Journal of Business Ethics (2006) 68:1933 DOI 10.

1007/s10551-006-9037-1

Springer 2006

Finance as a Driver of Corporate Social Responsibility

Bert Scholtens

ABSTRACT. Finance is grease to the economy. Therefore, we assume that it may affect corporate social responsibility (CSR) and the sustainability of economic development too. This paper discusses the transmission mechanisms between finance and sustainability. We find that there is no simple one-to-one relationship between financial development and sustainable development but there are various often indirect linkages. It appears that most of the literature concentrates on the role of public shareholders when it comes to changing corporate policy and performance in a more sustainable direction. However, this focus neglects the potential impact of the credit channel and private equity on a firms non-financial policies and performance. These very powerful mechanisms can govern business policies and practices. Therefore, there appears to be much more scope for finance to promote socially and environmentally desirable activities and to discourage detrimental activities than has been acknowledged in the academic literature so far. KEY WORDS: banks, corporate social responsibility, development, ethics, nancial markets, socially responsible investments, sustainable development JEL Classication: G200, G300, L210, M140, Z130

Introduction Finance is grease to the economy. As such, it can also affect the sustainability and social responsibility of the
Bert Scholtens received his Ph.D. at the University of Amsterdam in 1994. Since 1999 he has been working at the Department of Finance of the University of Groningen, the Netherlands. His research particularly looks into the interactions between nancial institutions and sustainable development/corporate social responsibility. He has recently published in, among others, Ecological Economics, Journal of Banking and Finance, Finance letters, Journal of Investing, and Sustainable Development.

rm. The World Business Council for Sustainable Development sees the nancial industry as a leader with respect to sustainability, and the industry itself claims it makes the world a better place to live in (Schmidheiny and Zorraqun, 1996). Socially responsible investing and shareholder advocacy would promote socially and environmentally desirable activities. Academics are more skeptical. They nd that the theoretical arguments as well as the empirical evidence so far are rather poor. Financial performance is only weakly linked to corporate social responsible behavior; many papers even nd a negative relationship between the two (see Margolis and Walsh, 2001). Furthermore, socially responsible investments do not earn signicantly higher returns than investments that do not take account of the rms non-nancial behavior (Bello, 2005). In addition, the sheer size of current socially responsible investments seems much too small to have any effect on the cost of capital or the direction of corporations (Heinkel et al., 2001). This has been a reason to qualify the impact of shareowners on rm behavior as rather limited (Haigh and Hazelton, 2004; Johnsen, 2003). The enthusiasm by some and the skepticism by others bear resemblance to the debate about the link between nance and economic development. Here too, we have enthusiasts and skepticists. Schumpeter (1912) is a member of the rst group. He stressed the essential function of entrepreneurs as innovators, creating new products and new distribution methods in order to gain competitive advantages in constantly developing and changing markets. Financial intermediaries, especially banks, were needed to help to make the entrepreneurs ideas come true and to commercialize inventions. This view was, among others, shared by Goldsmith (1969). Others saw this role for nance as highly overrated. For example, Robinson (1979) asserted that economic growth

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Bert Scholtens theory distinguishes four main banking functions: payment services, asset transformation, risk management and information processing, and borrowers monitoring (Allen and Santomero, 2001; Bhattacharya and Thakor, 1993). This boils down to activities like pricing assets, exercising ownership, and providing nance. Intermediaries translate needs and preferences of savers and investors into appropriate nancial services. Financial intermediaries are not just agents who screen and monitor on behalf of savers but are active innovative counterparts offering a product that cannot be offered by most individual investors to savers, namely the cover for risk (Merton, 1995; Scholtens and Van Wensveen, 2003). Given that nancial instruments are so important, it becomes clear why there is such a crucial role for the quality of the legal system as a driver of the interaction between nancial and economic development. Especially, creditor rights, enforcement mechanisms and transparency are the key constituents of the legal system (La Porta et al., 19981999). Three transmission mechanisms link nancial development to economic growth (Pagano, 1993): First is the way in which savings nd their way to investments. The nancial intermediary transfers a fraction (/ < 1) from savings into investments. It uses the fraction 1) /, for example the spread for the bank between borrowing and lending. This may reect market power or X-inefciencies in the intermediarys production process. Regulation also will affect this fraction. If nancial development reduces the leakages in the information process, it may result in a rise of /, which can lead to an increase of production growth. The second transmission channel is the marginal productivity of capital. Financial intermediaries can invest in information to assess the quality of alternative investment projects (Boyd and Prescott, 1986; Greenwood and Jovanovic, 1990). Furthermore, they can try to convince surplus households to invest their funds in more risky but more productive technologies by offering risk diversication (Diamond and Dybvig, 1983; Saint-Paul, 1992). Specialized nancial intermediaries, then, may reduce the costs of acquiring and processing information. The resulting increase in the productivity of capital will result in higher economic growth. Third is the impact on the savings rate. However, it is not clear whether there is a positive or a negative impact of nancial development on the savings rate. With

