What every manager should know about (1/5): Climate Change

before-the-flood

As your organization is getting ready for the implementation of EU guideline 2014/95/EU on the disclosure of non-financial information, I hand you a series of blog posts on non-financial topics that business managers might be less familiar with. My aim for this series of posts is twofold. First, to give you insight into concepts that are integral to non-financial frameworks on reporting, such as the Global Reporting Initiative (GRI) framework. Second, to show why and how you should integrate these specific non-financial disclosures into your overall risk management strategy.

The first blog in this series will discuss what climate change is and what climate change has to do with managing business risk. If you are in need of a broader perspective on climate change I recommend Leonardo DiCaprio’s clear and informative film Before the Flood.

Defining Climate Change

Climate Change, according to the Concise Oxford English Dictionary is:

The change in global climate patterns apparent from the mid to late 20th century onwards, attributed largely to the increased levels of atmospheric carbon dioxide produced by the use of fossil fuels.

In his insightful book Climate Change, A Very Short Introduction, Mark Maslin writes:

Over the last 150 years, significant changes in climate have been recorded, which are markedly different from the last at least 2,000 years. These changes include a 0.85°C increase in average global temperatures, sea-level rise of over 20 cm, significant shifts in the seasonality and intensities of precipitation, changing weather patterns, and the significant retreat of Arctic sea ice and nearly all continental glaciers. (…) The IPCC [Intergovernmental Panel on Climate Change] 2013 report states that the evidence for climate change is unequivocal and there is very high confidence that this warming is due to human emissions of GHGs [i.e. greenhouse gases, such as CO2].

To be able to visualize why it’s so hard to combat climate change caused by CO2, consider this illuminating analogy from Climate Shock, by Gernot Wagner and Martin Weitzman:

Think of the atmosphere as a giant bathtub. There’s a faucet – emissions from human activity – and a drain – the planet’s ability to absorb that pollution. For most of human’s civilization and hundreds of thousands of years before, the inflow and the outflow were in relative balance. Then humans started burning coal and turned on the faucet far beyond what the drain could handle. (…) Inflow and outflow need to be in balance, and that won’t happen (…) unless the inflow goes down by a lot.

Recently, we have learned (see a recent Guardian article) that the amount of CO2 in the atmosphere reached 400 parts per million (ppm); that’s 40% higher than pre-industrial levels (280 ppm). In Climate Shock we read why this is a serious problem:

Last time concentrations of carbon dioxide were as high as they are today, at 400 parts per million (ppm), the geological clock read “Pliocene”. That was over three million years ago, when natural variations, not cars and factories, were responsible for the extra carbon in the air. Global average temperatures were around 1-2.5°C (…) warmer than today, sea levels were up to 20 meters (…) higher, and camels lived in Canada.

The conclusion that we must draw from this is not that climate change is new. Rather, for the first time in the earth’s history, climate change is manmade and happens at a rate which would make it impossible for us to re-actively adapt our infrastructure accordingly. Think for example of shifting entire agricultural regions, or moving complete cities from their present-day ocean front locations.

For an illustrated (and witty) example of how extraordinary the current spike in average temperature really is, see A Timeline of Earth’s Average Temperature. Below, only the very last brief time period – with a sharp increase in average temperature – is shown; the full infographic shows much slower changing average temperatures in the last 20,000 years.

temperature

Skepticism towards climate change is like denying smoking causes cancer

Perhaps most of the general public would not see climate change as an urgent problem, as Wagner and Weitzman point out in Climate Shock.  Although the science behind climate change is solid and has been accepted by the scientific community on the weight of evidence of the research, there seems to be an amazing amount of skepticism around the subject in non-science circles. In trying to explain this phenomenon, Maslin writes:

…the media’s ethical commitment to balanced reporting may unwittingly provide unwarranted attention to critical views, even if they are marginal and outside the realm of what is normally considered ‘good’ science. (…) Add to this the greater ease of communication, from conventional media, such as newspapers, radio, and television, to more informal blogs, tweets, etc. Normal private debate among scientists and experts can easily be shifted into the public arena and anyone, what ever their level of expertise, can voice an opinion and feel it is as valid as that of experts who have dedicated their whole lives to studying areas of science. Overall, this contributes to a public impression that the science of climate change is ‘contested’, despite what many would argue is an overwhelmingly scientific case that climate change is occurring and human activity is a main driver of this change.’

