Do Directors Drive Corporate Sustainability?

Courtesy of Peter Iliev and Lukas Roth

Climate change and providing equal opportunities are some of the biggest challenges the world faces in achieving a better and more sustainable future for all. In recent years, firms’ environmental and social sustainability policies have moved into the spotlight. Policymakers, investors, and special interest groups push firms to increase their corporate sustainability performance—for example, lowering their carbon footprint, moving to more sustainable production technologies, paying fair wages, and improving worker safety.

Although the benefits of sustainability policies seem clear-cut to outside pressure groups, there are reasons to believe that not all the demanded changes are equally beneficial to firms and their owners. From the firm’s perspective, many of the requested changes are expensive to implement, with uncertain benefits that may materialize in the distant future.

Nevertheless, firms may have little choice but to move towards greater sustainability. For example, large institutional investors, who focus on long-term investment, push firms to increase their sustainability performance. In that spirit, Blackrock, the world’s largest asset manager, has started to vote against corporate directors in firms that do not do enough to fight climate change. In addition, regulators may directly influence firms’ behavior and reporting standards by implementing stricter environmental regulations (e.g., requiring greater environmental consultation for large infrastructure projects).

While outside pressures may force firms to change their sustainability behaviors, there is limited evidence on how firms’ internal pressures affect these environmental and social commitments. To the extent that corporate sustainability has a long-term focus and thus is strategic, the task of devising an efficient and effective corporate sustainability strategy falls in the domain of the board of directors. The board needs to assess the costs and benefits of investing in greater environmental and social commitments and must decide how much (or little) to invest in the firms’ sustainability. However, little is known so far about the board’s involvement in shaping corporate sustainability.

One of the biggest evidentiary challenges is to show a causal relationship between the board of directors and firms’ sustainability performances. Even if we estimate a positive correlation between a firm’s environmental and social performance and the board’s commitment to sustainability, a nagging question remains: is the correlation driven by a firm’s own choice to become more sustainable, or is it driven by the board of directors’ initiatives? Because the composition of a firm’s board (e.g., how sustainability-oriented the directors are) and a firm’s sustainability performance are jointly determined, a clear identification strategy is needed to draw causal inferences about the extent to which the board of directors drives corporate sustainability.

Our paper provides such causal evidence. To show that directors shape U.S. firms’ sustainability choices, we utilize the staggered introduction of environmental and social regulations and disclosure requirements in non-U.S. countries. We rely on a broad set of environmental and social regulations across 41 countries that were implemented over 16 years.

To measure the impact of regulations on U.S. boards, we construct a network of U.S. firms’ directors and their connections to non-U.S. countries through directorships they hold in firms domiciled outside of the U.S. We then trace the introduction of environmental and social regulations and disclosure requirements in non-U.S. countries through these director connections back to the U.S. firms. By exploiting the exogenous variation in regulations and disclosure requirements outside of the U.S. through director connections that were established before the passage of these laws, we can quantify the causal effect of greater exposure to sustainability concerns to changes in corporate sustainability in U.S. firms.

As an example, suppose a director of a U.S. firm also sits on the board of a firm domiciled in the U.K. In 2013, the U.K. government adopted a regulation that required all public firms to report on their greenhouse gas emissions. This new regulation increases the practical knowledge about environmental commitments for directors serving on U.K. firms’ boards, including the director that is concurrently sitting on the U.S. firm’s board. We study the transmission of environmental policies from the U.K. to the U.S. through this director connection. In our formal tests, we rely on a much larger sample of 24,425 firm-year observations that covers 2,860 U.S. firms during the 2001 to 2016 period. In all our tests we include a host of control variables as well as a tight set of fixed effects.

We find strong causal evidence that boards drive a firms’ sustainability performance. The economic magnitude is sizable: exposure to non-U.S. changes in regulation and disclosure requirements explains 17% of the standard deviation of firms’ sustainability performance. Interestingly, the overall effect comes entirely from improvements in environmental sustainability. We do not find strong evidence that boards shape firms’ social commitments. This result suggests that environmental sustainability is strategically more important for firms than social commitments. Another possibility may be that any push originating in non-U.S. countries to increase social performance is not as easily transferrable to U.S. firms as an environmental push.

Next, focusing on firms’ industry affiliations, we show that for firms in industries with weak sustainability commitments (e.g., firms in the mineral extraction and processing industry), the board is not instrumental in improving firms’ environmental performance. In contrast, we find evidence of ‘greenwashing’ activities, that is, a firm providing the misleading impression that it is more environmentally friendly than it is. Interestingly, firms in these so-called ‘dirty’ industries improve their social commitments instead. This is consistent with a cost-saving strategy, as investments in social sustainability are likely cheaper for these industries than investments in environmental sustainability.

Exploring the heterogeneity of our results, we find that the board of directors has a weaker impact on sustainability for riskier firms and firms with greater institutional ownership. The former speaks to the importance of financial constraints in adopting new environmental and social policies. The latter is consistent with previous research that shows that institutional owners push firms to improve their sustainability performance. Thus, in these firms, the board may be less important in shaping firms’ sustainability. Finally, we show that firms that are exposed to non-U.S. environmental and social regulation changes through their directors have greater future firm performance and productivity.

Overall, we show that the board of directors is a key driver of firms’ sustainability performance. Our results also show that the board weighs the costs and benefits of environmental and social investments. The net effect is an increase in corporate sustainability alongside an increase in firms’ profitability and productivity.

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