.”

Everybody can be happy under this model, the report states. For example, the strongest advocates of ESG can buy the highest-rated companies for the factors they care most about – and feel good about their investments while providing a lower cost of capital for the projects that are most important to them. In contrast, investors who do not care about nonpecuniary corporate actions can invest in companies with low commitments to other stakeholders and, in turn, these investors will earn higher financial returns in equilibrium.”

The study asks, “Can we actually observe the valuation premiums associated with nonpecuniary investor preferences that will serve as the inputs to corporate decisions? Research is digging into this exact question more deeply, but recent evidence summarized below suggests the answer is yes.”

However, they caution: “Even the most optimistic view of ESG must acknowledge several challenges in implementation. First, we remain far from consensus on sustainability accounting. Specifically, there remains a tremendous degree of disagreement among ESG data providers. How can we credibly manage outcomes if we cannot agree upon what to measure? A critical next step for the evolution of ESG investing will be an evolving consensus on sustainability accounting.”

Despite these issues, “the conversation around corporate stakeholders has undeniably shifted toward considering an increasingly broad range of players and issues. We are witnessing an expanded discussion about the role of business in addressing important societal issues that is heartening for many. Our year-long study indicates that there is much promise from this awakening – though pitfalls remain. Implementing a fully encompassing stakeholder-based solution is not a viable option. There are simply too many trade-offs that cannot be resolved (and win-win solutions are just a form of profit maximization.) However, shareholders can help move the needle toward conducting more stakeholder-focused business. Moreover, there are limits to what shareholders can do, and thus government intervention is necessary especially for addressing diffuse issues such as climate change. We have provided evidence and frameworks for some solutions, but many issues remain unresolved. In order to resolve them, we must begin by acknowledging the inevitability of trade-offs—and recognize that businesses and policymakers must work together to drive solutions informed by rigorous, evidence-based analysis.”

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