Or, maybe skepticism has to do with cognitive dissonance (i.e. a state of inconsistent thought, beliefs, or attitudes), write Wagner and Weitzman:

Whenever science points to the very real potential of these types of catastrophic outcomes, cognitive dissonance kicks in. Facts might be facts, the reasoning goes, but throwing too many of them at you at once will all but guarantee that you will dismiss them out of hand. It just feels like it can’t be true.

Leonardo DiCaprio in Before the Flood echoes this:

We keep being inundated with catastrophic news about the environment every single day, and the problem seems to get worse and worse. Try to have a conversation with anyone about climate change, and people just tune out.

The key point here is that the efforts to understand climate change are a scientific effort. Maslin rightfully states that ‘science is no belief system’. As Armand Marie Leroi points out in his book, this has been true ever since Aristotle invented science:

‘A scientist is someone who seeks, by systematic investigation, to understand experienced reality.’

Being skeptical towards climate change is therefore the same is being skeptical towards the process of scientific discovery itself. It is, Maslin states, to ‘deny that smoking causes cancer, or that HIV causes AIDS’.

Climate Change and business risk management

Integral risk management for your organization should include climate change risks. As the authors of Climate Shock put it: ‘First and foremost, climate change is a risk management problem’.  A risk analysis of climate change would lead to defining business risks that stem from both the direct consequences of climate change (like more severe weather events), and risks that stem from external stakeholders’ actions to curb climate change that, in turn, have an effect on the company’s operations or profitability (e.g. tighter regulations for GHG emissions). Without making any claims of exhaustiveness, as a minimum, your organization’s risk assessment should include the following risks in a risk assessment:

risk-matrix

Asset and infrastructure risk. We already see an increase in extreme weather events that could hurt a firm’s assets and supply chains. In Climate Change, A Very Short Introduction, numerous relevant examples are given:

[I]n recent years massive storms and subsequent floods have hit China, Italy, England, Korea, Bangladesh, Venezuela, and Mozambique. In England in 2000, 2007, and 2013/13, floods and storms classified as ‘once-in-200-years events’ have occurred within 13 years and frequently within a single year. Moreover, in Britain the winter of 2013/14 was the wettest six months since records began in the 18th century, while August 2008 was the wettest on record.

Organizations could use climate forecasting models to show which assets and infrastructure are more at risk because of climate change. A next step would be to develop scenarios that would lessen the impacts on your assets and supply chains (e.g. moving operations to areas less affected by extreme weather events).

Yield and price risk. When climate change starts to affect crop yields, it will also affect purchasing prices. The IPCC (Intergovernmental Panel on Climate Change) brings together key climate research conducted all over the world and provides a consensus of this research. The IPCC, 2014 report found:

Based on many studies covering a wide range of regions and crops, negative impacts of climate change on crop yields have been more common than positive impacts. [S]everal periods of rapid food and cereal price increases following climate extremes in key producing regions indicate a sensitivity of current markets to climate extremes (…).

Your organization should know which commodities are most at risk from the impacts of climate change. This should be a starting point for developing scenarios to mitigate yield and price risks.

Government regulations. Now that the Paris Agreement has come into force, we can see governments stepping up their work to implement policies that will make sure global average temperatures well below 2°C. Barack Obama in The Economist:

[S]ustainable economic growth requires addressing climate change. Over the past five years, the notion of a trade-off between increasing growth and reducing emissions has been put to rest. America has cut energy-sector emissions by 6%, even as our economy has grown by 11%. Progress in America also helped catalyse the historic Paris climate agreement, which presents the best opportunity to save the planet for future generations.

Any policy changes that try to curb climate change will impact business-as-usual. As a mitigation strategy, organizations should try to understand possible policy options and work out the effects on operations and profitability.

Reputation risk. Awareness of climate change in general is on the rise. Whenever the public is of the opinion that the firm’s activities are harmful (this obviously extends beyond climate change), there’s a probability that profitability is at risk. For example, the big palm oil trader IOI was accused of illegal logging recently  ̶  contributing directly to climate change because of loss of rain forest that stores CO2  ̶  , experienced extreme negative publicity (see this article in the Financial Times), and saw share prices and revenues tumbling. As a first step in creating mitigation scenarios, firms should make an effort in understanding external stakeholder’s views and wishes towards the firm’s climate change actions. As the IOI example shows, reputation risk does not only revolve around emissions but also around having supply chains that contribute towards climate change by deforestation (e.g. beef, soy, palm oil, and wood fiber). Your organization should therefore not only know which operations are most at risk from the impacts of climate change (direct risks), but should also know which commodities contribute the most towards climate change (reputation and regulatory risk).

