A primer on sustainable value creation

• Author: Iraj Fooladi,Ali Fatemi
• Date: 01 July 2020
• Published date: 01 July 2020
• DOI: http://doi.org/10.1002/rfe.1087

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wileyonlinelibrary.com/journal/rfe Rev Financ Econ. 2020;38:452–473.

© 2019 University of New Orleans

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INTRODUCTION

Much like other professionals, those in finance face many challenges in adapting their modus operandi to the digital age. Unlike

most others, however, the profession faces the tremendous challenge of not having been adequately prepared for the many

ethical challenges it faces. Among these are sustainability considerations in general and corporate social responsibility (CSR)

in particular.1

Most of today's senior academic staff, responsible for having educated the field's practitioners, completed their

advanced training at a time when two highly influential propositions reigned and were taught as if they were the words of the

Gospel: (a) that market solutions are always perfect and (b) that a corporation's only responsibility is to its shareholders and

maximizing their wealth is the only goal to pursue. This indoctrination has led the profession on the path of accepting these

propositions with enthusiasm and without any qualifications. In the meantime, the frequent incidences of market failures, lapses

of ethics, and damage to the social and environmental fabric of the society have been routinely dismissed as idiosyncratic and

not worthy of systematic examination. And, for a long time, the profession was afforded significant leeway to ignore the gath-

ering threats. However, the emerging signs of irreversible environmental degradation, the increasing frequency (and severity)

of incidences of ethical misconduct and corporate irresponsibility have now forced this issue to the forefront of the challenges

Received: 22 July 2019

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Revised: 12 September 2019

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Accepted: 19 September 2019

DOI: 10.1002/rfe.1087

ORIGINAL ARTICLE

A primer on sustainable value creation*

AliFatemi1

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IrajFooladi2

*We thank Lars Osberg, Hassan Tehranian and the participants at the Paris Financial Management Conference, Financial Management Association

conference, Global Financial Conference, The Academy of Behavioral Finance and Economics Conference, and Annual World Forum of International

Association Jesuit Business Schools for their helpful comments. All remaining errors are ours.

1Greenleaf Advisors LLC and DePaul

University, Chicago, IL, USA

2Doulas C. Mackay Professor of

Finance,Dalhousie University, Halifax,

NS, Canada

Correspondence

Iraj Fooladi, Doulas C. Mackay Professor

of Finance, Dalhousie University, Halifax,

NS, Canada.

Email: iraj.fooladi@dal.ca

Abstract

This paper argues that the current paradigm of value creation has led to a number of

unacceptable outcomes. Exaggerated by executive compensation incentives focused

on short‐term results, the model of shareholder wealth maximization spurs short‐

term profits that fail to take into account those costs that are externalized to other

stakeholders. We argue that the all‐inclusive costs can far exceed those explicitly

accounted for and that their magnitude is often such that it outweighs the short‐term

gains by a wide margin. The cascading nature of these costs, the growing voice of

other stakeholders in support of their interests, the erosion of public trust, and the

increasingly dire state of the global environment have accelerated the pace of calls

for the adoption of a model of sustainable value creation—one in which sharehold-

ers’ wealth is maximized without making any of the other stakeholders significantly

worse off. Taking an exploratory step toward developing such an ideal process, we

present a simple example of a valuation model that incorporates such a principle. We

also argue that markets, education, and regulation represent the three indispensable

cornerstones of a sustainable value creation framework.

KEYWORDS

corporate finance, corporate governance, ethics, shareholder model, sustainability

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FATEMI And FOOLAdI

faced by the profession.2

While the profession is well positioned to address the many challenges of the digital age, it is at a clear

disadvantage in dealing with the erosion of confidence (Callen and fang, 2013) and in dealing with the adverse consequences of

its, hereto, myopic orientation against a backdrop of an interdependent world. In this paper, we argue that even when considered

from a purely self‐preservation perspective, the profession owes it to itself to change direction and give due consideration to the

interests of other stakeholders.

