Archive for the ‘complexity’ Category

Ethics of Risk Management

Business is, in many ways, all about risk. It’s about investing in R&D and in productive processes that may or may not result in products that customers want to buy. It’s about hiring people and then putting your company’s reputation into their hands. It’s about trying and doing new things, always aware of the chance of failure. Society flourishes because businesses are willing to take risks. Of course, some risks should not be taken, and others should be taken only subject to suitable safeguards. Risk, in other words, needs to be managed.

Modern risk management, as that term is used in corporate contexts, has its roots in finance and refers primarily to the management of financial risks. It relies heavily on mathematical models used for asset pricing and portfolio assessment. Banks use risk management techniques to determine how many loans and mortgages of what kinds to hand out, and on what terms, and to figure out (within regulated limits) how much capital they need to keep on hand in case depositors come calling to reclaim their deposits. This all requires careful calculations. Take too little risk, and you’ve got money sitting idle. Take too many risks and, well, you end up with what we saw back in 2008.

Last week I had the pleasure of hosting Professor John Boatright, as part of the Business Ethics Speakers Series that I run at the Ted Rogers School of Management. John is the guy who literally wrote the book on ethics in finance. He’s author of Ethics in Finance and editor of Finance Ethics: Critical Issues in Theory and Practice. There simply is no one better on issues of ethics in finance. And his topic last week was an important one: “The Ethics of Risk Management: A Post-Crisis Perspective.”

As John’s talk pointed out, the advent of modern risk management strategies is, somewhat ironically, implicated in the financial crisis of ’08-’09, from which we are still recovering. The mathematical models risk managers use made possible the popularization of collateralized debt obligations (CDOs) and credit default swaps (CDSs). And the fact that there were actual hard-core equations behind these instruments — which Warren Buffett “financial weapons of mass destruction” — made them seem far safer than they were. This illusion of safety encouraged very high levels of leveraging, with what we now know to be disastrous consequences.

One of the other things that John’s talk clarified for me was that there’s a kind of ambiguity in the very term “risk management.” To the public, the idea of “managing” risks sounds very much like the idea of “reducing” risks. And that, of course, sounds like a very good thing. But risk management absolutely is not the same as risk reduction. Indeed, it can be quite the opposite. Risk management is the art of finding the right level and mix of risks, the right ‘risk profile.’ What matters ethically, as John pointed out is which risks are managed, by whom, by what means, for whose benefit.

The other point from John’s talk that I want to highlight here has to do with the ‘corporatization’ of risk management. As John pointed out, business firms both encounter and create risk, and risks are encountered by both firms and by individuals in society. If, as seems to be the case, risks to individuals are increasingly being managed by corporations, we as a society need to be acutely aware of the way corporations think about risk. John quoted author Michael Power as saying that “Risk is the basis for corporations to process morality.” In other words, risk is the lens through which corporations consider and act upon their obligations.

The problem here is clear: risk is an inherently outcomes-based construct, and not everything we care about ethically is a matter of outcomes. We also care about rights and duties, and about justice in the way good and bad outcomes are distributed. If risk becomes the lens through which obligations are examined, something important is being left out. Corporate risk management, in other words, is itself a mechanism that brings risks that need to be managed.

Needed: A High-Efficiency Oil Company

A Nimitz-class aircraft carrier is a hellishly complex piece of machinery. Picture a boat the length of three football fields, carrying several dozen heavily-armed aircraft into a war zone. It’s a boat with a crew of 3,200 plus an additional 2,400 involved in flying, maintaining, and launching aircraft. Oh, and it’s powered by a pair of Westinghouse A4W nuclear reactors.

As it happens, the US Navy has 10 such carriers. And on these unimaginably complex machines, errors of any significance are practically unknown. Time after time, F/A-18 Super Hornets laden with missiles are literally catapulted from the flight deck, sent out on missions, and then land again on the carrier’s super-short runway. And failure is practically unknown. This requires amazing skill on the part of pilots, but it also requires an incredible team effort, and a system built to include multiple redundant safeguards. The safety record of nuclear aircraft carriers is so good that they are now a standard example of highly-efficient, low-failure, complex systems, the kind that other complex systems should aspire to become. They are systems in which failure is simply not an option, and smart design makes sure it just doesn’t happen.

