Companies aren’t always successful in achieving environmental, social, and corporate governance (ESG) objectives individually, especially if their industry lacks agreement on standards and practices. Even if these industry frameworks are in place, which is necessary for sustainable capitalism to function, they can be fragile or ineffective without outside forces promoting them.

In a working paper, George Serafeim, the Jakurski Family Associate Professor of Business Administration at Harvard Business School, argues that certain types of investors are in a good position to encourage the development of frameworks—and that it’s in investors’ financial interest to promote socially responsible cooperation within industries.

Why Industry Frameworks Are Needed

For businesses, taking the first step toward mitigating environmental impacts or developing sustainable supply chains can be expensive. They may need to alter production processes or build relationships with new suppliers.

If only one company takes the first step while others in the industry go about business as usual, the sole company to act has higher expenses than its competitors, putting it at a competitive disadvantage in the short term. Companies are obviously reluctant to be at a disadvantage, even when it may ultimately lead to a long-term advantage. Therefore, each company may delay implementing sustainable practices. In addition, a company’s ESG efforts sometimes benefit its competitors, resulting in a “free rider” problem. And so competitors tend to compete, not cooperate.

The unique position of investors may enable them to help align industry players. Investors can encourage companies to participate in industry frameworks through both informal contacts and formal channels, including submitting shareholder proposals and participating in shareholder voting.

Can Index Funds Be the Key to Cooperation?

It’s been suggested that index funds may detract from sustainable capitalism because they often take a hands-off approach to corporate governance and the other ESG pillars. Serafeim, however, believes that index funds—and other institutional investors who own broad portfolios that approximate indices—can be a force for good. They have the two qualities that Serafeim believes can help industry promote frameworks successfully:

• They have a long time horizon. Committing to new standards and developing sustainable supply chains costs money in the short term, although these actions tend to pay off in the long run. Investors who are willing to wait for returns are more likely to advocate for industry frameworks.
• They own significant shares of multiple companies in the same industry or supply chain. Investors who have stakes throughout an industry are not looking to benefit just one player or to cut one company’s costs. They want what’s best for the industry or supply chain as a whole.

Index funds hold on to stocks for many decades rather than actively buying and selling, and they invest across the entire market. Thus, they face the right incentives to favor frameworks. And as passive investments form an increasingly large share of assets under management, index funds also have the power to influence companies. In a letter to the CEOs of public companies, BlackRock CEO Laurence Fink noted both this opportunity and its necessity: “Globally, investors’ increasing use of index funds is driving a transformation in BlackRock’s fiduciary responsibility and the wider landscape of corporate governance.”

Although index funds and similar institutions are great candidates for promoting industry frameworks, retail investors may be able to make a difference by calling attention to these issues. In fact, index funds may be prompted to take a stand once they see that industry frameworks are important to other investors and asset managers.

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