The effect of publishing a GRI sustainability report on financial performance

Transcription

1 The effect of publishing a GRI sustainability report on financial performance Datum: Course: Master Thesis Student: Edo Swinkels ANR:

2 Table of contents Management Summary 4 Chapter 1: Introduction Background and problem definition Problem statement Research Questions Conceptual model Hypothesis development Research Method Research design Sample Data analysis 10 Chapter 2: Corporate Sustainability and Corporate Social Responsibility What are Corporate Sustainability and Corporate Social Responsibility? The Global Reporting Initiative Conclusion 15 Chapter 3: The drivers and motivations of CS(R) reporting Theories related to motivations for CS(R) disclosures Political economy theory Stakeholder theory Legitimacy theory Agency theory Factors influencing the nature and extent of disclosures Corporate characteristics General contextual factors Conclusion 24 Chapter 4: CSR and financial performance Theoretical arguments Empirical evidence Measurement problems Conclusion 30 2

3 Chapter 5: Empirical analysis Influence of GRI sustainability reports on financial performance Test Test Influence of the application level on financial performance 34 Chapter 6: Conclusion, limitations and future research Conclusion Limitations and future research 36 References 38 Appendix A: Data Variables 44 Appendix D: Digital Appendix (CD ROM) 3

4 Management Summary Reporting on social and environmental practices by companies is on the rise in today s business environment. Although it is relatively new it nowadays is one of the focal points of research in the CSR field. The exact drivers and motivations for firms to disclose such reports still aren t exactly clear, however it is hard to imagine that companies would spend shareholder wealth without getting a return. This study investigates the relation between the disclosure of a GRI sustainability report by companies and financial performance in particular. A study by KPMG (2005) among the top 250 firms from the Global Fortune 500 indicated that 74% of the companies that publish these reports do it for economic reasons. Therefore this paper focuses on firms that publish these reports to see if this is the case and it is financial performance that motivates companies to publish sustainability reports. The results of this study suggest there is no relation between the publication of a GRI sustainability report and financial performance in general. Also this study offers no evidence of a relation between a firms application level of the GRI framework and guidelines and financial performance. This study however has several limitations and therefore future research can give these results more validity. 4

5 Chapter 1: Introduction In this chapter the problem under study is introduced. First a description of the problem investigated is presented in paragraph 1.1 after which it will be clear how the problem statement has developed. Also the academic relevance is explained in the first paragraph. Following from this the problem statement is formulated in paragraph 1.2. In paragraph 1.3 the research questions are formulated that need to be answered in order to answer the central question of this thesis followed by the hypothesis development. Paragraph 1.4 gives an outline of how this research is constructed by explaining respectively the research design and data collection, the sample and the analysis of data. 1.1 Background and problem definition Awareness for Corporate Sustainability (CS) is ever growing in today s business environment. The objective of CS is to balance economic responsibilities with social and environmental ones ( Van Marrewijk, 2003; Montiel, 2008). The fact CS in business is on the rise is clearly visualized by the increasing presence of socially and environmentally oriented investors in stock markets (Rockness and Williams, 1988; Harte et al, 1991). This phenomenon is also visualized by the strong increase in the number and quality of sustainability reports used by companies to evaluate their social and environmental performance (KPMG, 2005, Moneva et al, 2006). Sustainability reports are used as vehicles for firms to disclose information to stakeholders on their contribution to sustainable development (Moneva, 2007). Besides, this increase is an additional indication of the fact that firms are paying serious attention to incorporate environmental and social issues in their business strategy (Hoti et al, 2005; Hassel et al, 2005). What drives and motivates firms to voluntary disclose social and environmental information is still isn t exactly clear and has become the focus of many studies on CSR. However for CSR (reporting) to be a sustainable business practice its benefits should outweigh it cost. It is hard to imagine a business could proceed a policy that keeps realizing negative cash flows. Such a policy would be detrimental to 5

6 shareholder wealth and therefore being socially responsible should have financial benefits in order to be sustainable. Therefore my interest goes out to whether reporting on CSR increases financial performance. This study specifically focuses on firms publishing sustainability reports in accordance to GRI guidelines. This is an interesting perspective since a study of KPMG (2005) on CS reporting among the top 250 companies of the Global Fortune 500 (G250) found that report content is most commonly based on GRI guidelines. This study also brought forward that 74% of these companies use GRI guidelines for economic reason. If reporting proves beneficial to financial performance this could lead to a different approach of firms towards CSR and explain why some firms do and others don t engage in CSR reporting, hence also give more insight into motives. This study will therefore tend to give a rich and up-to-date description of the motivations for CSR reporting from both theoretical and empirical perspective and add to this the results of this study. The paper is structured as follows. Chapter two gives an overview of the primary concepts and definitions used in corporate social and environmental research. Chapter three looks into the motivations for firms to disclose social and environmental information and gives an overview of important characteristics that influence social disclosure practices and behaviours. Chapter four analyzes research on the link between corporate social and environmental responsibility and financial performance. Chapter five outlines the analysis or tests and presents the results. Finally in chapter 6 the conclusion and limitations of this study are presented. 1.2 Problem statement The central question of this study following from the problem statement is as follows: Do companies which disclose a sustainability GRI sustainability report have a better financial performance? 6

