Home » Issue Three »Research »Volume Three » Currently Reading:

Behavioral Economics and Corporate Sustainability

April 23, 2012 Issue Three, Research, Volume Three No Comments

By John Byrd, PhD and Kent Hickman, PhD

The likelihood of meaningful legislation supporting a shift towards more sustainable practices by business and individuals seems miniscule. Without government policies or incentives the move to sustainability depends largely on the voluntary actions of companies. Companies choose the types of products they produce–the materials they are made of, their recyclability, their energy consumption, their durability–and how the products are manufactured–production efficiency, working conditions and so on. In theory individuals, through their consumption choices, can send a message to companies about the types of products they want. But if the range of choices doesn’t include price competitive green alternatives this message never gets back to corporate decision makers.

Some companies include sustainability in their strategic planning, but the adoption rates appear well below those required to address the most urgent problems related to climate change, biodiversity loss, fisheries depletion and water availability. Abrupt changes in climate and increasingly expensive raw materials and energy threaten the ability of companies to continue to create value for stakeholders. So, why aren’t companies doing more?

We think that behavioral economics provides some insight into this lack of corporate initiative toward sustainability, and also offers some suggestions on how to overcome these impediments. Behavioral economics enriches the neoclassical economic model of rational profit maximization by recognizing that social and psychological factors play a role in decision making. This evolving discipline has uncovered systematic differences between the results predicted by models based on rational agents and what people actually do. This more nuanced view of decision making can be a valuable tool to help managers and policy makers shift organizations and individuals toward sustainability.

Heuristics: People use ‘rules of thumb’ to sort through complex problems. For the most part this is an efficient and effective approach to making decisions. Over time, the rules of thumb, or heuristics, evolve to be efficient and become embedded into the Standard Operating Procedures of organizations, such as simple rules about when to offer a new customer credit.

Some researchers argue that the use of heuristics leads to better decisions than those based on extensive data collection and formal modeling. Dr. Gerd Gigerenzer, the director of the Max Planck Institute for Human Development in Berlin, claims that relying on intuition produces quicker and better decisions because too much information prevents decision makers from focusing on the most important aspects of a problem (1). This is similar to the ‘thin-slicing’ approach to decision making made popular by Malcolm Gladwell in his book Blink (2). There he has a chapter titled, “The Theory of Thin Slices: How a Little Bit of Knowledge Goes a Long Way.” But he admits that gut-feelings can lead to poor decisions as well as good ones. In his book he discusses the Warren Harding effect, in which a tall, handsome man is elected President mainly because people intuited that his good looks implied good leadership. This bias persists, as Gladwell documents, with Fortune 500 CEOs being on average nearly 3 inches taller than average American men. Moreover, Gladwell says the greatest likelihood for thin-slicing errors is found among overconfident decision makers, a trait well documented among CEOs.

Heuristics, rules of thumb, and thin slicing work because people have acquired some expertise in recognizing patterns or traits within the decision framework. However, if the external environment changes–resources become scarcer, legislation about climate change occurs, consumers become concerned about the long-term impact of products, the life-cycle impact of a product begins to matter–then existing rules of thumb may not be appropriate. In fact, relying on old rules will almost guarantee that companies are not prepared for shifts to new ways of thinking.

Framing: The behavioral economics literature argues that the outcome of the decision process depends on how a decision is framed or articulated. Much of the conversation about sustainability centers on what companies should do and the extra costs they should bear. Framing sustainability as a cost center creates a natural aversion to examining sustainability initiatives carefully. Decision makers know that there are costs involved.  Therefore, it is easier for them to defer analysis than to promote a costly solution to the problem. Examples of companies that have begun to embrace sustainability show that they have changed the framing of their initiatives. General Electric’s “eco-imagination” was created as a revenue center. Wal-Mart embraces sustainability, and avoids framing their action as costly to the firm by pushing these costs onto its supply chain. Framing can also impact the acceptance of sustainable products, helping to create market driven demand for progress. For example, studies of consumer behavior have found that green products sell better when advertising focuses on the product’s benefits to individuals rather than their benefits for the overall environment (3).

