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Shareholders, Stakeholders and Standards:

The Value Puzzle of Corporate Social Responsibility

PRELIMINARY AND INCOMPLETE

Joanne Yoong

March 4, 2005

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1 Introduction

An increasing number of development initiatives have called for local or international

private sector participation, in order to better address challenges that have traditionally

been the province of governments, non-profits and international bodies. To borrow a

memorable phrase, misery loves companies, particularly when the resources of developing

countries are limited. One of the most well-known country-level programs of this kind

is the African Comprehensive HIV/AIDS Partnerships (ACHAP) in Botswana. This

is a formal partnership between Merck, the Gates Foundation and the government of

Botswana. Merck and the Foundation each donate $50 million and provide various other

inputs to a 5-year public health plan to combat AIDS, a crisis beyond the scope of the

Botswana government itself.

On the flip side, firms, particularly large and visible multinationals, are surrounded

by a growing concern with ethics and the value of socially-responsible business practices.

In a survey published in January 2005, the Economist Intelligence Unit reported that

85% percent of executives and investors surveyed said corporate responsibility was now a

central or important consideration in investment decisions, double the percentage (44%)

who responded the same way 5 years ago. Corporations are increasing (and increasingly

publicizing) activities with social returns. More consumer and investment products are

marketed towards buyers with a social conscience, supported by high media visibility and

extensive commentary. A Google search on “corporate social responsibility” on Feb 6th,

2005, for example, pulled up almost two million hits.

While at first glance, this convergence seems to hold great promise for underserved

populations, it has been greeted with both applause and skepticism. Those applauding,

such as the World Economic Forum, for example, subscribe to a new role for the firm, a

”corporate citizen” that contributes to social welfare not only by maximizing profits in its

core business activities but also through its social investment and philanthropy programs,

and its engagement in public policy in areas at the heart of economic development. 1

Those who are skeptical argue that the firm’s traditional and appropriate role is to maxi-

mize profits for its shareholders, and that these issues should therefore exist on its’ agenda

1Nelson and Bergrem (2004) identify five key emerging CSR issues of strategic importance to businessthat lie at the heart of development - climate change, social and environmental risks along the supplychain, product distribution and use, access and affordability of essential products (particularly in health-care and information technology) and increasing transparency with respect to corruption and humanrights.

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only insofar as they present legitimate profit-maximizing opportunities.

Should firms undertake such (costly)2 initiatives, given that a manager’s purported

objective is to maximize profits for shareholders, particularly in the context of transna-

tional issues such as human rights and global supply-chain standards where regulation is

not credible?

The answer that is often given is that demonstrating corporate social responsibility

(CSR) is good for business. Nelson (2004) lists the most cited strategic reasons for CSR-

initiatives as reputation-building, employee relations and competitive advantage: investors

prefer responsible firms, consumers prefer to buy their products and workers work harder

for them. In this scenario, CSR is welfare-improving for all.

Accordingly, existing empirical studies on CSR have focused very strongly on the links

between various measures of CSR and corporate financial performance (CFP). In their

wide-ranging survey of this literature, Margolis and Walsh (2001) state that

...research to date has been motivated, at least in part, by the belief that a

manifest relationship between CSP and CFP will persuade firms to invest in

social initiatives if the relationship is positive, or dissuade firms from doing so

if the relationship is negative.

In their survey of the past 30 years’ research, an overwhelming majority of the 95 stud-

ies reviewed find a weakly positive link between a firm’s overall CSR and CFP. However,

this literature is subject to both methodological and more fundamental epistemological

questions. Firstly, the diversity and subjectivity of measures does not lend well to ob-

jective analysis or comparison. The most prevalent methods - cross-sectional regression

with controls or portfolio-tracking - do not always adequately address potential selection

and endogeneity biases. Secondly, the focus on showing links between measures of CFP

and measures of a companies’ overall CSR performance ultimately may have little else to

say about relevant policy.

The indisputable fact is that firms already engage in an extremely wide range of

activities that come under CSR.A more appropriately focused question is why we observe

firms voluntarily undertaking specific types of initiatives or participating in social-welfare

increasing mechanisms, which can then lead on to a broader analysis of welfare and

appropriate design.

2The EIU estimates that a full-fledged CSR program can cost up to 2% of total revenue. EIU (2004)

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Motives for participation may well be consistent with potentially negative effects on

the bottom line. Firms may be responding to the threat of potential standardization or

regulation, or to interest-group pressure, at the cost of firm value. The genesis of this

trend clearly lies in the need to repair the individual and collective reputations of large

firms, following the wave of environmental, labor and governance-related scandals of the

1990s. Finally, we might also believe that managers are altruistic or seek to improve

their personal reputations, and take advantage of their agency to redistribute between

shareholders and other interest groups. In these cases, firm value is lost, although overall

welfare may improve.

This study applies a traditional event study methodology to one such mechanism -

the public adoption of a voluntary standard. Here, by analyzing the impact on firm

value from the addition and deletion of firms from a leading CSR index based on a set

of public, independently-verified standards, we seek to understand firms’ participation.

By determining whether a strategic business case in fact exists, we can draw a set of

implications about firms’ motivations.