Next, let’s look at another complex system, namely an oil company and its network of pipelines. Let’s look in particular at one Canadian company, namely Enbridge. Enbridge’s pipeline system, as far as I can tell, is significantly more prone to failure than an aircraft carrier. Just under a year ago, I wrote about a leak in an Enbridge pipeline running past the tiny northern Canadian town of Wrigley. That was a small leak, but one that raised serious concerns for the local native community that eked out its living from the now-polluted land. That leak involved maybe a thousand barrels of oil. But just a year earlier, an Enbridge pipeline running through southwest Michigan spilled 20,000 barrels into a creek leading to the Kalamazoo River. And now, this past Friday, another significant leak was reported. This time, the company’s “Line 14″ spilled about a thousand barrels of crude into a field in Wisconsin. And this is just to name a few of the company’s pipelines over the last decade.

Of course, there’s no special reason to pick on Enbridge. Other companies in the oil exploration and refining industry have spotty records, too. BP is perhaps the most dramatic example that comes to mind. It was the company behind the explosion on the Deepwater Horizon, and the subsequent spill that devastated a big chunk of the Gulf coast.

There’s little doubt that, for the foreseeable future, oil companies like Enbridge and BP are a practical necessity. Like it or not, our economy depends on them. They are as necessary to our economy as an aircraft carrier is to the US’s naval supremacy. But the fact that those companies are so essential is precisely the thing that dictates that they must do better. They must seek the kind of never-fail efficiency exemplified by carriers like the USS Harry S. Truman and the USS Abraham Lincoln.

There are of course important differences between an aircraft carrier and a system of pipelines. For one thing, an aircraft carrier exists in a single place, under the watchful eye of a single Commanding Officer; a pipeline can stretch for thousands of unobserved miles, necessarily subject to only infrequent inspection. For another thing, various corporate motives summed up very imprecisely by the term “the profit motive” mean that there will always be temptations for oil companies to cut corners. But the example is there, and the body of knowledge is there. Oil companies can, and must, do better.

The Hidden Ethical Value of Social Networking

Like it or not, we are in the middle of a social networking revolution. And of course, that’s hardly news. Endless ink, digital and otherwise, has been spent on worrying over whether Facebook, Twitter, and their rapidly-multiplying ilk are the best or the worst thing that has ever happened to humankind.

A recent story about car-pooling apps highlights the fact modern technology, including social media, has a role to play in making markets more efficient. And since efficient markets are generally a good thing, this counts as a big checkmark in the “plus” column of our calculations concerning the net benefit of social media.

Carpooling is a great example, because the relative lack of carpooling today is a clear instance of what economists call “market failure” — a situation in which markets fail efficiently to provide a mutually-beneficial outcome. Think of it this way. There are lots of people in need of a ride. And there are lots of people with rides to offer. The problem is a lack of information (who is going my way, at what time?) and lack of trust (is that guy a potential serial killer?) Social networking promises to resolve both of those problems, first by helping people coordinate and second by using various mechanisms to make sure that everyone participating is more or less trustworthy.

With regard to car-pooling, the obvious benefits are environmental. But the positive effect here is quite general: just about any time we find a way to foster mutually-advantageous market exchanges, we’ve done something unambiguously good. This is one example of the ethical power of social media.

Another big enemy of efficient markets is monopoly power, or more generally any situation in which a buyer or seller is able to exert “market power,” essentially a situation in which some market actor enjoys a relative lack of competition and hence has the ability to throw its weight around. Social media promises improvements here, too. Sites like Groupon.com allow individuals to aggregate in ways that give them substantial bargaining power.

The general lesson here is that markets thrive on information. Indeed, economists’ formal models for efficient markets assume that all participants have full knowledge — that is, they assume that lack of information will never be an issue. Social networks are providing increasingly sophisticated mechanisms for aggregating, sharing, and filtering information, including important information about what consumers want, about what companies have to offer, and so on. So while a lot of attention has been paid to the sense in which social media are “bringing us together,” the real payoff may lie in the way social media render markets more efficient.