7 1.2.1 Research Questions 1. What is corporate sustainability? 2. What does a GRI sustainability report consist of? 3. What are the drivers and motivations for publishing a CS(R) report? 4. What is the relation between CS(R) and financial performance? Conceptual model Reporting level + GRI sustainability report Financial performance Hypothesis development Dependent variable: A company s share price as an indicator of financial performance. Independent variable: Publication of a GRI G3 sustainability report. H1: There is a positive relationship between companies that publish GRI G3 sustainability reports and financial performance. A firm that incorporates social and environmental responsible policies in its business practices will experience an increase in financial performance. It s essential for a firm to satisfy its primary stakeholders since not doing so can be a direct threat to a company s existence and hence financial performance. The information provided in disclosures have the purpose of managing and manipulating the influential stakeholder groups in order to enlist their support essential for survival (gray et al, 1996). Next to this there is a widely accepted belief that satisfying stakeholder groups can have benefits beyond a continuation of participation (McWilliams and Siegel, 2001) Examples of such benefits of social and environmental responsible actions that can increase competitive advantage and have the potential to increase financial performance are increased employee motivation, an increased labour pool, a better public image and reduced operating costs (Parket and Eilbirt, 1975; Turban and Greening, 1997; Soloman and Hansen, 1985). Since a study by KPMG (2005) 7

8 pointed out that 74% from the top 250 companies of the of the Global Fortune 500 use GRI guidelines for economic reasons, I expect that firms who publish reports based on GRI guidelines are more effective in satisfying important stakeholder groups and realizing other benefits related to CSR. Therefore I expect companies which disclose social and environmental reports according to GRI guidelines will have a better financial performance than companies who don t. Dependent variable: A company s share price as an indicator of financial performance. Independent variable: The level to which a firm has applied the GRI and other Reporting framework elements. H2: The relation between the publication of GRI sustainability reports and financial performance is stronger for firms that have a higher application level. The greater the amount of CSR a firm undertakes and reports the better their financial performance will be. By disclosing more social environmental information firms will be more able to satisfy their stakeholders and gain more from other benefits related to social and environmental responsibility. Therefore I expect a positive relationship between financial performance and a firms application level of the GRI guidelines. 1.4 Research Method Research design There are three types of empirical research using secondary data that have studied the link between corporate social and environmental activities and financial performance (Jacobs et al., 2007). Portfolio studies compare a portfolio of companies with good social and environmental performance against the market to test whether their financial performance is better. Event studies estimate the impact of announcements on the market value of the company and look at the short term impact on financial performance. These studies have been used to investigate both the impact of positive and negative announcements. Then thirdly regression studies have been used to determine long-term relationships and use accounting based measures or some financial index of performance. This study uses both market and 8

9 accounting measures to evaluate the impact of GRI reports on long term financial performance by doing a regression analysis. From each type of financial performance measure two measures have been used. To asses financial performance based on accounting measures the ROA and ROE are used, two commonly used measures for financial performance. To evaluate market values total return to shareholders per share and Tobin s Q are used. Total return to shareholder per share is used based on the believe this is the most informative measure of returns to shareholders. Tobin s Q is generally used in research as an indicator of intangible value (Dowell et all, 2000). To measure Tobin s Q the simplified measure proposed by Chung and Pruitt (1995) is used who found little qualitative difference between this measure and the more complicated one proposed by Lindenberg and Ross (1981). Using multiple measures will give the results more validity. Accounting returns: Return on assets = (income before extraordinary items / total assets) 100 Return on equity = (income before extraordinary items / common equity) 100 Market returns: Total return to shareholders, per share = [(stock price at end of year stock price at beginning of year +dividends) / stock price at beginning of year] 100 Tobin s Q = firm equity value (outstanding shares X share price) + book value of long-term debt + net current liabilities 1 / total assets Sample A sample of US and Canadian listed firms form the population under study. US and Canadian corporations are chosen as subject of this study because of their leading position in the CS(R) field and the availability of financial data in the Compustat database of North American companies. To indentify the North American companies that publish reports based on GRI guidelines the GRI Reports List published in 2011 by the GRI organisation is used. This list includes all the companies worldwide that have published reports following the GRI guidelines over the sample period 2010 and 1 Net current liabilities refer to the current assets less current liabilities of an organisation. 9

