Business Risks Stemming from Socio-Economic Inequality

Socio-economic inequality has risen over the last 40 years in almost every part of the world and has been exacerbated by the COVID-19 pandemic. Inequality does not only affect societies – it can also have a significant impact on the success of business. We analyze the ways that socio-economic inequality creates material risks to business and how, despite these risks, there are very few ways for companies to consistently and effectively disclose them to investors. To address this challenge, we look for guidance to another systemic risk facing business: climate change.

Sources of Inequality and Risks to Business

On a macroeconomic level, inequality can affect economic growth, productivity, and political stability, which in turn has direct implications for corporate profitability.

As with most social science endeavors, there is a healthy debate as to the precise impact of inequality on growth. For starters, does it hinder or accelerate economic growth? Economic theory shows that with higher income and wealth come higher savings rates, and therefore a higher level of investment and gross domestic product. In this case, if marginal productivity is higher for capital than for labor, one can see that more inequality would create higher economic growth. Also, in economies with underdeveloped credit markets, significant investments can only be made if there is an accumulation of wealth. In the presence of imperfect capital markets and indivisibility of investments, an economy with higher levels of inequality may be able to introduce new industries, technologies, and markets and ultimately grow faster than the same economy with lower levels of inequality. Finally, there is an argument that reducing inequality reduces incentives to accumulate wealth through labor, entrepreneurship, and innovation, having therefore, a negative impact on long-term growth.

However, a healthy debate should not be confused with a balanced debate. The bulk of the literature supports the theory that inequality has a negative impact on economic growth. Studies that found a positive relationship between inequality and growth were focused on the short term, and studies that found a negative relationship were focused on the long term. In other words, inequality can produce a small contribution to growth in the short term but will have substantial adverse effects on growth in the long term. Empirical results have increasingly supported the arguments for impaired economic growth and a negative impact on productivity in the face of rising inequality.

Poor people without access to credit markets often defer health care treatments, cannot procure housing or transportation, and lack the means to further their education. This results in missed opportunities and diminished productivity and growth potential. The same applies to poor parents with multiple children, compared with wealthy parents with few children. The inability of poor families to invest in their children’s education, and the inability of poor workers to invest in developing job skills, because of either financial constraints or time constraints while working multiple jobs, can result in a reduction in overall skills and knowledge of the potential employee pool. That can have a drag on growth, productivity, and business performance. Finally, there is the problem of the indivisibility of consumption. In the absence of developed credit markets, expensive items can only be acquired through the accumulation of wealth. If the economy became more equitable, part of the population that was initially excluded from the acquisition of these goods would enter the market, encouraging the creation of new domestic industries.

Societies with higher levels of inequality also tend to have higher levels of crime, keeping a larger share of the labor force from productive activities and decreasing potential growth. Also, with the increase in social instability, trust and social cohesion can erode, leading to conflict, political crises, and the resulting retraction of investments. One of the potential consequences is the rise of nationalism and the splintering of support for globalization. This scenario has played out in economies around the world over generations. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, has warned of the corrosive effects of inequality on faith in capitalism and, therefore, the stability of the institutions and markets in which business operates.

The Role of Business in Addressing Inequality

For investors, understanding the financial risk from inequality requires assessing and measuring the ways in which external risk factors can become important for a company and its balance sheet. For example, the potential cost of inequality to a company may depend on exposure of the company’s assets to disruption from political instability or sensitivity of its workforce productivity to economic drag. This requires data on the company’s exposure to adverse macroeconomic conditions, the effect of those conditions on its operations (including its stakeholder relationships), and its responses thereto. As a result, there has been growing demand from investors for company-level data on inequality.

Several frameworks have emerged to address this demand. They include the Global Reporting Initiative (GRI) and the Corporate Human Rights Benchmark (CHRB), which seek to measure the impact of firms on inequality from a multi-stakeholder perspective. There are also frameworks like the Sustainability Accounting Standards Board and ISO 26000, which assess the impact of inequality on firms. Finally, regulations such as the European Union’s Non-Financial Reporting Directive mandate the disclosure of inequality-related information from corporations.

Yet these frameworks are largely limited to two sources of inequality attributable to a company. One is inequality arising from its relationship with its employees through compensation practices (i.e., differences in wages between different types of employees or between employees and executives or gaps between those wages and an external benchmark such as a living wage). Another source is inequality arising from efforts by corporations to shift, minimize, or avoid taxes, thereby depriving governments of revenue that could support investment in public infrastructure and services (i.e., measurement of a company’s tax policies and practices as well as, to the extent possible, its payments in different tax jurisdictions).

The narrow focus of these frameworks makes them less useful to investors and other stakeholders for the following reasons:

  • First, while there is increasing coordination and cross-referencing among different stakeholder-driven, investor-oriented, and regulatory frameworks, no single framework is comprehensive and universally recognized. As a result, companies in the same industry may choose to adhere to different stakeholder- or investor-oriented metrics or, depending on applicable legal requirements, may be subject to divergent regulatory metrics mandated by different governments. This fragmentation increases costs to companies and stakeholders and deters the adoption and use of inequality frameworks.[1]
  • Second, stakeholder-oriented frameworks are not necessarily tailored to facilitating disclosure of financially material information that is useful to investors.
  • Third, all of these frameworks cover a limited amount of risks and lack consistency as a result of different and multiple motivations for companies to disclose, resulting in differing levels of quality.
  • Finally, metrics used by these frameworks do not address the causal nature of business risks stemming from inequality, resulting in disclosed information that is insufficiently useful to investors in assessing the risk to a corporation or any of its stakeholders.

