Of Signals and Stakeholders

by | Aug 17, 2010 | Blogs | 238 comments

In my last post, I reported on the story of one LEED building that wasn’t actually so good for the world, and I noted that despite this it garnered a lot of “good will” from the local government. In my classes, I often hear such good will used as the justification for a company’s actions. The argument usually comes up when we are considering the tension between providing profits to your stakeholders versus protecting the environment. To get around this tension, students want to argue that there is actually no conflict between the two. Investing in environmental protection, they argue, even if costly, provides a positive to investors’ return by improving the good will of stakeholders. But does such logic make sense?

To make the discussion more concrete, let’s consider a classic case from the early 1990s. An independent energy corporation was building a power plant in Connecticut which would produce some additional greenhouse gasses – mostly CO2. To offset this effect, the company decided to invest in protecting or reforesting some areas in Guatemala. To do this, they spent a few million of their stockholder’s dollars. They took money from the pockets of their investors. How could one justify this, I asked my students? Commonly, the answer I hear is that buying trees creates goodwill among customers, employees, and regulators, because the purchase of the trees reveals something about the nature of the company. The purchase of trees could reveal to regulators, for example, that the company is run by responsible managers and, thus, any facilities the company constructs and runs will be done so in a safe and responsible manner. As a result, these regulators will be more likely to grant permission for construction and extension permits to the company. This easing of regulatory oversight will provide a financial benefit, and thus there is no conflict between profits and protection of nature. The argument seems to make a lot of sense.

Except that according to economic theory it shouldn’t. The students are proposing that the investment is a “signal” about something unobserved about the company – for example it is run by good-hearted people. This signal (the visible buying of trees) reveals something invisible (good heartedness). So far everything seems to be working, but now let’s consider what “bad hearted” managers of other companies should do. If buying trees provides value and they can do it for the same cost (and there is no reason to think they can’t) they should buy trees too. By extension, everyone – the good, the bad, and the ugly hearted – will decide to buy trees. It seems like this would create a good deal for society, but one last step in logic destroys that hope. If everyone will buy trees, then it will no longer provide evidence of who is good hearted and, sadly, if actors are rational and recognize this, no one will choose to buy trees.

What the students want to believe is that buying trees is what economists call a credible market signal. But what students often do not consider is the issue of credibility. Why did the purchase of trees reveal anything new and credible about the firm? There was no reason that a good company rather than a bad one hadn’t decided to take on this action.

One might be tempted to think that this story actually has a happy ending. After all, trees were purchased for Guatemala and the company received a lot of very favorable free press for its actions. Perhaps, but I am much less sanguine. I see in this story a real concern that stakeholders are not very good at distinguishing the credibility of market signals. Why is this important? Because if they are not, the door is left wide open for greenwashing. Firms can offset consumer pressure with all kinds of actions that provided no real social benefit AND reveal nothing about the nature of the firm. Think back for a minute to my story of the LEED building. Why exactly did the company that purchased the wasteful LEED building gain the support from the local government? Was such support a good thing?

I am very worried that stakeholder inability to distinguish the credibility and meaning of environmental actions could dissipate much of the pressure by the environmental improvement. Under pressure to improve the environmental performance of your vehicles? Don’t improve their gas mileage, but instead make “flex fuel” vehicles. Need to respond to stakeholder concerns about pollution? Invest in solar panels. Under pressure for profiteering on exotic drugs? Build a LEED building.

I guess there may be some good news in this story for scholars anyway. Perhaps our credulousness and acceptance of greenwashing reveals something interesting about human decision making. Perhaps we find people and companies credible when they claim they are doing something good for the tribe. Perhaps we want to believe good news about things out of control. And perhaps we can learn. That could be the most important question of all. What would help stakeholders distinguish between greenwashing and real action?

Finally, there is one more way of thinking about the examples above. That is that firms are actually selling a bundled good – some products/services and some charity. For example, when we buy electricity from the power company discussed above we are actually spending some money on power and giving some money for reforesting. When we buy a coat from Patagonia, we are paying something for the garment and giving something to their charities. If so, then we don’t need to infer that the charity reveals anything about the company. They are just coordinating our joint purchase of a good+altruism. But if this is so, is this really the right role for business? Are they really better at altruistic protection of the environment than say the Environmental Defense Fund?

Scholars inside and outside of ARCS are trying to untangle when corporate actions are philanthropy, signals, or just plain greenwashing. Off the top of my head I can identify names like Lyon, Maxwell, Prakash, Patoski, Rivera, Prado, and Toffel. Anyone else out there working and thinking on this important problem?

238 Comments

  1. Tom Lyon
    Tom Lyon on August 18, 2010 at 4:36 pm

    This piece makes a very good point. There have been many examples where voluntary corporate action staved off government regulation—even when the corporate action was pretty trivial. Indeed, the work of King and Lenox on the Responsible Care program strongly suggests that the chemical industry preempted tough regulations with a program that had little or no real impact.
    The only groups in society that seem to have the incentive and ability to call companies on greenwashing efforts are environmental NGOs. Greenpeace has been the most agressive on this front, and has put together a nice website at http://www.stopgreenwash.org/ But how many people actually visit such sites? How can the word be spread more widely? And can we trust environmental NGOs to give the straight story and not add their own spin?
    Perhaps social media like Twitter will ultimately be so effective at naming and shaming corporate greenwashers that greenwashing will become unprofitable. Until then, there is plenty of work for researchers and activists to do.

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