10 consists of 223 companies. To retrieve financial information the Compustat North America database is used. This database includes the financial information needed to calculate the dependent variables under study. To be able to retrieve financial information from the Compustat database company keys are needed for the firms from the GRI Reports List which doesn t include these keys. By extracting lists of the constituents of the S&P 500, S&P mid-cap 400 and the S&P small-cap 600 index with their company keys they can be indentified in an efficient and reliable way in Excel 2. The S&P mid-cap and small cap however delivered only few matches and were therefore excluded from the sample for practical reasons. Of the 223 US and Canadian companies that disclosed a GRI Sustainability Report in 2010, 110 companies are constituents of the S&P 500 index belonging to 9 different industry divisions based on SIC classification. Because of the limited sample size only the two industry divisions Manufacturing (SIC division D) and division Transportation, Communication, Electric, Gas and Sanitary Services (SIC division E) are included in the sample. By limiting the sample to these two divisions the preferred ratio (1 to 15) of independent variables to the number of cases is sufficient as the number of companies in each division is respectively 58 and 21 companies Data analysis A regression analysis is performed to test the impact of the independent variables on both market value and accounting measures of financial performance. Size, Risk and Industry have been indentified in previous research as variables that influence CSR as well as financial performance (e.g. Ullman, 1985). Therefore each of these variables are included in the regression model. Size is controlled for by the amount of total assets, risk will be controlled for based on a firms leverage (debt to equity ratio) as a proxy of a firms risk and the industry is determined by the 4-digit SIC and represented in the model by a dummy variable. 2 Appendix D: S&P 500 Identification 10

11 The relationship between firms that publish GRI sustainability reports and financial performance is examined in two ways. A regression analyses is performed on a sample of companies existing of the companies indentified that publish such reports and a control group that exists of an equal amount of companies from each industry which don t publish such reports. Next to this an independent two sample t-test is performed to test if a relationship exists by comparing the means of the dependent variables of both populations of companies. The following model (1.1) is used for the regression analysis: Y (Financial Performance) = α + β1totalassets + β2debt to Equity ratio + β3 D_IndustryDivision_D + β4d_grireport + ε To examine if there is relationship between a company s application level and financial performance a regression analysis is again performed on a sample of companies that disclose reports in accordance to GRI guidelines. However for this purpose the dummy variable GRI Reports in model 1.1 is replaced by the dummy variable Application Level. This dummy variable takes the values 0 to 3 which represent the application levels U (undeclared), A, B and C where U is considered the lowest level of application and A the highest. The following regression model (1.2) is used: Y (Financial Performance) = α + β1totalassets + β2debt to Equity ratio + β3 D_IndustryDivision_D + β4application Level (A,B,C,U) 11

12 Chapter 2: Corporate Sustainability and Corporate Social Responsibility This chapter in paragraph 2.1 starts off with the introduction of the central terms and definitions used in this study to refer to social and environmental responsible actions and behaviours. This will be followed in paragraph 2.2 by an introduction of the GRI organisation and the GRI reporting framework as GRI based disclosures are an important theme of this study. Paragraph 2.3 summarises the most important remarks made in this chapter and presents the conclusion that can be drawn with regard to this study. 2.1 What are Corporate Sustainability and Corporate Social Responsibility? The term Corporate Sustainability (CS) was introduced in the WCED report of 1987 our common future (Montiel, 2008). Development in this report is believed to be sustainable if companies can achieve their goals without compromising the ability of future generations to meet their own needs. Since then different CS related definitions have emerged which can be divided in two distinctive approaches of defining and conceptualizing CS. One way is to identify sustainability in relation with the environmental dimension of business (Shrivasta, 1995b; Starik and Rands, 1995). The other stems from the WCED definition and puts it in a broader perspective, viewing CS as a construct that consists of environmental, economic and social dimensions (Bansal, 2005; Galdwin and Kennedy, 1995). Historically research in social issues has been part of the CSR field and research on environmental issues of the environmental management (EM) field according to Montiel (2008) and Keijzers (2002). Only later did CS occur in discourse according to them, including social as well as environmental issues. A vast variety of definitions and key constructs for CS and CSR have emerged since the mid-nineties (Bansal, 2005), of which most stress the voluntary nature of CSR. This goes as well for other concepts and definitions that refer to a more transparent, ethical and humane way of conducting business (Van Marrewijk, 2003). This as a 12