As I already argued in my blog post The Business Case for Non-Financial Reporting, disclosing non-financial information can lead to insights on how to update your business strategy or improve stakeholder relations. Reporting on climate change gives you the opportunity to update your risk management framework. By breaking climate risks down into direct and external stakeholder risks, and putting in place mitigation scenarios, your organization will be well prepared for an age where climate change is at the top of the agenda.

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3 Reasons to Use Science-Based Measures in Your Sustainability Report

planetary_boundaries_2015

In the Guardian, the case is made that current reporting practices on sustainability are a great waste of time. According to researchers, nobody actually reads sustainability reports. One of the main reasons being, that reports are impenetrable: they’re just too thick to get through.  The authors identified a number of issues with current sustainability reporting practices which could be the cause for this.

The main culprit: most companies do not have a good process in place to determine materiality. The outcomes of a materiality assessment determine which aspects are to be included in your sustainability report.

One thing researchers missed, which could address both their worry that ‘sustainability reporting has stalled’ and help further discussions on the materiality issue, is the use of science-based metrics in sustainability reporting. I see a number of frameworks arising that all seem to stem from Johan Rockströms’ famous article in Nature, called ‘A safe operating space for humanity’. The premise is beautifully simple:

To meet the challenge of maintaining the Holocene state, we propose a framework based on ‘planetary boundaries’. These boundaries define the safe operating space for humanity with respect to the Earth system and are associated with the planet’s biophysical subsystems or processes. (…) Many subsystems of Earth react in a nonlinear, often abrupt, way, and are particularly sensitive around threshold levels of certain key variables. If these thresholds are crossed, then important subsystems (…) could shift into a new state, often with deleterious or potentially even disastrous consequences for humans.

In short:  we need boundaries – sufficiently underpinned by science – for Earth’s relevant subsystems and processes to continue using the Earth for our resource needs. Boundaries do have to be properly translated for use in existing models (such as the Global Reporting Initiative’s G4 Guidelines). Also, the boundaries must correspond with a firm’s size – as yardsticks against which to measure a companies’ sustainability effort.  This gives us the ability to benchmark a company’s progress against the reality in which it operates. A number of science-based frameworks are already adopted by some of the world’s leading companies on sustainability, e.g. Science Based Targets (Coca-Cola, Dell and Carrefour among many others), One Planet Thinking (Eneco) and Context Based Sustainability (Ben & Jerry’s).

I give you three reasons why your business should include science-based measures and boundaries in its non-financial or sustainability report.

1.     Make your report more relevant by showing your relative impact

The Guardian argues that most sustainability reports do not really invite us to continue reading. I tend to agree. Just pick-up a random sustainability report and you’ll be sure to get lost in tables, charts, figures, and the ubiquitous pictures of smiling, happy people. You immediately wonder how you should put together all these stats and figures to reach a conclusion on the companies’ sustainability efforts. Or, what I often ask myself: why do the things this company does towards sustainability matter at all? What is their impact if you would compare this to the size and scale of their value chain? By including science-based measures and boundaries, you show what your firm is achieving against objective yardsticks. In turn, it’ll make your sustainability report more relevant and credible to your stakeholders and investors.

2.     Show that your business is not ‘greenwashing’

Sustainability reporting is still often seen as a greenwashing operation. Although a claim of greenwashing is actually almost always too severe an accusation considering the definition of that word – ‘misleading information disseminated by an organization so as to present an environmentally responsible public image’ – I hear the term a lot when talking about the sustainability efforts of organizations.

I believe that the term greenwashing is used by the general public, because it is difficult for companies to understand which elements to focus on in their sustainability reporting. This leaves space for stakeholders to wonder about all of the sustainability elements companies chose not to include.

In the article ‘Raising the Bar on Corporate Sustainability Reporting to Meet Ecological Challenges Globally’, the United Nations Environmental Program raises similar doubts about the effectiveness of sustainability reports:

(…) the quality of these reports is insufficient to represent the full impacts of a company’s use of resources and materials on the environment and on communities.

And:

“Corporate sustainability reporting needs to be rapidly elevated from focusing on incremental, isolated improvements to corporate environmental impacts,” said Arab Hoballah, Chief of UNEP’s Sustainable Cities and Lifestyles Branch. “It should instead serve to catalyze business operations along value chains to achieve the kind of transformative change necessary to accomplish the Sustainable Development Goals and objectives by 2030. This is precisely what is needed to encourage countries and companies to act effectively at their respective levels.”

