Corporate Sustainability: A Strategy?

Ioannis Ioannou is Associate Professor of Strategy and Entrepreneurship at London Business School and George Serafeim is Professor of Business Administration at Harvard Business School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

In recent years, a growing number of companies around the world voluntarily adopt and implement a broad range of sustainability practices across the environmental, social and governance (ESG) domains. In doing so, they try to integrate sustainability into their strategy, business models, and organizational processes and structures (Eccles, Ioannou and Serafeim, 2014). In fact, the accelerating rate of adoption of these practices has also provoked an academic as well as a wider debate about the nature of sustainability adoption and its long-term implications for organizations: specifically, is the adoption of sustainability practices a form of strategic differentiation that can lead to superior financial performance or is it a strategic necessity that can ensure corporate survival but not necessarily outperformance?

On one hand, there are those who argue that sustainability is spreading as a “common practice” and as such, it may be a necessary condition for survival, but it cannot be a sufficient condition for building a competitive advantage. For example, some companies adopt environmental, or water or waste management systems to exploit cost efficiencies and thus improve their bottom line. Although such systems would typically be considered as adoption of sustainability practices—and would be accounted for in ESG ratings—arguably few, if any, companies would expect to establish a competitive advantage simply by adopting them. Typically, competitors can easily acquire such systems directly from third parties. In this spirit, Porter and Kramer (2011) explicitly note that sustainability, like philanthropy, is “at the margin” of what companies do rather than at the center and therefore, these are not practices through which they can achieve economic success (p.4). More broadly, the literature provides evidence for a link between the extent of imitation and reductions in inter-firm performance heterogeneity (e.g. Barney, 1991; Posen and Martignoni, 2018). Thus, when an imitator copies the focal firm’s practices, these practices make the imitator and the focal firm more similar, and consequently, profitability converges (Posen and Martignoni, 2018) and likely declines. Yet, by adopting common practices (i.e. by being the “same as” peers), a firm can benefit by being recognized as legitimate (DiMaggio and Powell, 1983; Meyer and Rowan, 1977; Pfeffer and Salancik, 1978).

On the other hand, there are those who argue that sustainability can be a strategy that generates a competitive advantage and therefore, results in above-average performance (i.e. “doing well by doing good”). For example, companies that adopt innovative circular-economy-based business models, or adopt practices that enhance employee recruitment, engagement and retention through a unique corporate purpose (Gartenberg, Prat and Serafeim, 2018) do so to differentiate themselves and therefore, occupy an unexploited or underexploited position through developing a unique and difficult to imitate strategy. This could result in persistently superior performance because a unique and successful strategy can remain unmatched even though it is open to public scrutiny, and it can also be slow to diffuse even if it leads to superior profits (Rivkin, 2000). In this sense, by being different, a firm may benefit because it would face less competition (Barney, 1991; Baum and Mezias, 1992; Deephouse, 1999; Porter, 1991).

This debate, we argue, raises fundamental questions for scholars of organizations in general, and strategy scholars in particular. In fact, the arguments on both sides conceptually relate to Michael Porter’s seminal 1996 “What is Strategy” article in which he draws a sharp distinction between operational effectiveness and strategy. He argues that strategy “is about being different” and that “the essence of strategy is choosing a unique and valuable position rooted in systems of activities that are much more difficult to match” (p. 64). The debate also relates to an ongoing discussion in the literature that focuses on the tension between the need for a firm to be different, so as to limit competition, and the need to be the same, so as to gain legitimacy (e.g. Deephouse, 1999). Is sustainability then a differentiating strategy or a practice that is bound to spread through imitation and thus, has limited potential to be a basis for a competitive advantage? To what extent have firms in recent years converged in their adoption of sustainability practices? What are the likely drivers of inter-industry variation in the extent of convergence? And importantly, what are the implications for corporate performance accounting for the industry-level trends in terms of overall convergence of practices?

Our overarching thesis in this paper is that investigating the extent of convergence of sustainability practices over time within an industry is important for understanding whether such practices can become the foundation of a competitive advantage. To develop our theoretical propositions, we draw extensively on the institutional theory, and we build on prior literature (e.g. Hawn and Ioannou, 2016; Durand, Hawn and Ioannou, 2018) to argue that it may not always be useful to consider sustainability as a monolithic theoretical construct; instead, the extent of convergence can help us distinguish between practices that are increasingly more common over time, and those that are not. This latter set of practices arguably identifies sustainability dimensions along which companies try to implement relatively more differentiated strategies. Hence, we would expect that although common practices are necessary for survival and for acquiring legitimacy, it is the less common sustainability practices that will be associated with strategic differentiation and therefore, superior performance. At the same time, we expect to observe differences across industries in the magnitude of convergence as a function of the industrial organization of sustainability practices. Shedding light on the determinants of inter-industry variation also improves our understanding of why some industries have more developed practices than others in the broader domain of corporate sustainability.

We use data from MSCI ESG Ratings, the largest provider of ESG data in the world, for the period 2012-2017 for all companies that appear in the MSCI consistently across all years—i.e. about 3,802 companies—to ensure that our analysis is not contaminated by changes in sample composition. We find that within most industries, sustainability practices have converged over time. This finding implies that, on average, companies adopted an increasingly similar set of sustainability practices during the sample period, raising the possibility that they are becoming common practices and as such, are less likely to serve as a strategic differentiator and more likely to be a strategic necessity. Moreover, we explore the determinants of inter-industry variation and find that one of the most important factors associated with a higher level of convergence is the (early in our sample period) adoption of sustainability practices by the industry market leader; relatedly, we find that the overall degree of convergence is affected by the extent to which environmental and/or social issues are more important than governance issues.

The granularity of the MSCI ESG dataset also allows us to distinguish across sustainability practices and to investigate performance implications: in particular, for each industry, we identify the set of sustainability practices upon which companies converge over time—which we term “common practices”—and those for which they do not—which we term “strategic.” Our exploratory results confirm that the adoption of strategic sustainability practices is significantly and positively associated with both return on capital and market valuation multiples, even after accounting for the focal firm’s past financial performance. In contrast, the adoption of common sustainability practices is not associated with return on capital, but it is positively associated with market valuation multiples.

With our work, we contribute towards moving the broader field of corporate sustainability beyond the narrow focus on the cross-sectional understanding of sustainability practices and the implications for performance, towards developing a more dynamic, complex and multi-level understanding of the adoption of these practices over time. We hope, through the findings in this paper, to be opening up avenues for future research whereby the dynamics of adoption become a central consideration.

The complete paper is available for download here.

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