13 result lead to great diversity and overlap in terminology, definitions and conceptual models complicating research on the subject (Göbbels, 2002). Research on the concepts and definitions of CS(R) by Van Marrewijk (2003) lead him to conclude that the quest for an all enhancing definition of CS(R) should come to an end. He states that more and tailored definitions matching the development, awareness and ambition levels of organizations should be accepted. However study has shown a convergence over time of concepts and definitions of CSR and CS (Montiel 2008; Keijzers 2002). The essence of both concepts nowadays boils down to the same according to Montiel (2008) based on his study on both. That is to balance economic- with social and environmental responsibilities. Some researchers like Garriga and Melé (2004) therefore see CS as just one approach to conceptualizing CSR or vice versa. This overlapping of terms is well reflected by the names that companies which disclose social and environmental reports based on the guidelines set up by the global reporting initiative (GRI) use to refer to their reports. Montiel (2008) found in a sample consisting of 112 US corporations reporting under GRI guidelines that multiple names were used such as Global Citizen Report, Corporate Responsibility Report, Environmental Sustainability Report, Sustainability Report, to refer to their disclosures summarizing their social and environmental achievements. Closely related to the concepts of CS and CSR is the concept of Corporate Social Performance (CSP). CSP is nowadays commonly used to refer to a company s overall level of social responsibility (Montiel, 2008). A widely used definition by Wood (1991) defines CSP as the process of corporate social responsiveness and the outcomes of corporate behaviour, including impact, policies and programs. CSP as an indicator of a company s level of social and environmental responsibility is generally measured in four ways: CSP reputation ratings, social audits, CSP processes and observable outcomes (e.g. charitable contributions) and CSP disclosures (Post, 1991). 13

14 2.2 The Global Reporting Initiative The global reporting initiative was established 1997 with the mission for developing globally applicable guidelines for reporting on economic, environmental and social performance for any business or governmental or non-governmental organization. The main reason for setting up the guidelines was a lack of comparability between reports from different companies. The GRI organization contains representatives from global business, civil society, labor, academic and professional institutions. The reporting framework is as they mention on their website 3 developed through a consensus seeking process with multiple stakeholders. Which means in practice that a stakeholder council continuously evaluates what the content and lay-out of the reports should be. The framework sets out the principles and Performance Indicators that organizations can use to measure and report their economic, environmental, and social performance. Reports based on the most recent generation of GRI guidelines, the G3, should contain the following parts: Strategy and Profile: Disclosures that set the overall context for understanding organizational performance such as its strategy, profile, and governance. Management Approach: Disclosures that cover how an organization addresses a given set of topics in order to provide context for understanding performance in a specific area. Performance Indicators: Indicators that elicit comparable information on the economic, environmental, and social performance of the organization. After completion of the GRI report companies should assign an application level to their report (Global Reporting Initiative Guidelines, 2006). This means that companies indicate to which extent they have applied the GRI reporting framework. This declaration of an application level gives a clear communication of which elements of the GRI Reporting Framework have been applied. There are three level of application C, B and A and each level presents an increasing level of coverage of the reporting framework. Since the application levels are self-declared firms can get external

15 assurance of their application levels from the GRI organisation or some other assurance providers after which the application level receives a plus ( ex. C+, B+, A+). Since 2006 the guidelines that comprise the framework are based on these G3 guidelines. This is the third generation of guidelines formulated by the organization. These guidelines are applicable for all organizations no matter their size, sector or location and can be implemented voluntarily, flexibly and incrementally. This offers organizations the opportunity to plot a path for continual improvement of their sustainability reporting practices as stated on their website. 2.3 Conclusion Research on the concept and definitions used to refer to corporate social and environmental responsibility found there are multiple definitions used referring to the same practices. The main definitions found in contemporary literature are Corporate Social Responsibility (CSR) and Corporate Sustainability (CS). The lack of a uniform definition to relate to these actions and behaviours complicates research on the subject as Göbbels (2002) pointed out. However Montiel (2008) and Keijzers (2002) in their studies found there is a convergence visible nowadays of concepts and definitions as they tend to share the same vision of balancing economic responsibilities with environmental and social ones. Therefore in the coming chapters these terms are used interchangeably to refer to corporate social and environmental responsible actions and behaviours. The second part of this chapter made clear what the Global Reporting Initiative is and presented a basic outline of the contents of the reports. Furthermore it explained how the application are assigned which will help to interpret the results of this study. 15