Customizing Ethical Products

So-called “ethical” products are in the news again. This time, the controversy is over whether the fairtrade movement should expand to include certification of large farms.

A controversy like this serves to highlight the complexity of the notion of an “ethical” product. After all, any product has many different characteristics, and hence many different dimensions of ethical concern. Just for starters, two food products of the same kind (say, two different brands of coffee) might vary in terms of whether they are FairTrade certified or not, whether they are organic or not, whether they are from countries with bad human-rights records, and so on. So the choice we face isn’t just between the ethical brand and the “other” brand; it might well be between two brands with different combinations of more, or less, ethical characteristics.

So here’s a thought experiment. Imagine a world in which mass customization technology make it possible for you, by purchasing online, to hyper-customize the products you buy, according to various ethical characteristics. Imagine you could choose, with a click of your mouse, any or all of a range of characteristics. And to make things more interesting (and likely more realistic) let’s say that each additional characteristic you ask for implies some additional cost. After all, some “ethical” production processes are costly, and some certification schemes are costly. So let’s imagine, say, that each additional ethical characteristic you opt for results in a modest 2% increase in the price of the product.

Given the opportunity to buy such customized products, which ethical characteristics would you choose to pay for?

Consider, for example, what you would choose faced with a website that let you order coffee and gave you the following options:


Or imagine being able to buy beef and to select from among the following characteristics:

Or again, imagine being offered the following choice with regard to the cotton from which your newly-tailored shirt is to be made:

This thought experiment raises several questions. For you, the consumer, it raises the question of which combination of ethical values you really want — and would be willing to pay for — in your purchases. For purveyors of “ethical” consumer products, it first raises doubts about the term itself, and about how confident companies can be that they’ve already identified “the” characteristics that make up an ethical product. Consider the light this sheds on the case of so-called “ethical veal,” as discussed in a recent story from the Guardian. Sure, the veal referred to in that story is ethically better in at least one way. But have the people selling it cognizant of the range of characteristics that different people regard as essential to making a food product truly ethical?

Of course, the shopping scenario imagined above is science fiction for now. You can buy customized shoes online, and customized chocolate bars, but as far as I know foods customized ethically are not yet on sale. If they were, would that make the choice faced by ethical consumers easier, or harder?

Investment Advice and Fiduciary Duties

Most of us rely on accredited professionals for a range of services. Doctors, lawyers, accountants and so on play a huge role in our lives, giving us advice and rendering services that we would be foolish to provide for ourselves. Some topics, in other words, are beyond the ken of even the dedicated do-it-yourselfer. Financial planning is in that category. If you plan to do anything much beyond storing your money in a mattress, you probably want help from a professional. And you hope — really, really hope — that that professional is on the ball and has your best interests at heart.

A recent story highlights some of the difficulties in this regard. The story is about an independent insurance agent facing jail time for selling a particular kind of investment — an indexed annuity — to an 83-year-old woman. The catch: prosecutors say the woman showed signs of dementia, and the implication is that the agent took advantage of the fact that the buyer may not have understood the limits and disadvantages of the investment instrument she was buying.

Even minus the question of the buyer’s competency, there are worries here. For perspective on this story, I talked to Prof. John Boatright, who literally wrote the book on ethics in finance. He pointed out to me that Equity-Indexed Annuities are so complex that they’re a dubious product quite generally. He also pointed out that such annuities are investment instruments sold by people in the insurance industry who are not truly investment specialists. Most investment instruments are regulated such that they can only be sold by investment professionals with suitable training and credentials.

But regardless of the kind of professional you go to for investment advice, the underlying ethical question is whether that professional is going to have your best interests at heart. When the thing you’re buying is too complex to understand, you have to put your trust in the seller. Such trust is best underpinned by what are called fiduciary duties. A fiduciary, roughly speaking, is someone to whom something of value is entrusted. And a professional who bears a fiduciary duty has a stronger obligation than a mere salesman. Someone out to sell you something — a car, a stereo, whatever — has a plain obligation not to deceive you, but generally isn’t obligated to make sure that the product is right for you. Whether the product is right for you is up to you to decide. But a fiduciary is held to a higher standard. As Alexei Marcoux points out, we are vulnerable in various ways to professionals of various kinds, and that vulnerability generates duties on the part of those professionals, not just to be honest to us but to put our interests first. The transaction between a professional and a client is not a regular market transaction; rather, it is (or ought to be) governed by the higher standard implied by a fiduciary relationship.

Whether financial advisors and financial planners proclaim and live up to such a high standard is another matter. It certainly seems they should. In some places, financial professionals are explicitly expected to live up to the standard applied by a fiduciary duty, and other jurisdictions are moving in that direction. If ever there were a circumstance in which we were vulnerable, a situation in which we are trusting a stranger to tell us what to do with our life’s savings seems to fit the bill.

Ethical Consumerism is Hard

It’s not easy being an ethical consumer, these days — especially if you’re hoping to buy products that embody all or most of the ethical values you care about.

Here’s an example. If you like salmon, and if you’re the sort of consumer who wants to eat ethically, should you buy organic salmon or buy wild salmon? After all, there’s a huge effort these days to promote organic foods as ethical — gentler on the earth, and so on. Of course, others aren’t so sure that there’s much benefit to organic foods, and some even argue that the organic label is more a status symbol than anything else.

Now what about wild vs farmed? Some people think that farmed salmon is always bad. Others, like food-policy expert James McWilliams, argue that for whatever its current flaws, farmed fish provides our best hope for a future that includes significant amounts of protein at acceptable environmental costs. Eating wild fish, on the other hand, puts pressure on fragile wild populations.

But still, there are plenty of people who are dedicated to eating organic, and plenty of people who are quite insistant upon eating only wild fish.

The problem is, you can’t have it both ways. Wild salmon cannot, by definition, be organic, because it’s impossible to control what wild salmon eats. It can only be truly organic if it’s raised in captivity. Damned if you do, damned if you don’t.

This is just one tiny example of the challenges of ethical consumerism. Any given product can embody any number of incommensurable values — values that can’t just be added up to arrive at a total “ethics quotient.” The same problem applies to wind power (which produces no air pollution but kills birds) and oil from Canada’s oil sands. (which is produced in a democracy but is environmentally-dodgy).

Of course, none of that means that it’s not worth some effort to try to buy conscientiously. It just means that, as often as not, values-based consumerism is going to mean purchasing according to values that matter to you, rather than hoping to buy in a way that is ‘truly ethical,’ in some grander sense.

Sustainability Isn’t Everything

The word “sustainability” doesn’t just refer to everything good. If it did, we wouldn’t need the word “sustainability” at all; we would just use the word “good.”

I’m just a small-town philosopher who likes words to mean what they mean. That’s why I got cranky when I saw the new Global 100 Ranking, which is ostensibly a sustainability ranking. (See my blog posting here.) Why cranky? Because over half of the criteria used to arrive at that ranking have nothing to do with what I — and, I suspect, most people — think of when they hear the word “sustainability.”

But let’s set aside the fact that this usage is potentially misleading; words evolve, and maybe the public will catch up with the Global 100 in its broad understanding of the term “sustainability.” Does this new, revised meaning of “sustainability” make sense?

Let’s start with the word “sustainable.” Well, standard dictionary definitions suggest that it means something like, “Able to be maintained at a certain rate or level.” OK, good. That’s a positive thing, right? But wait. No one cares about corporate sustainability in that sense, with the possible exception of certain narrow-minded shareholders. We want businesses that are more than merely capable of being maintained. We want businesses that are worthy of being maintained.

So sustainability needs some normative content. It needs some goodness baked in.

In this regard, the touchstone is the U.N.’s Brundtland Commission. In 1987, the Brundtland Commission asserted that “sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” And ever since then, at very least, the words “sustainable” and “sustainability” have had very significant environmental overtones. OK, good. Here, “sustainability” is being used to indicate some plainly good things: environmental sustainability isn’t the only good thing in the world, but it’s definitely a good thing from a social point of view, embodying not just the value of the natural environment but also a sense of intergenerational justice.

But some people (including the people behind the Global 100) want to expand the term “sustainability” to include other, non-environmental dimensions. From a certain point of view, this makes sense: other things required to allow a company to “sustain” operations. But then further problems arise.

Note that when we expand “sustainability” this way, a subtle bit of sleight-of-hand takes place. Previously, we were talking about business operations that were environmentally sustainable. Now, we’ve switched to sustainable organizations. What does it take to sustain an organization? Lots of things, and not all of them are good. And being sustainable isn’t, in itself, a good thing. The tobacco industry has lasted for centuries, leaving millions of dead bodies in its wake. Very, very sustainable. But bad.

As noted above, we don’t generally care whether companies can stay in business. We want them to merit staying in business. And if the companies on the Global 100 merit staying in business, why not just say so?

In the end, I guess my point really is that environmental sustainability is important all on its own, and doesn’t need to be fluffed up with issues like workplace safety or leadership diversity or CEO pay; and issues like workplace safety and leadership diversity and CEO pay are too important to stuff into the simple concept of sustainability.

Moneyball and Business Ethics

I’m finally getting around to reading Moneyball, Michael Lewis’s best-selling ode to the study of baseball statistics (and the source material for the new Brad Pitt movie of the same name). It’s one of the most engaging books I’ve read in a long time — something that won’t surprise those of you who happen to have read The Big Short, Lewis’s lively account of the 2008-2009 financial collapse.

What did surprise me as that Moneyball isn’t really a book about baseball. It’s fundamentally about epistemology. Epistemology is the critical study of knowledge itself — how we get it and how we use it. And though Lewis doesn’t (as far as I can recall) use that word, Moneyball is all about epistemology: the epistemology of baseball, yes, but much more than that. It’s fundamentally about how managers should use information to achieve better outcomes.

Moneyball holds important lessons for business managers generally, but in particular it holds lessons about business ethics. But the messages aren’t the obvious ones you’d expect from a book on baseball — they aren’t about the ethics of labour negotiations, for example, or the incomplete alignment of the twin goals of satisfying your fans and making money.

Three key lessons of the book, as far as I can see, are as follows:

1) The numbers matter. So, don’t guess — measure. In baseball, this means scouts need to look closely at a player’s stats, rather than relying on the fact that he’s got a “nice swing” or a “body made for baseball.” In business, it means measuring actual performance — not just bottom-line financial performance, but social and environmental performance, too, rather than just relying on the vague feeling that your company is “doing OK.”

2) The numbers don’t come out of thin air. The numbers you have available to you aren’t just a feature of the universe around you. The numbers represent what happens to have been measured. The “bottom line” (net income) is no more a natural feature of business than “Earned Run Average” is a natural feature of baseball. Both are artefacts of a particular system, one with a particular history and its own set of biases.

3) Numbers can lead you astray. Managing based on the numbers someone else more-or-less arbitrarily decided to keep track of can result in disaster. This is especially the case when those decisions are rooted in idiosyncratic interests or biases. Lewis points out, for instance, that early baseball stats didn’t bother to record the number of walks a batter earned — mostly because one of the early promoters of baseball stats, a journalist named Henry Chadwick, happened to be a fan of cricket, a sport where there’s just no such thing as a ‘walk.’ Chadwick decided not to keep track of how many walks a batter achieved. The result was that there was no way to track which batters had the good judgment to watch a high-and-inside fastball sail past instead of swinging at it. It matters to their performance, but for a time there was no way for coaches to include it in their management strategies. The exact same point can be made about various elements of social and environmental reporting.

The overarching lesson, here, is about the need for (pardon the pun) a measured approach to the use of numbers in business. Numbers matter, and they matter a lot. The old saw that “you can’t manage what you can’t measure” is surely a vast overgeneralization, but one that contains a kernel of truth. But what matters even more than the numbers is knowing what the numbers mean, and what they can and cannot tell you.

Food Industry Ethics, Regulatory Reform, and Corporate Citizenship

I blogged yesterday about the importance of sound government and rule of law as a background condition for ethical corporate behaviour. Here in Canada (as in most other developed economies) we grumble about our government and our system of regulation, but we’re actually relatively lucky that way, by world standards. Our economy is thriving (quarter-to-quarter hiccups aside) in large part because businesses here have the luxury of doing what they do against a background of generally-stable government and generally-sane regulations.

