Thursday, September 14, 2017

MANAGEMENT SPECIAL ......Should Industry Competitors Cooperate More to Solve World Problems?

Should Industry 
Competitors Cooperate 
More to Solve World 
Problems?


George Serafeim has a theory that if industry competitors collaborated more, big world problems could start to be addressed. Is that even possible in a market economy?

George Serafeim has a startling suggestion to fix the world’s biggest environmental, social, and governance (ESG) problems such as water pollution, deforestation, and wealth inequality: encourage companies within industries to do less competing and more cooperating.
For example, he argues, fashion industry competitors could agree among themselves to collectively manage resources to reduce the water pollution caused by their manufacturing processes.  The beef industry could agree to collaborate on ranching practices to reduce deforestation. These partnerships would happen pre-competition, meaning everyone would be starting on a level playing field when eventually competing in the market.
Wouldn’t such collaborations throw a monkey wrench into free-market capitalist competition? Serafeim says no, that collaboration is different from collusion. In this case, companies will be explicit about their cooperation and under scrutiny from investors, regulators, and their own legal experts. “Similar to airlines cooperating by purchasing jets together in order to lower costs collectively, collaborations are mutually beneficial but do not affect the fundamental relationships of competitors,” he says.
Serafeim, the Jakurski Family Associate Professor at Harvard Business School, discusses his theory in a recent email interview. His paper is calledInvestors as Stewards of the Commons?
Sean Silverthorne: Why is your proposal needed? Aren’t current ESG efforts already being done by  business enough?
George Serafeim: Think about the following: in the past two decades, most companies have established sustainability departments, hired more people for social impact, invested more resources, and published more reports, among many other wonderful things. In some cases, these efforts have brought real results. For example, many companies have increased diversity in their workforce. But overall, all these efforts have not been enough to actually stop or reverse serious challenges we are facing. Environmental degradation and challenges in social inclusion and equity are persistent issues that in many cases have worsened.
In our competitive landscape, ESG efforts are guided by economic incentives. Indeed, my research with colleagues has shown that improving firm performance on business-relevant ESG issues based on a firm’s industry membership has a positive association with future financial performance. A company’s efforts to improve its social impact could result in cost savings, increased brand value, innovation, employee productivity, and lower cost of financing. A great number of studies and researchers have documented such effects. Professor Geoffrey Jones’s new book, Profits and Sustainability: A History of Green Entrepreneurship, documents systematically some of the early business leaders who saw opportunities in this space.
While these studies suggest that positive social impact and financial returns could be complementary, it is not clear that over time firms will act in a way that will provide solutions to many of the problems we face today for three reasons. First, while in a relative sense a firm that improves its ESG performance could be better off financially in the future compared to other firms, it does not mean that the action is enough to make a meaningful contribution to the problem. For example, a firm might be better off by lifting wages for lower-level employees by $1 per hour, but it might not be economically viable to lift wages by $2 per hour. However, increasing wages by $1 could still leave these people with below-living wages.
Second, there are cases where improving a firm’s social impact does not help financially. In some cases consumers are not willing to pay more for “green” products, and in most cases only subsets of the customer base for specific products are willing to choose greener products. As a result, firms that take costly actions to source products in a sustainable way could find themselves with a higher cost structure, with lower profitability margins, and as a result at a competitive disadvantage.
Third, increasing wages or selecting suppliers with better environmental practices might bring a financial benefit in the long term; however, short-term pressures on the firm might make business leaders averse to making such investments. The market for corporate control, the design of executive compensation packages, and the board of directors’ evaluation horizons could be barriers to such decisions.
My work so far has concentrated on the ESG issues where firm-level action is actually producing value both for the company and for a positive social impact. With this paper, I am expanding the tent to incorporate ESG issues where that might not be the case, asking what is the role of investors in enabling companies to increase their social impact.
Silverthorne: What conditions must be present in an industry for this plan to work? Are there certain industries you think would have the most success?
Serafeim: The first condition in the context of the paper is that addressing the issue must be a value-creation opportunity for the whole industry. We are unlikely to see progress in cases where collaboration is unprofitable in both the short and the long term.
Second, large institutional investors must have significant ownership of a sizeable part of the key industry players. It is unlikely that much progress would be made for problems in industry settings where investors do not own some of the main industry competitors. If that is the case, then it would be harder to move a significant part of the industry to collaborate and effectively decrease the temptation to free ride.
Silverthorne: What would be the incentives for companies competing in the same industry to cooperate?
Serafeim: Most of the business leaders I have interacted with over the years genuinely want to do good. They recognize that there are many issues that need to be addressed either on environmental practices or on inclusion and equity. Addressing these issues is critical for the future competitiveness of these industries.
First, attracting talent to the industry is an important reason why companies might collaborate. Many great organizations operating in carbon-intensive businesses, for example, are worried about this point. How will you attract top talent graduating from universities if your company is considered to destroy the environment?