creates demand for nancial instruments and that where enterprise leads nance follows. Lucas (1988) also dismissed the nanceeconomic growth relationship stating that economists badly over-stress the role nancial factors play in economic growth. King and Levine (1993) solved this debate with convincing arguments and statistics supporting the position that there is a strong link between nancial and economic development. Levine (2004) provides an excellent overview of both the theoretical and empirical research since the early 1990s. Our paper tries to nd whether there is theoretical evidence for a relationship between nance and sustainable development or corporate social responsibility (CSR). To this extent, the article discusses a wide range of potential linkages between nance and the economy and discusses how sustainable growth and corporate responsibility can be involved in this realm. The structure of the remainder of this article is as follows. Section What do nancial intermediaries do and how does this relate to the economy describes the interaction between nancial and economic development. It briey discusses transmission channels between the two. Section Finance and corporate social responsibility analyzes the relationship between nance and sustainable economic development at the micro and the macro-level. We analyze the traditional transmission mechanisms, especially shareholder activism and socially responsible investments. We also come up with alternative nancing mechanisms that have an impact on CSR, especially bank credit, private equity, and project nance. A discussion and conclusion is in section Discussion and Conclusion.

What do financial intermediaries do and how does this relate to the economy? Finance affects the size and timing of economic operations. Financial systems produce ex ante information about possible investments and allocate capital, monitor investments and exert corporate governance after providing nance, facilitate the trading, diversication, and management of risk, mobilize and pool savings and ease the exchange of goods and services (Levine, 2004). Financial intermediaries add value by offering nancial services to savers and investors. The contemporary banking

Finance as a Driver of CSR higher nancial development, households have more opportunities to insure themselves against income and wealth shocks and are better able to diversify their wealth. However, they have fewer incentives to save. The net effect of nancial development on the savings rate is not clear beforehand. Screening, monitoring, and enforcement are the key actions of the nancial intermediaries when nancing economic activities. Screening is the information production and processing about prospective lenders or investment objects. The lender or investor is primarily concerned with the trade-off between risk and return. By economizing on the information costs, nancial institutions improve the assessment of the investment opportunities, with positive effects on resource allocation. By improving information about enterprises, management and market conditions, the nancial institutions may accelerate rm growth as well as economic growth. Greenwood and Jovanovic (1990) argue that the intermediaries that produce better information on rms will fund rms that are more successful. King and Levine (1993) nd that intermediaries increase the rate of technological change by identifying entrepreneurs who have the best chances of successfully initiating product and process innovations. Monitoring is checking on the project and the rm once the loan is granted. Financial intermediaries monitor how rms use the funds. In case creditors and shareowners effectively monitor rms and induce their managers to increase rm value, this will result in a more efcient allocation of resources. However, a lack of nancing arrangements that enhance corporate governance may block the mobilization of savings and may keep capital from going to the most protable investments (Stiglitz and Weiss, 1981). There are various strategies for investors to inuence the rm (Jensen and Meckling (1976) point out the weaknesses of the strategies): 1. Voting on crucial issues, such as business strategies, mergers, etc. Here, the concentration of the ownership of stock in the rm is an issue. Especially small and diffuse holdings will encounter barriers to exerting control over the rm (Stulz, 1988). 2. Engaging in dialogue. Shareholders may directly discuss corporate policies with management. However, whether management

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will take the time and effort to discuss with all shareholders is questionable. 3. (Co)Filing shareowner resolutions. With shareholder proposals, the investor can present an issue in front of other shareholders and management. 4. Investing in or divesting from the company. Using the entry or exit option is a clear signal by which investors reveal their preferences. Enforcement is the way in which the nanciers deal with the borrower when he or she breaches the contract terms or in case of default. The enforcement of contract terms is relevant both for banks and for nancial market participants. The legal system determines the potential for the nancial intermediaries to enforce their rights and as such structures the way in which they nance enterprises. Generally, banks have access to different assets under different conditions than shareholders (see La Porta et al., 1998). Based on the preceding arguments, we come up with the following framework to assess the interaction between nance, the rm, and the economy (see Figure 1). A cultural and societal framework can help to understand the behavior of nancial intermediaries (Kindleberger, 1993; Stulz and Williamson, 2003). The law and nance view of economic and nancial development illustrates the importance of the legal structure and law enforcement (see La Porta et al., 1998, 1999). Especially creditor rights and governance issues are determined in this realm. There are various linkages between the operations of nancial intermediaries and CSR and sustainable development: From a macro-perspective, nancial intermediaries affect the amount of savings and investments. They affect the marginal productivity of capital by granting funds to particular projects and not to others, they affect the overall level of economic activity by providing and maintaining the payment system, and they affect the costs of intermediation. From a microeconomic perspective, intermediaries offer risk management to consumer and business households, they screen and monitor households and exert governance. At the same time, the availability of nance and expertise as well as the screening and monitoring of rms and projects gives direction to the rms operations. As such, it directs the economy (see Allen and Gale, 2000). It is especially in this realm that nancial intermediaries