Moving towards more contextual-based reporting – i.e. taking into consideration both boundaries and the impact that is expected from your organization in respect to its size and span of your value chain – will surely make your organization less susceptible to charges of greenwashing and will make your positive impacts (or the steps you take to mitigate negative impacts) clearer to your stakeholders.

3.     Safeguard your business against the Slippery Slope argument

Activist NGOs surely serve a purpose in raising important topics. However, their solutions might go a bit far at times. The way activist NGOs attack businesses often reminds me of something Theodore Dalrymple wrote (on an entirely different topic but the words resonate):

I was still of the callow – and fundamentally lazy – youthful opinion that nothing in the world could change until everything changed.

Hardin, in his magnificent Filters Against Folly, called this the Slippery Slope argument:

The punch line goes by many names, among which are the [The Camel’s Nose,] Thin Edge of the Wedge, and the Slippery Slope. The idea is always the same: we cannot budge a millimeter from our present position without sliding all the way to Hell. (…), the fear of the Nose/Wedge/Slope is rooted in thinking that is wholly literate and adamantly antinumerate.

Hardin goes on to call this the demand for absolute (or extreme) purity:

The greed of some enterprisers in seeking profits through pollution is matched by a different sort of greed of some environmentalists in demanding absolute purity regardless of cost.

And:

When costs are paid out of a common pot, extreme purity in one dimension can be achieved only by impoverishment or contamination of others. Trying for too much we achieve less. Rational limits must be set to every ideal of purity.

Thus, Hardin states that everything that we do will lead to some unwanted consequences. Our actions need to be analyzed with the right terminology (‘literacy’), but, on top of that, we will also need the right measures (called ‘numeracy’; for more on these very useful terms, also see my blog The Business Case for Non-Financial Reporting).

Numeracy doesn’t just mean quantifying things; it means making the numbers relative to certain boundaries that give the numbers meaning. Using science-based measures to show the performance of your business towards certain boundaries or limits makes for a compelling argument to counter any Slippery Slope argument. In a way, what you are doing is making both ‘purity’ and ‘pollution’ more relative. Now, it can be measured and actions can be discussed and taken more objectively.

By way of conclusion: moving closer to a world we want

I have given you three reasons why you should consider moving towards science-based measures and boundaries in your non-financial reporting. As I already argued in a previous blog post, see Beyond Shareholder vs. Stakeholder Value, a firm’s main purpose is to provide maximal value to the economic system, but it should do so by adjusting to changing stakeholder demands. I believe moving to science-based measures and boundaries is the next step in these stakeholder demands and could take non-financial reporting to the next level, benefiting both companies (through the three reasons I gave you) and society as a whole (by introducing planetary boundaries).

Including science-based metrics will not solve everything, but let us see it as the next step and acknowledge that we cannot solve all issues at once. To paraphrase Theodore Dalrymple, moving forward, let us be:

realistic without being cynical, and let us be idealists without sounding like utopians.

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Beyond Shareholder vs. Stakeholder Value

In a recent article in the Economist (Analyse This), shareholder value is still seen as ‘the governing principle of firms’. Despite increasing calls to start running firms for the sake of stakeholders, the influential newspaper sticks to running the firm for shareholders and thus to an idea that was described by Milton Friedman in his seminal Capitalism and Freedom in 1962:

 There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it … engages in open and free competition, without deception or fraud.

In contrast to Friedman’s (and The Economist’s) view, there’s an ever increasing movement that calls for running firms for the sake of its stakeholders (e.g. employees, local communities, public interest groups and financiers) instead of its shareholders. Frameworks are being developed that try to capture more than the financial value of a firm (e.g. the Integrated Reporting framework). Even arguably the most famous of the management scholars, Michael Porter, turns his back on shareholder value. In a 2011 Harvard Business Review article he argues:

A big part of the problem lies with companies themselves, which remain trapped in an outdated approach to value creation that has emerged over the past decades. They continue to view value creation narrowly, optimizing short-term financial performance in a bubble while missing the most important customer needs and ignoring the broader influences that determine their longer-term success. How else could companies overlook the well-being of their customers, the depletion of natural resources vital to their businesses, the viability of key suppliers, or the economic distress of the communities in which they produce and sell?

I propose to move away from the confusing discussion about shareholders and stakeholders for two reasons.

