Boards, Incentives, and CSR

Boards, Incentives and CorporateSocial Responsibility: the case for achange of emphasis

Craig Mackenzie*

Boards of large UK companies are devoting more time to the governance of corporate socialresponsibility (CSR). This is in line with the Combined Code on Corporate Governance’srequirement that boards set standards and values for companies and ensure they meet theirsocial obligations. But is board activity in this area as effective as it could be at achievingcorporate compliance with CSR standards? This paper draws on the economic literature tooffer an analysis of the primary causes of breaches of corporate responsibility standards.Based on a small survey of the board CSR activities of 20 of Britain’s largest companies, itassesses whether boards are addressing these causes effectively. The tentative conclusion isthat board activity might usefully be reoriented to do more to address the fundamentalincentives problems that often cause corporate responsibility failures, namely market failureand misaligned performance management systems.

Keywords: Board, corporate social responsibility, United Kingdom, internal controls, evalua-tion of the board

Introduction

T here is a growing interest in the notion ofcorporate social responsibility (CSR) from

companies, investors and regulators.1 Onedoes not have to embrace radical “stake-holder” agendas (Letza et al., 2004) to see whythis is so. Companies see non-compliance withcorporate responsibility standards as a signifi-cant source of risk to their reputations withcustomers, employees and other stakeholders.Recent examples include: perceptions of soft-ware companies’ complicity with humanrights abuses in China; breaches of ethicalexpectations about sourcing in supply chainswith labour problems; failures by oil compa-nies to take due care to safeguard health andsafety in refineries; exploitative marketing offinancial services products; not to mention thenumerous dishonest and fraudulent practicesassociated with the wave of scandals followingEnron. In all these examples, valuable reputa-tional assets have been destroyed because of

breaches of accepted standards of corporateresponsibility.

Corporate responsibility is not just per-ceived to be about avoiding risk. Companiesalso see strong performance in this area as asource of opportunity to strengthen trust intheir brands and to enhance employee motiva-tion. Advocates of investment in intangibleassets such as customer loyalty see responsiblebehaviour as key driver (Reichheld, 2001).

In addition to any business benefits, there is aview that many of the most basic CSR obliga-tions are also legal requirements. As onecompany chairman has explained to me: CSRfor him is about fulfilling both the letter and thespirit of the law. And you don’t have to look farin legislation to find ethical concepts requiringcompanies to, among other things, treat peoplefairly, be honest about their products, and takedue care of the safety of staff.2 Compliance withmany of the most basic CSR standards is there-fore a requirement for companies that wish tobe in full compliance with the law.

*Address for correspondence:Centre for Ethics in PublicPolicy and Corporate Gover-nance, Glasgow CaledonianUniversity, 70 CowcaddensRoad, Glasgow G4 0BA, UK.E-mail: [email protected]

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There are continuing questions about justwhat responsibilities companies have and towhom, but few if any companies reject theidea that they have some corporate socialresponsibilities. As a result more and morecompanies are establishing programmes andpublishing CSR reports. As of early 2006, 73 ofthe UK’s largest 100 listed companies haveissued a public statement indicating the CSRprinciples that they accept (Ethical InvestmentResearch Service, 2006).

Company boards are key participants inensuring companies meet CSR standards. TheUK Companies Act 2006 makes explicit arequirement for board directors to have regard(amongst other matters) to the impact of thecompany’s operations on the community andthe environment and to the desirability of thecompany maintaining a reputation for highstandards of business conduct (s 172). AndBritain’s Combined Code on Corporate Gover-nance recommends that “directors should setthe values and standards of the company andensure that it meets its obligations to share-holders and others” (Financial ReportingCouncil, 2003). More and more boards in theUK seem to be explicitly accepting this role bycreating special board committees on CSR.Half of Britain’s largest 20 listed companiesnow have committees on this topic (or relatedtopics such as “sustainability” or “health,safety and environment”), while none did 20years ago.