16 Chapter 3: The drivers and motivations of CS(R) reporting Because social and environmental reports are the focus of this study it is evident to understand why corporations publish such reports. This will also enable us to get a better understanding of possible differences in financial performance between companies who publish sustainability reports and those who do not. To start off the analysis on what motivates/influences corporations to report on social and environmental activities paragraph 3.1 will first explain the theories most referred to in literature in this context. Paragraph 3.2 will subsequently give an overview of specific factors indentified in literature influencing the nature and extent of such disclosures. Paragraph 3.3 as the final part of this chapter presents the conclusion and summarizes the important remarks made in this chapter. 3.1 Theories related to motivations for CS(R) disclosures Several theories are used in literature to explain the flow of information between organisations and society (Gray et al, 1995). These theories are rather broad and overlap each others. Consensus is that the social and political theories that focus on the role of information and disclosures in relation to organisations, the state, individuals and groups best explain corporate social and environmental disclosure behaviour (Gray et al, 1995) Political economy theory The political economy theory explicitly states that there is a fundamental relationship between political and economic sources in society. According to this theory society, politics and the economy are interrelated and so none of these perspectives can be considered a part from each other. For the firm to survive it has to gather support of both primary stakeholder (such as customers, suppliers or providers of capital) without whom the firm cannot function and secondary stakeholders (such as the media and regulators) which are indirectly related to the firm but however significantly able to influence the firm s success (Clarkson, 1995). CSR and related disclosures in this view are part of the communications process to acquire and maintain that support. Literature often refers to stakeholder theory and legitimacy theory as theoretical perspectives in support of the political economy theory. They shouldn t be regarded distinct and delineated but should be viewed as overlapping perspectives 16

17 on issues situated in a framework of assumptions supporting the political economy theory according to Gray et al. (1995) Stakeholder theory The stakeholder theory focuses on the impact of different stakeholder groups within society. From the perspective of managerial stakeholder theory corporate disclosures are used to provide information to a firms most influential stakeholder groups such as employees, consumers, shareholders and investors. This brings up the important question of which stakeholders have some right to information and how to rank their interests (Gray, 2001). This process inherently brings conflict among stakeholders as not all their interests can be reflected in disclosures. Therefore stakeholder theory acknowledges that its essential for a firm to become able to balance the conflicting demands of various stakeholders in the firm (Robberts, 1992). However the more important stakeholder resources are to the firm s success or viability the more likely it is their demands will be met (Miles, 2002). The information provided in these disclosures have the purpose of managing or manipulating the influential stakeholder groups in order to enlist their support or to distract their opposition or disapproval, essential for survival (Gray et al, 1996). Research interpreting disclosures from a stakeholder theory standpoint has been very limited. Neu et al. (1998) examined environmental disclosures of Canadian firms in environmentally sensitive industries. They concluded that the level and type of corporate disclosures and the way they are communicated depends on a company s relevant publics and is mainly influenced by the power of these relevant publics, ignoring issues raised by marginal publics. Also Roberts (1992) and Ullman (1985) have similar findings concluding that firms use disclosures as a way of managing stakeholders and the organisational environment. 17

18 3.1.3 Legitimacy theory Legitimacy theory is grounded in the belief that a social contract exists between business and society. The theory states that society allows businesses to have rights and exist, expecting companies to live up to societies expectations about how their business should be operated. Not living up to these standards will be a direct threat to their existence and therefore they need to operate in accordance to societies norms and values. If these expectations aren t fulfilled a legitimacy gap may arise. This can be caused by a company if its behaviour is not or is perceived as not being in accordance to expectations. Dowling and Pfeffer (1973) speak of three ways to improve or establish legitimacy. According to them a company can: adjust its operations to societies norms and values, alter existing definitions in line with existing business operations or engage in communication to promote its public image with socially legitimate symbols, values and institutions. Corporate social disclosures must be in line with at least one of these strategies as implementation of a legitimization strategy requires both communication (disclosure) by the organisation as well as addressing norms, values and believes of relevant publics (Van der Laan, 2009). Research on the application of legitimacy theory in this context has delivered mixed results however most recent studies found a positive link between disclosures and legitimization motives (Brown and Deegan, 1998; Deegan and Rankin, 1996; Patten, 1992). These studies for example have looked at disclosure patterns in relation with changes in societal opinions to find practical evidence for legitimization theory. At the root of such studies lies the belief that the nature and extent of disclosures changes as societal opinions change. Legitimacy theory nowadays is the dominant theory used in explaining disclosures as evidence is growing managers adopt legitimization strategies such as explained above (Cambell et al, 2003). Clearly both theories have great similarities, viewing the organisation as part of a larger social system where it influences and is influenced by other groups in society. However there is also a clear distinction. Stakeholder theories distinguishes itself by focusing on identifying expectations of the most powerful stakeholder groups in 18

19 society where legitimacy theory focuses on expectations from society in general. So the stakeholder theory recognises that different stakeholder groups have different perspectives on how a business should operate and therefore more social contracts have to be negotiated than one for society in general Agency theory Also the agency theory is often mentioned in relation to CS(R) disclosures and therefore should be mentioned. Agency theory is based on the view that managers will only disclose CS(R) related information if the benefits of providing such information outweigh its costs. Agency costs arise when management (agent) acts in self-interest thereby negatively affecting financial performance and hence shareholders (principal) wealth. Reverte (2008) in this context refers to CS(R) disclosures as being potentially useful for determining contractual debt obligations, managerial compensation contracts or implicit political costs. Hence because management will want to avoid agency costs they want to appear acting in shareholder interest by providing such (financially) relevant information (Jensen and Meckling, 1976). However this focus on wealth considerations among agents who trade in information efficient markets, inherent in agency theory, limits the scope for CS(R) disclosures with respect to deciding on relevant information and its intended purposes (Cormier et all, 2005). Many which potentially are interested in such information such as pressure groups like Greenpeace for example may actually not act in these markets at all (Reverte, 2008). Here it is where the fundamental difference lies with the previously mentioned theories. In contrast to the Agency Theory, Legitimacy- and Stakeholder Theory make no assumption about rational individuals trying to maximize their wealth in efficient capital markets to explain motivations for CS(R) disclosures. 19