Preliminary results suggest that, contrary to the bulk of the empirical literature, on

average, there is no significant evidence of a strategic benefit in terms of firm value.

There is no impact from being disqualified and a significantly negative effect on value

from becoming qualified, which is likely to reflect the cost of compliance. Nevertheless,

firms are observed to seek addition.

This result has a limited but useful implication. The lack of an obvious strategic

business case implies that firms have other motives that may include both political and

altruistic decisionmaking. In practical terms, this suggests that when designing mecha-

nisms to improve social welfare, it is possible to secure compliance from firms that requires

losses even without explicit regulation. Firms’ actions reflect both the need and the abil-

ity to move beyond a naive “win-win” vision, when looking towards a role for the private

sector in development.

2 A Framework for Corporate Social Responsibility?

2.1 The Problem of Definition

One of the key analytical problems with corporate social responsibility(CSR)is that inher-

ently broad and inclusive nature. In his analysis of stakeholder theory, Clarkson (1995)

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the term is a brilliant one; it means something, but not always the some thing,

to everybody. To some it conveys the idea of legal responsibility or liability;

to others it means socially responsible behavior in an ethical sense; to still

others, the meaning transmitted is that of “responsible for”, in a causal mode;

many simply equate it with charitable contributions

In current practice, CSR embraces activities as diverse both in scope and in inten-

sity as compliance with environmental and labor regulations, good corporate governance,

“socially-responsible” investment and charitable giving. Part of this diversity is no doubt

attributable to corporate opportunism or “greenwash”, but part of it reflects the reality

of a multi-dimensional, process-based concept.

2.2 Players

Part of the confusion lies in the analytical failure to distinguish between motive, practice

and outcome. Baron (2001) presents a framework for thinking about CSR that is attrac-

tively clear. Although his model of private politics is fairly specialized and hence omitted

here, this section leans heavily on his set-up.

In this framework, the players are consumers, firms (managers and shareholders),

stakeholder groups and stakeholder advocates, and potentially a regulator. Both managers

and consumers are assumed to have some degree of altruistic preferences.

By definition the firm is a legal entity owned by shareholders and operated by man-

agers, Shareholders can distribute rights and proceeds as they please. The implication of

corporate law, however is that firms maximize their market value. However within the

firm, shareholders are also vulnerable to managers, as a problem of hidden action exists.

Managerial discretion is protected by business-judgement rules, but is limited, as they are

subject to dismissal.

Stakeholder groups are defined in accordance with stakeholder theory (Clarkson, 1995)

as those affected by firm practices. The literature sometimes makes a distinction between

groups that consist of primary stakeholders - shareholders, customers, employees and

suppliers - and secondary stakeholders, such as indigent groups, women and minorities,

the environment or the community at large.

Stakeholder advocates are players that seek to alter firm behavior, with the objective

of redistribution from shareholders to their members or to the cause. Examples of such

advocates are activist groups, unions, organizations, coalition partners who use media,

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politicians etc. Advocates can apply pressure through campaigns causing the firm to

change its practice, for example through consumer boycotts, political lobbying, the refusal

to add firm to an index, publication of firm in top 100 lists etc.

CSR in this framework applies to two things. As part of profit-maximizing practice,

the firm can choose to provide some level of a social good in response to altruistic con-

sumer demand, equating the marginal benefit of provision with its cost. This is purely

strategic CSR that increases shareholder value. However, as a result of politics or man-

agerial altruism, redistribution may occur which also falls under the heading of CSR. This

can take the form of both standard lump-sum transfers e.g. charitable contributions, or

changes in business practices, that necessarily affect the firms’ cost-structure.

2.3 Why do Companies Undertake CSR?

2.3.1 Increasing Demand

Since consumers are assumed to have some degree of altruistic preferences, firms may face

demand that increases with provision of a good which has some social value. Therefore,

profit-maximizing firms provide this good up to the point where the marginal cost of

provision equates to the marginal benefit, which may well be positive. This is the most

straightforward source of strategic CSR.

2.3.2 Competitive Advantage

Another strategically-motivated reason for CSR is future competitive advantage. Com-

panies may contribute to building a market, or gain access to resources that increase

productivity. For example, local companies participate in the South African Business

Trust, an initiative of 145 companies in South Africa working in partnership with gov-

ernment. It undertakes targeted job creation and capacity building programs, specifically

in tourism and schooling. Private enterprise commits to a concerted effort to improve

these sectors, including dedicating a percentage of after tax profits to targeted tourism,

schooling and crime reduction programs over and above our established corporate so-

cial responsibility programs. In exchange, the government commits to co-funding these

initiatives and public works programs that address critical impediments to tourism and

education, such as crime and public health. In addition, senior members of the private

sector are given the opportunity to regularly meet with high-ranking government officials.

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Returning to the African Comprehensive HIV/AIDS Partnerships (ACHAP), Merck

is donating its antiretroviral medicines for the duration of MASA, the government’s an-

tiretroviral therapy program.3 This represents a large commitment for Merck, but it can

also be viewed as strategic. One of the key issues with ARV therapy is that patients often

do not observe benefits, because they do not properly adhere to the complicated regimen,

which leads to a loss of credibility for the drug. In this program, the government plays

a critical role in the initiation and monitoring of programs such as nationwide testing,

referral and diagnostic services, ensuring that the medication is properly taken and that

benefits are demonstrated on the ground, setting up a future market for Merck’s ARV

drugs both in Botswana and elsewhere in Africa when the program is completed.