But are UK boards taking the necessarysteps to ensure companies comply withaccepted corporate responsibility standards?Are these new board committees concentrat-ing on the governance activities that would bemost effective at achieving compliance? Thispaper draws on the economic literature to offeran analysis of the primary causes of breachesof corporate responsibility standards. Then,using data gathered from a modest empiricalstudy of the board activities of 20 large UKFTSE 100 listed companies, it offers a prelimi-nary indication of whether board CSR commit-tees are addressing these causes effectively.The tentative conclusion is that board activitymight usefully be reoriented to do more toaddress the fundamental incentives problemsthat often cause corporate responsibility fail-ures, namely market failure and misalignedperformance management systems.

Market failure and corporateirresponsibility

I suggest that the most substantial literature onthe causes of corporate irresponsibility is ineconomics, and specifically the economics of

market failure. The business ethics literaturetends not to address explanatory questionsabout the causes of CSR breaches – instead itfocuses on either normative questions (e.g.what responsibilities should companies have)or on descriptive questions (e.g. how manycompanies have adopted formal ethics codes)(Collins, 2000). There is also some practitioner-oriented management literature on this topic(Zadek, 2001), but this tends to describe thecurrent view of “best practice” managementrather than offer an account of causes ofproblems.

The welfare economics literature on theother hand has provided a rich account ofthe conditions under which markets serve thepublic interest and under what conditionsthey fail to do so. The literature on marketfailure provides useful insights about whycompanies act in ways that breach CSR stan-dards. In a sense this branch of economicsdoes for CSR what agency theory does for cor-porate governance (Eisenhardt, 1989). In bothcases, economics provides an account of theincentives facing economic actors, and indi-cates how this might motivate their behaviour.

The basic picture provided by welfare eco-nomics is that, under favourable conditions –where information flows freely, where there isstrong competition, and where costs are“internal” to the market transactions – marketsprovide incentives for profit-seeking compa-nies to act in ways that serve the public interest(Akerlof, 1970; Arrow, 1971; Cornes andSandler, 1986). However, when these condi-tions are absent, these incentives go intoreverse. It is as if as there is an “invisible foot”(Hunt and D’Arge, 1973) to accompany the“invisible hand”, that drives companies toundertake harmful activities even when doingharm is no part of their intention. It is thisincentives problem – rather than malice orwickedness – that leads companies to breachaccepted standards of CSR.

Let me start by providing an example toillustrate this problem. In summer 2005 I helda discussion with a divisional director of alarge UK bank about his division’s apparentnon-compliance with the bank’s CSR policy.The division concerned sells, among otherthings, payment protection insurance (PPI) tocustomers who take out loans from the bank.The market for this product does not operateunder the favourable conditions mentionedabove. Specifically, information does not flowfreely and there is a significant asymmetry ofinformation between providers and custom-ers. The problem is that customers do not inpractice have very good information about theproduct and so are not able to make effectivechoices. There are various reasons for this,

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including the fact that much of the key infor-mation about the product is buried in smallprint. The difficulty customers have in under-standing what they are buying means thatsuppliers can charge high prices (adding asmuch as 40 per cent to the cost of the loan) andimpose restrictive conditions on the insurancepolicy that limit payouts when customersattempt to make claims. This makes PPI veryprofitable for banks (on some estimates itaccounts for 10 per cent of the profits of someUK banks). But it also means that largenumbers of customers buy products that arefar more expensive than they realise, thatcould be bought much more cheaply else-where, and that often fail to meet their needs(Financial Services Authority, 2005b).

In the face of this problem, governmentregulators, public interest pressure groupsand others have called on companies to adhereto standards of corporate responsibility – totreat customers fairly (Financial ServicesAuthority, 2005a). But the enormous rewardsavailable to companies who breach these stan-dards create a strong incentive for them to doso.

I suggest that this example is not an isolatedcase, but an example of a general problemwhere structural problems with markets createincentives for companies to breach corporateresponsibility standards. These incentives pro-blems are not confined to PPI, but have been aregular source of “mis-selling” problems inthe UK financial services marketplace for overa decade (Financial Services Authority, 2004).Nor are they confined to financial servicesmarkets, but to a wide range of markets whereinformation asymmetry problems apply,including, in perhaps the most cited article onthis topic, the market for second-hand cars(Akerlof, 1970).