20 3.2 Factors influencing the nature and extent of disclosures. Legitimacy and stakeholder theory seem the most successful in explaining the motivations for corporations to disclose social and environmental information (Gray et al, 1995 ; Milne, 2002). These theories all boil down to the notion that firms report mainly to safeguard their reputation and identity (Hooghiemstra, 2000). However it is difficult to explain the nature of reports and the extent to which companies report with these theories as this fluctuates across companies, industries and time (Hackston and Milne,1996). Various studies have shown that these fluctuations are determined by firm and industry characteristics that have an impact on the relative cost and benefits of disclosing such information (Reverte, 2008) Corporate characteristics A great deal of recent studies focusing on corporate characteristics of disclosures studied environmental reports and therefore the results have to be interpreted with caution. Also the samples used differ in size and industrial composition from sample to sample as well as the countries, time period and explanatory variables. However this makes it difficult to generalize findings, some insightful relationships have been identified. Several empirical studies have found size of corporations as an important variable in relation to disclosure (Adams et al 1998; Cowen et al, 1987; Patten 1991). According to Watts and Zimmerman s (1986) political cost hypothesis large firms are more exposed to public scrutiny and more vulnerable to intrusions from government into their activities. Because of their size these companies attain more public attention, have greater market power and are more newsworthy. This makes them more susceptible for matters such as public resentment, consumer hostility and the attention of government regulatory bodies. Also their size increases their impact on society, and therefore they naturally have a bigger group of stakeholders influencing the company (Clark and Gibson-Sweet, 1999). Thus voluntary disclosures in this context can be regarded as an effort to avoid regulations and reduce political costs (Adams et al 1998; Clark and Gibson-Sweet, 1999). Larger firms are more political visible and therefore are probably more heavily engaging in legitimating behaviour (Dowling and Pfeffer, 1975). 20

21 Next to size industry is a factor that is often referred to in literature to explain the nature and extent of social and environmental disclosures (Reverte, 2008). Studies on this relation show that firms active in industries that have manufacturing processes with a negative impact on the environment disclose more voluntary information regarding their environmental impact than firms from other industries. Other industries like for example newer manufacturing industries or the service sector have far smaller environmental impact and have fewer environmental issues. Therefore these firms are logically expected to experience less pressure from stakeholders concerning their environmental performance, and therefore expected to be less inclined to disclose such information. Firms in the mining, oil and chemical industries generally report more on environmental, health and safety issues, while for example the financial services sector emphasize information with respect to social issues and philanthropy (Clarke and Gibson-Sweet,1999). Several studies suggest there is a positive relationship between social disclosure policy and profitability, which are mostly grounded in stakeholder theory (Roberts, 1992; Ismail and Chandler, 2005). However the empirical evidence doesn t always support that positive relationship (Cowen et al, 1987; Patten, 1991). Belkaoui and Karpik (1989) explain this positive relationship with management knowledge. They argue that a management that has the capability to make a firm profitable also has the ability to integrate social and environmental responsible policies, this leading to more social and environmental disclosures. Giner (1997) refers to agency and political cost theory to explain this relation, based on the fact that management in very profitable firms disclose more detailed information in order to support their own position and compensation. Also the legitimacy theory is used in this context, based on the believe that profitable firms attract more public attention and experience more political pressure. Ng and Koh (1994) argue that they therefore use more self regulatory mechanisms such as disclosures to avoid regulation. The most obvious explanation lies in the slack resources theory. This theory states that firms that are profitable will be more likely to disclose social and environmental information opposed to less profitable firms because the latter will focus on activities that have a more direct effect on earnings (Robberts, 1992; Ullman, 1985). 21

