Legitimacy Theory and Its Testing: Carbon Disclosure and Risk

This report delves into the application of Legitimacy Theory within the context of corporate governance and carbon emissions. It examines how companies use voluntary disclosures to manage their carbon footprint and maintain legitimacy with stakeholders. The report explores the practical and theoretical aspects of this, including a literature review of social contracts, legitimacy theory, and related concepts. It presents a hypothesis regarding the relationship between carbon risk management and carbon disclosure, supported by data from the Carbon Disclosure Project and other sources. The analysis considers the motivations behind corporate carbon emission disclosures, distinguishing between companies driven by genuine environmental concerns and those seeking to avoid penalties. The report highlights the importance of this theory in ensuring companies adhere to government regulations and maintain a positive reputation, providing a comprehensive overview of the factors influencing corporate environmental behavior and its impact on financial performance. The report utilizes various methodologies like regression to test the hypothesis and derives conclusions based on the analysis of data from various sources.

LEGITIMACY THEORY
AND ITS TESTING
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Contents
INTRODUCTION...........................................................................................................................................3
MOTIVATION...............................................................................................................................................3
PRACTICAL...............................................................................................................................................3
THEORETICAL...........................................................................................................................................4
LITERATURE REVIEW....................................................................................................................................4
HYPOTHESIS.................................................................................................................................................6
APPENDIX....................................................................................................................................................7
REFERENCES..............................................................................................................................................10
2

INTRODUCTION
Each and every company is required to maintain the good corporate governance and is required
to follow the generally accepted accounting policies and the relevant accounting standards. In
case the company does not follow then it will end up with the failure. In the literature review, the
company’s mandatory or the voluntary disclosures have been discussed with reference to the
base theory which is known as the Legitimacy Theory. The presence of the legitimacy theory is
very essential in every business whether it is trading or manufacturing. The main focus has been
laid down on the theoretical and the practical applications that are being followed by the
company. It is related to the climate change that the country in which the company operates is
facing. Two variables have been considered – one is voluntary management (dependent) and
other one is legitimacy crisis (independent). At first the motivational factors has been detailed
and after that the literature review has been conducted with the hypothesis testing. The main aim
or issue of the literature review is that what are the guidelines issued by the Government
regulations and what motivates the companies to follow them. They follow it mandatorily or
voluntarily.
With this aim the review has been divided into the different headings and the subheadings.
MOTIVATION
The issue of maintaining the climate in its original condition is very important in current
scenario. In the today’s world every company is emitting the carbon and thus is becoming the
reasons for the climate change. The motivation of considering the issue for discussion has come
from the below two factors:
PRACTICAL
The major source of the carbon emissions are the companies operating in different parts of the
World. Every company shall work in such a manner that the carbon emissions shall be at the
minimum and shall not affect in any manner to the society and the environment of the country.
For doing this the company has started making voluntary disclosures as to how much they have
emitted during the year and how the financial performance of the company has been affected by
3

such emission. On practical note, till now the Government has not made it mandatory for the
companies to disclose the carbon emissions. In order to survive in the market the companies are
required to disclose it so as to gain the interest of the stakeholder of the company. Data has been
obtained from the Carbon Disclosure Project.
THEORETICAL
The theory that has been underlined over the study is the Legitimacy theory. The theory aims
that the company shall follow all the guidelines and the policies of the government authorities
and shall disclose all the financial and non financial information of the company in the Annual
report and other reports annexed to the annual report. In the current scenario, the companies are
more convenient with the disclosure of the information for the user of the financial statements.
Earlier researches have been conducted which has been done in relation to social contracts and
the accounting by following the auditor and auditee relationship.
LITERATURE REVIEW
Social Contracts - The term social contract implies the arrangement or the agreement that is
entered into between the two parties. In the context of this literature review the social contract is
the arrangement entered into between the government and other stakeholders of the company and
the company. The basic premise of the social contract is that the company is required to protect
the stakeholders of the company and the society from the negative effects of the working of the
company in the country. For instance the social and environmental effects like carbon emissions,
production of hazardous gases, etc. If light is thrown in the history of the World, the social
contract was first entered into by the people of the country with the king so as to protect them
from the acquirers outside the state. The basic objective is to save the life of the people staying
and residing in that country (Baker, 2013 and Cruess, 2008).
Legitimacy Theory - The word legitimacy is single but it has relevance in almost all the fields.
The term shall be considered all the time and in performance of every task. It provides the belief
that the work that has been done has been so performed within the pre defined rules and
regulations and the underlying policies (Burlea, 2013). It is also said that if the work has not
4

been performed as per the rules and regulations then the work so performed is tend not to be
legitimate. The similar case applies to the different companies operating across the World. They
have entered into the social contracts with the society and environment and the government and
therefore, they have the responsibility to provide all the useful information to the stakeholders of
the company. The legitimacy theory is based on the three theories namely – Institutional,
Management and the stakeholder theory (Donaldson & Preston, 2005). According to the
institutional theory, the company is required to follow the predefined rules and regulations for
the performance of the work; the management theory entails that all the work shall be integrated
and focused towards the accomplishment of the common goals and the stakeholder theory states
that the company shall perform its activities in such a way that the wealth of the shareholder
shall be increased and the other stakeholder’s interest shall, be considered as the top priority. In
such sense, the theory of legitimacy covers all the aspects which are required by the Carbon
Disclosure Project.
Following the legitimacy theory, most of the companies have started disclosing all the relevant
information in their annual report and the corporate social responsibility statement along with the
sustainability report.
In the current scenario, the companies know that it is very necessary to reduce the carbon
emission and save the environment and the society. In order to survive in the market, the
companies are required to disclose how much emission they have made during the year. By
following the industry norms, some companies have targeted the percentage above which the
carbon shall not be emitted from the operations of the company. The setting of target by the
companies to reduce the carbon emission is the part of the technique known as the Carbon
Management. The companies set the minimum target and disclose it publically by making it
available on the website of the Government under the Climate Disclosure Project. Sometimes
setting the target and disclosing the carbon emissions have been seen as wrongful. It is because
of the attitude of the company then it has while performing the work. The setting of the target is
itself an example of the commitment made by the company towards the compliance with the
reduced carbon emissions as laid down in the Carbon Disclosure Project.
There are two types of companies which disclose all the information. One is good company
which discloses all the information in the view that the company will be able operate in the
industry and will have good reputation and by disclosing the same the company will not be in
5