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Cultural and Societal System Legal system

Bert Scholtens ical, and environmental performance of the rm. This market imperfection results in external effects (Bator, 1958). Another example is that it is very difcult for both the poor and for entrepreneurs with new environmental technologies to get access to nance and insurance (Admati and Pfeiderer, 1994; Denis, 2004). The fourth column gives some market, product and process innovations, which may act as solutions to the problems listed in column 3. The main activities of nancial intermediaries are in the rows. They are often interrelated. For example, by transforming assets and providing nance, the intermediaries also manage risk. We assume that there is no relation between payment services and sustainability. From Table I, it appears that most business areas in nance face the challenge of social and environmental problems. Various responses are already underway (some will be discussed later on). As we are interested in how nance affects CSR, we rst discuss the interlinkages the current literature analyzes (viz. the environmental Kuznets curve and the public stock market). Then, in section Bank lending, private equity, and project nance, we discuss alternative transmission mechanisms.

Financial Intermediaries

Screening Monitoring Enforcement

Finance & Advice

The Firm

Profits

Investments

Corporate Social Responsibility

Economic Development

Sustainable Development

Environmental Kuznets Curve and the public stock market

Figure 1. Financial intermediaries, the rm, and the economy.

can have an impact on socially responsible behavior of the rm and, on an aggregated basis, on the sustainability of the economic development. Finance and corporate social responsibility In this section, we analyze how nance and CSR are related. To this extent, we rst present Table I, which illustrates how nancing activities relate to sustainability and CSR. The rst column gives the main activity types of the nancial intermediaries (see Bhattacharya and Thakor, 1993). The second column gives the operational areas through which the nancial institutions intermediate with business. The third column lists the main problems with respect to sustainable economic development. For example, prices generally do not reect social, eth-

Three linkages between nance and sustainable development or CSR are the subject of discussion in the economic literature: the environmental Kuznets curve (EKC) (Gylfason, 2001), socially responsible investment (Sparkes and Cowton, 2004), and active stakeholders (SIF, 2005). The (EKC) describes the relationship between economic development and the environmental burden to society (Grossman and Krueger, 1995). The EKC is an inverse U-shaped relationship between per capita GDP and the per capita pollutant factor. It reveals how a technically specied measurement of environmental quality changes in the course of economic development. Many studies nd that environmental quality deteriorates at early stages of economic development and subsequently improves at later stages. This suggests that environmental pressure increases faster than income at early stages of economic development and slows down at higher income levels. There are various explanations for the EKC phenomenon. For example, progress of

TABLE I Finance and sustainable development (in part derived from: Financing the Future, 2005) Business (2) Social and environmental problems (3) Innovations (4) Measurement of corporate performance and impact on value and risk Shareholder engagement Create market in unpriced assets Assess + integrate these risks in credit risk assessment Include sustainability impact in nancing Listing requirements Set up specialized investment funds Specialist underwriting capacity Encourage mitigation and adaptation Transfer weather risk to capital markets through new derivatives Cost-cap, liability and other insurance instruments to mitigate risks and browneld facilitation

Functions (1)

Pricing and monitoring: information production

Asset transformation: nancing Access to nance difculties for innovative projects and for the poor

Asset management Stock selection Corporate governance Investment banking Research Trading Commercial banking Credit Leasing Investment banking

Equity or debt prices not reecting sustainability performance Ownership not being exercised to promote sustainable asset use Sustainability risks not integrated

Finance as a Driver of CSR

Risk management

Project nance New issues Private equity Insurance Reinsurance Non-life Investment banking

Derivatives

Lack of experience of risks and therefore of cover for key new technologies Threat to reinsurers and lack of cover because of climate change Contaminated-land browneld development hindered by unforeseen liabilities and clean-up costs overruns

Payment services

Commercial banking Credit card payments Netting Electronic fund transfer Investment banking Clearing Settlement

