Socially responsible investment, ethical rating, and separating contracts: A theoretical exploration in hospitality industry

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Highlights

  • Theoretically, role of ethical rating agency is explored.

  • Hotels with low ESG risk prefers signaling their worthiness.

  • Bayesian approach is followed to show the decision making process.

Abstract

This study theoretically examines the role of the ethical rating agencies. First, in an infinitely repeated game framework, it shows that hotels with low environmental, social, and governance risk would prefer to signal their worthiness to isolate them from risky ones. Next, by employing the Bayesian approach, this study shows that a socially responsible investment (SRI) would advise a hotel to obtain an ethical rating when the expected value of sample information turns positive. This analysis could guide future empirical investigation and policy frameworks about the ethical screening.

Introduction

It is essential for the firms in the hospitality industry like any other corporations to be ethical in their business perspective for achieving a sustainable growth. Following Wempe (2005), ethical firms are not only involved in making profit, however, drives the business in a way that benefits the society and doesn’t harm the environment. They, though, focus on business growth, profit-seeking remains as a secondary objective behind promoting societal well-being and achieving broader developmental goals (Power et al., 2017). Therefore, building a positive “ethical identity” for a firm in the tourism industry ranging from travel agents to international hotel chains is of utmost important due to the intangible nature of offerings and the subjective perception of the performance in its engagement with all stake holders including investors, employees, guests, regulators and society at large (Martínez et al., 2014). A firm is identified as an ethical one by virtue of its “social connectedness, openness, critical reflexivity, and responsiveness” (Balmer et al., 2007). One of the key ways to signal the “ethical identity” is to highlight the “ethical rating grade”. A hospitality firm with higher “ethical rating grade” is expected to attain higher ethical standards in its business activities.

An “ethical rating grade” issued by an ethical rating agency (ERA) shares information with the stakeholders that supplements common knowledge (Scalet and Kelly, 2010). Since the “opinions” of ERAs are broadly disseminated, extensively used, and unambiguously understood by all stakeholders including employees, customers, society, regulators as well as investors, “ethical rating grade” can communicate information on the business ethics of a corporation to a wider spectrum of potential investors. In contrast to the conventional “rating grade” that takes only the financial performance into account, ERAs build their “ethical rating grade” around a number of criteria based on the corporation’s business ethics and line of activity (Igalens and Gond, 2005). It is noteworthy to mention that ethical entrepreneurs, in the domain of hospitality industry, not only face monetary risk but also functional and social risks (Power et al., 2019). An “ethical rating grade” assigned by an ERA through a thorough and systematic assessment is expected to help the hotels to formulate strategies to cope with such risks.

The major players among these ethical rating agencies are EthicScan Canada Limited, KLD Research & Analytics Inc., MSCI ESG Research LLC, Sustainable Investment Research Institute Pty Ltd., IMUG Consulting Company, Novethic, and Sustainalytics, to name few. While these ethical rating agencies make use of diverse rating scales with various combinations of rating for sub-themes making up the final “ethical rating grade”, all rating grades are measured on an ordinal scale. For example, ethical rating provided by MSCI ESG Research LLC is based on three pillars – environment (E), social (S), and governance (G). “Environment” covers four themes – climate change, natural resources, pollution and waste, and environmental opportunities. “Social” pillar consists of four themes – human capital, product liability, stakeholder opposition, and social opportunities. The third pillar, “governance”, has two themes – corporate governance and corporate behaviour, which covers key issues like business ethics, anti-competitive practices, and tax transparency. Based on the assessment to what extent a corporation is managing it’s environmental, social, and governance (ESG) risk, it is awarded an “ethical rating grade” among the following seven rating grades – AAA, AA, A, BBB, BB, B, and CCC –in an ordinal scale. While “ethical rating grade” of AAA and AA indicates that the corporation follows the best risk management practices as compared to its peers and carries least exposure to the ESG-risk. They are termed as leader. Corporations with “ethical rating grade” of A, BBB, and B, are those who may be exposed to high ESG risk, but moderate in managing the risk. At the bottom, highly exposed corporations, with poor risk management practice, receive “ethical rating grade” of B and CCC. They are called laggard. This “ethical rating grade” provided by an ERA helps the socially responsible investments to build a portfolio with corporations having low ESG-risk.