2.3.3 Preventing Stakeholder Entry In An Influence Game

A second set of arguments is that voluntary CSR preempts future punishment, either

directly or by preventing stakeholder politics. In Lyon(1991), for example, firms in a

regulated industry cut prices to avoid rate reviews that would be more onerous.

It also is possible that some CSR comes about, in the words of the Financial Times, as

the product of an undemocratic collaboration between multinationals and campaigning

organizations, the former buying peace and acceptability by succumbing to the demands of

the latter 4 Firms demonstrate CSR in order to put off stakeholders to prevent stakeholder

advocates from influencing the government, or from launching a boycott.

Maxwell, Lyon, and Hackett (2000) assume an oligopolistic industry, where consumers

have price and non-price concerns that can be addressed through a set of (costly) firm

controls. A three-stage game is played in which firms invest in a level of control, following

which consumers observe the outcome and decide whether or not to incur the fixed cost

of entering the second stage, an influence game. In the influence game, both firms and

consumers have the ability to lobby the government, and in the final sub-game, the level

of regulation is determined. i.e. regulation is endogenous.

The authors show that it may be optimal for firms to collude and voluntarily self-

regulate, using a “fat cat strategy” to indirectly buy stakeholder(customer) silence. Stake-

holder welfare increases as firms invest, and lobbying for them is costly. For an interme-

diate level of consumers’ political costs, firms may be able to match stakeholders’ net

utility from lobbying for government regulation by voluntarily investing in a lower level

3Merck Annual Report, 20004Oct 05 2001 Corporate social responsibility can do wonders for your brand - Financial Times

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of self-regulation. This pre-empts stakeholders’ entry into the influence game, heading off

more stringent future regulation. 5

Baron (2001)’s model is similar, but in this case no regulator exists; the final ar-

biters are consumers. Firms voluntarily redistribute their profits to stakeholders(i.e. give

transfers or self-regulate) in order to pre-empt a stakeholder advocate who may otherwise

launch a boycott that triggers a fall in consumer demand.

One example that may reflect this kind of appeasement strategy is the formation of

the Global Alliance for Workers and Communities, an initiative of the World Bank, the

International Youth Foundation, Nike and Gap Inc., which recently ended its mandated 5-

year term. Nike and Gap Inc. were previously both the targets of significant labor-rights

activism. In conjunction with local NGOs, the Alliance delivered health services and

training, improved health clinics, offered management training, and established worker

savings cooperative in factories in China, India, Indonesia, Thailand, and Vietnam. The

companies committed to compliance programs and transparency, while the World Bank

and the project’s academic partners - St. John’s University and Penn State University -

provided technical expertise for practice and evaluation. Apart from these direct bene-

fits, the Alliance claims its activities also positively impacted local suppliers and overall

productivity.

Another example might be in that 2004, UNDP-Angola, USAID and Chevron-Texaco,

which is heavily involved in local oil extraction, began the ”Angola Partnership Initia-

tive”. Chevron committed $25 million over the 3-year program, pledging to support the

development of micro and small-businesses in Angola by investing in training, business

development and credit expansion through micro-loans.

2.3.4 Quality Leadership As A Strategic Sunk Cost

Lutz, Lyon, and Maxwell (2000) model corporate leadership by assuming that minimal

standards exist but that future regulation can be influenced by corporate actions. Product

5The example provided is toxic emissions in the US. With a fall in organizing costs (through mandatedemission disclosure in 1986) or increased threat of federal regulation (signaled by the EPA 33/50 programin 1991), emissions fell significantly. In a cross-section regression analysis, states with higher income andhigher per capita membership in conservation group show lower rates of unregulated toxic chemicals. Inaddition, they provide other suggestive examples such as the ”Responsible Care” program initiated bythe Chemical Manufacturer’s Association, which has been explicitly used by at least one member to avoidadoption of stricter standards.

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quality is vertically differentiated in a duopoly model. Firms choose quality levels and a

regulator fixes a minimum quality standard.

Lutz, Lyon, and Maxwell (2000) compare a simultaneous move game to the games

in which the firms and the regulator move first respectively. If firms move first, the firm

that eventually produces the high-quality good chooses to commit to a quality level above

the existing minimum standard, but this standard is lower than that of the simultaneous

move equilibrium. This pre-commitment prompts a welfare-maximizing regulator to set a

lower new standard than it would if the regulator were allowed to move first. Thus lower

quality is produced by both firms. If the regulator moves first, however, the quality level

of both firms is higher, at the cost of profits for the high-quality firm.