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Bert Scholtens
TABLE II Sources of net nancing by non-nancial enterprises 19701989 Germany Internal nance External nance Of which loans Trade credit Stocks Bonds Other 81 19 11 )2 1 )1 10 Japan 69 31 31 )8 4 5 )1 US 91 9 16 )4 )9 17 )11 UK 97 3 20 )1 )10 4 )10

economic development coincides with a structural change, from clean agrarian economy to polluting industrial economy to clean service economy. Another explanation is that people with higher income tend to have higher preferences for environmental quality (see Dinda, 2004). As nance is an important constituent of economic development, we may expect there to be some relationship with environmental issues too (Gylfason, 2001). A well-developed nancial system will result in market interest rates that fully reect the relative attractiveness of different investment opportunities. Furthermore, well-developed nancial systems improve the opportunities of the public to hedge against unforeseen events and, therefore, may bring more stability to society. On the other hand, nance as a catalyst for development brings transition and modernization and widens the consumption potential of the public. The underpinnings of the EKC are subject to erce opposition from a theoretical and from an empirical perspective (see Stern, 2004). Many developing countries are addressing environmental issues, sometimes adopting developed country standards and technologies with a short time lag. Sometimes, developing countries perform better than wealthier countries. In addition, many EKC results have a weak statistical foundation. Therefore, it is uncertain whether there is a strict relationship between the economy and the environment. Second is that the impact of nancial development via economic development on the environment is ambiguous. It may have a substitution effect (making better use of scare resources) as well as an income effect (resulting in more income and consumption). The net effect is not clear beforehand. To analyze the interlinkages between nance and CSR from a microeconomic perspective, most attention focuses on the impact of stakeholder activism and responsible investment on corporate behavior (see Haigh and Hazelton, 2004). This is the monitoring channel (Table I); other channels are neglected. This can result in an underestimation of taking social and environmental aspects of nancing into account, because most rms in the world have much more nance from banks than from the stock market. To this extent, Table II shows that bank loans are dominating external nancing in the worlds major economies (see also Mayer, 1988;

(source: Corbett and Jenkinson 1994, p.11)

Rajan and Zingales, 1995). It is only in the US that net nancing by bonds is of about the same size as that via bank lending. Elsewhere, bank loans are much more important than stocks and bonds. We rst discuss the traditional transmission channel (i.e., stocks) before turning to alternatives (loans, private equity). Socially responsible investment takes into account non-nancial characteristics of rm performance and policies (for a discussion, see Cox et al., 2004; Dillenburg et al., 2003; Sparkes and Cowton, 2004). Evaluating corporate governance, environmental, social, and economic factors allow investors to manage their funds in a way that is consistent with the investors mission and values. The investor can make a trade-off between the performance and policies of the rm with respect to these factors and its nancial performance (i.e., risk and return). Different studies of socially responsible investing suggest that ethical screening of companies is likely to affect the characteristics of the assets included in the portfolio. As such, screening for social responsibility affects the portfolio (Rudd, 1981; Grossman and Sharpe, 1986; Diltz, 1995). A growing number of empirical studies of the nancial performance of socially responsible investment funds have appeared in the recent past (see Bauer et al. 2005; Bello, 2005; Gezcy et al., 2003; Hamilton et al., 1993; Statman, 2000; Statman, 2005). They nd that there is no signicant difference in the returns on the relatively more socially responsible funds compared to conventional funds. Financial risk also is about the same. Thus, it appears that screening does not have a signicant impact on the risk and return

Finance as a Driver of CSR characteristics and socially responsible investors do not forego many opportunities. By the way, most empirical studies are on retail funds, which actually only is a proportion of socially responsible investments. Unfortunately, it is not clear how large or small this portion is. How can socially responsible investment affect rm behavior? Johnsen (2003) argues that the size of socially responsible investment funds usually is much too small for the funds portfolio decisions to have an impact on rm behavior. Therefore, Johnsen argues, socially responsible funds should encounter in active ownership. However, the prospects of this policy are limited too. First, there are institutional and legal constraints, as in many countries mutual funds face ownership restrictions. Second is that the share of co-operating socially responsible investors needs to be quite substantial. Heinkel et al. (2001) nd that at least 25% green investors are required to induce any polluting rms to reform. The existing empirical evidence suggests that in the US at most 12% of the funds are invested by green investors (SIF, 2004). Third, shareholder activism can affect the direction of the business strategy. Shareholder activism is a process by which the shareholders of a listed company, under the provisioning of securities legislation in various jurisdictions, can request its members to meet and vote on specic resolutions. It consists of various elements: proxy voting, resolutions, and dialogue. As to proxy voting, Domini (2001) argues that ethical investors can raise many issues and have substantial inuence. But Haigh and Hazelton (2004) do not nd empirical evidence for this view. The Social Investment Forum (2005) nds that socially responsible investment funds are much more active than conventional funds. Dialogue allows management to gain a greater understanding of shareholder concerns and to discuss corporate performance and policies with shareholders in a non-formal, non-confrontational environment. However, there are no systematic surveys of the de facto impact of these efforts on rms policies and performance.