22 Also risk is a factor often referred to when determining why it is that companies disclose social and environmental related information. Empirical research has shown that there is a negative relationship between CSP and subsequent (financial) risk, meaning CSP is used as a way to decrease financial risk by such measures as variance in earnings and stock returns (McGuire, 1985; Olitzsky and Benjamin, 2001;). There are two main arguments in support of this relationship which are based on good management theory / stakeholder theory. The first argument supporting this relation is that investors may see firms with low CSP as riskier investments because they consider management capabilities at the firm as low (Spicer, 1978, Alexander and Bucholtz, 1978). Then the second argument is that investors are more likely to invest in firms which in their view have high CSP as this reduces the risk of claims by stakeholders in the future (McGuire, 1988). Examples of such future claims would be government levies and lawsuits or some regulatory intervention by the government. Such examples can off course also have a direct effect on earnings. Roberts (1992) on the other hand has found evidence of this relation working the other way around. He found that firms with low systematic risk have higher levels of CSP as measured by their levels of social responsibility disclosures. He argues this is because firms with lower systematic risk have more stable returns which should enable them to commit to CSP initiatives more easily. His argument has similarities with the slack resources theory mentioned earlier in this paragraph General contextual factors Next to corporate characteristics influences of the general contextual factors have also been examined in relation with corporate disclosures. However this relationship seems to be much more complex because of difficulties determining the contextual variables and the complex relationship between them. Despite these difficulties study on the relationship has lead to the following conclusions. Various studies over the years have found that both the nature as the extent of disclosures is related to country of origin (e.g. Adams, 1999; Adams and Kuasirikun, 2000). The variation in these differences is hard to determine sometimes 22

23 because of the differences in characteristics between firms (industry composition, firm size) making up the samples from each country in a specific study. There is a relationship between the nature of disclosure and the social and political context. These variables are intertwined and interconnected and can be bidirectional. Longitudinal studies have showed differences in the extent and nature of disclosures on for example the portrayal of woman (Adams and Harte, 1998) and the occurrence and disappearance of reporting on value added (Burchell et al., 1985) and then contemporary social, political and economic context. There are also examples of the influence working in opposite direction. Arnold and Hammond (1994) found examples of how reporting was used to influence the social and political climate in favour of corporate interests. Also the state of the economy is related to the nature of reports although its less influential than the social context. A study by Guthrie and Parker (1989a) on a particular company s social disclosures found a great variation in its corporate social reporting practices. They found intervals in peaks ranging from ten to thirty years. The occurrence of these peaks in disclosures bear little resemblance with important economic events influencing the company. Cultural context (Adams and Kuasirikum, 2000) and ethical relativism (Lewis and Unerman, 1999) have also found to be related to reporting. Cultural factors have an influence on moral values which in their turn at least influence the issues which companies deem necessary to report on. Also ethical relativism has to be mentioned in this context. Gray (1988) examined four accounting / reporting values including transparency versus secrecy linked to Hofstede s four cultural values. This study puts German and Anglo-Saxon accounting systems at the opposite ends of the spectrum with the German systems being the most secretive and those of Anglo Saxon firms the most transparent. However study by Adams and Kuasirikum (2000) showed that German firms are clearly not more secretive opposed to Anglo Saxon firms when it comes to ethical reporting which can be explained by ethical relativism. 23

24 Patten (1992) has found a link between the extent of reporting and specific events. He discovered that firms in the oil industry significantly increased environmental disclosures in reaction to the Exxon Valdez oil spill. This as an attempt to legitimize their operations in reaction to stakeholder concerns. Other industries also faced an increase in disclosures following this event according to Brown and Schwarz (1997) and concluded that firms respond to public policy pressures in the face of such events. The extend of reporting is found to be influenced by media pressure. A positive relation is identified by Brown and Deegan (1998) between levels of environmental disclosures and media exposures of a variety of industries with regard to their environmental impacts. Media coverage increases a company s visibility leading to more public attention and scrutiny increasing the public policy pressures faced by corporations (Patten, 2002). 3.3 Conclusion This chapter showed that the nature and extent of social and environmental disclosures varies between companies, industries, countries and time. Corporate characteristics have been identified as important factors influencing the relative costs and benefits of disclosing such information (Reverte, 2008). Research showed that stakeholder and legitimacy theory seem to be best suited to explain the nature and extent of social disclosures (Gray et al, 1995; Milne, 2002). These two closely related theories fall under the umbrella of the political economy theory and have great overlap. According to the political economy theory it s essential for firms to gain the support of both primary and secondary stakeholders in order to survive (Clarkson, 1995). Although these theories are closely related they differ in a sense that legitimacy theory is more focused on expectations from society in general opposed to the stakeholder theory which focuses on expectations from powerful stakeholder groups to explain disclosure behaviours. Based on this chapter it can be concluded that the main motivation for the disclosure of corporate social and environmental information for firms is to legitimize their operations as not living up to expectations from relevant groups would be a direct threat to a firms functioning and existence. 24