The authors imply that the typical delays in standard-setting can be injurious to

social welfare, allowing leading firms time to position their products and influence final

standards. Furthermore, visible corporate leadership in setting ”best-practices” should

be treated with more skepticism than has generally been the case. 6

2.4 Managerial Agency

One final concern for shareholders is that managers may undertake CSR, altruistically or

strategically, to reward himself rather to reward his employers. Jensen and Murphy (1990)

show that overall management compensation is not strongly tied to firm performance, and

that other non-pecuniary rewards or political pressures may cause a rational manager not

to maximize firm value.This is a classic agency problem : the manager optimally chooses

a level of CSR that maximizes his personal status for example, or his attractiveness to

the outside job market, at the expense of firm value.

3 Current Empirical Literature

The empirical literature on CSR is large and growing, with the first study published

by Bragdon and Marlin in 1972.20 other studies followed during the 1970s, 32 in the

6The authors cite the case of EPA effluent guidelines, which were proposed 11 years after beingmandated by the Clean Water Act of 1972. Like many standards, the final standards did not requirethe use of the most effective technologies available, but were heavily influenced by the existing practicesof industry leaders - in this case, literally by averaging effluent quality at plants that were identified asexemplary.

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1980s, and 42 in the 1990s. In the most recent five-year period from 1996 through 2000,

researchers published 31 new studies.

3.1 A Positive Link?

In the popular cross-sectional regression, CSR is treated as an independent variable, pre-

dicting financial performance. The overwhelming majority of results (Roman, Hayibor,

and Agle (1999) and Margolis and Walsh (2001)) point to a positive relationship be-

tween corporate financial performance and social performance. For example,Waddock

and Graves (1997) reviews 486 firms and finds numerous significant relationships between

an index of corporate social responsibility and profitability measures such as return on

assets and return on sales.

Another approach is to track the historical performance and risk-return characteristics

of a portfolio established on CSR-related criteria. Sauer (1997), for example, compared

returns of a US CSR index, the Domini Social Index 400 (DSI) to those of the S&P 500

and CRSP Value-Weighted Market Index through 1994. He found that the DSI would

have underperformed both benchmarks on a risk-adjusted basis for the first half of the

study period. However, aggregate risk-adjusted returns exceeded those of both unscreened

benchmarks for the later period Waddock, Graves, and Gorski (1998) uses the Compustat

database to compare the returns of those S&P 500 companies included in the DSI with

those excluded from it, and found that included companies outperformed excluded firms

on a 3-year, 5-year, and 10-year basis.

Griffin and Mahon (1997), Roman, Hayibor, and Agle (1999) and most recently, Mar-

golis and Walsh (2001) survey this extensive literature and conclude that, although the

approaches may vary, existing evidence favors a positive relationship between CSR and

financial performance. Where a positive relationship is not to be found, the evidence is

held to be inconclusive rather than negative. Roman, Hayibor, and Agle (1999) for ex-

ample, find that, in 51 studies surveyed, 33 demonstrate a positive relationship and only

5 demonstrate a negative one.

3.2 Measurement Error and Bias

As a corollary to the fundamental confusion of trying to answer the question of how

socially responsible a firm is, Margolis and Walsh (2001) cite the use of reputation-based

measures derived from surveys of business students, faculty members, or leading business

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executives in Fortune magazine, or the magnitude of charitable contributions. Other

studies count the number of women or minorities on a company’s board, or the presence

of disclosure about CSR in company reports. A more comprehensive approach uses rating

systems such as the Kinder Lydenberg Domini (KLD) system, which scores performance

on a variety of measures and consolidate them. Financial performance is equally difficult

to pin down. Here, Margolis and Walsh (2001) report 70 different accounting and market-

based measures, the most popular being return on equity and return on assets.

There is a high possibility that these results reflect a significant upward bias, from two

separate sources. Selection bias is a major concern that derives in part from the question

of measurement. Reputation-based measures are particularly subject to such bias, as

large well-known firms are more likely to appear at the top of the list. The addition of

control variables to control for bias is a common solution. However, the multiplicity of

the controls makes it very difficult to compare results across studies. In fact, Margolis

and Walsh (2001) record that 19 of the 95 studies employed no controls and forty-seven

different controls were investigated in the remaining 76 studies. Another key concern is

endogeneity bias. One might argue that firms are more likely to invest in CSR when they

become more successful and have more resources to spend.

3.3 Event Studies

Event-studies represent an approach that is attractively simple to implement, and has the

advantage of avoiding the biases inherent in cross-sectional regression or portfolio tracking.

More importantly, rather than attempting the questionable evaluation of a firms “overall

CSR”, event studies allow us to ask a very specific question about a very specific group -

what effect did a particular change have on shareholders?

For example, Jones and Murrell (2001) finds that that a signal of CSR is a positive

indicator of a firm’s business performance to shareholders. Jones and Murrell (2001) con-

duct an event study of firms named to Working Mother magazine’s list of ”Most Family-

Friendly Companies” between 1989 and 1994. They find significant positive abnormal

returns for such firms.

Margolis and Walsh (2001) state that event studies may be most promising for research

into CSR , but they also argue that it has been difficult to collect data on discrete CSR-

related events, and that the time-horizon for assessing the implications surrounding such

events is not always clear. In the literature, this has lead to conflicting results, about the

same event, even in the face of a very straightforward methodology.