Nor is asymmetric information the onlymarket failure that gives rise to incentives forcompanies to breach corporate responsibilitystandards. A second kind of market failure isthe absence of competition (Arrow, 1971).When markets are not competitive because ofbarriers to entry, companies will be able to sellpoor value products for high prices. They willnot face the usual incentives to offer goodvalue for the simple reason that their custom-ers cannot go elsewhere. This does not muchmatter if the uncompetitive market is forluxury handbags, but it is crucial if the marketis for, say, AIDS drugs in developing countries.Until recently, the monopoly conferred bypatents enabled pharmaceutical companies tocharge $10,000 for an annual course of anti-retroviral therapies in Mozambique, eventhough generic drugs companies could haveprovided the same course for a few hundred

dollars, had they been allowed to compete(Oxfam, 2001).

Similarly, the third and perhaps most sig-nificant cause of market failure occurs whensome of the costs of a transaction are externalto it (Cornes and Sandler, 1986). When costsare external to companies, markets can createvery damaging incentives. For example,climate change arises because the costs of emit-ting carbon are external to market participants.It is, as Nicholas Stern recently put it “thegreatest example of market failure we haveever seen” (2006, p. 1). Externalities are also atthe root of problems associated with toxicchemical emissions, deforestation, over-fish-ing, the collapse of biodiversity, and somehealth and safety failures.

Common to all these cases of market failureis the problem that in the absence of favourableconditions, markets can create incentives forcompanies to act in ways that are against thepublic interest and, often, in breach of corpo-rate responsibility standards. This, I want tosuggest, is the fundamental cause that boardsmust address if they are to be effective atensuring companies comply with many corpo-rate responsibility standards.

Internal incentives

Though market failure provides an account ofthe fundamental cause of corporate breachesof corporate responsibility standards, thisaccount is incomplete. Welfare economicstends to represent companies as unitary agentsand glosses over their internal structure(Simon, 1991). It seems likely that this internalstructure has a part to play in completing anaccount of how market failure causes breachesof corporate responsibility problems.

Let me return to the Payment ProtectionInsurance example. The board of the companyconcerned had recently issued a corporateresponsibility policy requiring that the compa-ny’s staff should comply with corporateresponsibility standards, including require-ments to be fully transparent about productsand to treat customers fairly. I suggested to thedivisional manager that his division’s market-ing of PPI appeared to breach this policy. Heaccepted that this was probably true, at least insome respects. So I asked him, why was hedoing it? His answer was that while the boardhad issued a new CSR policy prohibitingcertain behaviours, it had also issued him withobjectives and performance targets relating tothe sale of insurance products, including PPI.These performance objectives, he said, werenot consistent with complying with the com-pany’s CSR policy. And given the choice


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between meeting the objectives he had beengiven and complying with a CSR policy, heargued that he should meet the former becausethey specified his role at the company, andwere the basis on which his performance wasappraised and rewarded.

Furthermore, he suggested that the board’sfailure to change his performance objectivesled him to doubt that they meant the CSRpolicy to be taken entirely seriously. After all,he pointed out, PPI is very profitable for thebank and the board needs to avoid disappoint-ing the shareholders. However, he also saidthat if the board were to give him new objec-tives and performance targets that werealigned with the CSR policy, he would be quitehappy to comply. Indeed, he said he wouldprefer this to the current conflicted situationthe board had created for him.

In this example, breaches to corporateresponsibility standards arise not solelybecause of market failures, but because theorganisation’s internal incentives structurerewards rather than penalises managers forexploiting them. There is a substantial litera-ture on this broad topic (see, for example, Fisseand Braithwaite, 1993; and for a recent appliedexample, see US Chemical Safety and HazardInvestigation Board, 2007) which I will notattempt to summarise here. I merely wish tosuggest that if boards are to ensure compliancewith corporate responsibility standards, theyshould address two kinds of incentive prob-lems: those arising from market failure andthose arising from their own incentives or per-formance management systems.