Moving Towards Decision-Useful Inequality Risk Disclosure

The recent push to standardize disclosure of efforts to address climate change and its associated financial risks serves as a useful model for addressing business risk from inequality. Moving inequality risk disclosure forward will require the following three steps.

First, inequality disclosure and other corporate transparency frameworks will need to be harmonized. Harmonization would make it easier to compare data and processes across companies, thereby facilitating benchmarking and providing useful ESG data on inequality to investors and other stakeholders. Efforts to harmonize inequality disclosure are already underway. For example, the Taskforce on Inequality-related Financial Disclosures (TIFD) was formed by the Predistribution Initiative and Rights CoLab in 2021.[2] It will be important for initiatives such as the TIFD to build on the success of existing ESG disclosure frameworks and standard setting organizations. An inequality risk disclosure framework would not supersede or replace existing disclosure frameworks. Rather, it could be created through coordination between policymakers and regulators (for example facilitated by the OECD or the International Organization of Securities Commissions (IOSCO)) or through the identification of common best practices by stock exchanges (for example through the UN’s Sustainable Stock Exchanges Initiative).

Second, sector-based working groups will be needed to refine industry-specific inequality reporting metrics. These working groups would develop industry-specific metrics for inequality business risks. Such initiatives have already been created on an ad hoc basis for broader ESG disclosure. In the banking industry, a dozen international banks partnered with PRI and co-developed two methodologies to assess the transition and physical risks of their assets, according to recommendations by the Task Force on Climate-Related Financial Disclosures (TCFD). The World Business Council for Sustainable Development (WBCSD) has convened similar working groups on certain issues for major sectors.[3]

Finally, training programs will be needed for key players in corporate disclosure, including sustainability and financial officers, in-house attorneys, and auditing firms. How will inequality risks be identified? What liability might arise from identifying inequality risks as material to the business? How would inequality disclosure fit with broader ESG disclosure requirements and voluntary efforts? We suggest using the outreach and educational know-how of universities, trade groups, and corporate sustainability think tanks to develop executive education programs to address these and related questions. These programs should be targeted at corporate executives as well as employees responsible for the collection of data and compliance with regulations. Some templates for this model exist in the area of climate risk disclosure, including the TCFD Preparer Forums convened by the WBCSD[4].

As a source of business risk, socio-economic inequality is rising in importance both because levels of inequality are rising and because governments globally have shown less capacity to buffer its effects through social safety nets. The result – for companies, investors, and other stakeholders alike – is an increasingly urgent need for more and better information from corporations on their efforts to identify and mitigate the potential risks stemming from inequality. Yet existing disclosure frameworks and practices lag significantly behind climate change disclosure because inequality has traditionally been considered as occurring outside of companies and due to the difficulty of measuring a company’s performance in the face of risks stemming from inequality.

There is a clear need for a more unified approach to corporate disclosure on inequality risks. As presented above, the TCFD offers the basic structural elements by focusing on internal corporate structures, strategy, metrics, and targets with an eye toward the financial implications of the risks. However, to effectively address inequality will require a number of modifications to the elements that underlie the TCFD. They must include greater understanding of the effectiveness of government safety nets, particularly with regard to scenario analysis of macroeconomic and political risks. In addition, corporate governance structures (including associated metrics) will need to be targeted specifically to perceptions among stakeholders that result from high levels of inequality as the predominant driver of risk, rather than the physical-science drivers that underlie climate change risk.

In addition, key actors, such as sector-based associations and global organizations working on corporate sustainability, will need to identify sector-specific metrics and to construct and convene education and training efforts for key stakeholders inside and outside of the companies. As evident with the TCFD in the context of climate change, a framework for inequality risk disclosure must take into account the operational constraints of companies, the different ways in which companies are exposed to (or are the cause of) inequality risk, and the expectations of different stakeholders.

ENDNOTES

[1] O’Connor, C. & Labowitz, S., ‘Putting the “S” in ESG: Measuring Human Rights Performance for Investors’ (2017), https://www.stern.nyu.edu/experience-stern/global/putting-s-esg-measuring-human-rights-performance-investors.

[2] TIFD, ‘Task Force on Inequality-related Financial Disclosures (TIFD)’ (n.d.), https://thetifd.org/ (accessed April 11, 2022).

[3] World Business Council for Sustainable Development, ‘Disclosure in a time of system transformation: Climate-related financial disclosure for food, agriculture and forest products companies’ (2020), https://www.wbcsd.org/Programs/Redefining-Value/External-Disclosure/TCFD/Resources/TCFD-implementation-for-food-agriculture-forest-products.

[4] See World Business Council for Sustainable Development, Task Force on Climate-related Financial Disclosure (TCFD) Response and Development (n.d.), https://www.wbcsd.org/Programs/Redefining-Value/TCFD (accessed April 11, 2022).

This post comes to us from Todd Cort at the Yale School of Management, Stephen Park at the University of Connecticut School of Business, and Decio Nascimento at Norbury Partners. It is based on their recent paper, “Disclosure of Corporate Risk from Socio-Economic Inequality,” available here.

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