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A file photo of an adult education class conducted by NTPC in collaboration with local NGOs.
A file photo of an adult education class conducted by NTPC in collaboration with local NGOs.

The mandatory CSR law’s 2% solution

The law is still nascent in the Indian context and has attracted a lot of attention from various stakeholders

We conceptualize corporate social responsibility (CSR) as the corporations’ obligation to take necessary action to reduce the negative externalities and enhance the positive externalities associated with their business. In doing so, the corporations could protect and promote the interests of their stakeholders and society as a whole.

Corporations around the world have been voluntarily spending a significant amount of money on CSR activities. There have been examples of CSR spending dating as far back as the 1800s. For example, the companies that built the railroads in America were also instrumental in the proliferation of Young Men’s Christian Association (YMCA) in North America. Since the railroads passed through difficult terrain and sparsely populated areas, the railroad companies established YMCAs in those areas to provide lodging, boarding and entertainment to the railroad workers and also the local population in the surrounding areas. This was a prime example of corporations protecting and promoting the interests of their stakeholders and also society.

Till recently, all CSR spending was strictly voluntary in nature. However, India became the first country in the world to mandate a minimum CSR spending (2% of average profits of the past three years) for corporations above a certain size.

This law has generated considerable debate. While the law is prima facie appealing because it mandates corporate spending on socially relevant causes, there were several arguments against it—the law is difficult to implement, hurts investor sentiment and so on. Critics have also gone on to question the legality of the law, along with pointing out that the Indian social sector may not be fully ready to absorb these funds in an effective manner.

A major question that needs to be addressed from a public policy angle is: Are the problems about the law purely operational in nature, or could there be other side-effects one needs to be concerned about? Another issue that needs to be addressed is to understand the ways in which one could make the law more effective, and achieve its primary objective: Enhancing societal welfare through corporate contributions.

Anchoring and CSR

Research in behavioural economics and psychology has shown that human beings have a tendency to focus heavily on initial information while making decisions. (Following Daniel Kahneman, a Nobel-winning economics/psychologist, marketing researchers refer to such focus as the “anchoring effect".) A potential problem with the 2% rule is that large companies that usually spend more than 2% of their profits on CSR-related activities could “anchor" their CSR spending on the minimum stipulated limits which, in turn, could actually reduce their CSR spending. Such a result would be contrary to the objectives of establishing such a minimum limit.

A recent research study conducted by us, in collaboration with Arindam Tripathy at University of Washington (Tacoma), indicates that the anchoring effect does transfer to charitable contributions as well. Participants’ charitable contribution was significantly higher when no minimum limit was stipulated compared to when a minimum limit was stipulated. A similar pattern of anchoring towards percentages was discernible in an experiment conducted on executives of leading Indian companies, where they were asked to take a decision on CSR-related spending. Whenever 2% was mentioned explicitly, there was a downward movement towards the 2% mark in the intended contributions towards CSR activities, thereby reducing their overall CSR-related spending.

A relevant question is whether there are any factors that mitigate this strong anchoring in CSR spending. In other words, what other information can constitute as a potential anchor? We find that the nature of CSR activity the company undertakes can also provide a strong anchor. The experiment on executives referred to earlier has shown that contribution to CSR activities was significantly higher when the company had the option of spending its CSR funds on a project that directly benefited its stakeholders (for example, schools in the underprivileged areas where the company’s manufacturing facilities are located). The study further shows that monetary requirement for local CSR activities, and the past history of the company’s CSR spending, also help companies anchor on CSR-related decisions. However, the impact of these is mitigated by the presence of the mandatory CSR spending. In such a case, 2% seems to be the stronger anchor.

Conclusions and implications

The new law not only mandates a minimum spending on CSR activities, but also limits the activities for which CSR funds could be used. More specifically, as per the new law, any spending on social causes that are related to the company’s core business or which directly benefit its stakeholders will not be treated as CSR spending. This clause of the law goes counter to implications of prior research that has suggested strategic benefits accruing to companies that invest in CSR activities related to their businesses. The results of the study cited earlier indicate that it could be counter-productive for CSR. Initiatives like Project Shakti (by Hindustan Unilever or HUL) illustrate this argument. A recent article in Harvard Business Review by professor Kasturi Rangan and others say that this project has led to increased sales for HUL, while providing a sustained livelihood to more than 65,000 households. The article suggests that the goal of CSR activities is to “align a company’s social and environmental activities with its business purpose and values".

For CSR to be sustainable and effective, it has to be aligned with the company’s goals. All stakeholders (employees, customers, suppliers, banks, etc.) but one group of a corporation have enforceable contracts which explicitly promise benefits to the stakeholders. Only the shareholders are not promised explicit rewards. Shareholders are claimants of residual value after all other stakeholders have been compensated from a corporation’s profits. Mandating CSR spending is effectively an expropriation of shareholder wealth.

To make such an expropriation sustainable in the long run, it is necessary to ensure that the shareholders gain some value-enhancing benefits from such spending. Therefore, to make CSR spending sustainable in the long run, it is necessary to align such spending with the core business and overall goals of a corporation.

The mandatory CSR law is still nascent in the Indian context and has attracted a lot of attention from various stakeholders. Notwithstanding these debates, the law is here to stay; therefore, it is imperative that policymakers, regulators and various stakeholders work to make this law more effective and beneficial to all.

Viswanath Pingali is a faculty member in the economics area, and his research interests include experimental economics, modelling competition and government regulations. Naman Desai, a faculty member in the finance and accounting area, has his research interests in the areas of auditing, corporate governance, fraud risk assessment and measuring behavioural changes in social contexts.

The article presents the authors’ personal views and should not be construed to represent the institute’s position on the subject.

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