Stakeholder Capitalism as ESG-Constrained Shareholder Capitalism

Intense debates are alive and well on the nature and meaning of corporate purpose and corporate personhood. In a new paper, I analyze proposals by the U.S. Securities Exchange Commission to require that all reporting companies make periodic, mandatory Environmental, Social, and Governance (ESG) disclosures of comparable, standardized, and quantifiable metrics.

Shareholder capitalism leaves the protection of customers, employees, and other non-shareholder stakeholders to areas of law other than corporate law.  This delegation by shareholder capitalism is problematic because, as Tim Wu has written, it “ignores public choice theory and the obvious incentives of corporations who are told to maximize shareholder welfare to prevent the legal system from actually providing protections that might decrease corporate profit.” Also, trees, oceans, and our environment can lack legal standing.

Even parties with standing may not always sue to enforce their legal rights. The #MeToo viral social movement demonstrates how mere laws against sexual harassment are not enough to prevent it, partly because the enforcement of laws is contingent on adequate funding and motivation of government agencies.  Laws are also often personally and professionally costly for individuals to enforce. All legal rights are options in the sense that people may have to pursue costly litigation to exercise them. As former Harvard law school dean and university president Derek Bok said, “There is far too much law for those who can afford it, and far too little for those who cannot.”

Stakeholder capitalism conceives of companies as maximizing their long-term value while considering the interests of all stakeholders rather than just shareholders. A common and fundamental criticism about stakeholder capitalism is that corporate actors cannot maximize the interests of multiple, conflicting, stakeholders. To conceive of  stakeholder capitalism as the simultaneous maximization of all stakeholder interests is thus problematic.

Consider instead reframing stakeholder capitalism as the maximization of shareholder value subject to constraints about other stakeholders’ interests. Such a corporate objective function is an example of a constrained optimization problem, which is canonical in standard economic theory and the mathematical field of nonlinear programming.

Mandatory ESG disclosures can serve as report cards measuring the sustainability and ethical impacts of reporting companies on other stakeholders besides shareholders. In effect, this one regulatory change means that reporting companies will effectively maximize shareholder value subject to ESG constraints regarding other stakeholders’ interests, just as corporations now maximize profits subject to economic, legal, market, scientific, and technological constraints.

Conceptualizing stakeholder capitalism as shareholder capitalism subject to mandatory ESG disclosures means that other stakeholders’ interests can be viewed as constraints that corporate directors must satisfy while maximizing shareholder value. Because ESG disclosures involve quantitative metrics, corporate directors can set ESG targets to meet every quarter or year, just as they set earnings targets. This vision of stakeholder capitalism provides clear guidance to directors about how to make business decisions.

What influences directors’ choice of ESG targets? Community norms, social norms, industry norms, media coverage, social media, and reputation. Directors may wish to generate negative corporate externalities because they believe not doing so puts their company at a competitive disadvantage. Seeing competitors choose publicly visible ESG target levels may assure directors that not generating negative corporate externalities does not disadvantage them competitively. There might even be a race to the top as directors try for competitive advantage to set more ambitious ESG targets to meet faster. The market forces of competition for consumers and investors who care about ESG issues can be powerful as the importance of ESG considerations grows in society.

Does greater diversity of board members make a difference? A new empirical study finds that more racially diverse Federal Reserve Bank boards are linked to greater lending to underbanked minority communities and underserved populations by Federal Reserve-regulated banks. Mandatory corporate diversity disclosures are just one part of realizing diversity. Other complementary non-corporate diversity efforts must also happen.

The latest report from the Intergovernmental Panel on Climate Change warns that global climate changes require immediate corrective action because they create  an existential threat for humanity and this planet. The Financial Stability Oversight Council released a report in October 2021 identifying “climate change as an emerging and increasing threat to U.S. financial stability.” That report included a recommendation for the SEC to develop climate risk disclosures. While preventing global climate catastrophe may eventually require carbon taxes and direct regulation of emissions, a more politically feasible policy would be to require that reporting companies disclose their carbon emissions. Mere disclosure of corporate carbon footprints would not necessarily reduce those footprints, just as disclosing annual CEO pay did not lead to reductions such pay. As former SEC Commissioner Joe Grundfest quipped, envy is more powerful than shame among CEOs.

After the United Kingdom in 2013 required UK-incorporated listed firms to disclose their annual carbon footprints, carbon emissions of those companies decreased by approximately 8 percent over the next couple of years, in comparison with a control group of similar European firms. Moreover, there was no adverse impact on the financial performance of the corporations reducing their carbon footprints. Finally, mandatory carbon disclosures provide valuable information to asset managers, investors, and policymakers about how to manage carbon transition risk and, even more important, to speed up the rate of reducing future carbon emissions until they reach net zero targets. Carbon disclosures become more important if the Supreme Court restricts or eliminates the EPA’s authority to reduce greenhouse gas emissions by power plants.

Naturally, the details of carbon disclosures matter, including the questions of 1) whether mandated carbon disclosures are only of “direct emissions” a company releases by its own activities or also include a company’s indirect downstream and upstream emissions; and 2) how to deal with the possibility of companies arbitraging mandated carbon disclosure by “divesting their  ‘dirty energy’ assets to private companies or private investors.” The SEC must ensure that ESG disclosures are of comparable, standardized, and quantifiable metrics. The SEC should require that ESG disclosures be user-friendly by following principles from the art and science of how to make communication of numbers meaningful.

Requiring ESG disclosures is the least radical way of radically repairing the current and misguided form of shareholder capitalism. Mandatory ESG disclosures do not entail more fundamental corporate governance reforms.  Mandatory ESG disclosures make use of the current and dominant federal securities regulatory paradigm of mandatory disclosures. Nonetheless, adding ESG disclosures effectuates a fundamental shift from shareholder capitalism to stakeholder capitalism.

Many of the world’s most important problems today result from shareholder capitalism’s leading to corporate negative externalities, such as global climate catastrophe, rampant environmental and noise pollution, skyrocketing health insurance costs, and toxic forever chemicals. Some corporations and people believe in the virtue of greed in the sense of a Hooray for Me and Frack Everybody Else (HFMAFEE) attitude. After all, HFMAFEE attitudes are psychologically comforting and even to a degree consistent with some cherished American values, namely personal autonomy, freedom of choice, rugged individualism, self-determination, and self-reliance.

ESG disclosures remind corporate actors and others to be more mindful of how their corporate decisions have ESG impacts. ESG disclosures remind corporations and humans that acting on HFMAFEE attitudes is problematic for all of the carbon-based life forms who are living on this planet, which is only a pale blue dot in the cold and vast darkness of space.

This post comes to us from Professor Peter H. Huang, the DeMuth Chair of Business Law at the University of Colorado Law School. It is based on his recent paper, “Realizing Diversity, Sustainability, and Stakeholder Capitalism,” forthcoming in the Emory Corporate Governance and Accountability Review and available here, and also on his forthcoming book, A Grown-up Child Prodigy’s Ideas About Realizing Diversity and Stakeholder Capitalism.