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«1. Introduction In recent years, the environment has moved from a fringe concern on the corporate agenda to a mainstream part of management. By ...»

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Chapter 38

On the Profitability of Corporate Environmentalism

Thomas P. Lyon and John W. Maxwell

1. Introduction

In recent years, the environment has moved from a fringe concern on the

corporate agenda to a mainstream part of management. By “corporate

environmentalism,” more specifically, we refer to environmentally beneficial actions

undertaken by corporations that go beyond what is required by law. Because such actions

benefit society as a whole, corporate environmentalism is often viewed as part of corporate social responsibility (CSR). The question of whether corporate environmentalism is profitable arises naturally from the ongoing debate over CSR that was started by Milton Friedman’s (1970) famous article on the social responsibility of business.

In Friedman’s view, the only social responsibility of a business was to increase its profits. He expressed disdain corporate executives who sacrificed profits for the social good, likening the practice to “taxation without representation.” For Friedman, an action only counts as an act of CSR if it is unprofitable. Socially beneficial actions that increase profits are merely “hypocritical windowdressing.” Friedman opposed such “hypocrisy” because he felt it conveyed the notion that there was something wrong with the pursuit of profit maximization.

Under our definition, corporate environmentalism can be profitable; all that matters is that the actions taken are not required by law. Friedman would not object to corporations taking such actions, although he might object to corporate executives attributing altruistic motives to them. The notion that corporations can undertake socially responsible actions that raise their profits is now generally accepted. To get a good sense of the evolution in the general perception of CSR, it is interesting to read articles on the topic in The Economist (2004, 2005 and 2008). While the first of these articles champions Freidman’s view, the latter concludes that CSR is “just good business.” To better distinguish the two views of CSR, Baron (2001) distinguishes CSR (which is driven by altruistic motives and is unprofitable) from “strategic CSR” (which is profitable). Since the production and consumption of goods and services requires energy and generates pollution, it is often costly for firms to engage in actions that are “friendly” to the natural environment. Consequently, much of the theoretical work in this area focuses on strategic corporate environmentalism, explaining why profit maximizing firms would engage in costly actions when they are not required to do so by law. There is some theoretical work on purely altruistic (unprofitable) corporate environmentalism, although it is a much less developed area. Empirical work has focused primarily on the drivers of corporate environmental actions, but there has also been considerable interest in assessing whether it pays to be green, and if so, under what circumstances.

We examine three main drivers of corporate environmentalism: market forces, government regulation and civil regulation. The main market forces driving corporate environmentalism include cost reduction, consumer demand, access to capital, employee retention and supply chain pressures. It is sometimes the case that the quest to reduce costs can lead to innovations that benefit the environment, such as new production methods that require less inputs or reduce waste. These innovations are often labeled “win-win” in the literature. If consumer demand for green products is sufficiently large, businesses will find it profitable to satisfy this demand by supplying products that have a lower environmental impact. Firms may also find corporate environmentalism profitable if it helps attract and retain highly productive employees. Finally, firms that profit from being green might pressure their suppliers to engage in acts of corporate environmentalism to avoid the criticism that their concern for the environment is merely greenwash.

Compliance with government regulations does not constitute an act of corporate environmentalism, but government regulation, or the threat of it, can result in many actions and strategies that do fall under this label. Firms may voluntarily engage in pollution abatement to preempt stricter and more costly regulations from emerging. This could occur if the public observes the resulting reductions in pollution, or even if the public simply perceives that businesses are tackling the environmental problem.

Sometimes a firm or subset of firms may be able to gain an advantage if environmental regulations are put in place. For example the firm might be able to comply with a regulation at a lower cost than its rivals. In this case, an act of corporate environmentalism might be used to signal the regulator that the overall cost of the regulation is lower than she might have thought otherwise. Alternatively the voluntary adoption of an abatement technology might constrain the regulator’s ability to impose stricter regulation simply because asking companies to abandon the technology they have just adopted would be too costly. If regulations are to be effective, they must be enforced.

It is costly to prepare for environmental audits and there is always the possibility that those audits might result in penalties. A firm might find it profitable to voluntarily invest in abatement technologies that reduce the likelihood of being out of compliance, so as to deflect enforcement to other firms.

Government regulation is not the only form of regulation about which firms are concerned. Civil regulation, sometimes referred to as private politics, is increasingly important. With the rise of the Internet, activist NGOs have gained considerable clout in shaping firm activities---like-minded activists find meeting and organizing easier and they also find it easier to get their message out to the public. Sometimes these NGOs can be useful partners of firms, allowing them to credibly convey the quality of their environmentally friendly products to consumers willing to pay more for green products.

Often, however, NGOs attempt to punish firms they see as environmentally irresponsible.