Board responses

From an economics perspective, for boards tobe effective at avoiding breaches of corporateresponsibility standards, they must addressthe fundamental incentives that motivate non-compliance. If we accept the arguments above,this requires them to respond to market failureand adjust the incentives arising from theirperformance management systems.

Boards have limited ability to resolve marketfailures by themselves. The economics litera-ture suggests that market failures require gov-ernment action for their solution, eitherthrough regulation or the use of economicinstruments such as taxes. While there hasbeen some debate about the appropriatebalance between government and market-based solutions and the type of solution to bepreferred (Aslanbergi and Medema, 1998),there is a consensus that some kind of govern-ment activity will be necessary, particularly insituations where large numbers of people areinvolved and transaction costs are high.

If government action is the solution, thenboards may feel that the matter is out of theirhands. This is far from the truth; companiesand their trade associations often play a highlyinfluential role in the development or non-development of regulation (Ayres and Braith-waite, 1992; McRae, 2005). If companies chooseto be obstructive, they can sometimes derail orsubvert regulatory action so that market fail-ures persist or are exacerbated. If, on the otherhand, companies choose to be constructive, itis more likely that effective regulation willresult, reducing or removing the pressures thatlead to breaches of accepted corporate respon-sibility standards. The message for boards isclear: if boards wish to avoid breachingaccepted standards of corporate responsibilityon issues ranging from climate change, accessto medicines in poor countries and financialservices mis-selling, they should seek toensure that their companies play a construc-tive role in the public policy process to encour-age appropriate regulatory solutions formarket failure. In practice this might meanissuing company policies that support regu-lation on key public policy issues; tightlyoverseeing implementation of these policiesthrough the company’s lobbying and govern-ment relations activities; and even reviewinglobbying undertaken on the company’s behalfby its trade associations.

While correcting market failures may ulti-mately be the way to remove the causes ofmany breaches of corporate responsibilitystandards, it is also important for boards toaddress the incentives arising from perfor-mance management systems. In the PPIexample, above, the divisional manager wasexplicit about his willingness to meet CSRstandards if the board adjusted his objectivesand performance incentives accordingly. Thechallenge of aligning incentives is familiar inthe corporate governance literature, because itinvolves the same kinds of considerationrequired to tackle agency problems. Exceptthat here the challenge is not to align manag-ers’ interests with shareholders, but to alignthem with the company’s corporate responsi-bility policies.

So, if boards wish to avoid CSR failures, theyneed to ensure that the company’s perfor-mance management systems are appropriatelydesigned. In practice this might mean takingspecial care to review the objectives and per-formance targets of managers responsible forareas of business exposed to substantialmarket failures, and seeking to develop modi-fied objectives and performance targets.

In some cases this may involve makingawkward trade offs between encouragingCSR and encouraging short-term profit-



maximisation. If PPI is responsible for 10 percent of a bank’s profits, and a significant pro-portion of these profits result from exploiting amarket failure, then shareholders may well bedispleased with the negative earnings conse-quences of a board’s decision to voluntarilyforgo these profits. But responsible companiescannot duck this dilemma, and addressing it isan important aspect of the board’s role andcannot be delegated entirely to management(Carver, 2002).

The conflicts of interest will often, however,be more apparent than real. Frequently thekind of short-term profit-seeking described inthe PPI example will be at the expense of long-term value-drivers such as reputation, cus-tomer satisfaction and good relations with theregulator. Boards that modify the PMS so thatit is more long-term focused may well deliverbetter CSR performance as well as shareholdervalue (Deckop et al., 2006), though this is by nomeans a foregone conclusion.