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For example, Teoh, Welch, and Wazzan (1999) studied the effect of the boycott of the

South Africa’s apartheid regime, and find that the announcement of legislative/shareholder

pressure of voluntary divestment from South Africa had little effect either on the valuation

of banks and corporations with South African operations, or on the South African finan-

cial market, suggesting, in their words that “financial markets seem to have perceived

the boycott to be merely a ”sideshow.” Meznar, Nigh, and Kwok (1994), in another

study, find that announcement of withdrawal were associated with a significant drop in

firm value,suggesting that “managers were considering the interests of groups other than

stockholders”.

McWilliams and Siegel (2000) explain the diversity of results in their critique of the use

of event studies in management, arguing that research design often violates the assump-

tions of market efficiency is often violated (by using excessively long event windows), the

unanticipated nature of events (by ignoring leakage prior to formal announcements) and

confounding events (by neglecting to control for other events such as mergers, earnings

or dividend announcements and litigation that might affect share price).

McWilliams and Siegel (2000) specifically address the application to CSR by looking

at Meznar, Nigh, and Kwok (1994) and Wright, Ferris, Hiller, and Kroll (1995), which

studies the impact of awards for exemplary affirmative action programs on stock returns.

Both these papers report significant changes in value from CSR-related announcements -

positive in the case of Wright, Ferris, Hiller, and Kroll (1995) and negative in the case of

Meznar, Nigh, and Kwok (1994).

For one, they argue, to achieve significance the authors resort to the use of extremely

long event windows (up to 41 days in the case of Meznar, Nigh, and Kwok (1994)). After

replicating the analysis and carefully removing confounding events, the results become

insignificant over all event windows, and the admissible sample size shrinks dramatically.

Finally, they take issue with the validity of events such as affirmative action awards,

noting that these do not regularly appear in the popular financial press. Given these

revisions, the authors find no empirical basis to infer that in general, shareholders are

hurt or harmed. 7

Keeping this in mind, however, an appropriately-designed event study with a specific

interpretation may prove useful in our attempt to parse the meaning behind firms’ actions.

7McWilliams and Siegel (2000)’s main theoretical gripe is that, even in the case of sound methodology,event studies demonstrate only the effects of CSR-initiatives on stockholders, not the overall social impact.However, this is not always a negative, as it may be important to isolate this effect.

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At the very least, event study allows us to distinguish profit-maximizing CSR from CSR

with other motivations, which may help us better understand why companies choose to

comply with various mechanisms that attempt to induce CSR.

4 Voluntary Public Certification

Nelson (2004) provides a fairly comprehensive list of current mechanisms currently in

place with the stated objective of increasing CSR, some of which are reproduced below:

Mechanism Example

Regulation Sarbanes-Oxley, UK Pensions Act

Fiscal Incentives carbon taxes, tax incentives on charity

Official procurement/financing IFC and World Bank requirements

Commercial financing Environmental and social loan criteria; Association of

British Insurers guidelines

Multi-stakeholder certification Marine Stewardship Council, Fair Labor Association

Multi-stakeholder guidelines US-UK Voluntary Principles on Human Rights and Se-

curity, Extractive Industry Transparency Initiative

Consumer labelling Clean Clothes Campaign; Publish What You Pay

Industry frameworks Responsible Care; WRAP

Individual corporate policies Company codes; appointment of director or committee

We examine just one of these alternatives in detail: voluntary third-party certification.

A firm agrees to be reviewed by a third-party who sets commonly-known CSR standards,

and the results of the review are made publicly known. By focusing on firms that are

known to be under the standard but then comply (or conversely, firms that are known to

comply but drop out later), we focus on the response to a known and presumably costly

change in status. Provided that the third-party is sufficiently well-known and credible,

and that capital markets are efficient, an event-study should allow us to determine changes

in firm value from this change.

4.1 FTSE4Good Indexes

One of the two leading investable UK indexes of CSR is the UK Financial Times’ FTSE4Good

Index. The FTSE4Good index series is a series of real-time indices created and managed

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by global index provider the Financial Times Group that covers four markets: UK, Eu-

rope, US and Global. This analysis focuses on the FTSE4Good, because addition and

deletion to the FTSE4Good reflects firms’ decision to adhere to a voluntary standard, in

a manner that differs from other CSR indexes.

The most-known US equity index of CSR is the Domini Social Index 400, based on the

KLD ratings system. Ideally, to be comparable to previous studies in the US, we would

wish to use an index based on the KLD ratings. 8 However, there are significant issues

with the DSI for this purpose. Addition or deletion depends on a relative performance

scale. The other major UK index, the Dow Jones Sustainability Index is also based on the

“best-in-class” approach (positive screening). Thus, significant confounding effects exist,

meaning that firms are not added or deleted solely due to CSR-related criteria.

FTSE4Good on the other hand, is based on a review of potentially all firms in the UK

market, and all firms satisfying the criteria are admitted. A committee of independent

practitioners in socially responsible investment (SRI) and CSR review the indices to ensure

that they are an accurate reflection of current CSR best practice.