Status Quo Bias and Groupthink: Behavioral economists have found that decision makers exhibit a bias toward established regimes or ways of doing things. Significant or disruptive change only occurs if there are strong reasons to change. Reinforcing this bias is the structure of corporate boards and management teams. Corporate directors and high-level executives tend to have very similar backgrounds and worldviews (c.f., 4 5). For example, Chhaochharia and Grinstein (6) show that the vast majority–well over 60 percent–of directors of US companies are employed in industry. If those categorized as being in financial fields or retired are added to this group the proportion approaches 80 percent. O’Hagan and M. Rice (7), looking at companies in the northeastern US, find that high-level managers have a long personal history in the region, which may limit their ability to respond or adapt to new circumstances. This can lead to a ‘groupthink’ mentality in which there is a reluctance to pursue alternatives, especially alternatives that vary from the established perspective. Robert Shiller, an economist at Yale, explained how groupthink played a role in the US housing crisis that contributed to the current recession (8).

Groupthink is related to herd behavior. Herd behavior is common in business and has implications for the adoption of sustainability activities. In essence, people can hide in herds. If a decision is similar to those made in other companies (i.e., acting like the herd) then poor decisions are justified as conforming to what everyone else was doing. An unusual initiative (i.e., different than the herd) that fails risks being blamed on an individual’s incompetence leading to potentially serious repercussions. The herd mentality is strong. In 1997 John Browne, then Group CEO of British Petroleum, gave a speech at Stanford University acknowledging the potential seriousness of climate change. BP was the first major corporation, other than reinsurance companies, to take a position on reducing greenhouse gas emissions. This anti-herd behavior was so surprising, especially from an oil company, that his speech has been hailed as ‘groundbreaking,’ and became the subject of several academic articles (c.f., 9, 10, 11).

Loss aversion: The concept of risk aversion that underlies much of economics says that people assign a larger value to a loss than they assign a benefit of an equivalent size. This lop-sided valuation effect produces the risk aversion that explains the existence of the insurance industry. Conversely, behavioral economists have found that risk aversion is largely limited to uncertainty at a given level of positive wealth changes, and in cases of negative wealth changes, individuals may systematically turn to risk-seeking behavior (12). Thus, if environmentalists pose a picture of dire hopelessness, the average citizen and consumer may opt for increased consumption with less attention to its environmental consequence. The effect is aptly portrayed in the well-known Gary Larson cartoon depicting two fishermen in a boat with a mushroom cloud in the background…one fisherman says to the other, “I’ll tell you what this means, Norm.  No size restrictions and screw the limit!”

How To Overcome Behavior Impediments

We have argued that several aspects of behavioral economics create impediments for companies to become more sustainable. The shift to sustainability asks companies to think and operate differently, but psychological and organizational bias slow this process.  What can employees, shareholders and consumers do to overcome these impediments?

Within The Firm

Employees and sustainability advocates need to frame sustainable initiatives in both a positive and a personal light. Avoid doomsday forecasts as the motivation for action. An advocate can make the business case for sustainable initiative by explaining why they are profitable opportunities or will reduce risk. Value is created by increasing revenue and/or by reducing risk. By enabling the firm or organization to avoid shocks that negatively affect its cost structure or the integrity and authenticity of its brand name, sustainability helps create durable and profitable organizations. Moreover, individual motivation is likely greatest when benefits are seen as having a personal impact. It is critical, therefore, to link benefits first to the individual and family, next to the firm or organization, and finally to society and the environment in general.

Employees and sustainability advocates need to learn the skills of being effective change agents. An employee who wants to implement green changes in an organization needs a well-stocked toolkit. First, they need to be knowledgeable about the particular sustainability issues they want to advocate.  This could be technical knowledge about a process, product or material that can be improved, or more general information about broader programs like re-cycling or flexible scheduling. They also need to develop communication skills so they can quickly and clearly explain the benefits of adopting the changes. They need to be politically aware of how changes occur in their company, and generous about sharing credit. Finally, they need to be willing to persevere: change rarely happens on the first try.

Outside The Firm

Shareholders have a role to play in moving companies toward more sustainable practices.  They can use their proxy power to elect a more diverse board. The first step might be to raise the issue of more diversity among director nominees. Groups such as Catalyst.org actively push for board diversity, so following that group’s activities would be a good starting place for modeling diversity advocacy. The SEC (US Securities and Exchange Commission) has been modifying rules regarding director nominations (13).  The new rules allow investors or groups of shareholders who have owned three percent of a company for at least three years to include a director candidate(s) on proxy statements for shareholder vote. The ownership threshold is substantial, but it is a first step toward more shareholder democracy.

