Milton Friedman was wrong.

In his seminal 1970 essay, the Nobel Prize-winning economist wrote that companies have no social responsibility beyond making money for shareholders. This doctrine of shareholder primacy guided generations of business executives, board members, and policymakers who ensured that firms forged ahead in the free market with profits as the sole objective.

Perhaps Friedman, who died in 2006, would have been surprised when the Business Roundtable — an association of the country’s top chief executives — released a statement in 2019 that revised the purpose of a corporation as promoting an “economy that serves all Americans,” including customers, employees, suppliers, and communities.

“It’s amazing how much governance has changed,” said Wharton finance professor Luke Taylor. “My view is that companies should not be maximizing shareholder value. Instead, they should be maximizing shareholder welfare. There’s a difference there because shareholders may care about more than just profits.”

Taylor spoke during a November 16 panel discussion titled “Redefining Corporate Governance.” The virtual event was part of the ongoing Beyond Business series, which explores the most complex and pressing issues affecting organizations and individuals around the world. An expansion of the Wharton School’s Tarnopol Dean’s Lecture Series, Beyond Business is streamed live on Wharton’s LinkedIn page. (See video below.)

Wharton Dean Erika James led the discussion, which also included Wharton management professor Mary-Hunter “Mae” McDonnell and Brian Stafford, a Wharton graduate who is chief executive officer of Diligent Corporation, the largest governance, risk, compliance, and ESG SaaS company.

The panelists said that even a cursory look at the make-up of modern boards reveals how significantly they have changed. Environmental damage, social and racial injustice, gender inequality, the COVID-19 pandemic, technological disruption, and other pressures are pushing companies to take a broader look at their purpose and mission. They want board members with specific expertise in areas such as impact investing, human resources, auditing and accounting, crisis management, and AI.

“Many boards are not equipped to offer strategic guidance on these kinds of nonmarket crises that arguably carry the most enterprise risk for firms today,” McDonnell explained. “Firms are [adapting] by adjusting the profile of directors that they’re onboarding. This shift is equipping boards to better understand and guide firms through more turbulent social and political environments.”

Firms are moving away from a model in which board members have an almost adversarial relationship with managers, toward one of greater collaboration. McDonnell likened the transformation among board members to a change from “policemen” to “umpires.”

Stafford agreed and said, “We found a lot of board members just lean in. Where they have expertise, they just kind of dive in much more directly with management and actually help management with all the issues at hand.”

These changes not only help companies navigate rough waters, they also help companies meet the demands of customers and employees. These stakeholders want companies to be transparent and authentic about environmental, social, and corporate governance goals (ESG). The chief executive is now expected to serve as a political statesman of sorts, Stafford said, and boards are quick to intervene if the CEO speaks out of turn with the company’s views.

Compensation Matters

Consumer attention to ESG has also shone a spotlight on executive compensation. The panelists said pay is a hot topic because it is directly linked to corporate values, at least in the eyes of customers and employees.

“It ties back to the conversation of what are you trying to maximize? Are you trying to maximize the value for your stakeholders, or are you trying to maximize value for your shareholders,” Stafford said.

“It’s useful for boards to understand why pay inequity matters.” –Mary-Hunter “Mae” McDonnell

According to McDonnell, executive pay is skyrocketing based on the pay-for-performance notion that doesn’t extend down to rank-and-file employees who also contribute to the company’s success. Research has linked that disparity to harmful outcomes within the company and society at large, including lower morale, reduced collaboration, underinvestment in public goods, and higher crime rates.

“It’s useful for boards to understand why pay inequity matters,” she said. “We do need to pay attention to the broader social effects of having pay that is enjoyed by only the people at the very top.”

McDonnell said firms can incentivize executives to pursue social or environmental performance by using the long-term incentive portion of compensation packages to reward executives for meeting non-financial performance targets, rather than treating ESG targets as “something of a bonus.” About half of the S&P firms currently attach some measure of executive pay to social and environmental outcomes, she said, and the research suggests that it works to help move ESG goals forward.

A Greener Investment Strategy

While compensation can be a strong lever to affect ESG performance, it is eclipsed by the power of investment strategies. Taylor has been studying ESG investments, which have performed well in recent years. That’s because environmental concerns have strengthened more than anticipated, increasing investors’ demand for green stocks and customers’ demand for green products.

“ESG investors alone are not going to save the world.”  –Luke Taylor

But there is no indication that ESG returns will remain high, Taylor said. Green stocks are expensive, as ESG investors have pushed up their prices.

The rise of ESG investing has made capital cheaper for green companies and more expensive for nongreen companies. Taylor said he expects all companies to become greener in order to increase their share price, and for capital to be reallocated toward green firms.

“We should see less coal mines. We should be seeing more solar farms, thanks to the rise of ESG investing,” Taylor said.

But he warned that the free market can’t resolve all problems; policymakers must draft better regulations. “ESG investors alone are not going to save the world,” he said. “We need a lot more than ESG investors. We also need smart rules. We need smart laws on the books.”