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shareholders. While shares and shareholder rights indeed are an instrument to impact upon the direction of the rm, they are not the only means. Private capital and bank credit are important nancial instruments too, if it comes to providing external nance to the rm (see Table II). However, they are much more opaque than nancing via the market for stocks or bonds (Boot and Thakor, 1997). For illustrative purposes, Table III gives the size of bank credit to the private sector as a percentage of GDP as well as the market capitalization of listed companies in three groups of countries: G-7 countries, seven major emerging markets, and seven developing
TABLE III Stock market capitalization and domestic private credit 2003, selected countries Market capitalization of listed companies (% of GDP) US UK Canada France Germany Italy Japan Average Argentina Brazil China India Indonesia Russian Federation South Africa Average Armenia Bangladesh Ecuador Egypt Pakistan Sri Lanka Ukraine Average 130.3 134.4 104.4 77.1 44.9 41.9 70.7 86.2 30.0 47.6 48.1 46.5 26.2 53.3 167.5 59.9 1.0 3.1 7.9 32.8 20.1 14.9 8.7 12.7 Domestic credit to the private sector (% GDP)

Bank lending, private equity, and project nance We nd that the micro linkages between nance and CSR analyzed so far center on the role of public

238.7 148.4 81.3 90.2 117.3 85.8 102.4 123.4 10.8 34.7 147.3 32.0 24.2 20.9 142.1 58.9 6.0 28.8 19.9 61.5 25.7 30.0 24.6 28.1

(source: World Bank, World Development Indicators 2005)

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Bert Scholtens Our examples are early entrepreneurial nancing, community investing, and project nance. They show that intermediaries can signicantly affect nonnancial behavior and performance of the borrower. With early entrepreneurial nance, we refer to the rst stages of nancing the rm (see Denis, 2004). In the early years, the rm makes many strategic decisions and its culture and general attitude gain shape. As such, the providers of early nance (seed, start-up, and second-stage) have a huge impact upon business culture and strategy. Especially with start-up nancing and second-stage nancing, business angels and venture capitalists offer their expertize and practical knowledge in tandem with the nancial funds. These nancial intermediaries potentially do have a lot of inuence on the way in which the business is structured and, therefore, on its CSR. Moore and Wustenhagen, (2004) illustrate the role of entrepreneurial nance in sustainable energy projects. Randjelovic et al. (2003) give a description of the green ventures industry. They nd that the main problems with green venture capital relate to the lack of a proper network where entrepreneurs and nanciers can meet, to different meanings for sustainability, to the lack of adequate business plans, to a mismatch in the timing of the nance needs and the availability of nance, to the lack of expertize and skills, and to the lack of market potential (Randjelovic et al., 2003). Of course, these problems are interrelated. Green Project Finance in the Netherlands provides an example of green venture capital. This nance scheme offers credit for investment projects that improve the environment. Green investors that earn somewhat less on this investment than on their ordinary savings put up the funds. So far, more than e 6.5 billion has been allocated to green projects (Scholtens, 2005). In Canada, there are similar programs (http:// www.canadianenvironmental.com). The New Ventures of the World Resources Institute (http:// www.new-ventures.org/resources.vcgreen.html) is another nancial instrument that is used to green start-ups and ventures. Our second example is community investing. Community investing is capital for communities underserved by traditional nancial services. How banks perform in this respect is a matter of great public concern. For example, the National Community Reinvestment Coalition, a US-based non-

economies. The two indicators are very rough measures for the potential of the two transmission channels (public stock and bank loans). Table III shows that bank lending is much larger in the G-7 countries than stock market capitalization. In the selected emerging markets, they are of about the same size. In the developing countries, we have that credit is more than twice the size of stock markets. It is quite common for nancial institutions to assess non-nancial attributes. They often regard qualitative attributes of the rm and the entrepreneurs as proxies for the viability of the project and the rm (Denis, 2004; Matthews, 2002; Saunders and Allen, 2002). Furthermore, they select rms and projects based on their performance with respect to non-nancial characteristics. This screening of rms is a very important instrument for nancial intermediaries to allocate their funds. It literally directs the way in which the funds are used. The nancial intermediary not only provides nance, but also is involved in project design and implementation (Jappelli and Pagano, 2002; Haupt and Henrich, 2004). The literature on private equity and bank lending in relation to CSR is very limited so far. It predominantly focuses on the relevance of social, ethical, and environmental issues for intermediaries. CSR is often regarded as a risk to the nancier. This risk is threefold. There is a direct risk when the bank or the venture capitalist takes possession of collateral. In case it is contaminated or poses a threat to the environment or is otherwise potentially burdensome, this can become costly (Coulson and Dixon, 1995; Case, 1996). An indirect risk is present too as changes in legislation or consumer preferences because of social and environmental considerations can affect a companys revenues and thereby its default probability (Thompson and Cowton, 2004). Furthermore, there is reputational risk where actions of borrowers may negatively feedback on its nanciers (Buxton, 1997). These risks are an incentive for banks and venture capitalists to include social, ethical, and environmental considerations in their rm or project appraisal (Coulson and Dixon, 1995; Coulson and Monks, 1999; Lundgren and Catasus, 2000; Moore and Wustenhagen, 2004; Morgera, 2004; Soppe, 2004; Thompson and Cowton, 2004). We will discuss three examples of non-public stock nancing to illustrate the potential impact on CSR.