Board activity in practice

If boards wish to ensure compliance with cor-porate responsibility standards, the economicsliterature suggests that they should focus onaddressing the fundamental incentives prob-lems that cause breaches of these standards. Isthis what they are in fact doing? While there isa growing literature on board effectiveness(Nicholson and Kiel, 2004), this specific aspectdoes not appear to have been addressed in anydetail. So, in order to answer this question theauthor has conducted a modest empiricalsurvey of board practice of 20 of the largest UKlisted companies.3 This survey involved threeroundtable discussions attended by some 30FTSE-100 board directors.4 It also included 20interviews with board directors, company sec-retaries and CSR managers about aspects ofboard practice on corporate responsibility. Iwould have liked to also include observationsat a number of actual company board meetings,but this proved impossible to arrange giventhe sensitivities involved. The roundtable dis-cussions and interviews were held under theauspices of a project initiated by Insight Invest-ment, Business in the Community and FTSEGroup.5 The author has also reviewed the termsof reference for the relevant board committeesof FTSE top 20 companies (where such commit-tees exist),6 as well as the CSR reports andpublished policy documentation.

UK boards are unitary and comprised of amix of executive and non-executive directors(for a comparison of UK vs US boards see Agu-ilera et al. (2006)). Most UK companies del-egate some of their work to a small number of

board subcommittees. The Combined Coderecommends that these should include anaudit committee and a remuneration commit-tee, and should be chaired by, and be largelycomprised of, independent non-executivedirectors. Some companies have also createdadditional committees to address a range oftopics including governance, corporate re-sponsibility, risk and external affairs. Help-fully, the Combined Code recommends thatcompanies publish the terms of reference ofboard committees; and many have done so.This, in addition to my interviews and discus-sions, provides the basis for my assessment ofboard activity.

A review of the terms of reference of boardCSR committees indicates that they tend tofocus on the following activities:

• Reviewing CSR issues. The first objectivespecified in the GlaxoSmithKline (GSK)terms of reference is: “To review GSK’s poli-cies and practices in anticipating and man-aging external issues that have the potentialto seriously impact upon the Company’sbusiness and reputation” (GlaxoSmithKlineplc, 2004). Six out of 11 committees includethis topic in the terms of reference.

• Identifying non-financial risks and monitor-ing risk management. BAT’s committee istasked with this objective: “to identify, inconjunction with management, significantsocial and environmental risk areas and toevaluate management’s handling of suchareas” (British American Tobacco plc, 2003).Five out of 11 committees include this topic.

• Establishing policies and standards. “Thepurpose of the committee is to ensure thatRio Tinto management has in place thepolicies, standards, systems and people re-quired to meet Group social and environ-mental commitments” (Rio Tinto plc, 2004).Ten out of 11 committees include this topic.

• Monitoring compliance with and perfor-mance against companies CSR policies. BP’sEthics and Environment committee “moni-tors the observance of the executive limita-tions relating to non-financial risks to thegroup” (BP plc, 2006). Eight of 11 commit-tees include this topic.

• Reviewing company reporting on CSR.“[K]eep under review the extent and ef-fectiveness of the Company’s externalreporting of CSR performance, and its par-ticipation in relevant external benchmarkingindices” (National Grid plc, 2005). Four outof 11 companies include this.

• Overseeing philanthropic activity. GSK’scommittee is tasked with reviewing “on anannual basis the expenditure and othercommitments by the Group on corporate



donations, product donations, communityprogrammes and charitable support of anykind” (GlaxoSmithKline plc, 2004). Threeout of 11 companies include this topic.

In addition, one committee also reviews thecompany’s adoption of external codes andinclusion in CSR indices (e.g. FTSE4Good);and two companies look at managementimplementation plans and targets.

In summary, these terms of reference docu-ments indicate a focus of board CSR activityon: discussing issues and risks, setting stan-dards, reviewing implementation and disclo-sure, and philanthropy. With two partialexceptions, the terms of reference documentsdo not include an explicit remit relating tomarket failure, the oversight of governmentaffairs activity, or to the design of performancemanagement systems in as far as they relate toquestions of corporate responsibility.

