Do Institutional Investors Drive Corporate Social Responsibility? International Evidence

Hannes Wagner is Associate Professor of Finance at Bocconi University. This post is based on article, forthcoming in the Journal of Financial Economics, authored by Professor Wagner; Alexander Dyck, Professor of Finance at the University of Toronto; Karl Lins, Professor of Finance at the University of Utah; and Lukas Roth, Associate Professor of Finance at the University of Alberta.

Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst and Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here).

In making investment decisions, shareholders today are asked to assess, and can easily track, not only measures of a firm’s financial performance, but also metrics covering a firm’s environmental and social (E&S) performance—two components of corporate social responsibility. Yet, whether E&S performance is beneficial to the average shareholder remains controversial.

In our article, we take a different tack to shed light on the importance of environmental and social performance to shareholders. We test for a relation between share ownership and firms’ E&S performance. It is hard to dismiss the hypothesis that E&S investments are beneficial to shareholders if they are a driving force behind firms’ E&S choices.

We examine whether shareholders drive E&S performance for firms around the world, since pressure for E&S improvement is a truly global phenomenon. We specifically investigate institutional investors because these shareholders own and vote the bulk of the world’s equity capital. We construct firm-level environmental and social performance measures using line items (covering areas such as CO2 emissions, renewable energy use, human rights violations, and employment quality) from several E&S data providers. We combine these measures of firms’ E&S performance with institutional ownership data and financial data to build a sample of 3,277 non-U.S. firms from 41 countries over the 2004-2013 period.

Across these 41 countries, we find that institutional ownership is positively associated with firm-level E&S performance, with multiple tests suggesting a causal relation. For example, to support a causal interpretation, we take advantage of a quasi-natural experiment provided by the BP Deepwater Horizon oil spill in 2010. This costly environmental disaster represents an unexpected shock that increased the perceived financial value of having in place robust environmental policies and procedures, particularly for firms in extractive industries. If institutional ownership drives changes in firms’ environmental policies, then we expect that firms with greater institutional ownership at the time of the shock will be more reactive in improving environmental performance in the years following this shock. We find precisely this result.

These surprising findings matter because they demonstrate that mainstream institutional investors care about E&S issues, and actively push firms to improve their E&S performance. While one might expect activist investors, such as environmental and social impact funds, to push for such changes, we instead find that a broad range of mainstream investors do this.

Next, if money is all the same, and institutional investors are interested only in financial returns, then the cultural origin and social norms of investors should not matter. Instead, we find that cultural origin matters—foreign institutional investors domiciled in countries with social norms supportive of strong E&S commitments are the ones that impact firms’ E&S performance. This result suggests that a society’s social norms flow through the channel of portfolio investment into firms and provides new evidence on the way in which culture makes its way into economic decision making.

More focused tests of the importance of social norms accounts for investor type. Of particular interest are independent institutional investors (e.g., mutual funds) as they face a clear tradeoff. They compete for capital and lower performance will affect fund flows, heightening the importance of financial returns. But they are also exposed to social norms as they need to network and raise capital locally and are mindful of local E&S social norms. Our tests show that for independent institutional investors, there is essentially no impact on firms’ E&S performance if the investor is from a country where E&S social norms are relatively weak—e.g., the U.S. However, when independent institutional investors come from countries with strong social norms towards E&S issues—e.g., from the Netherlands—they have a significantly positive impact on firms’ E&S performance. Strong enough social norms can overcome market pressures to focus primarily on financial returns. We find that pension plans consistently influence firms to strengthen E&S performance no matter their country of domicile.

In another set of tests, we replicate our analysis using U.S. firms (instead of international firms). U.S. investors have an insignificant impact on U.S. firms’ E&S performance. However, foreign investors that come from high E&S norm countries have a strong and significant positive impact on U.S. firms, for both their E and S performance. Thus, foreign investors’ social norms also make their way into U.S. firms.

To see the effect we document, compare a Dutch mutual fund investing in a US firm with a US mutual fund investing in a Dutch firm. We find that the Dutch fund, and others like it, will successfully push the US firm towards better environmental and social performance. The US fund instead will not exert any such pressure on the Dutch firm. The rationale for this is that institutional investors cater to the social norms of their constituents. US social norms towards environmental and social issues are relatively weak. When instead social norms towards E&S issues are strong, such as in the Netherlands and throughout Europe, the foreign investor transplants (Dutch) social norms into (US) firms.

From a CEO and firm management standpoint, the success of foreign investors transplanting their social norms into the firms they own adds an additional dimension to the importance of institutional investors. This ‘color of money’ effect is unlikely to be without conflict—executives of firms from low-social-norm countries would have both social norm and fiduciary duty incentives to push back. Our results help inform the debate about increasing investor power by, for example, giving investors enhanced access to the proxy. To the extent that domestic social norms place less value on E&S performance, calls for enhanced investor power are likely to be challenged by management and domestic regulators.

The full article is available for download here.

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