As the world returns to something more recognizably normal, it seems natural to ask what the economy will look like after the pandemic. Will things ever go back to how they were, or are we facing a new – and altogether different – reality?
Whenever a crisis – political, economic, or social – impacts the business world, the same questions often arise: What is the purpose of a corporation? Is the purpose of a corporation to make money, or do they have a larger role to play in advancing a more diverse range of social values? In short, does a business have a social responsibility to improve the world?
Answers to this question vary. At one extreme are those who continue to insist that a business has “only one” social responsibility – “to increase its profits.” On the other side of this debate are those suggesting that companies must consider environmental and social factors together with “good” (or at least better) governance in their operations.
This latter conception of the purpose of businesses is often referred to as stakeholder capitalism, as it aims to satisfy a constituency broader than the shareholders. This incorporation of a more diverse range of values into thinking about how a company organizes its activities is now referred to as environmental, social, and corporate governance, or “ESG.” Although it exerts a significant influence on business and policymakers, ESG still receives a lot of pushback. And – for sure – many companies use ESG statements as empty marketing tools to respond to the growing social and political pressure to be more socially and environmentally responsible. It is not hard to be a little skeptical about such statements.
Despite the emergence and increasing influence of ESG, there has been much less discussion about how ESG strategies and ESG reporting might affect small and medium-sized enterprises (SMEs). Our new paper offers a preliminary attempt to think about the impact and potential benefits of ESG on SMEs. Moreover, we consider the role of regulations in nudging firms towards more socially responsible strategies post-digital transformation and post-COVID.
We first revisit the bigger question of the value and relevance of ESG in today’s world. A recognition of the broader responsibilities of businesses should not be dismissed as insincere and empty jargon. ESG strategies seem to have had a real-world impact and are here to stay. Moreover, companies that ignore this trend find themselves in a difficult position with diverse stakeholders, ranging from investor-owners to employees and customers. We see business leaders being put on the spot and asked, “What is your company doing to make the world a better place?” They are increasingly held accountable for their responses and criticized for their failure to meet the standards set in their public pronouncements. Silence or evasion isn’t an option either. This is viewed as inaction or evidence of a lack of concern and implicit endorsement of the status quo. Smooth talk doesn’t seem to work either and is equated with a lack of sincerity and commitment. These new pressures affect all firms, irrespective of size.
Skeptics of ESG often suggest that the claim that companies should look beyond shareholder value doesn’t add anything new. Concerns of other stakeholders can be analyzed perfectly well under old models, and shareholder value maximization includes – or at least has the potential to include – some version of stakeholder capitalism. In one sense, this is perfectly true. Concerns about stakeholders and ESG may be just another aspect of shareholder value; it is simply a question of how one chooses to frame the metric of success. Nevertheless, the problem is that by framing the issue of business success exclusively in terms of shareholder value, we create a series of hierarchical and adversarial relationships between the different groups of stakeholders within a business that potentially distort incentives in damaging ways.
The problem is not so much that the traditional theory about the purpose of the corporation is wrong but rather that it overemphasizes the importance of maximizing shareholder value. Such an approach can create adverse behavioral outcomes that cause long-term damage to any firm. For example, a focus on maximizing shareholder value incentivizes a short-term mindset among executives and window dressing by managers and employees who wish to portray a positive image of company performance to appease investors. The result is, at best, wasted resources and, at worst, a crippling effect on the long-term prospects of a business as it is distracted from its core tasks of product or service development and market-building. Again, there is no reason to think that these distorting effects don’t similarly apply in the case of SMEs. The results may be worse as a smaller firm may not have the resources or know how to insulate itself from the negative effects of a myopic focus on shareholder value.
In contrast, an ESG-oriented approach seems to offer at least two potential benefits for smaller and medium sized enterprises. First, engagement with ESG may offer firms the opportunity to connect with a more diverse pool of investors worldwide to explain and discuss growth strategies and invite input. These discussions can assist management in making better decisions and avoiding tunnel vision. A focus on ESG can develop firm capacities to identify new opportunities and gain a better sense of their peers and competitors and facilitate better decision-making. Second, proactive ESG engagement might help management identify expertise gaps in the board of directors and executive teams. In a collaborative context, investors and other stakeholders may be best placed to have a meaningful impact on the ESG strategy of SMEs creating positive feedback effects.
There is already some recognition amongst policymakers of these benefits. Within Europe, for example, the EU proposal for Directive 2021/0104 will require corporations to report on non-financial matters and provides SMEs with the option to report on non-financial issues. It should also be noted that in Europe, banks, investors, and financial consultants are required under EU Regulation 2019/2088 to report on their approach in evaluating ESG efforts spent by investee companies.
It is important to stress that none of these benefits are necessarily unique to smaller enterprises. However, more empirical research is needed on how ESG might play out in such a context. And, of course, the fear is that ESG engagement and reporting might come at a heavy price for smaller organizations if it diverts resources without delivering any benefits. But, as recently suggested by Richard Bernau, an ESG director at KPMG, the task of ESG reporting might not be as difficult for SMEs as initially feared. While they do have fewer resources compared to large publicly-listed corporations, the size of SMEs does mean that faster decision-making and more dynamic implementation of ESG strategies is possible. Furthermore, as the popularity of ESG reporting grows, this requirement should not present an insurmountable burden to smaller firms, and like tax reporting it can become a routine feature of their operations. Bernau also recommends that ESG reporting be “proportionate to the size and financial return of the company.” Crucially, on this view, ESG might become a “central driver of enterprise value.” As Bernau noted, even among the “hardest of hard-nosed investors,” ESG is becoming increasingly important when looking at the future viability of a scaling business.
Thus far, there has been little discussion about how ESG might impact SMEs and whether it might offer solutions to some of the challenges SMEs face in a post-digital transformation and post-COVID world. This seems unfortunate as the pressure to engage with such issues seems set to increase and impact all firms, irrespective of their size and the sector of the economy in which they operate.
Mark Fenwick is a Professor of International Business Law at Kyushu University.
Tronel Joubert is a Lecturer of International Business Law at the Tilburg Law School of Tilburg University.
Sanita Van Wyk is a Lecturer of International Business Law at Tilburg University.
Erik P. M. Vermeulen is a Professor of Business and Financial Law at Tilburg University and Tilburg Law and Economics Center. He is also Senior Counsel at the Corporate Legal Department of Signify (formerly Philips Lighting).
This post is adapted from their paper, “ESG as a Business Model for SMEs,” available on SSRN.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.