Finance as a Driver of CSR governmental organization (NGO), monitors bank behavior and nds that it is especially minorities, women, and low- and middle-income borrowers that are likely to be underserved by nancial intermediaries and victimized by predatory lending practices in metropolitan areas (NCRC, 2004). Community investing provides access to credit, equity, capital, and basic banking products that these communities would otherwise not have. It makes it possible for local organizations to provide nancial services to low-income individuals, and to supply capital for small businesses and vital community services, such as childcare, affordable housing, and healthcare. Quantitatively, the importance of community investing is rather small. For example, in the US, community investing was about US$ 14 billion at year-end 2003. This is fewer than 1% of the total amount of socially responsible investing (SIF, 2003). Nevertheless, and in contrast to investing in the public stock market, these funds directly affect deprived communities. Community investing is part of the much broader concept of micronance (Murdoch, 1999). Micronance programs have demonstrated that it is possible to lend to low-income households while maintaining high repayment rates (even without requiring collateral). The programs alleviate poverty and spread nancial services. They serve millions of poor households. Cull et al. (2005) nd that the pattern of protability and the nature of customers vary considerably with the design of the micronance institutions and their contracts. A growing body of economic theory demonstrates how new contractual forms offer a key to micronance success. For example, Becchetti et al. (2005) nd that the matching of socially responsible savings and micronance can enhance the role of inclusion and value creation of the nancial intermediary. So far, the empirical studies after the impact of community nance on non-nancial performance of the customers are scarce and anecdotal. Our third example is project nance. Here, some major providers have decided to comply with a generic social and environmental policy that will apply to all large projects, the so-called Equator Principles. The nancial industry, just like any other, complies with various codes of conduct and has different policies in place with respect to social, ethical, and environmental issues. Examples are the

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UN Global Compact, the London Principles of Sustainable Finance, OECD Guidelines for Multinational Enterprises, ILO Conventions on Workplace Practice, Global Reporting Initiative, ISO standards, AccountAbility 1000S, Social Accountability 8000, and the Equator Principles (Unwin, 2002). The Equator Principles is an arrangement among 30 leading international banks about how to conduct their project nance. Project nance involves the creation of a legally independent project company nanced with equity from one or more sponsoring rms and non-recourse debt for investing in a capital asset (Esty, 2004). With project nance, lenders base their credit appraisals on the projected revenues or cash-ows from the operation of the facility, rather than on the general assets or the credit of the sponsor of the facility. They rely on the assets of the facility, including any revenue producing contracts and other cash-ow generated by the facility, as collateral for debt. In project nancing, the sponsors credit support or the value of the physical assets of the project is not the basis for the debt terms. Project performance, both technical and economic, is the core of project nance. By accepting the Equator Principles (see Appendix I), the nancial intermediaries commit to provide credits only for projects in which the sponsors consider environmental and social standards. This voluntary self-undertaking applies to nancing with a minimum investment volume of US$ 50 million. The Equator banks account for around 85% of the market for project nance in developing countries, which on average is about US$ 90 billion per year during the period 19982002 (see Esty et al., 2005). The guidelines of the World Bank and its subsidiary, the International Finance Corporation (IFC), are at the basis of the principles. The principles classify a project as high, medium, or low environmental and social risk. Medium and high-risk projects require an environmental impact assessment (EIA). The EIA covers, among others, the development and use of renewable raw materials, job safety and hygiene, the protection of endangered species and sensitive ecological systems as well as efcient energy production, provision, and use. Additionally, the borrower must prove to the bank that the project complies with the respective national laws and the environmental provisions of the IFC and the World Bank. In the case of projects in

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Bert Scholtens that nance only has a very limited effect on the sustainability of economic performance. Why might the stock market have such a limited impact and why might banks and venture capitalists be more successful in greening business? An important reason is that the stock market hardly provides new nance to the rms. It is a vehicle that is very suitable for exercising control rights and for investing. However, the liability of the shareholders is limited and most of them hardly feel responsible for the non-nancial performance of rms in which they invest. Furthermore, shareownership often is widely dispersed. There is some opportunity to change the direction of the rm but this is rather limited. As changing products, processes and markets is necessary in order to achieve sustainability and as this change requires nance, we argue there is much more scope for the direct providers of nance to green business. So far, the nancial industry recognizes several sustainability problems and various institutions have come up with process, product, and market innovations. The examples of early-stage entrepreneurial nancing, community investing, and project nance show that by providing the funding for projects and ideas, it is possible to shape and direct these ideas in a more sustainable direction as well. Some progress in this direction is clearly underway but the solutions chosen often are subject to problems too. The three nancing modes open the potential to direct the economic activities in a way that takes account of social, ethical, and environmental issues. This clearly complements the microeconomic transmission channels that were the object of study so far, i.e., shareholder activism and making responsible investments. These two use the stock of the rm with respect to two characteristics, namely the shareholder rights and the cost of capital. In addition, we argue that private equity and credit have a role to play too. When we feedback this to the general activities of nancial intermediaries, the transmission channel that concentrates on listed shares is directed at the monitoring and the enforcement stages of the relationship between rm and nancier. Finance also is crucial in the screening stages and especially here it is possible to amend the course of business activity in a more socially responsible direction. With lending and venture nancing, the screening of projects is crucial and nanciers can affect CSR more directly than via the public stock market as