Second, competitors are interested in avoiding new regulations that might end up significantly increasing the burden for the industry. The financial industry is a good example. Banks used to be innovative, really providing service to customers and attracting top talent. They are now becoming utilities, facing an incredible amount of regulation largely because of their own conduct failures.
Third, they could reduce risk from exposure to major scandals. Pharmaceutical pricing is a good example here. More business leaders in the health care sector recognize that industry actors that engage in egregious pricing of drugs bring all kinds of problems to the whole industry.
Silverthorne: You note that companies by themselves are not likely to come to this point on their own. Investors have the power to bring them to the table. Which investors are most likely to be able to exert influence?
Serafeim: I identify two characteristics of investors that are likely to engage with companies at the industry-level on issues of environmental and social importance: they have a long time horizon and a significant common ownership of companies within the same industry or supply chain. Two types of investors satisfy both criteria. First, large, mostly passive asset managers such as BlackRock, State Street, and Vanguard. These investors hold significant shares of the equity, and as long as a company remains in the index they will keep holding the stock. Second, large pension funds such as Norges Bank Investment Management, AP, and the New York State Common Retirement Fund. They also tend to hold significant portions of the equity shares of many companies while matching assets to long-term liabilities.
These investors now formally recognize the importance of ESG issues for investment returns and stewardship. Large index investors have built teams that engage with companies in their portfolios, and large asset owners have been among the leaders in engaging with companies on environmental and social issues.
This does not mean that other investors do not have a role to play in this theory of change. In fact, I suggest that two other types of investors, socially responsible investment funds and individual investors, play a key role in addressing free-rider problems at the large institutional investor level (i.e., temptation of one asset manager to free ride on the engagement efforts of other asset managers) and providing direct incentives for engagement to large institutional investors.
Silverthorne: Could you give a hypothetical example or two of pre-competitive collaborative actions that investors could motivate?
Serafeim: Many cases and each one has its own strengths and weaknesses.
Beef is one of the biggest drivers of deforestation globally. Converting forests to pasture for beef cattle, primarily in Latin America, destroys 2.7 million hectares of tropical forests each year (an area the size of Massachusetts). It is costly for meat producers to address the issue of deforestation on their own. If they agree to slow down the process, they face the risk of losing market shares and revenues because they will not be able to find new pastures for beef cattle while other players in the industry keep cutting trees down. As a result, the issue of deforestation requires coordinated action from the major players. Ceres and the PRI (Principles for Responsible Investment) initiated a partnership in 2016 to tackle widespread, global deforestation driven by escalating production of beef, soy, and timber, focusing initially on South America. The two organizations support global institutional investors pressing food and timber companies to eliminate deforestation and other related concerns.
In another example, apparel production is associated with water pollution at many stages of the value chain. Agricultural crop production (particularly cotton) has been linked with inefficient agrochemical use, resulting in over-application and excess chemicals leaching into water systems. Wet processing is also particularly impactful. The World Bank estimates that 17–20 percent of industrial water pollution worldwide comes from textile coloration and treatment alone. When it comes to water, fashion brands face the same risks across their supply chains. The geographical dispersion of production sites is low, and therefore different players can benefit from collaborating on select engagements in priority river basins.
Other examples include tackling obesity and nutrition in the context of the food and beverage industry, bribery and corruption in the construction industry, and access to affordable products and inclusion in the education sector.
Silverthorne: Are there examples of this kind of intra-industry collaboration working elsewhere?
Serafeim: There are many such collaborations around the world. The International Council on Mining and Metals has developed transparency principles for mining firms, and the Responsible Care program of the chemical industry has focused on outcomes ranging from employee safety to environmental impact. Similarly, the Global Agri-business Alliance is developing an agreement for companies operating in different parts of the agriculture value chain on standards of conduct for improving livelihoods of farmers, among other outcomes. Some collaborations are effective, and others are not.
The research is mixed on their effectiveness because incentives (for companies) to defect are large at certain points in time. Commitment mechanisms are needed, and investors can be one of those commitment mechanisms. Professor Michael Toffel has done important work on self-regulation and its effectiveness.
Silverthorne: If embraced, do you think this idea would have much success in correcting the pressing problems of the world?
Serafeim: The number of people that believe this is the sole responsibility of governments [to solve] is decreasing. I see this as a chance to increase the scope of business leadership and create more win-win opportunities in the future. As more of these collaborations become effective, an increasing number of companies will be able to engage in activities that create a more positive social impact. Professor Rebecca Henderson is writing a fascinating book on this topic, which is inspired by the course Reimagining Capitalism: Business and Big Problems that we teach in the Elective Curriculum of the MBA Program.
While it is unlikely that investors will be able to solve many of the pressing societal problems, progress can be made.


by Sean Silverthorne

http://hbswk.hbs.edu/item/should-industries-forgo-competition-to-solve-the-world-s-biggest-problems?cid=spmailing-16602223-WK%20Newsletter%2008-30-2017%20(1)-August%2030,%202017

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