Some Thoughts on Regulations

The more I read and listen to about creating larger social, environmental and economic capital, the further I drift from seeing a solution to the pressing problems the world is facing today. The challenges that we talk about – poverty, political instability, social and economic inequality, unemployment, malnutrition, food shortage, water resources, climate change, terrorism – are huge, complex, interrelated and deeply rooted. In addition to that, if not done right, solving one challenge might elevate other in the negative direction.

As said by one of the professors during my MBA program, Confusion is the start of process of discovery towards insight. But confusion itself has to be structured. You can’t be confused about the confusion. So I decided to put my thoughts onto a paper with the hope that one day I could reflect upon my journey through the challenging times that we are facing today.

The engine of the world economy runs when people earn livelihoods, which is facilitated by public sector, private sector and social sector organizations. These organizations are the representatives of groups of people, commonly called the stakeholders, who have a set of interests and who want their representative organizations to pursue those interests. Generally speaking, it is hard for any organization to pursue and fulfill the interests of all its members. So as a compromise, the organization chooses to pursue the most common interests of those members with the highest voting power and greatest influence.

So far so good. Let us start with private sector organizations. Private sector has played an enormous role in building and shaping overall well-being of the humanity. In addition to creating livelihoods, private sector provides marketable skills, builds infrastructure, catalyzes urban migration, raises economy of scale, provides tax capital, leads innovation and so on and so forth. In addition to that private sector is involved in many CSR activities. For example, Vale, the world’s second largest mining company, provides education and skills to low income families in the areas they operate in. Tata, in India, has built townships that provide education and overall positive environment for the well-being of its employees.

Most private sector organizations, especially those that contribute significantly toward running the economic engine, are represented by those that have above average wealth. To a large extent the objective of the private sector organization still is to maximize the value of its shareholders in short to medium term. Of course there is nothing wrong with that per se. We human, by nature, are greedy and perhaps we are better that way. The problem starts to arise when the private sector organizations create value at the expense of non-member individuals by direct misappropriation or by imposing negative external costs.

Fortunately, direct misappropriation has become less common (though not that much so as evident through the recent financial crisis) but most non-members still continue to pay the cost of externalities without receiving the benefit in any form. For example, the communities living close to the coal power plants often breath toxic gases such as carbon monoxide. They pay enormous costs with shorter life. The early demise of sole bread earner in such communities further perpetuates the poverty trap. The irony is that they work hard to light millions of houses at a very high personal expense while their own homes have no access to electricity.

Let us have a sky level view of the public sector organizations. One can argue that a democratically elected government, in true sense, is a representative of every citizen of the country and is thus bound, legally or morally, to fulfil the interests of its citizen. So if we compare the representation of the bottom half of the population of a country in public and private institutions, the public sector would fare better. Public sector, by choice or necessity, corrupt or honest, efficient or bureaucratic, is the system that the bottom of the population puts its trust in to vanguard its interest.

It has been well establish that it the bottom half of the population that pays for the costs of externalities. So the first step for the organization that represents the bottom half of the population is to transfer that cost to its origin. How do we transfer the cost back to where it occurred? I see three ways by which the external costs can be transferred back to the entities that created those costs in the first place.

1. Self-correcting behaviour of the private sector organizations
2. Lifting the social and economic status of the individuals to become influential in the private sector so they can demand the internalization of the cost
3. Regulations to transfer the cost from the bearer to the producer/consumer

The possibility of option two happening anytime soon is quite unlikely. And this option would require high degree of social and economic equality, which would be hard to achieve without bringing democracy, capitalism, peace and innovation into the danger zone. So let us focus on option 1 and 3.

Should the government and the bottom of the pyramid leave it to the moral or economic judgement of the private sector organizations to make this transition or should the government regulate the private sector to adopt more responsible practices and take on the additional cost?

Some experts argue that the private sector industry exhibit self-correcting behaviour and that the non-sustainable practices, in long term, would weed out any competitive advantage that they enjoy. This would force them to adopt sustainable social and environmental practices while creating value for shareholders as well. This is commonly known as shared values or triple bottom like – People, Plant and Profit. We have seen the example of many organizations, such as Unilever, Proctor & Gamble, that have taken significant steps towards achieving sustainable production. However, such examples are limited both in terms of number of firms and scale of adoption and impact. Secondly, even though the consumers are becoming more environmentally conscious, Green Washing still remains a common practice even in many reputable multinationals.

As we have seen in a recent CEO study done by Accenture, the businesses have reached a plateau (or Nash equilibrium) and they find it significantly harder to create social value without compromising on the business value. We understand that to get out of this Nash equilibrium, the private sector needs to collaborate within a legal framework. But doing so would require long term thinking, mutual trust and moving out of “you first” attitude. Unfortunately, the pressure on the private sector to perform well in short term undermines any long term strategy that managers dare to envision, leading to the classic problem of market failure. Thus solution 1 doesn’t seem to be that viable.

The solution to this problem is not that complicated, at least I would like to believe so. We need to tackle sustainability on the supply as well as on the demand side. The current practice of buying and trading carbon credits is simply not effective enough and can easily be gamed. Sector wide regulations on firms need to be imposed to internalize the cost of externalities. Such internalization should be in the form of carbon tax, water tax, fair wages tax etc. This internalization would affect the bottom line and thus would ultimately be reflected in the share price. To financially sustain, the firms would need to innovate keeping a long term vision. Such regulations would immediately align the short term interests of an organization, i.e. maximizing shareholders value, with the long term interests of the society as well as the shareholders.

The demand side of the equation is somewhat difficult to correct. While making the buying decision, we tend to ignore the external cost of the product. A temporary increase in production cost would be passed onto the consumers, which might create a societal backlash. Therefore, such measures must be accompanied by educational campaigns. The democratic governments need to get out of the populist mindset and take bold steps even though it might temporarily slide the economy downwards.

The challenges we face today have reached a level that can not be reversed. In a recent conversation with a high level official at the UN, I learnt that such a well informed and powerful agency as the UN, never imagined that such events could ever unfold. But they did. The one and only thing that could save us from the dangerous unknown we are heading towards is greater global cooperation.