We provide ample evidence in support of our argument that the contemporary global conditions are characterized by (a)

increasing incidences of unethical and self‐serving behavior that have led to the erosion of public trust, (b) increasing vocal

presence of other stakeholders who demand due consideration of their interests and that of others seeking such a change, and

(c) a world stretched to its limits and prone to irreversible degradation. We further argue that, when considered over the long

term, the interests of shareholders align with those of other stakeholders. As a result, the consideration of other stakeholders’

interests would also preserve the shareholders’ long‐term interests.

In what follows we present examples of unacceptable outcomes that a strict adherence to the shareholder wealth maximiza-

tion has produced. We discuss the reasons behind the failure of this traditional model and argue that some of the most vexing

problems of our times, rising inequality and climate change included, are the direct consequences of an exclusive reliance on

shareholder wealth maximization as the model of value creation. Drawing parallels with the root causes of the financial crisis,

we argue that the profession needs to treat climate change as a risk management issue with an attendant low‐probability cata-

strophic outcome.

Taking an exploratory step toward the development of a robust framework for wealth creation, the paper offers a model of

sustainable value creation within which shareholder wealth is maximized subject to the constraint that other stakeholders are

left no worse off and one that properly accounts for all incidental costs. We posit that the rapid deterioration of the global social

fabric, the alarming rate of environmental degradation, and the increasing influence of other stakeholders will leave the deci-

sion‐makers no choice but to abandon the traditional paradigm of shareholder wealth maximization in favor of the sustainable

value creation model. At its core, sustainable value creation comprises an optimization model that maximizes equity value with-

out externalizing costs involved to other stakeholders. Within such a framework, we argue that only firms conducting their af-

fairs in a manner consistent with the principles of sustainability are positioned to create long‐term value for their shareholders,

and that the value created by firms that ignore the interests of other stakeholders can only be described as fleeting. At the heart

of this argument is the premise that markets, when properly informed, are capable of recognizing the long‐term net benefits of a

sustainability focus and of rewarding it accordingly. However, while the role of markets is of paramount importance, two other

elements play indispensable roles in the process of sustainable value creation: education and regulation. In other words, we

argue that for markets to work consistently in the direction of sustainability, they need to be supported by effective regulations

and by education. More importantly, the paper also specifies the steps needed to move in the direction of a new paradigm.3

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SHORTCOMINGS OF THE TRADITIONAL MODEL OF VALUE

CREATION

The causes and the effects of the 2008 financial crisis have been thoroughly analyzed, investigated, and reported (e.g., Bair,

2012; Crouhy, Jarrow, & Turnbull, 2008; Morgensen & Rosner, 2011; Rajan, 2010). The broad consensus among such inquir-

ies has been that collateralized debt obligations (CDOs) backed by subprime mortgages triggered the tsunami of events that

eventually brought the global financial system to its knees.4

Mortgages were collected into large pools of assets and sold to

wholly owned organizations that were established solely for the purpose of purchasing these assets and moving them off the

banks’ balance sheets. These organizations in turn divided their assets into different tranches and sub‐tranches, marketed them

as safe investments and sold them to investors the world over. Relying on a key assumption that home prices would not fall in

all areas at once, and invoking the principles of rationality (individuals act rationally) and efficiency (markets work perfectly

well), rating agencies granted their highest ratings (AAA) to a large portion of these CDOs. Ex post, it is now fairly clear that

the financial system had inadvertently ignored a sizeable body of evidence that runs counter to these assumptions, i.e., that

investors’ rationality is bounded by their emotions and fears, and that bubbles are an integral part of the history of financial mar-

kets. It is also clear that markets had acted as if they had chosen to concentrate on expected outcomes and ignore the tail events.

With its focus on sustainability, this paper's main tenet is that when it comes to sustainability issues, an oversight of a similar

nature may be in the making. However, we argue that this particular oversight is potentially far more consequential. We also

argue that continuing business as usual, i.e., ignoring the environmental, social, and governance (ESG) factors, is likely to lead

to unacceptable and potentially disastrous outcomes. We further reason that successful long‐term value creation requires that

these factors be duly and adequately considered. The path ahead, in other words, calls for the abandonment of the standard