“Ethical rating grade” is similarly important to the non-listed specialized hospitality firms such as eco-friendly resorts as it is to the publicly listed Hotel Chains. For example, upon studying 24 medium to large size hospitality properties during 2010–2014, Kularatne et al. (2019) suggest that being environmentally responsible substantially boosts the efficiency of the property, particularly in terms of enhancing energy efficiency and better management of waste. On average, half of a property’s' electricity consumption is attributed to the air-conditioning, followed by 20 percent for illumination. Non-listed specialized hospitality firms that may not signal their strength on ESG to the investors, even gain by the “ethical rating grade” as their very initiative on the water and energy management fronts would make them cost competitive, save money and attract guests who are environmentally concerned. Along similar lines, recent scholarly investigations (e.g., Martínez García de Leaniz, 2015; Martínez García de Leaniz et al., 2017; Wang et al., 2018; Merli et al., 2019) suggest that guests duly recognize a property’s environmental commitment and a property’s green initiatives positively influence guest’s satisfaction and loyalty. A higher “ethical rating grade” may not be used by a privately held eco-friendly property to attract investors, but would differentiate it from the peers by signalling its environmental and social commitments to the environmentally concerned guests and improve their occupancy rate (O’Neill and Mattila, 2006). Additionally, higher end (i.e., luxury) properties, that are perceived to be less socially focused in general (Pinto et al., 2019), would also opt for ethical rating to solicit investment from the social investors. Therefore, in recent years, an increasing number of firms in the tourism industry, both from the listed and non-listed segments, are opting for “ethical rating grade”.

In contrast to the extensive empirical research on the usefulness of ethical rating, theoretical research on ethical rating is still limited (noted exception, Adam and Shavit, 2008). This study attempts to fill this void in the existing literature. From the methodological front, first, I have used the infinitely repeated game framework. As investors are long run players that participate in multiple rounds of investments based on the profit potential of a firm, I select infinitely repeated game over that of the games with finite stages. Bayesian approach is also employed here as it is a useful technique for inferring probabilities in games with asymmetric information among the players. Given limited amount of information about the counter economic agents, participants attempt to determine other players’ information by following each other’s action. Those observed actions along with their consequences are used to estimate the probabilities of those information. Bayesian rule is a tool to infer such probabilities (Dixit et al., 2010, p. 358).

I follow the approach of deductive reasoning, where I start with a general infinitely repeated game theoretic model and Bayesian tool of inferring probabilities in games with limited information. Then I apply this general theory in the context of the hospitality industry. I have derived the conclusion through the logical reasoning where the conclusion pertaining to the hospitality industry necessarily follows from the fundamentals of game theory. By virtue of its applicative nature, the outcome of the theoretical modelling for the hospitality industry shows that both the SRI looking for hotels with low-ESG risk for investing and low-ESG risk hotels favour ethical rating to overcome the challenges of asymmetric information. This theoretical postulation would guide towards the building of hypotheses and choice of appropriate research method for conducting survey based study or even experimental research. Furthermore, a strong theoretical framework as postulated in this study would always complement the data driven scientific inquiry not only in helping to choose the right variables but also to understand how those key variables would vary under different circumstances.

The present study endeavours to contribute in the following three ways. First, it develops a single-period investment game, which is extended to an infinitely repeated game, to show that the market, in which socially responsible investments choose hotels and vice-versa, without an ethical rating agency eventually leads to pooling contracts. Under pooling contracts, ethical hotels with low ESG-risk are forced to subsidize their risky counterparts by paying the same price as their risky counterparts. This analysis shows that the ethical hotels would prefer to signal their worthiness in ESG parameters through “ethical rating grade” to isolate them from the risky ones. Second, from the investor’s perspective, it is explored when a hotel should be advised to be rated by an ERA. By employing the Bayesian approach, it is shown that a socially responsible investment would advise a hotel to obtain an ethical rating if and only if the expected value of sample information, i.e., the difference between the expected payoff with more information from an ethical rating and the expected payoff without an ethical rating, is positive. From the hotel’s perspective, this analysis shows that an ethical rating is beneficial if and only if the net financial benefit from the separating contract, over that from the pooling contract, covers the financial outlay associated with obtaining an ethical rating. This approach has hardly been employed in the extant theoretical literature on socially responsible investment and ethical rating developed thus far.

The outcome of this theoretical modelling would be useful to firms across the service and product domain as a higher “ethical rating grade” would strengthen a firm’s “ethical identity”. As “ethical identity” differentiates a firm from its competitors (Siltaoja, 2006), over a period, more firms in a brand-crowded hospitality industry are engaging themselves in building a positive ethical image (Heikkurinen, 2010;) and vetting their engagement with the society at large through the ERAs. Evidence (e.g., Herstein et al., 2007; Herstein and Mitki, 2008) shows that hospitality firms with strong “ethical identity” have increased their market share besides taking a positive role in expanding the market size. O’Neill and Mattila (2006) suggest that hotels with strong “ethical identity” not only enjoy easier access to both the debt and equity markets, but also attain higher profitability through better occupancy and higher revenue per available room. As hospitality firms have identifiable corporate social responsibility (CSR) given their deeper involvement with local society and natural environment (Henderson, 2007), stronger “ethical identity” signalled by higher “ethical rating grade” helps a hospitality firm achieve a greater synergy between CSR duties and brand building exercises (Martínez and Rodríguez del Bosque, 2013; Karaosmanoglu et al., 2016).

The rest of this paper proceeds as follows. Section 2 reviews the literature. The first sub-section under Section 3 analyses the market without ethical rating agencies, followed by an analysis of the market with ethical rating agencies. The final section draws conclusion of this study.

Section snippets

Literature review

This study draws its motivation from the continuous debate on the usefulness of ethical rating. Primarily, there are three different strands, in the existing literature, regarding the effect of ethical screening on the performance of the stocks that clear the screening mechanism. The first set of research is in support of ethical screening (e.g., Fischer and Khoury, 2007; Herremans et al., 1993; Slager, 2012; Crifo and Mottis, 2013; Capelle-Blancard and Monjon, 2014) that argues for higher

Basic model: market without ethical rating agencies

We analyze a market with two risk-neutral economic agents, namely, a socially responsible investment (SRI) interested in an institutional investment in enterprise with low ESG risk and a hotel.

Consider the investment game1, where at the beginning of the game the hotel has approached the SRI with an investment proposal of amount. Investment amount I would yield a

Conclusion

In this study, first, an infinitely repeated investment game is developed to show that without ethical rating agencies, hotels that stand high on environmental, social, and governance parameters, i.e., those with low ESG risk, are forced to compensate their risky counterparts by paying a uniform price, to the institutional investments, in terms of dividend payment. This calls for the involvement of ethical rating agencies to independently vet the worthiness of individual hotel and assign

Declaration of Competing Interest

None

Acknowledgements

I am thankful to the Editor and three anonymous referees for their helpful comments that have improved the paper substantially. I also thank Manojit Chattopadhyay and Subrata Kumar Mitra for valuable insights. However, I am solely responsible for any error.

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      However, investors' increasing demand for ESG-related products is forcing the investment management industry to rebalance the financial versus social impacts of their investment decisions. The term that describes this investment philosophy can vary with the investor and has grown over the past several decades to include “socially responsible” investment (e.g., Adam and Shauki, 2014; Auer, 2016; Ballestero et al., 2012; Derwall and Koedijk, 2009; Domini, 2001; Drut, 2010; El Ghoul and Karoui, 2017; Galema et al., 2008; Hill et al., 2007; Humphrey and Lee, 2011; Jin et al., 2006; Losse and Geissdoerfer, 2021; Martí-Ballester, 2015; Pal, 2021; Renneboog, Ter Horst, & Zhang, 2008b; Shieh, 2016; Widyawati, 2020), “ethical” investing (e.g., Bauer et al., 2005; Cowton, 1999; Cummings, 2000; Delle Foglie and Panetta, 2020; Narayan et al., 2021; Schwartz, 2003), and “values-based” investment (e.g., Kirchsteiger et al., 2006). In general, an investment style that considers environmental (E), social (S) and governance (G) factors in making investment decisions is referred to as “ESG investing.”

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