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short-termism and corporate responsibility

February 2004

Good CSR practice is built on sound corporate governance,
says Craig Mackenzie

Good corporate governance is a prerequisite for truly effective corporate responsibility, and there is one particular reason for this. It is now widely accepted that at least some corporate responsibility initiatives have significant positive pay-offs for companies over the long term. For example, they can reduce litigation and reputation risk, reduce costs and increase customer trust and employee motivation. The problem, however, is that while corporate responsibility initiatives create long-term shareholder value, they sometimes do not serve the personal financial interests of a company’s directors. In other words, there are circumstances in which firms, their investors and society share a common long-term interest in corporate responsibility, but company directors and managers do not.

This problem arises primarily because the financial interests of company managers are geared to shorter time horizons than those of companies and their shareholders. Managers frequently have strong financial incentives to care about what happens next year, but only weak incentives to care about what happens in five years’ time. Short-termism has particular implications for corporate responsibility because, unfortunately, many of the benefits of corporate responsibility arise over the long term while many of the costs arise today. Why should an executive back initiatives that will create long-term benefits for the company and society, but at the expense of short-term profitability – to which the value of his or her share options is closely linked? The problem is exacerbated by the short tenure of managers in many companies today. Why care about long-term shareholder value if you are unlikely to be around for long?

One might retort that managers should back corporate responsibility because it is the ‘right thing’ to do. Only a cynic would say all company managers and directors are motivated solely by money. However, misaligned financial incentives are surely important in preventing managers from supporting serious corporate responsibility initiatives.

This is why corporate governance matters. Strong remuneration policies, produced by independent-minded directors and scrutinized by attentive shareholders, can help ensure that directors and managers do not have overly short-term incentives. Good governance practices– such as effective long-term risk management – can also help create the checks and balances that make it harder for managers to take inappropriate risks with the company’s future.

Some of the most entrenched corporate responsibility problems will only be solved when the effect of misaligned management incentives – and the crucial role of strong corporate governance in this regard – is better understood. It is time for the quality of a company’s governance to become a key part of assessing what commitment it has made to corporate responsibility.

Craig Mackenzie is head of investor responsibility at Insight Investment
www.insightinvestment.com/responsibility




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