any danger situation. The other company is the company which in actual emits carbon in excess
of the industry norms and discloses the relevant information in the view that the disclosure of
any kind of information will not give negative effects but non disclosure of the information may
lead to the penalty and thus they discloses it. All disclosures are required to be made under the
Carbon Disclosure Project. Although it has not been made mandatory but the companies have
started following it voluntarily (Rahman, 2014).
Through this theory, the companies will be motivated to present the true and the fair financial
position to the stakeholders of the company and also the correct non financial information.
Out of the largest G 500 companies, 288 company’s data have been used for the analysis and
thereafter the hypothesis has been developed. The first hypothesis for which the model has been
developed is that there is the clear and the positive relationship between the carbon risk
management and the disclosure by the companies. 297 companies have not been considered
because of the reasons that they have not disclosed the information about the carbon emission.
Carbon Disclosure Scores have been found using the two proxies (Najah, 2011). One is the
Carbon Disclosure Leaders Index, 2009 and other one is the Carbon disclosure score which is
based on the report of the company – Sustainability report forming part of the annual report of
the company. The first proxy has been developed by the Big Audit firms. Following the
hypothesis testing, Carbon disclosure project performance methodology has been used wherein
the final score obtained by the companies are calculated using the percentage formula which
helps in assessing the performance of the company. After that the regression method has been
adopted and on the basis of the regression method adopted on the hypothesis, the results have
been obtained.
HYPOTHESIS
The result of the first hypothesis is that the carbon risk management is directly linked with the
carbon disclosure made by the management of the company. Thus, the legitimacy theory makes
the company to disclose all the information.
6

APPENDIX
S.
No
.
Author Dat
e
Title Journal Type of
Paper
(Theoretic
al or
Empirical
)
If
Empiric
al,
Researc
h
Method
and
Sample
If
Empirical,
Dependent
and
Independe
nt
Variables
Summary
1 Najah
M
201
1
Are
Climate
Change
Disclosure
s an
indicator of
superior
climate
change risk
manageme
nt
Universit
y of
Queensla
nd
Empirical Sample
and Data
Collecti
on
Carbon
Disclosure
and
Carbon
Risk
Manageme
nt
The
hypothesis
testing has
laid down
that the
carbon
disclosure
and the
carbon risk
manageme
nt s
directly
linked to
each other.
While
performing
the testing
the author
has
7

adopted
the
regression
methods.
2 Rahman
N
201
4
Exploring
the
difference
between
the Carbon
Performan
ce,
Reporting
and Firm
Performan
ce
Journal of
Science
Direct
Theoretic
al
NA NA It has
linked the
Carbon
emissions
and
delivered
through
the Green
House
Emissions
and
Protocol.
3 Talbot
D
201
3
Accountin
g for Green
House Gas
Emissions
Universit
y of
South
America
Theoretic
al
NA NA It helps in
analyzing
the quality
of the
climate
informatio
n that has
been
disclosed
by the
companies
in their
sustainabili
ty report.
4 Ennis C 201 Exploring Journal of Theoretic NA NA It has
8

3 the
Relationshi
ps between
the Carbon
Disclosure
and the
Performan
ce
Social
and
Behavior
al
Sciences
al thrown the
light on the
Carbon
Disclosure
project and
how the
companies
have
complied
with the
project
guidelines.
5 Stephan
ie Y
201
6
Corporate
Carbon
Emission
and
Financial
Performan
ce
Henley
Business
School
Theoretic
al
NA NA The study
has been
majorly
conducted
for United
Kingdom
and it has
been
verified
the
relationshi
p between
the
emission
and the
performan
ce.
9

REFERENCES
Burlea S, (2013), “Legitimacy Theory” available on
https://www.researchgate.net/publication/303928907_Legitimacy_Theory accessed on
30/08/2017.
Baker E, (2013), “Social Contract, Essays by Locke, Hume and Rousseau” Read Books Ltd., p
34 -43
Cruess R L, (2008), “Expectations and obligations: professionalism and medicines social
Contract with society. Perspectives in Biology and Medicine”, 51(4), 579-598.
Donaldson T, & Preston, L. E, (2005), “The stakeholder theory of the corporation: Concepts,
Evidence, and implications Academy of management Review” 20(1), 65-91.
Najah M, (2011), “Are Climate Change Disclosures an indicator of superior climate change risk
management”, available at http://mams.rmit.edu.au/myfzrqb7lhvw1.pdf accessed on 30-08-2017
Rahman N, (2014), “Exploring the Relationships between the Carbon Disclosure and the
Performance”, Journal of Social and Behavioral Sciences, 164, pp 118-125
10