CSR may not be a game-changer

Updated: May 10 2014, 09:33am hrs
Discharging corporate social responsibility (CSR) is now mandatory in India. According to Section 135 of the Companies Act, 2013, every registered company, above a minimum size, has to spend at least 2% of its net profit on CSR activities every year. The provisions of Section 135, which came into effect from April 1, 2014, are seen by many as corporate sectors contribution towards the development of the nation.

However, there is considerable debate regarding whether companies should be mandated to discharge CSR. Proponents of mandatory CSR argue that companies that use national resources and infrastructure facilities provided by the government have a responsibility that extends to the society at large, beyond those of the companys immediate shareholders and stakeholders. This idea is encapsulated in the triple-bottom-line approach that emphasises a company should balance economic, social and environmental objectives (ESG) while addressing the expectations of its shareholders and stakeholders. Many believe that investors use the ESG framework to evaluate corporate behaviour and to determine the future performance of companies.

Others are, however, cautious on the issue of mandated CSR. Many believe that stakeholder value maximisation, which forms the basis of CSR activities, is inconsistent with efficient operation of a company. The multiple objectives that the stakeholder theory envisages distort managerial incentives as it is not clear what the manager should maximise. What will be the weights on the different objectives of the different types of stakeholders and who will determine them There is also the possibility that managers may strategically use stakeholders value maximisation as a pretext for making personal gains. A very strong form of this view is reflected in the Friedman doctrine that the only objective of the corporation is to maximise profit and any social responsibility beyond this should be deemed as corporate social irresponsibility.

In addition, there is also the concern that mandated CSR may impose disproportionate cost on smaller and younger companies for whom net profit (or internal sources of capital) forms an important source of funds for investments. Forcing such companies to make mandatory CSR expenditure increases the opportunity cost of funds as existing research has shown that smaller and younger companies are the predominant drivers of long-run growth of nations. Thus, many believe that economic efficiency dictates CSR spending should be made voluntary and companies would undertake it if the perceived benefits at the margin outweigh the opportunity cost. It is in this spirit that most countries have avoided mandating CSR spending, and have instead chosen to influence CSR activity through mandatory reporting, leaving the spending decision to the discretion of the company and perception of the market forces.

Keeping the foregoing arguments in the background, how does Section 135 measure up both in terms of conception and in terms of implementation A systematic evaluation of the arguments both in favour and against mandated CSR indicates the rules provided under Section 135 are conceptually strong and well laid out.

First, the current CSR rules do not distort economic objectives. Under the rules, CSR expenditure is an appropriation from profit and avoids the relevant issue of multiple objectives inherent in the stakeholder theory. Companies still have shareholder value maximisation as a single objective from which, ex post, 2% of the net profits are to be appropriated towards CSR activities. Second, the amount of 2% of PAT is not a huge demand on corporate resources. For example, a company with annual sales of R1,000 crore and a 10% rate of profit has to spend R2 crore per annum, which is not a very large amount. Third, the CSR rules adopt a comply or explain approach and thus leave room for companies to assess the opportunity cost of CSR. Smaller companies for which opportunity cost of internal capital is likely to be high are exempt from CSR. Further, a company which determines that CSR spending of 2% may not be in its best interest may not spend or spend less than the required amount, provided its explanation is acceptable by the regulator. Finally, mandated spending with justifications for exceptions may generate more CSR spending by companies than voluntary spending with mandated reporting due to pressure of social norms.

Notwithstanding these arguments, most people would like to consider the mandated CSR provisions under Section 135 as an implicit tax on the companies. However, there is one key difference, namely the CSR provisions work like a centralised tax with decentralised utilisation. Under explicit taxation, there is no guarantee that the money collected by the government will be spent on CSR and not appropriated for other uses. The implicit tax gives companies control over the disbursement of their own funds with greater incentives to choose the right projects that have synergies with their lines of operation (which the rules allow for), and greater incentives to monitor its efficient utilisation. The likely result is better project delivery and reduced funds that are the main challenges of large-scale government welfare schemes.

However, there are some issues and concerns that will come up during the implementation of the new CSR provisions that need to be addressed by having appropriate mechanisms in place. First, one should be concerned about whether too much resources will be generated under the new CSR rules leading to challenges for companies to identify appropriate projects on a sustained basis. It is important to realise that companies need to pump in 2% of their net profits every year. This, in turn, could put a strain on the companys management to search for, select and implement additional projects and monitor its ongoing CSR activities, all of which will cumulatively build up over time both in terms of scale and scope. A quick analysis of all the BSE-listed companies can help one to get a perspective of the problem as the accompanying table shows.

According to the analysis, had the present CSR criterion been applied to listed companies in 2012, an estimated amount of R8,343.9 crore would have been spent on CSR activities by these companies based on their net profit figures for FY2012. Moving the figure to FY2015 and taking into account that the CSR rules apply to unlisted companies too, the amount could be well around R10,000 crore per year. Other estimates appearing in the press put the total annual CSR spending to around $3 billion. In terms of our data analysis, the CSR spending by the median firm managing a turnover of R33 crore is about R55 lakh per year, and CSR projects worth this value would have to be identified annually and followed through. For large companies, the issue of identifying appropriate projects on a sustained basis could be even more challenging. Companies like Reliance and ONGC would have to spend upwards of R400 crore every year towards CSR. Spending such large amounts may require large companies to have dedicated centres that identify, implement and monitor large-scale projects or a large number of smaller projects. This would entail additional costs for a company that need to be factored in evaluating the benefits from CSR. The rules foresee this to some extent and allow companies to carry out their CSR activities through registered trusts set up by the companies or outside trusts with good track records, but the activities of these trusts would in turn be challenging and may need effective monitoring.

Second, there is the issue of coordination of CSR projects across companies in a particular region to prevent the duplication of and overinvestment in similar types of CSR projects. This is particularly true as the CSR rules recommend that companies give preference to local areas in their CSR spending. An analysis of the distribution of CSR activities by large listed companies for 2011 show that typically companies engage in not more than three types of activities, and in activities largely related to education, health and sanitation, women empowerment and provision of material and financial aid. In instances where large investments are necessary such as in hospitals and schools, smaller companies may be better off by pooling their CSR resources as it may help them to collectively undertake such projects. To achieve better coordination across companies in a particular region, formal partnerships or consortiums can be set up.

Third, an unintended consequence of mandated annual CSR expenditure could be the cumulative build-up of social welfare programmes in and around geographical regions where larger and better performing corporates are concentrated. High levels of CSR spending by such companies can benefit certain regions/states disproportionately more while other localities with sparse corporate sector activity can fall further behind, leading to regional inequality. Avoiding such unintended consequences at the macro-level would necessitate the setting up of an coordinating agency at the central or at least at the state level, to see that CSR spending of companies are harmonised for the betterment of all.

In conclusion, the current CSR provisions are not a case of government abrogating its responsibility to the private sector. The estimated annual amount of CSR spending by corporates, judged in context of total social sector spending by the government, is just around 1%, based on a rough estimate. In that sense, the current CSR provisions may not be a game-changer. Yet the decentralised spending by companies may promote efficiency in project choice and implementation without the CSR rules coming into serious conflicts with the primary objective of shareholder value maximisation. Social and economic incentives seem to have been well-balanced in the new CSR rules and one can hope that the corporate sector will lend a helping hand to the government in contributing to the inclusive growth of the nation.

Jayati Sarkar and Subrata Sarkar

The authors are professors at Indira Gandhi Institute of Development Research; and currently visiting professors at the Shiv Nadar University