25 Chapter 4: CSR and financial performance The previous chapter has already revealed a relationship between social and environmental responsible actions and policies and profitability. It turned out that firms mainly report to legitimise their operations as not doing so is perceived a direct threat to a firms survival and hence financial performance. The relationship between profitability and social and environmental performance has been the subject of various studies. Chapter 4 therefore offers an oversight of the most important and relevant (empirical) studies that have focused on this relationship. 4.1 Theoretical arguments Research on the relation between CSR and financial performance has been grounded in several theoretical arguments. Those arguing the relationship is negative explain this negative relationship with two models: The trade-off hypothesis and the managerial opportunism hypothesis. Those arguing the relationship is a trade-off suggest that being socially and environmentally responsible incurs extra costs upon the firm which puts them at an economic disadvantage opposed to less socially and environmentally responsible firms (Friedman, 1970). These extra costs come from actions like establishing environmental protection procedures, promoting community development plans or maintaining plants in economic depressed areas for example. The managerial opportunism hypothesis is based on the belief that management will reduce social and environmental expenditures when firms experience strong financial performance in order to enhance their own short-term gains. On the other hand according to this belief management will do the opposite and increase these kind of expenditures when firms experience a weak financial performance as a way to attempt to legitimise their poor performance (Preston and O Bannon, 1997). Then there are those arguing for a positive relationship between these variables. The value creation school of research regards CSR as a way to realize a competitive advantage and its impact on economic returns is expected to be positive according to this school of thought (Konar and Cohen, 2000). This reasoning has a direct link with political economy theory. As was explained in the previous chapter this theory states it is essential for a firm to satisfy both its primary and secondary 25

26 stakeholders. Since not doing so can be a direct threat to the firms survival as it exposes the firm to the risk of stakeholder withdrawing from the firm altogether (Clarkson, 1995). Next to this there is a widely accepted belief that satisfying stakeholder groups can have benefits beyond a continuation of participation (McWilliams and Siegel, 2001) Examples of such benefits of social and environmental responsible actions that can increase competitive advantage and have the potential to increase financial performance are increased employee motivation, an increased labour pool, a better public image and reduced operating costs (Parket and Eilbirt, 1975; Turban and Greening, 1997; Soloman and Hansen, 1985). Then off course there are theorist arguing for the possibility that there is simply no relationship between social and financial performance (Ullman, 1985; McWilliams and Siegel, 2001). At the root of this argument is the assumption that there are numerous variables influencing the relation and it therefore makes no sense to expect a relationship, except possibly by chance. Besides this, they argue that measurement problems complicating CSR research make it very hard to identify any relationships. Finally there are those claiming the relation may be a virtuous circle (Waddock and Graves, 1997). Thus meaning that a high social performance can lead to enhanced financial performance which consequently leads to a higher social performance. Hence this should also work the opposite way according to this theory in case of a low financial performance. This argument has its roots in the slack resources theory. 4.2 Empirical evidence Over the years numerous empirical studies have been conducted to identify the exact relationship between social/environmental performance and financial performance. Despite all this research till this moment the exact relationship isn t clear as to its strength and direction. The results of study on the relationship between environmental- and financial performance are mixed and vary from positive and negative to insignificant. According to Chand (2006) out of 51 studies done between 1970 and 1995, 33 found a positive relationship, 9 found a negative relationship and also 9 found no relationship. 26

27 There are essentially two types of empirical studies used to evaluate the impact of CSR on financial performance. The first one mentioned here is the event study methodology which looks at the short term impact on financial performance. Event studies examine the impact of the announcement or release of information relating to social responsible or irresponsible acts on stock prices (abnormal return). So basically they examine the reaction of investors towards these announcements. McWilliams and Siegel (1997) have analyzed these studies and found mixed results. These mixed results are well illustrated by studies that studied the effect of divestures from South Africa during the Apartheid controversy on short term financial performance. Posnikoff (1997) reported a positive relationship opposed to Wright and Ferris (1997) who identified a negative relationship while Teoh et Al. (1999) found no relationship. The second type of studies measure the long term impact of CSP on financial performance. These studies consist of two types of financial performance measures, market based (investor returns) and accounting based (accounting returns) measures. Studies performed with these types of measures again produced mixed results. Waddock and Graves (1997) for example found a positive relation between CSP and financial performance measured by ROA and ROE. McGuire (1988) found evidence pointing the other way suggesting that prior financial performance (measured by ROA, and growth in sales, assets and income) was more closely related to CSP than was subsequent performance and Ingram and Frazier (1983) who used ROI as their measure of performance found no relationship. Also studies with market based measures vary in their results. Vance (1975) studied 14 firms over a 3 year period in a response to a study done by Moskowitz (1972), who used excess market valuation to measure financial performance, claiming that a positive relationship exists. This study looked at stock returns and used the same sample of firms identified by Moskowitz as social responsible firms and found a negative relationship. Vance concluded that social responsible firms aren t good investments. To support his conclusion he performed an analysis on firms identified by business week as having high and low levels of CSR and found the latter outperformed the former. His final conclusion was that investors were better of 27