The partial exceptions are Rio Tinto and Uni-lever. Rio Tinto’s terms of reference documentdoes give its committee a remit to review thecompany’s “political involvement” (Rio Tintoplc, 2004). However, its scope is limited toreviewing involvement in party politics andpayments to politicians, rather than oversightof government lobbying activity. Unilever is amore interesting exception. Unlike the other 10companies, its committee does not focus oncorporate responsibility per se but on “ExternalAffairs and Corporate Relations”. While itcovers questions of corporate responsibilityand compliance with the company’s ethicscode, it also reviews “developments” relatingto “government relations” and the “effective-ness” of this function (Unilever plc, 2005).However, the terms of reference do not givethe committee an explicit remit to assess theimplications of government relations activitywith regard to corporate responsibility issues.So it is not clear that even this case is a realexception to the general observation that boardcommittees do not review the implications oflobbying activity or performance incentivesystems for corporate responsibility.

My discussions with several of the boardcommittee members and the company officersthat report to and serve as secretaries to thesecommittees broadly confirmed this observa-tion. These interviews revealed a basic modelof operation: the board committee discusses anissue or a risk. This is often driven by stake-holder concerns or issues emerging in themedia related to the sector. The committeethen considers proposals for managementinitiatives to address the issues concerned.Typically these involve adopting policiesspecifying various voluntary company actionsto seek improved performance on the issue

concerned. Finally, the committee reviews thecompany’s performance against its policies,often as part of an annual CSR reporting cycle.(In many cases, the part of the responsibilityfor reviewing those aspects of corporateresponsibility performance most closely asso-ciated with legal compliance is retained by thecompany’s audit committee).

Perhaps this model oversimplifies things,and masks the variation between companies’committees, but I think it contains the coreelements of UK board CSR committee pro-cesses. And this model is similar in somerespects to the recommendations of the limitedgovernance literature that has addressed thistopic (Bonn and Fisher, 2005; Cadbury, 2002).

The interviews revealed that many of theissues and risks that board committees dis-cuss are those that the economics literaturemight view as arising from market failures.However, board committees do not tend tocharacterise them as such, nor do they tend tosee government action as the obvious solution.One interview emphasised that CSR was aboutvoluntary action by companies, not regulatoryaction. There were a couple of notable excep-tions to this. In two cases examples were givenwhere the board had issued public statementscalling for more government regulation. Inboth cases, these related to climate change andmade clear the company’s acceptance of theneed for government intervention to providemarket mechanisms to reduce carbon emis-sions. But these were exceptions rather thanthe rule.

Similarly, while there was an acceptance(when prompted) that the incentives gener-ated by company performance managementsystems could be a part of the problem, boardCSR committees do not tend to interfere withthese systems, or review the risks they posesystematically. And this is not part of theirterms of reference.

Discussion

The overall picture that emerges from thisempirical work is that board CSR committeesare aware of the symptoms of market failureproblems, but do not seem to have a clear diag-nosis of their underlying economic causes, andso their activities are not targeted at address-ing them, at least not systematically. There istherefore some scope for boards to redirecttheir activities in this area. Before we acceptthis conclusion, there are some objections toconsider.

The first is that the economics literature maynot provide an accurate analysis of the causesof CSR problems. I concede that market failure



is not the whole story here. Some CSR prob-lems, such as gender or racial discriminationin the workplace, do not obviously arise frommarket failure. The racial or gender relatedprejudice of some managers may provide abetter explanation. Similarly, I suspect thatquite a number of CSR breaches arise becauseof management ignorance and incompetence,which suggests economics arguments aboutbounded rationality may provide a usefulsupplement to those from welfare economics(Simon, 1982). However, the argument thatboards should devote systematic attention tomarket failure and related PMS incentiveproblems does not require market failure to bethe only cause of problems, merely a signifi-cant cause. And the examples given aboveseem to indicate that many important CSRproblems arise from the kinds of market-failure-related reasons described above.

