05 July 2022

ECGI: There’s more to corporate purpose than ESG

 With increased geopolitical risks, energy transition in trouble and inflation spiraling out of control, some large institutional investors are now changing tack, supporting new investment in oil and gas infrastructure, and suggesting that the effort on decarbonization should slow down. In addition, the rather critical views on ESG that some asset managers’ senior executives have recently expressed are raising concerns about how green ESG investment is. It is no surprise that regulators are stepping in and adopting tougher scrutiny of ESG funds.

Free markets and entrepreneurship bring great benefits to society, but companies’ activities also have negative effects on the environment and communities. Neither greenwashing nor higher energy costs due to a disrupted energy transition will wipe these negative externalities away. Companies must come up with effective solutions.

The fight against climate change should involve not only regulators and investors; it badly needs the alignment of companies themselves. Some experts assume that a growing number of investors pushing for ESG goals or stricter regulation would be enough to turn the corporate world around and make it more environmentally and socially responsible. Companies have a key role to play: they are polluters, but also have the capacity to innovate and create new products that can meet society expectations. Corporate governance needs to embrace ESG and build on the notion of purpose.

ESG factors were formally born in 2004 as a joint-effort by the UN Global Compact and some large financial institutions with the goal to define investment principles that would take into account the environmental and social negative effects of companies’ activities. Financial investment and asset management have since been and remain the drivers of ESG growth.

But the notion of purpose has a much longer tradition than ESG in the corporate world. In management theory, ‘purpose’ or ‘mission’ - has been used for decades (Barnard, 1938; Selznick, 1957; Mayer, 2018).

Purpose adds an important governance and management perspective, helping to prioritise customer needs and long-term value objectives. It goes beyond ESG considerations to simultaneously consider customer needs, innovation and competitive advantage.

The divergences are also significant. ESG policies work by controlling and eventually reducing some corporate risks regarding the environment, social effects and governance. Purpose works through a different channel. It signals the firm’s willingness to be an effective organization that creates value by serving customers in a unique way, engaging employees and caring about other key stakeholders. In this way, purpose is a source of innovation. Purpose operates through engaging and motivating employees (Edmans, 2011), by offering them a sense of meaning (Gartenberg, Prat and Serafeim, 2019) and a relation based on trust (Henderson and Van den Steen, 2015). It can also appeal to customers by offering products that are better or environmentally friendly. Purpose can become a driver of sustainable competitive advantage, which is the engine of superior economic performance.

Some criticisms of purpose suggest that the goal of maximizing shareholder value offers a more direct and simple objective for boards and CEOs and the introduction of an integrated purpose raises the possibility that decision-making could become less effective. As Simon (1976) suggested, maximizing profits may not be possible in the real world of management with bounded rationality and uncertainty. However, in management theory, the hypothesis that general managers should tackle a broader view of goals and policies and manage trade-offs to govern companies has been the rule, not the exception. It is part of a senior manager’s job. Some CEOs will do it well and others will fail.

The empirical evidence emerging from many companies that have adopted a notion of purpose varies. When purpose is integrated into corporate strategy and business model, it becomes a source of competitive advantage. This is what we observed on European companies such as Henkel, Ikea, Nestlé, Puig, Schindler, Schneider Electric, Unilever, among others, is the necessary condition for sustainable long-term value creation (Canals, 2023).

Schneider Electric offers a useful reference. Its energy goals in 2006 embodied a strategic option that the board and the senior management selected, introduced in its mission, articulated in a long-term strategy to foster innovation in product development in coherence with that goal, obtained shareholders’ support and eventually delivered on performance. Sustainability has unsurprisingly become well-ingrained in the firm’s strategy and business model and it is at the root of a very strong competitive advantage. As this case and many others point out, purpose becomes relevant when it is not only authentic, but also connected with a corporate strategy that generates a sustainable competitive advantage. Purpose – not only ESG factors - becomes a driver of positive change while ensuring that companies continue to create economic value.

There is also evidence of the opposite. In recent years, companies such as Danone, GE, Johnson& Johnson or PepsiCo that also adopted a certain notion of purpose, were not able to deliver the value that they promised. It was not that their purpose was mediocre or that their ESG goals were not well-defined. The main problem was the lack of consistency between purpose and the firm’s strategy and business model.

When embedded strongly in strategy, purpose can unquestionably help to create value for shareholders and stakeholders in a sustainable way and make companies more respected institutions in our society.

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Jordi Canals is Professor of Strategic Management and the holder of IESE Foundation Chair in Corporate Governance, IESE Business School, Barcelona, Spain.

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