developing countries, the banks must comply with the Safeguard Policies of the IFC (these contain guidelines on the protection of natural habitats, resettlements, dam safety, and the preservation of national heritage). Furthermore, an environmental management plan (EMP) is prepared for all high-risk projects, and for medium-risk projects if required. The plan serves as a management and control tool for the environmental and social risks of the project and denes appropriate compensation measures. In addition, borrowers have to reach agreement with persons directly affected by a project development at local level for example indigenous peoples or local pressure groups on an appropriate implementation of the project. The borrower provides evidence of compliance with the Equator Principles in regular reports throughout the duration of the project and independent experts if required check this. The Equator Principles illustrate how screening and monitoring a project or a rm may affect the social responsible behavior and performance of the rm. As such, it will affect the actual operation of the rm nanced under the Equator Principles. However, there also are some weaknesses. A number of leading project nance banks continues to opt out of the principles. NGOs also want the principles to apply to all types of nancing, not just large projects (Watchman, 2005). BankTrack, a consortium of global NGOs, criticizes the signatory banks for nancing projects that violate the Equator Principles, and for a lack of transparency about implementation of the principles (BankTrack, 2004). BankTrack (2005) also criticizes the limited transparency and disclosure of many banks as well as the lack of governance and accountability.

Discussion and conclusion Finance relates to the sustainability of economic development and to CSR. This is because economic production affects environmental performance and nancial development is intertwined with economic development. So far, we nd that especially the linkages that run via the public stock market (socially responsible investments, shareholder activism) and the EKC are seen as the main channels through which nance impacts on the economy. The academic literature nds that these linkages are rather weak and

Finance as a Driver of CSR these activities are much closer to the rms investments and project design. A natural weakness of nance when it comes to affecting CSR is that it is of an indirect, intermediate character. Finance facilitates economic operations. By providing nance, the nancier contributes to the realization of all kinds of activities and projects. However, in the end, the entrepreneur is accountable for the success or failure of the project. Now, when taking account of social, ethical, and environmental conditions in the provisioning of nance, the nancial intermediaries come up with additional requirements with respect to the ways in which the entrepreneur realizes and manages the business. From the perspective of the nancier, multiple goals are at stake: the nancier wants the money back in the end (either via the market or from the rm itself), wants to earn a decent return, and wants to improve the social, ethical and environmental performance of the rm. Most nancial intermediaries do not make the tradeoff between these goals very explicit so far. Additionally, the different nanciers do not co-ordinate their actions. This can result in not well-focused claims on the rms with respect to CSR, which may aw the contract design and result in suboptimal performance. These coordination problems will be much larger in the case of dispersed share ownership. In all, we have identied alternative transmission mechanisms by which nance may affect the social, ethical, and environmental behavior and performance of the rm. When we feedback our ndings to the existing literature about nance and development, we can make the following amendments (see Pagano, 1993) when we consider CSR: First are the intermediation costs. These costs are likely to rise, as the nancial intermediaries will scrutinize rms, projects, investment objects in many more dimensions than primarily nancial risk and return. This increase will have a depressing effect on overall economic activity. Second is the productivity of capital. We expect that the marginal social productivity of capital will improve. This is because nanciers consider external effects when they assess the sustainability or responsibility of activities that want to nance. This certainly will improve economic welfare. Third is the amount of funds available for investment. Households adapt the way in which they make their consumption and savings decisions when nancial intermediaries account for