A second route that shareholders have to changing companies is through shareholder proposals. The ownership threshold to submit a proposal is about $2,000 (or alternatively 1% of the company’s stock) held for at least a year. Proposals that satisfy the SEC’s requirements are included in company proxy statements and voted on at annual meetings.  These proposals make it very clear to directors what shareholders are concerned about.  While votes on shareholder proposals are non-binding (the board can ignore even a majority vote) they do have an effect. Byrd and Cooperman (14) found that in response to shareholder proposals about climate change reporting, about 20 percent of the companies took action despite the non-binding nature of the vote. Often, companies facing a shareholder proposal negotiate with the initiator to find an acceptable solution and have the proposal withdrawn. Byrd and Cooperman also found that over 50 percent of withdrawn proposals resulted in the companies taking action regarding the proposal topic within two years.

Just as internal change agents need to make the business case for sustainability, shareholder proposals must show how the company benefits from making the proposed change. Shareholders must also be willing to negotiate and withdraw a potentially embarrassing proposal, if it helps a company become more sustainable.

Conclusion

Behavioral economics offers important insights into why companies may be reluctant to embrace sustainability. Advocates for corporate sustainability, both within and outside of the corporation, may be more successful if they recognize the behavioral bias decision makers have, and recast their efforts to reduce the effect of those behavioral habits.

References

1. Worstall, T. (2011, December 26) Why Rules of Thumb, Intuition, Gut Feelings, Work in Business Decisions. Forbes. Retrieved March 27, 2012 from http://www.forbes.com/sites/timworstall/2011/12/26/why-rules-of-thumb-intuition-gut-feelings-work-in-business-decisions/

2. Gladwell, M. (2005). Blink: the power of thinking without thinking. Boston: Little, Brown, 2005.

3. Okada, E. & Mais E. (2010) Framing the “Green” alternative for environmentally conscious consumers. Sustainability Accounting, Management & Policy Journal, Vol. 1 (2), 222 – 234.

4. Davis, G., Yoo M. & Baker W. (2003) The Small World of the American Corporate Elite, 1982-2001. Strategic Organization, Vol. 1 (3), 301-326.

5. Nguyen, B. (forthcoming) Does the Rolodex Matter? Corporate Elite’s Small World & the Effectiveness of Boards of Directors, Management Science.

6. Chhaochharia, V., & Grinstein Y. (2007) The Changing Structure of US Corporate Boards: 1997-2003. Corporate Governance: An International Review, Vol. 15, (6), 1215-1223.

7. O’Hagan, S., & Rice, M. (forthcoming) The Geography of Corporate Directors: Personal Backgrounds, Firm & Regional Success, The Professional Geographer. DOI:10.1080/00330124.2011.614567

8. Shiller, R. (2008, November 2) Economic View: Challenging the Crowd in Whispers, Not Shouts. The New York Times,  (Page BU5).

9. Lowe, E., & Harris, R. (1998) Taking Climate Change Seriously: British Petroleum’s Business Strategy. Corporate Environmental Strategy, Vol. 5 (2), 22-31.

10. Rowlands, I. (2000) Beauty & the beast? BP’s & Exxon’s positions on global climate change. Environment & Planning C: Government & Policy, Vol. 18 (3), 339 – 354.

11. van den Hove, S., Le Menestrel M. & de Bettignies, H.-C. (2011) The oil industry & climate change: strategies & ethical dilemmas. Climate Policy, Vol. 2, (1), 3-18.

12. Kahneman, D., & Tversky, A. (1979) Prospect Theory: An Analysis of Decision under Risk. Econometrica, Vol. 47 (2), 263-291.

13. US SEC (2011, Septemebr 15) Facilitating Shareholder Director Nominations. 17 CFR PARTS 200, 232, 240 & 249 [Release Nos. 33-9259; 34-65343; IC-29788; File No. S7-10-09]

14. Byrd, J., & Cooperman B. (2011) Do Shareholder Proposals Affect Corporate Climate Change Reporting and Policies? University of Colorado Denver working paper.

Contributor Biographies

John Byrd is Senior Instructor in the Finance and Managing for Sustainability MBA programs
at the University of Colorado at Denver.  He has been involved in population, environmental
and sustainability issues since attending the UN Conference on Population and Development
in Cairo, Egypt, in 1994.  His teaches courses in corporate governance and business and climate change.
He is on the board of The dZi Foundation, which does development work in rural Nepal. With his family,
he lives in Durango, Colorado.

Kent Hickman is Professor of Finance at Gonzaga University, where he initiated the school’s first course in sustainable business.   Dr Hickman has published in the area of behavioral economics in Journal of Economic Behavior an Organization.  He and Dr. Byrd have co=authored a textbook in Corporate Finance, and they team-teach sustainable business courses at the Rouen Business School, in Rouen, France.

Comment on this Article: