Capitalism and Crises

Regulation has been getting a bad press.   It will be diluted in the US under the Trump administration, it will be curtailed in the EU to revive flagging European economies, and it is blamed for failures in privatized utilities in the UK.   An instrument that is supposed to be at the heart of policy formulation has become a source of social division and political polarization around the world.

Why is this happening?  My most recent book, Capitalism and Crises: How to Fix Them, explains this.  It argues that at the heart of the problem is the fuel that drives capitalism – profit.   Profit is the source of the resources that power and incentivize firms.  Without profit there is no capital in capitalism.  In many cases, profit promotes benefits for us as individuals, societies and the natural.   But in some cases, it does not – it creates detriments, not benefits, in the form of pollution, global warming, biodiversity loss, inequality and social exclusion.

These are conventionally classified in economics as “negative externalities” that arise because of “market failures” – incomplete markets, asymmetric information, imperfect competition and transaction costs.  One solution to these failures is regulation to prevent firms engaging in activities that cause harms.  As a result, the last few years have seen a plethora of new rules that regulate virtually all aspects of economic activity in one form or another.  This has been a source of growing concern and has come under increased scrutiny.

The problem that has arisen is both the ineffectiveness of regulation to prevent harms and the harmful effects of regulation on output, growth, investment and competitiveness.  The former prompts demand by those on the political left for more regulation with stronger enforcement, and the latter creates calls by those on the political right for deregulation.  The result is social fracturing and ideological intransigence.

It is important to appreciate that the individual, social and environmental problems which have come to the fore over the last few decades are not just negative externalities – external and extrinsic to firms.  They are very much internal and intrinsic to the fuel that powers firms, namely their profits.  So long as the problem is attributed to externalities, we will continue to misdiagnose the problem and mis-specify the solution. 

Businesses lobby against the imposition of regulation and seek to avoid and minimize its impact.  International mobility of firms and failures to harmonize regulation across countries limit the ability of governments to curtail such behaviour, and accelerating technological advances leave regulators behind, tackling yesterday’s problems with today’s tools. The nature of regulation needs to be reformed if it is to correct market failures effectively.

What is required is for regulation to align the interests of companies in earning profits for their investors with those of individuals, societies and the environment on whom they impact.  At present regulation is either focused on the inputs that companies use or the outputs they produce.  For example, regulation of the prices utilities are allowed to charge their customers is based on labour, material and capital inputs and projected operating and capital costs.  Regulatory standards are specified in relation to the quality of firm’s outputs, their products, and the criteria by which those outputs should be assessed – safety, reliability, risk and effectiveness. 

However, it is not just inputs and outputs that should be the focus of regulation but also the outcomes and impacts of firm activities – their processes and procedures as well as their inputs and outputs.  The firm affects the world around it through the changes it brings about (the outcomes) and the effect that those have on human and natural world wellbeing and flourishing (the impacts). 

To quote from Capitalism and Crises (pp. 148-149): “Take the example of a car.  A car company produces vehicles that allow passengers to move at speed and comfort.  But they also create noise and environmentally damaging emissions.   The inputs are the resources used (materials, labour, capital) in producing the outputs, which are the cars.   The outcomes are speed and comfort of travel for the passengers, and noise and pollution for pedestrians and residents.  The impacts are positive solutions to problems of mobility and enjoyment for passengers, and negative environmental detriments for pedestrians and residents.

There are therefore two aspects to evaluating the performance of a firm.   The first is to determine the changes that occur from what a company does as well as what it produces, in this case not just the transportation benefits and pollution detriments of its cars but also the effect of its production on countries from which it extracts material resources and the communities in which it produces cars. 

The second element is to identify the effects of these changes on the wellbeing of affected parties – beneficial for customers, passengers, and employees, detrimental for pedestrians, residents, and local and foreign communities where the cars are produced, and its material resources sourced.  The first relates to the internal governance of the firm’s productive activities and products, and the second to its external governance and engagement with other parties.”

The role of “external governance” through regulation is to address the negative environmental detriments for pedestrians and residents, and the environmental and social detriments for communities where cars are produced and resources are extracted.   What regulation should be doing is to seek to align the incentives on firms to earn profits with the avoidance of detriments, not just through restricting production of cars or raising costs of production, but by incentivizing the avoidance of pollution and social harms.

This is done by measuring the outcomes that companies create and looking to them to “profit without harm”, i.e., without imposing detriments on other parties.  The metrics are no different from key performance indicators (KPIs) that companies conventionally employ when measuring their inputs and outputs, extended to include the impacts they have on other parties.  There is no need to convert these metrics into monetary terms; they are measured in whatever units reflect the effects that their activities have on others, e.g., decibels of noise or density of particulates. 

In the case of utilities that are natural monopolies, for example water and railways, regulators should seek not only to avoid detriments but also to determine the prices that companies can charge for the goods and services they provide.  Prices and permitted rates of return on capital employed should relate to the positive outcomes and impacts that companies have on their customers, communities and environment as well as to the avoidance of detriments.  For example, there is currently considerable concern about discharge of raw sewage into rivers, lakes and seashores by water companies in the UK.  Their performance should be measured in terms of prompt eradication of untreated sewage, as well as delivery of water of required standards to customers.

By focusing on outcomes, regulation is no different from how companies conventionally evaluate their performance in relation to the delivery of positive benefits and avoidance of negative detriments for their customers, employees, and communities, and the financial value they create for their investors in the process of doing this.  It renders the concept of environmental, social and governance (ESG) factors redundant because these are just some of the many KPIs that companies employ when evaluating the outcome of their activities.

This makes clear that the source of financial value creation for firms is the delivery of benefits without detriments for customers and other parties.   Companies profit from solving not creating problems for others.   Regulators lay down criteria by which the avoidance of detriments should be determined and the detrimental outcomes that companies must avoid or remedy in the process of delivering financial returns for their investors.

This also emphasizes the importance of “internal” as well as “external” governance of firms in the delivery of profits without detriments.  It is the role of the board of a company to ensure that its strategy, values and culture are aligned with the attainment of profitable problem solving without problem creation.   Regulators will wish to have oversight of this in utilities and other licensed businesses, such as banks, for which they are responsible.   In particular, the internal governance should ensure that there is complete acceptance throughout the organization of the corporate purpose of profiting from problem solving not creation, and a strong understanding by everyone from the board to the shop floor of their role in delivering on the company’s problem-solving purpose.

Most significantly, this approach addresses and resolves the political polarization that regulation has created.   There is no conflict between sound and effective regulation to align corporate interests with those of communities and the environment, and the interests of business, politicians and society in economic activity, growth, employment and investment.  A focus on financial value creation from problem solving encourages greater economic activity because it aligns the interests of governments in delivering public benefits with those of business in making money. 

This is therefore a way of forging effective partnerships between private and public sectors for the benefit of both, where at present there is a high level of mistrust and conflict between the two parties.   Companies profit from solving the problems that governments wish to address in the public interest, and governments in turn support companies that do this through public procurement, investment, subsidies, public charters and licences.  Outcome-based regulation that ensures profiting without harm thereby allows companies to capitalize on the positive externalities that they create for the benefit of society and the natural world, as well as their customers and investors.