4.1.1 Inclusion Standards and Independent Review

To qualify for the FTSE4Good, companies are evaluated with respect to standards in three

areas - environmental sustainability, stakeholder relationships and support for universal

human rights. The environmental criteria vary by industry, but increase in stringency

with the adjudged impact of the industry and require policy reporting and quantita-

tive assessment. The humans rights criteria are similarly varied, but universally include

commitment to ILO core labor standards, board responsibility and impact assessments.

In order to meet the criteria for stakeholder relationships, a company must adopt any

two of seven indicators which include adopting a code of business ethics, providing evi-

dence of adequate equal-opportunity, training or health and safety systems for workers,

straightforward charitable giving in excess of a certain amount or even the simple assig-

nation of responsibility for such giving to a senior manager. Since the index series was

launched in July 2001, the environmental criteria and human rights criteria have both

8In addition, adds and deletes to the DSI are not publicly announced in a major newspaper. It is likelythat adds and deletes, which account for 6-8% of the DSI 400 portfolio, are monitored by a self-selectedgroup of investors. Finally, although index changes occur due to unrelated events such as corporaterestructuring, detailed data reports on decisions with regard to composition are only published by KLDfor additions to the index, and only goes back to 2003.

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been strenghtened. As of 2004, FTSE also introduced standards pertaining to the corpo-

rations’ supply-chain. Companies that are involved in producing tobacco or weapons are

automatically excluded.

4.1.2 Eligible Universe

All companies in the eligible universe of existing FTSE indexes that pass the FTSE4Good

criteria are members of one of the benchmark indices.

Companies are ranked in the benchmark index according to their free-float and liquid-

ity adjusted market capitalization. Companies in the FTSE4Good Tradable indices are

the largest 100 or 50 stocks in the benchmark indices.

Starting Universe Benchmark Index Tradable Index

FTSE All-Share FTSE4Good UK FTSE4Good UK 50

FTSE Developed Europe FTSE4Good Europe FTSE4Good Europe 50

FTSE US FTSE4Good US FTSE4Good US 100

FTSE All-World Developed FTSE4Good Global FTSE4Good Global 100

Since addition and deletion to/from any tradable CSR index depends on non-CSR

related rankings, I focus on the benchmark CSR indexes. Of these 4 indexes, I chose the

UK Benchmark index for this analysis due to the relative consistency of the data and

because of greater certainty of the UK press coverage of the FTSE index relative to the

international of US press. At the time of writing, the FTSE Allshare, which represents

the UK universe consists of 702 firms, 98 % of the total UK market capitalization, and

the FTSE4Good consists of 296 firms.

5 Event-Study

In this section, I apply the traditional event-study methodology based on Brown and

Warner (1985). The event of interest is defined for all securities as addition or deletion.

I assume that firms not in the index at the inception did not (or are assumed by

the market) not to have qualified, and thus are known to make costly changes in their

business practices in order to qualify. The hypothesis to be tested is that firm value

increases when a firm is added, indicating that there is a strategic case for incurring the

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cost of compliance. Conversely, a fall in firm value indicates a politically or altruistically

motivated firm decision.9

5.1 Determination of Additions/Deletions Sample

The indexes were incepted in July 2001, but the incidents of September 2001 resulted in

some delays as to their announcement. Our sample period thus begins on 1 December

2001. I compile a record of all constituent changes to the index and the documented rea-

sons for the change using archived press releases. Price data for the individual constituent

securities is obtained from Datastream. Data and press on the FTSE index is obtained

from Yahoo Finance and the FTSE website 10

To avoid confounding events as far as possible, changes to the index that involve only

investment re-weightings or that result from mergers or restructuring are dropped. From

the initial sample of additions and deletions, I retain only those firms who are added or

deleted due to changes in compliance with standards-related eligibility criteria. 11 Firms

that enter or leave the index as a result of entering or leaving the baseline universe without

any changes to their compliance status are dropped. Finally, firms with insufficient data

for the analysis are also dropped. This results in a final sample of 19 deletions and

93 additions over the period of 1 December 2001 - 1 December 2004.12 The pattern of

entry and exit is regular and semi-annual rather than continuous, corresponding to the

FTSE4Good index review schedule.

9As discussed in great depth by McWilliams and Siegel (2000), the value of this event study dependsfundamentally on the validity of the event as a unanticipated signal of CSR. Teoh and Shiu (1990)find that companies do not alter their investment decisions based on company assertions of CSR e.g.annual reports, but that investors respond to CSR announcements based on 3 conditions: whether ornot the information was quantified, focused on specific issues and reported by third-parties. As such,an announcement of FTSE-reported adds and deletes satisfies at least the first and the third criteria,and may be taken to be a valid event representing new information. The key rationale is that investorsinterpret such a signal as a trigger for action, which is significant differently from the regular stream ofcompany-released CSR-related data.

10http://uk.finance.yahoo.com,http://www.ftse4good.com/index.jsp11Reasons for addition/deletion are named on the individual press releases12A review of the FTSE4Good index on 21 December 2004 resulted in 3 deletions, but these were due

to removal from the benchmark index and so would not be included in our sample

16

6 Methodology

The following section follows Brown and Warner (1985) very closely, and an informed

reader may choose to skip it.

6.1 Event and Estimation Periods

I define day 0 as the day of the event for a given security. Following Brown and Warner

(1985), for each security I compile 250 daily return observations for the period around

its respective event, starting at day - 244 and ending at day + 5 relative to the event.