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social and environmental issues. They may increase or decrease the amount of money saved based on their utility functions. However, we do not expect these changes to continue. Furthermore, the overall effect of nancial development on savings itself already has not been clearly determined. The combined effect of the impact on development of nance interacted with CSR is not clear beforehand. Until now, most attention in the academic literature has been paid to the stock market as a vehicle to make rms more socially, ethically, and environmentally responsible. Shareholders may affect the cost of capital to the rm and they can use their voice to guide the rm in the direction of more responsible behavior. However, as the amount of funding of rms via the stock market is rather limited in most countries, governance mechanisms are far from perfect, limited liability reduces the incentives to monitor non-nancial performance, and share ownership is often widely dispersed, it is not very surprising that the academic research nds that shareholders have little impact on CSR. In contrast, venture capitalists and banks provide the bulk of external nance to the rm in most countries. As such, they too have an opportunity to make business more sustainable. They also have the incentives to do so as their borrowers performance in this respect directly or indirectly will feedback on the nancier. In this paper, we have clearly shown that there are numerous reasons to believe and expect that VC and bank lending potentially have more impact on CSR than the equity market. However, further empirical research will have to establish the actual impact of different types of nance on CSR. Appendix I Equator Principles Preamble Project nancing plays an important role in nancing development throughout the world. In providing nancing, particularly in emerging markets, project nanciers often encounter environmental and social policy issues. We recognize that our role as nanciers affords us signicant opportunities to promote responsible environmental stewardship and socially responsible development.

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Bert Scholtens (a) Assessment of the baseline environmental and social conditions. (b) Requirements under host country laws and regulations, applicable international treaties and agreements. (c) Sustainable development and use of renewable natural resources. (d) Protection of human health, cultural properties, and biodiversity, including endangered species and sensitive ecosystems. (e) Use of dangerous substances. (f) Major hazards. (g) Occupational health and safety. (h) Fire prevention and life safety. (i) Socioeconomic impacts. (j) Land acquisition and land use. (k) Involuntary resettlement. (l) Impacts on indigenous peoples and communities. (m) Cumulative impacts of existing projects, the proposed project, and anticipated future projects. (n) Participation of affected parties in the design, review and implementation of the project. (o) Consideration of feasible environmentally and socially preferable alternatives. (p) Efcient production, delivery and use of energy. (q) Pollution prevention and waste minimization, pollution controls (liquid efuents and air emissions) and solid and chemical waste management. 4. For all Category A projects, and as considered appropriate for Category B projects, the borrower or third party expert has prepared an EMP which draws on the conclusions of the EA. The EMP has addressed mitigation, action plans, monitoring, management of risk and schedules. 5. For all Category A projects and, as considered appropriate for Category B projects, we are satised that the borrower or third party expert has consulted, in a structured and culturally appropriate way, with project affected groups, including indigenous peoples and local NGOs. The EA, or a summary thereof, has been made available to the public for a reasonable minimum period in local language

In adopting these principles, we seek to ensure that the projects we nance are developed in a manner that is socially responsible and reect sound environmental management practices. We believe that adoption of and adherence to these principles offers signicant benets to ourselves, our customers and other stakeholders. These principles will foster our ability to document and manage our risk exposures to environmental and social matters associated with the projects we nance, thereby allowing us to engage proactively with our stakeholders on environmental and social policy issues. Adherence to these principles will allow us to work with our customers in their management of environmental and social policy issues relating to their investments in the emerging markets. These principles are intended to serve as a common baseline and framework for the implementation of our individual, internal environmental and social procedures and standards for our project nancing activities across all industry sectors globally. In adopting these principles, we undertake to review carefully all proposals for which our customers request project nancing. We will not provide loans directly to projects where the borrower will not or is unable to comply with our environmental and social policies and processes.

Statement of principles We will only provide loans directly to projects in the following circumstances: 1. We have categorized the risk of a project in accordance with internal guidelines based upon the environmental and social screening criteria of the IFC as described in the attachment to these Principles. 2. For all Category A and Category B projects, the borrower has completed an Environmental Assessment (EA), the preparation of which is consistent with the outcome of our categorization process and addresses to our satisfaction key environmental and social issues identied during the categorization process. 3. In the context of the business of the project, as applicable, the EA report has addressed:

Finance as a Driver of CSR and in a culturally appropriate manner. The EA and the EMP will take account of such consultations, and for Category A Projects, will be subject to independent expert review. 6. The borrower has covenanted to: (a) Comply with the EMP in the construction and operation of the project. (b) Provide regular reports, prepared by inhouse staff or third party experts, on compliance with the EMP and (c) where applicable, decommission the facilities in accordance with an agreed Decommissioning Plan. 7. As necessary, lenders have appointed an independent environmental expert to provide additional monitoring and reporting services. 8. In circumstances where a borrower is not in compliance with its environmental and social covenants, such that any debt nancing would be in default, we will engage the borrower in its efforts to seek solutions to bring it back into compliance with its covenants. 9. These principles apply to projects with a total capital cost of $50 million or more. The adopting institutions view these principles as a framework for developing individual, internal practices and policies. As with all internal policies, these principles do not create any rights in, or liability to, any person, public or private. Banks are adopting and implementing these principles voluntarily and independently, without reliance on or recourse to IFC or the World Bank. References
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Bert Scholtens Department of Finance University of Groningen PO Box 800, Groningen, 9700 AV, Netherlands E-mail: L.J.R.Scholtens@rug.nl