In new research, Jitendra Aswani finds that India’s mandatory corporate social responsibility contribution for large firms increased corporate borrowing costs, but transparency and clear communication to investors about these contributions reduced the additional costs.

Neoclassical economics emphasizes that firms should not be expected to act voluntarily in socially or environmentally responsible ways but should be expected to focus on maximizing profits instead. The management of externalities and the provision of public goods is seen as the responsibility of governments, guided by public preferences and democratic empowerment. This division of responsibility between corporations and governments is often referred to as the classical dichotomy, as outlined by Milton Friedman.

Recent research, however, including by Oliver Hart and Luigi Zingales, has progressed from merely questioning the existence of corporate social responsibility (CSR) to examining its impacts on society, the economy, shareholder value, and stakeholder welfare. Studies in this field have focused on the motives behind CSR, including value creation or win-win scenarios, delegated philanthropy, as described by Roland Benabou and Jean Tirole, or as manifestations of agency problems. While previous studies have explored how investors react to a firm’s CSR activities or the strategic benefits firms gain from engaging in CSR, these studies have not been able to provide definitive causal links due to unclear motives for CSR.

My research utilizes the 2013 mandatory CSR rule in India as an empirical design to provide causal insights into the relationships among investors, firms, and CSR. This regulatory development offers a chance to study the responses of investors (debtholders, in this case) to the mandatory CSR rule, observe changes in firms’ access to external financing based on anticipated investor reactions, and assess whether improved CSR governance and transparency in spending can influence investor reactions. Understanding these causal relationships is crucial from a policy perspective, as it can inform and prepare other nations about the potential impacts of mandating CSR.

On August 29, 2013, both houses of the Indian parliament, the Lok Sabha (lower house) and the Rajya Sabha (upper house), passed a mandatory CSR rule (Clause 135) under the Indian Companies Act. This marked one of the world’s largest experiments in introducing CSR as a mandatory provision by imposing statutory obligations on companies to undertake CSR projects for social welfare activities, such as eradicating malnutrition, hunger, or poverty, or promoting health care. According to this rule, if a firm has a net worth of at least five billion Indian rupees (approximately USD $83 million), sales of INR 10 billion (about $167 million), or a net profit of INR 50 million (around $830,000) or more during any fiscal year, it must spend 2% of its average net profits from the last three years on CSR-related activities. Notably, the Indian government not only mandated CSR expenditure thresholds for targeted firms but also imposed requirements for CSR governance. Firms affected by this rule must establish a CSR committee comprising at least three directors, including one independent director. This committee is responsible for formulating the CSR policy, recommending expenditure levels, and periodically monitoring its implementation.

The Indian Companies Act also included financial provisions that would make companies’ finances more transparent for investors and thus reduce the cost of raising capital. These included the revision of financial statements, increased auditor liability, and mandatory auditor rotation. The Act created a natural experiment to show how mandatory CSR impacts the cost of capital, with the control group comprising those companies below the CSR threshold and the treatment group those firms above the threshold, and thus affected by the rule. Presumably, the financial provisions of the Act should reduce the costs of capital. If companies above the threshold do not subsequently see lower costs, it is because the CSR rule raised them.

After gathering data from reputable databases such as SDC Platinum, NSE InfoBase, and ProwessDx, and preparing it for the empirical examination, the study encompassed 183 firms and 2,413 bond issues over a period spanning from August 30, 2010, to August 30, 2016. The analysis reveals that mandatory CSR regulations increased the yield spread of corporate debt by 43 basis points for targeted firms, effectively negating the benefits from the financial provisions of the Indian Companies Act. In a counterfactual world without the mandatory CSR rule, the Act would have likely reduced the cost of capital for all firms by 1.08%, on average. The introduction of mandatory CSR obligations led affected firms to experience a widening gap due to a loss in free cash flow, which is crucial for investor confidence. However, these firms appear to have anticipated investor reactions by reducing their reliance on external financing (proxied as amount issued by sale), which decreased by 14.4% during the period of this study.

Noteworthy, though (and also the lesson from the financial provisions of the Act), is that firms above the threshold that made transparent the costs of their CSR expenditures and the mechanisms by which they observed the stipulations of the CSR rule, such as which NGOs they involved to execute their CSR initiatives, were able counterbalance the rise in costs for raising capital. One possible explanation for this phenomenon is that increased transparency allayed investors’ concerns that CSR funds were being misappropriated and were being spent to enhance the firm’s value and brand. There have been reports of CSR funds being laundered.   

Another key aspect to explore is whether investor reactions and firm responses are driven by the mandate of CSR expenditure or CSR governance. To address this, I used a large language model to extract data on CSR committees and governance from CSR reports, including the composition of CSR committees, specific CSR activities carried out, their execution, and compliance with CSR regulations. Using an approximation of the number of members on CSR committees as a proxy for dedication to CSR governance, I observed that having at least three committee members correlated with a 1.2% increase in the external financing for such affected firms. However, this did not alter the yield spread, indicating that changes in yield spread are predominantly influenced by mandatory CSR expenditure rather than governance aspects.

Overall, this study establishes a causal relationship between investor responses, firm actions, and mandatory corporate social responsibility (CSR) policies. Following the implementation of mandatory CSR regulations in India, investors raised the cost of capital for affected firms by at least 43 basis points compared to unaffected firms, primarily due to a reduction in free cash flow. In the absence of these regulations, these firms would have benefited from the financial provisions of the Indian Companies Act 2013. Anticipating investor reactions, firms responded by reducing their reliance on external financing. However, firms that maintained transparency in their CSR expenditures—by disclosing details on capital allocation and the roles of in-house foundations or external NGOs—were able to sustain or even increase their external financing levels, and experienced a less severe negative response from investors. This scenario provides valuable insights for countries considering the adoption of mandatory CSR. The findings suggest that investors prioritize returns over sustainability or social responsibility. If regulators aim to compel firms to deliver social goods, transparency regarding these social contributions is crucial. Clear communication about social initiatives can mitigate increases in capital costs and help firms maintain their external financing levels.

Author Disclosure: the author reports no conflicts of interest. You can read our disclosure policy here.

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.