Diversity delivers dividends

This new state of affairs was captured dramatically in a statement last year by America’s most powerful business lobby, the Business Roundtable.

"Why is Friedman sacrosanct? Yes, he was a Nobel Prize winning economist. But that doesn’t make him infallible.”

The “statement on the Purpose of a Corporation” was signed by 181 CEOs who “commit to lead their companies for the benefit of all stakeholders - customers, employees, suppliers, communities and shareholders”.

Predictably, this was met with counter-arguments that “fuzzy” concepts such as purpose, or indeed environmental, social and governance (ESG) issues, had no place in business strategy.

Infallible

Inevitably, the Chicago School economist Milton Friedman gets wheeled out to justify a view business should have a very narrow interest and that interest should be returns to shareholders. That is, don’t talk about climate change, diversity, equality or any “social” issue.

That line of argument is flimsy. For a start, why is Friedman sacrosanct? Yes, he was a Nobel Prize winning economist. But that doesn’t make him infallible - indeed taking his arguments as dogma would have been anathema to Friedman. The always readable but never dogmatic Anatole Kaletsky of Gavekal has presented this argument at length, for example in Goodbye, homo economicus.

Friedman, like Freud, like Darwin, like indeed Adam “the invisible hand” Smith or Milton “trickle down” Keynes, was a man of his times. Our understanding of the world has grown since their times - indeed because we have been able to stand on their shoulders.

But actually, what did Friedman say? Would he have scoffed at purpose?

Cause and effect

Friedman of course wasn’t simplistic. He did say “there is one and only one social responsibility of business - to use its resources and engage in activities designed to increase its profits”. But he added “so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud”.

Critically, it is the “rules” of the game which are complex and, long term, are built social licence as well as black-letter regulation. Moreover, when Friedman says “increase its profits” he is talking about long term profits. He would be aghast at the idea of a company which milked short term opportunities, pillaged a common resource - such as the environment - failed to respect all its employees and customers and delivered a profit spike only to later fail.

“Open and free competition” means a company must explicitly pay for its inputs - be they natural resources or labour - otherwise it is not engaging in “open and free” competition with companies that do.

With International Women’s Day approaching, take diversity as an example of one debate around what is truly the realm of business. Companies embrace diversity because it is right. But does it also help shareholders?

There is increasingly more evidence it does, on multiple fronts. It pays - in matching customer bases, winning talent, being alert to risk. There is also a growing body of empirical data.

Top-quartile

One of the seminal pieces of research was undertaken by McKinsey & Company in 2014. Diversity Matters argued not only was the moral case for workforce diversity clear but so too was the business case.

“Top-quartile companies for racial and ethnic diversity were 35 per cent more likely to have financial returns above their national industry medians,” McKinsey reported while companies in the top quartile for gender diversity were 15 percent.

“Bottom-quartile companies were less likely than average ones to achieve high financial returns,” the consultancy found.

“The unequal performance of companies in the same industry and country suggests that gender, racial, and ethnic diversity are competitive differentiators: more diverse companies lure better talent and improve their decision making, customer orientation, and employee satisfaction.

“Diversity in background, age, sexual orientation, and work experience also probably confer some level of competitive advantage.”

McKinsey, and many other credible research bodies, have since looked at this in more detail.

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In 2018, a study, Delivering through diversity, reaffirmed the global relevance of the link between diversity, which McKinsey defined as a greater proportion of women and a more mixed ethnic and cultural composition in the leadership of large companies, and company financial outperformance.

Ergo, if you’re interested in profits you can’t ignore diversity.

Multi-coloured swans

While faint justification, some may make the argument that this is just a matter for shareholders and if a company fails or underperforms, the market will adjudicate.

But this ignores the negative externalities of failure - a negative externality being something that is paid for by others. In the case of climate change, for example, while emission intensive industries may garner returns, the damage to the climate is paid for by society - and taxpayers in particular.

The global bank regulator, the Bank of International Settlements (BIS), came up with the catchy phrase “green swan” to describe this impact. A “black swan” event is one which was never expected - until it happened. Until Australia was discovered, all swans were white.

But the BIS argues we should not be surprised by a “green swan”.

“Traditional backward-looking risk assessments and existing climate-economic models cannot anticipate accurately enough the form that climate-related risks will take,” the BIS said in its report The Green Swan: Central banking and financial stability in the age of climate change.

“These include what we call ‘green swan’ risks: potentially extremely financially disruptive events that could be behind the next systemic financial crisis. Central banks have a role to play in avoiding such an outcome, including by seeking to improve their understanding of climate-related risks through the development of forward-looking scenario-based analysis.”

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But, the BIS added, it is not the role of central banks to pay for this. There is a role for the BIS but, even more importantly, for policy makers to establish an environment where the risk to taxpayers is diminished.

Failure on that front leads to market failure, the so-called “free rider” problem where a company which doesn’t adhere to beneficial market practices - be they environmental or proper payment of staff - actually gain an unfair advantage.

In practice, this means establishing regulation where those companies responsible must pay for the externalities - along the lines of how mining companies are responsible for rehabilitating mine sites after mining finishes.

At the corporate level, good governance is essential - and in a neat completion of the loop there is also growing evidence more diverse boards are more alert to operational risk and measure up better on governance all round.

Andrew Cornell is Managing Editor of bluenotes