Read time: 5 mins
Agency Theory and Corporate Sustainability
Agency theory is used to understand roles and relationships, including accountability, in business contexts. Specifically, it defines managers and directors of a company as agents to the owners or shareholders. In this video, Todd Cort, Program Convenor in the Corporate Sustainability Management: Risk, Profit, and Purpose online program from the Yale School of Management Executive Education, discusses how this theory identifies a vacuum of accountability in corporate settings.
Agency theory has large implications for the sustainability challenges facing organizations today. Leaders who understand this theory can support the implementation of an effective sustainability strategy; one that addresses all levels of hierarchy and recognizes corporate responsibility.
Transcript
Agency theory points to the idea that the managers and the directors of the company are agents to the owners of the company or the shareholders. Agency theory has also been called shareholder primacy: the idea that shareholders are really the ones that need to be listened to whenever the directors or the management of the company are making a decision.
Agency theory also has implications both on the company and on society. One of the biggest challenges that have arisen because of agency theory is a vacuum of accountability. Agency theory says that the owners or shareholders are responsible for the actions of the company, and yet the owners and shareholders do not manage the company. That’s done by the management and the directors.
And therefore we have a difference between who is responsible for the impacts and implications of the company. And this creates that vacuum of accountability, where a company can create negative impacts on the environment and society, but there is no one within the company that is responsible for those impacts.
The second challenge from agency theory has been the externalization of environmental and social aspects. If we consider that shareholders, as owners, are the only ones responsible for the direction of the company, then that implies that we need to externalize all costs in the interest of maximizing profit and revenue for the company. That means that if I can put costs up for the environmental impact and degradation onto someone else other than the company, that is good for the owner or the shareholder, because we’re assuming that that owner is only interested in short-term profitability.
Well that has implications where that cost goes. That cost is then externalized to the environment. It is externalized to communities. And this is true across a lot of sustainability issues where we assume shareholders are interested in short-term profit maximization. Then those externalities are, by definition, pushed out of the company onto other people around the company. And you can see in the world of sustainability that becomes a huge challenge for how we convince a company that it needs to take responsibility and take action for these sustainable issues.
The third potential challenge, with agency theory, is that it can have an effect of exacerbating inequality. If a company is meant to bring resources in, convert those resources or capitals into financial capital, and return them to a small group of shareholders, then we are essentially concentrating capital into the hands of a few. And that can be the definition of exacerbating inequality.
Exacerbating inequality can have impacts on the company itself. It can slow growth down, it can make it more difficult to recruit and retain strong talent, and a variety of other impacts. So by exacerbating inequality, by concentrating financial capital, we might actually be dragging the business down.
Shareholder expectations are changing as they understand the impacts, the risks, and the opportunities from sustainability.
Legal precedent is supporting the relationship between shareholders and managers, not as agents, but as fiduciaries of one to the other.
The result is that sustainability is not only considered to be important around companies, but we’re starting to see how it is part of fiduciary responsibility itself. The appropriate and the responsible fiduciary today almost has to consider sustainability aspects. If you don’t consider these material risks of environment and social aspects, in the way that you are managing your company, then you could be violating your fiduciary duty. You could be violating your responsibility to shareholders to act with independent judgment on their behalf as beneficiaries.