Another kind of objection is that while boardCSR committees may not address market failureand PMS incentives problems, boards may doso in other ways. There is probably some truthin this. The board directors I spoke to about thissubject acknowledged that regulatory issueswere discussed by the full board from time totime. This is no surprise: where companiesoperate in situations of significant marketfailure, it is highly likely that boards will con-sider their attitude to regulation for the simplereason that in such situations the market failureis likely to raise important strategic dilemmas.However, a board discussion of market failureand regulation from a strategic perspective isnot the same as a board discussion of the topicfrom a CSR perspective. After all, the centralpoint of the economics arguments aboutmarket failure is that exploiting market failureis a strategic opportunity for business. So a boarddiscussion motivated solely by strategic consid-erations may very well lead a company toexploit market failures and resist regulatoryinterventions, rather than to exercise self-restraint. Given the strong dysfunctional incen-tives that market failures can create forbusinesses, a special board discussion focusedon their implications for CSR would seem to benecessary, undertaken in full awareness of thepotential conflicts of interest, with short-termprofit maximisation considerations placedfirmly to one side. Whether this should takeplace at the CSR committee or at a main boardmeeting is a secondary consideration.

Having said this, as my interviews withcompany management indicated, the oneimportant exception here seems to be climatechange, where several constructive publicpolicy positions have emerged from severalcompanies (including BP and Rio Tinto) inrecent years. However, this kind of activity

appears to be the exception rather than therule. Given the prominence of climate changein the public policy arena, and the growingfears of its devastating long-term effects, thepressure for boards of high-emission compa-nies to consider it has been substantial. Formore routine kinds of market failure, thesepressures are more attenuated.

There is also a case for saying that incentivesproblems associated with the PMS may beaddressed elsewhere by boards. After all, oneof the basic jobs of boards is to consider theobjectives and performance incentives for theexecutive directors. And all UK boards haveremuneration committees that consider thelatter in great detail. However, boards prima-rily consider these incentive structures with aview to encouraging value creation for share-holders, rather than discouraging breaches ofcorporate responsibility standards. But someboards have been starting to take a wider viewof the issues. In some cases there has been anexplicit attempt to balance financial incentiveswith incentives to support responsible behav-iour. As one board director told me, “Morebalanced incentives reduce conflicts and enablebetter focus on what creates long-term value.”7

For example, several oil and mining companieshave introduced occupational health and safetytargets into executive incentives (HendersonGlobal Investors/USS, 2005) to balance finan-cial targets. Other companies have adopted amore systematic balanced scorecard approach(Kaplan and Norton, 1996) to executive remu-neration, which as one director told me, hassignificantly shifted focus away from short-term financial goals to long-term value creation,which he argued made more space for CSR.

So some progress on this topic is beingmade. However, many of the board directors Ihave spoken to confirmed that their executivecompensation system was based exclusivelyon financial metrics. One board director Italked to rejected the idea that incentivessystems should be tampered with for CSR pur-poses. As he put it, “Conflicts of interestshould be managed by good executive direc-tors. It is up to [the] board to appoint peoplewho have the leadership and skills and integ-rity to manage those conflicts.”8 And eventhose who include some reference to CSRfactors in the design of incentives tend to takethe view that they play a minor role. Moreover,very few boards seem to systematically reviewthe risks associated with their PMS muchbelow the level of the board. (The divisionalmanager I referred to in my example aboveoperated one level below the board). Giventhat the risks often arise at this level, thiswould seem to be a missed opportunity forboards.



Conclusion

There is some mismatch between what boardsare currently doing to avoid non-compliancewith CSR standards and what the economicsliterature implies they should be doing inorder to be effective in this respect. This con-clusion draws on a study of the very largestUK companies. It seems reasonable to supposethat if these boards are not addressing marketfailure systematically, then few boards ofsmaller companies will be doing so.

I am not suggesting that boards are entirelyignoring regulatory solutions to market failureand incentives problems associated with theirPMS. But their approach to CSR does not seemto include a sufficiently theoretically informeddiagnosis of the fundamental causes of CSRbreaches, nor does it appear to employ anunderstanding of the fundamental conflicts ofinterest and incentive problems in the choiceof solutions, at least not systematically.