In this setting, acts of corporate environmentalism can be profitable if they serve to deflect a costly NGO campaign towards another firm. In this way the firm is able to preempt or perhaps shape civil regulations in much the same way it uses corporate environmentalism to deal with traditional government regulation.

The rest of this chapter is organized as follows. Section 2 lays out a theoretical framework for understanding when corporate environmentalism is profitable, and section 3 reviews the empirical evidence. Section 4 concludes.

2. The Theory of Corporate Environmentalism The growing attention to corporate environmental initiatives in the business press strongly suggests that market forces---in the markets for products, capital, and labor---are increasingly powerful drivers of corporate environmental improvement. In this section we first discuss how demand- and supply-side forces affect the level of corporate environmentalism mangers undertake. We then turn to the role of political forces in the promotion of corporate environmental actions. Two political forces are examined. First we study how traditional government regulation, or the threat of it, leads firms to undertake corporate environmental initiatives. Then we turn to the role of private politics, in which activist NGOs promote civil regulation as an alternative to traditional government regulation.

2.1 Market Forces The simplest explanation for managerial engagement in corporate environmental actions is that they arise naturally from profit maximizing actions. Firms, in their quest to maximize profits, adopt production practices that are both more efficient and better for the environment. These adoptions are often referred to as “win-win.” Porter and van der Linde (1995) provide numerous examples of firms that have increased their resource use efficiency, reducing pollution and costs at the same time. The presence of waste does not mean that pollution abatement has been transformed into a strictly negative-cost enterprise, however. There is likely nothing unique about environmental efficiency improvements as a way to cut costs. Indeed, it is possible businesses can reduce costs just as effectively by rooting out waste in human resources, outbound logistics, or any other business function as by improving environmental efficiency. Nevertheless, the presence of internal inefficiency means that environmental regulations may often cost firms less than they initially expect. Porter and van der Linde (1995) suggest that government regulations that raise the price of polluting the environment might spur innovation to such an extent that the resulting cost savings might more than cover any costs associated with the new regulation. This notion has been dubbed the Porter Hypothesis.

Even when there are no cost-reduction opportunities, firms that produce both brown and green products that are imperfect substitutes can profit by colluding to reduce their production of the “brown” products, as shown by Ahmed and Segerson (2011).

Such collusion raises the price of brown products and consumer demand for green products, which increases prices and profits for both products.1 A second source of profitability in corporate environmental actions can arise from green consumerism. Production and sale of environmentally-friendly products is a growth business, from organic food to organic cotton shirts to hybrid cars and solar energy. Arora and Gangopadhyay (1995) were the first to provide a rigorous economic explanation of this growth in green consumption, applying a standard model of vertical product differentiation to capture consumer heterogeneity in willingness-to-pay for environmental attributes. In this setting, one firm has incentives to increase its quality in order to reduce price competition with a rival. The notion that green products command a price premium has since been incorporated into numerous other models that study additional aspects of corporate environmentalism.2 As long as firms can extract enough of consumers’ willingness to pay for enhanced environmental attributes to cover the additional cost of producing them, profits can be had from supplying these consumer wants.

The authors assume that collusion on the green product would be a violation of antitrust laws.

These include the political economy model of Lutz, Lyon and Maxwell (2000), the labeling models of Feddersen and Gilligan (2001) and Heyes and Maxwell (2004), and the private politics model of Baron and Diermeier (2007).

As one might expect, the level of competition in a market affects the amount of corporate environmentalism firms undertake. As shown by Bagnoli and Watts (2003), if the market for “brown” products is highly competitive, then their prices will be low, and fewer consumers will wish to buy “green” products. However, if the brown market exhibits market power, then prices will be high and consumers will switch to the green good.

Uncertainty about standards weakens green consumer-motivated corporate environmental activities. Consumers often rely on product labels to determine the environmental quality of the products they purchase, but they do not necessarily know exactly what a label means. When there is uncertainty about the standard that lies behind a label, then consumers tend to give firms less credit for having a label, and may also give the benefit of the doubt to firms that do not have the label. Harbaugh, Maxwell and Roussillon (2011) show that both of these factors reduce firms’ incentives to label their products.

There has been much popular discussion of the role of green investors in driving companies to adopt greener practices. The amount of so called “ethical” investing is on the rise. Theoretical work, however, is only beginning to explore this issue (Graff Zivin and Small 2005; Baron 2006b, 2007). In this research, investors allocate their wealth between savings, charitable donations or shares of a socially responsible firm. If some investors prefer to make their social donations through investing in socially responsible companies (perhaps in order to avoid taxation of corporate profits), then corporate environmental actions can increase the value of the firm by attracting these investors.

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