The first 239 days in this period (- 244 through - 6) are designated the as the estimation

period, and the following 11 days ( - 5 through + 5) are designated the event period.

Event periods of 0 days (i.e. abnormal return on the announcement date only) and (-3

through +3) are also estimated.

6.2 Measures of Return

The return for a security i on day t is defined as Ri,t =Pi,t−Pi,t−1

Pi,t−1where Pi,t is the stock

price. 13 I compute abnormal returns in three ways:

1. Mean-adjusted Abnormal Return

Ai,t = Ri,t − Ri (1)

Ri = 1239

∑−6−244 Ri,t (2)

2. Market-adjusted Abnormal Return

Ai,t = Ri,t −Rm,t (3)

where Rm,t is the return on the FTSE All-share Index at date t

3. CAPM Abnormal Return

13I do not include dividends at present but could incorporate this in the next step

17

Ai,t = Ri,t − αi − βiRm,t (4)

where α and β are estimated by OLS over the estimation period.

6.3 Test Statistic

The null hypothesis to be tested is that the mean day 0 excess return (the simple average

of market model excess returns) is equal to zero i.e. that there is no effect from the event.

The Brown-Warner test statistic to be computed for any date t is At

S(At)where At is

the sample mean excess return on date t and S is its standard deviation (estimated from

the time-series of mean excess returns). The formula below is applied to the sample of Nt

firms:

At = 1Nt

∑Nt

i=1 Ai,t (5)

S(At) =√

(∑−6−244(At − ¯A)2)/239 (6)

¯A = 1239

∑−6−244 At (7)

14 I compute the test-statistic for the three measures described above. In addition to

the event-day excess return, I compute the test-statistic using the mean cumulative excess

return defined over an event window of 3 and 5 days around the event as the numerator,

as well as event windows beginning on the day itself.

7 Preliminary Results

Below, I report results from the whole sample of additions and deletions for the three

market measures. In keeping with McWilliams and Siegel (2000), the event window is

measured for -1/+1, -3/+3 and -5/+5 days, to account for prior leakage, but for robustness

checking, the window is measured for only 0-1, 0-3 and 0-5 days. In addition, with the

results of the market model, I include a binomial Z-test as a nonparametric check for

outliers.14If the values of A are independent, identically distributed, and normal, the test statistic is distributed

Student-t under the null hypothesis. Brown and Warner (1985) also note that by using a time-series ofaverage excess returns, the test statistic takes into account cross-sectional dependence in the security-specific excess returns.

18

7.1 Sample of Deletions

As the results below show, for the sample of 19 deletions, we find no significant effect for

various event windows. As the sample size is small, it is not possible to infer significant

conclusions. However, it is important to note that the sign of the effect is (mostly)

generally positive, although insignificant.

Abnormal Return Brown-Warner statistic

Event Window: -1/-1 days

Mean-adjusted 0.47% 0.89

Market-adjusted 0.38% 0.63

CAPM 0.43% 1.04


Event Window: -3/+3 days


Market-adjusted 0.67% 1.11

CAPM 0.53% 1.28




Market-adjusted -0.27% -0.44

CAPM 0.11% 0.26

7.2 Sample of Additions

7.2.1 Symmetric Event Window

For the larger sample of 93 additions to the index, the results are significant and negative.

The average magnitude of the drop is not as large as the 5.5% reported by Meznar, Nigh,

and Kwok (1994) in the case of withdrawal from South Africa, but at first glance looks

more realistic.

19

CAR Brown-Warner Stat. % Positive Z Stat.

Event Window: -1/-1 days

Mean-adjusted -0.56% -1.18 40.86%

Market-adjusted 0.20% 0.45 48.39%

CAPM -0.22% -0.59 44.09% -0.53



Mean-adjusted -1.81% -3.82 37.63%

Market-adjusted -0.80% -1.82 48.39%

CAPM -1.21% -3.21 39.78% -1.37



Mean-adjusted -2.24% -4.72 44.09%


CAPM -1.74% -4.64 45.16% -0.33

7.2.2 Restricted Event Window

When the event window is restricted to on or after the event date, the effect is smaller.

The direction of the finding is qualitatively unchanged however - the negative results

remain significant.


Event Window: 0/+1 days

Mean-adjusted -0.36% -0.75 44.09%

Market-adjusted 0.19% 0.43 46.24%

CAPM -0.10% -0.25 43.01% -0.74

20



Mean-adjusted -1.24% -2.60 38.71%


CAPM -0.78% -2.09 40.86% -1.16



Mean-adjusted -1.37% -2.88 37.63%

Market-adjusted 0.06% -0.15 47.31%

CAPM -0.68% -1.81 38.71% -1.57

7.2.3 Addition Increases Over Time

The results show that addition to the index results in a fall, on average, in firm value,

which is robust to the definition of the event window. Nevertheless, firms continue to seek

addition.15

Figure 1: Number of Additions (Cumulative) to FTSE4Good UK

15The graph reflects all 102 additions, of which 9 were dropped in our sample for incomplete data