But that’s not to say that there isn’t room for improvement. One key area in need of (constant?) improvement is food policy. It’s an incredibly complex area, with an enormous range of interests at stake and a huge range of values at play. Public policy is, as a result, pretty messy. For more details, see this new report by the Conference Board of Canada’s Centre for Food in Canada (CFIC). Here’s a summary, from Better Farming: Canada’s food policy system overloaded: report

Out of date policies, laws and regulations as well as conflicting government involvement stymie innovation and economic growth in the country’s food sector says Conference Board of Canada report…

(You can download the report here.)

Economic growth in the food sector isn’t of direct relevance to consumers (though it is of direct relevance to those employed in the sector). But consumers still have plenty of reason to care about food policy. All questions of food policy have a more or less direct impact on the health and/or pocketbooks of consumers; and hence all questions of food policy raise ethical issues (many of which I’ve blogged about). For example, according to the BF story:

The report reviews the Canadian approach to food regulation based on a study of six issues: food additives, genetically modified foods, health benefit claims, country-of-origin labeling, inspection, and international trade. [hyperlinks added]

Industry, of course, has a role to play in helping to reform regulation in this area. But in doing so, industry must think especially carefully about its ethical obligations. Normally, the slogan “Play by the Rules!” sums up the lion’s share of a company’s obligations. But when the issue at hand involves figuring out what the rules — i.e., regulations — should be, industry needs to consider very carefully the full ethical weight of the notion of “corporate citizenship,” and remember that a citizen is someone who participates in policy debates with an eye not just to their own interests, but to the public good as well.

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Thanks to Prof. Richard Leblanc for bringing the CFIC report to my attention.

Are they Competing, or Just Trying to Sell You Something?

Peaceful coexistence isn’t always a good thing. In the marketplace, competition is what drives different producers of a good to improve their wares, and having one producer explain the superiority of his or her product is — embellishment and puffery aside — how consumers learn to differentiate among products. When different suppliers fail to engage in competition, the consumer is left in the dark. Let me give you two examples.

Here’s the first example. One of the problems — or rather, one of the warning signs — about so-called “alternative” medicine is that there are dozens of different kinds of alt-med, all making different and presumably conflicting assumptions about how the human body works, and yet they all get along cozily together. Nowhere do you find homeopaths, for example, explaining why their methods are superior to those of acupuncturists. Nor do you find Reiki therapists dissing Ayurveda. Crystal therapy gurus are unlikely to tell you about the problems with Traditional Chinese Medicine. And so on. As Robert Park wrote with reference to alt-med, in his book, Voodoo Science (p. 65), “there is no internal dissent in a community that feels itself besieged from the outside.” Of course, the existence of different alt-med treatments isn’t in itself surprising or problematic. Mainstream medicine too uses different treatments for different illnesses. But the different treatments offered by mainstream medicine are all, without exception, underpinned by a single coherent body of theory: the heart circulates blood, germs cause infection, physiological effect varies according to drug dosage, and so on.

So the fact that various systems of alternative therapy, underpinned by very different understandings of the human body (and indeed of metaphysics), can get along so chummily is a huge red flag. It suggests that purveyors of alt-med either a) aren’t thinking critically, or b) are more interested in sales than in healing.

Roughly the same concern arises with regard to different perspectives on how businesses should behave. Some will tell you that the obligations of business are all rooted in the notion of sustainability, with its indelible environmental overtones. Others will say no, it’s a matter of CSR — Corporate Social Responsibility. Still others say it’s all about values. Or leadership. Or citizenship. Or the (ug!) Triple Bottom Line. And each of those seems, at least, to be underpinned by a different understanding of the nature of the firm, its role in society, and what it is that makes an action right or wrong. And yet all kinds of folks seem to want to cleave to all of the above, or to glom onto one of them seemingly at random, as if it doesn’t matter which one you choose.

Again, this should be a big red flag.

I’m sure I’m going to be told that these different schools of thought don’t need to compete with each other — what’s really important, they’ll say, is that, you know, we focus on fixing the way business is done. But again, as with the case of alternative medicines, if someone tries to sell you some and isn’t willing to even try to explain why theirs is better than the other stuff, you should at least wonder whether they aren’t thinking critically, or are merely trying to sell you something.

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