If this is accurate then there would appear tobe opportunities for boards to reorientate theiractivities in order to more effectively avoidbreaches of accepted CSR standards. Specify-ing these alternative actions in more detail is atask for another paper (see Mackenzie andHodgson (2006) for a schematic attempt at thislarge project). However, to sketch an outline:my argument suggests that boards should con-structively address market failure by establish-ing board policies supporting governmentaction on relevant issues; they should overseeimplementation of these policies by the com-pany’s lobbying and government relationsdepartments; and perhaps also keep a checkon the lobbying activities of any relevant tradeassociations in which the company partici-pates. They should also address PMS incen-tives problems by reviewing the risks createdby the performance management system inthose areas of the business where marketfailure is a problem, and by seeking to developmodified objectives and performance targetsto mitigate these risks.

One persistent feature of debates about CSRis a deep scepticism about the intentions ofcompanies. There is a recurrent suggestion(e.g. Bakan, 2004) that CSR activity is justwindow-dressing aimed at distracting atten-tion from the real problems. Most of the boarddirectors I have spoken to reject this criticism.They claim to be sincere in their desire toensure that their companies behave responsi-bly in addressing the major social and environ-mental impacts associated with their businessactivities. I suggest that scepticism about CSRinitiatives arises in part because of a percep-tion that the actions companies take on CSRare superficial and not well suited to dealing

with the deep-seated causal factors that drivebreaches of corporate responsibility standards.If these fundamental causes arise from thekind of incentives problems described above,then this perception may be accurate. Bychanging the emphasis of board activity in theway recommended by this paper, directorsmay be better placed to meet their CSR objec-tives and restore trust in their sincerity.

Notes

1. See, for example, the discussion by Mackenzie(2006) and Aguilera et al. (2006) on investors; seewww.csr.gov.uk for the UK government’s enthu-siasm for CSR.

2. See for example Financial Services Authority(2005a), the 1975 Sex Discrimination Act and the1973 Health and Safety at Work Act.

3. The companies included Boots Group plc, BPplc, British Land Company plc, BAT plc, BTGroup plc, Centrica plc, EMI Group plc, GSKplc, GUS plc, HBOS plc, Holidaybreak plc, HSBCHoldings plc, Kingfisher plc, National Grid plc,Next plc, O2 plc, Rio Tinto plc, Shell Transportand Trading Co plc, Shire PharmaceuticalsGroup plc, Unilever plc, Vodafone Group plc.

4. I am grateful to Sir Derek Higgs, Chairman ofAlliance and Leicester plc; Lord Stevenson ofCodenham, Chairman of HBOS plc; and MarkMakepeace, CEO of FTSE Group for chairing theseries of board director roundtable discussions

5. Additional output from these discussions can befound in Mackenzie and Hodgson (2006) (www-.bitc.org.uk). This report was published withsupport from Insight Investment, Business in theCommunity and FTSE Group.

6. Anglo American plc, BG Group plc, BP plc, BHPBilliton plc, British American Tobacco plc, GSKplc, HSBC Holdings plc, National Grid plc, RioTinto plc, Shell plc, Unilver plc.

7. This quote is from a FTSE 100 board directorattending a roundtable discussion hosted jointlyby Insight Investment, Business in the Commu-nity and FTSE Group. These discussions wereheld under the “Chatham House Rule” allowingcontributions at the meeting to be quoted but notattributed to the individual concerned.

8. This quote is from a FTSE 100 board directorattending a roundtable discussion (see note 5above).

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Craig Mackenzie is Director of the Centre forEthics in Public Policy and Corporate Gover-nance at Glasgow Caledonian University.Between 1997 and 2006 he directed the cor-porate governance and socially responsibleinvestment functions at Insight Investmentand Friends Provident. His research interestsinclude responsible investment, corporatesocial responsibility and business action onclimate change.



http://www.fsa.gov.uk/pubs/other/ppi_thematic_report.pdf

http://www.fsa.gov.uk/pubs/other/ppi_thematic_report.pdf

Documents

Boards, Incentives, and CSR