21

8 Discussion

One argument for complying with FTSE standards, made by FTSE itself, is that in fact

promotes profit-maximization. 16 FTSE4Good markets itself as an important part of

brand-marketing for its constituents, based on its information-dissemination capacity as

well as the strength of its own brand. Furthermore, FTSE reports that there are now

more than 60 retail socially-responsible investment funds in the UK, with the estimated

value of these funds standing at around 4 billion in August 2001, an increase of over

2001% from 199.3 million in Q2 1989. 17

FTSE4Good also makes an operational efficiency argument, claiming that companies

report cost savings from complying with their environmental standards, saving money

on electricity bills, resource use and waste removal.18 FTSE also suggests explicitly that

companies with good corporate responsibility standards are better able to attract and

retain high quality staff, reducing employee turnover rates and recruitment costs, but do

not state that this is true for their members.

However, the results suggest that none of these factors prevail strongly enough that,

on average, firms see an increase in their value. Theory implies that a drop in firm value is

consistent with firms’ preemptive behavior. Firms may be complying with FTSE criteria

in order to avoid stakeholder activism that might provoke future, more stringent regula-

tions or to collusively set a voluntary standard that substitutes for more onerous future

regulations. This is not an unusual conclusion to draw, given the current environment

in which calls for regulation and standardization are increasing. Legislation is under-

way, not only in the form of the U.S. Sarbanes Oxley act, but required “triple bottom

line reporting” for UK pensions and French corporations that requires disclosure of so-

cial, environmental and financial performance. Government officials in Canada, Norway,

Japan and Denmark, Sweden, South Africa, the Netherlands and Australia are also in the

process of adopting CSR reporting regulations. (EIU, 2004) International bodies, such

as the EU and the OECD have launched initiatives to develop standards and reporting

initiatives, and an ISO standard is in development. However, there is a significant time

16In line with this reasoning, Feddersen and Gilligan (2001) model an information intermediary, anactivist provides information to consumers who have a demand for a credence good, whose quality cannotbe determined from consumption. By providing information to consumers, the activist mitigates a marketfailure due to incomplete information about quality.

17http://www.ftse4good.com/ftse4good/companies.jsp18http://www.ftse4good.com/ftse4good/companies.jsp

22

lapse before such standards are formed, leaving corporations a large amount of room to

preempt or to manipulate them. Even FTSE standards themselves are based to some

degree on “best practices”. 19

Another, not-exclusive implication is that managers are not seeking to maximize share-

holder utility. Managers maximize their own utility, whether out of altruism or a desire

for personal reputation. The Economist notes that “there are some kindly CEOs out

there, and some with a troubled conscience...there are quite a few vain CEOs who enjoy

the attention which CSR leadership brings them, and many others who...seem to find

running a profitable company too small a test of their talents.”20

8.1 Next Steps

In terms of the empirical analysis, the next stage is to establish the robustness of the

results and to examine other relationships in the data. The following steps are proposed:

• Identify and obtain data on other characteristics of the firms, and to see if these

results vary meaningfully. Key characteristics would be the level and type of in-

stitutional ownership (no data source located yet) to test the hypotheses regarding

cross-sectional variation. A second set of firm-level identifiers would be region and

industry, as well as other characteristics such as firm size and age.

• Repeat the analysis on samples of events occurring at different times to see if the ef-

fect of adds/deletions changes over time. One hypothesis might be that the negative

effect of adds or the insignificance of deletions might decrease over time.

• Replicate the analysis on the other available indexes (US and European) to examine

market-level differences.

8.2 Conclusion

When criticizing CSR, Milton Friedman stated that “the first step is examining the doc-

trines of the social responsibility of business is to ask precisely what it implies for whom.”

The possibility of a business case for CSR has undeniably motivated much of the research

and practice of CSR to date. In an address to the U.S. Chamber of Commerce in 2001,

U.N. Secretary General Kofi Annan described the “win-win” vision for private partners in

19INSERT FOOTNOTE HERE FROM COMPLIANCE DOCUMENT20The Economist, The Union of Concerned Executives” January 22 2005

23

the development process as “a happy convergence between what your shareholders want

and what is best for millions of people the world over”.21 The Economist claims that

“every firm believes that its CSR actions fall in the “win-win” box.” 22

While adopting a very simplified view of a very specific type of CSR performance, the

preliminary results of this paper suggest that in the current period, shareholders are not,

on average, landing in the “win-win” box. We therefore need to examine other motives

for participation. While “doing well by doing good” may have started the movement,

it cannot account for the sustained participation of companies today. A response to

community and regulatory pressure may play a role, as may a trend towards altruism.

A spokesman for Ericsson, a mamber of the FTSE Europe Index, stated that “we don’t

even calculate a return on our investment in CR...It is one of our core values and so we

do it.”(EIU, 2004).

The ability to distinguish between these remaining motives and, more significantly,

their welfare effects lies beyond the scope of this paper. If shareholders lose, does the total

welfare gain offset this loss? Argubly, the most critical question of all remains unanswered.

Future research will pursue a more detailed empirical and theoretical investigation of the

mechanisms underlying firm participation, with the hope of better understanding their

true implications for overall social welfare.

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