First, shareholder value never seems to be properly defined in the general debate. And certainly not when it’s in the hands of stakeholder-theory proponents. It often gets twisted into something that makes the business world look immoral: businesses will do just anything to make a profit at the expense of everything else. This is, however, not the shareholder theory Friedman had in mind. I included his quote at the start of this text to show that the shareholder view actually calls for ‘free competition, without deception or fraud’ (italics mine). The important phrase ‘without deception or fraud’ seems to be left out of the discussion by stakeholder-theory supporters all together. Furthermore, the attack on shareholder value usually includes the argument that shareholders aim for short-term profits. Business valuation theory, however, actually teaches us that the valuation of a firm is an outcome of its long-term operating income (or cash-flow) and not short-term profit (or short-term rise in stock prices). I do not think it is possible to change the general public’s feelings about the shareholder value concept. It has a tarnished reputation that cannot be mended.

Second, the concept of running a firm in the interest of all its stakeholders is flawed. Stakeholders often have conflicting interests. You cannot shut down environmentally damaging operations without cutting jobs (in the short-run at least). Cheap raw materials or supplied goods can keep prices for consumers down, but might fuel bad ethical practices by suppliers. A firm might be able to balance those interests but can never acquiesce to all without hurting the bottom-line.

Some concepts to change the debate

If a stand-off between a stakeholder and a shareholder view is not the answer, what is? First, try to think of businesses as entities that maximize value to the economic system, i.e. long-term positive cashflow that secures jobs and tax income. Second, acknowledge that firms cannot possibly adhere to all stakeholders’ demands instantaneous and simultaneous. That would certainly hurt the long-term positive cashflow, and thus jobs and tax income. Instead, allow firms to balance the interests of stakeholders and their own long-term positive cashflow goal. In fact, firms are increasingly adopting materiality analysis in which the social and environmental impacts are weighed against the impact on the firm’s profitability.

In combining these two aspects – a firm balances the interests of all stakeholders whilst safeguarding long-term positive cashflow – a model arises where a firm can perform its task of providing maximal value to the economic system by adjusting to changing stakeholder pressures. The task of stakeholders (maybe society in general is an even better concept) is to guide behavior of all entities in society to behavior it deems beneficial. Firms can choose to be front-runners by using Environmental, Social and Governance topics (ESG-topics) to craft strategies to gain competitive advantage (maybe even working together with certain groups of stakeholders). Or firms can take a more defensive stance and wait until regulators or market conditions push them to include ESG-topics into their business practices. For most firms, especially SMEs, the latter strategy may seem the only viable option considering available resources anyway.

In other words, if society wants to push sustainable strategies in companies it should not put pressure on companies alone. Society should put pressure on governments and regulators to adopt rules and regulations to develop the world it wants. A model would arise in which society as a whole moves the world in a direction it wants to go, a world that ought to be. (The ultimate guiding principles in this respect could be the 17 Sustainable Development Goals, which were put forward by the United Nations recently.) The world that ought to be should be translated in rules and regulations. For citizens. But also for companies.

There will, of course, always be companies that shape the world that ought to be in accordance with stakeholder views. But this is not the corporate world’s main task. A firm’s main task is to create maximum value to the economic system by supplying jobs and generating tax income. It should do so in a context where the rules are set by others.

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The Business Case for Non-Financial Reporting

With an EU directive on non-financial disclosure now being translated into national legislature, social and environmental reporting seems to become a reality for an increasing number of organizations. Although it still isn’t mandatory for all companies to disclose non-financial information, the trend is clearly towards greater disclosure. In this month’s piece, I argue that your organization should start reporting on social and environmental topics even if regulators aren’t (yet) requiring this.

What’s the current status on non-financial reporting? The EU directive states that listed companies, banks and insurance firms will all have to disclose non-financial information on environmental and social topics. My guess is that it won’t stop there: the Netherlands is already opting to extend the scope to other public-interest entities such as pension funds, housing associations and utility firms.

Beyond the group of organizations already mentioned, other firms are also experiencing increasing pressure from stakeholders to disclose more information on their operations and supply chains. Whatever the reason (e.g. regulation, pressure from stakeholders, or maybe even new worldviews such as radical transparency or the purpose economy), companies are faced with mounting pressures to report beyond mere financial statements. We could see this as an increased attention to the distribution of “goods” and “bads” as Garrett Hardin already pointed out in his 1985 classic Filters Against Folly:

Every human activity produces both things that we want – “goods” – and things we don’t want – “bads”. How should society distribute these goods and bads?

Hardin goes on to argue that:

.. most people living today would say that even if it is historically true that the widespread externalizing of business costs was causatively responsible for the rise of modern civilization, we cannot, from here on out, tolerate the practice. Regardless of the past, future policy must insist on internalizing the cost of production.

It seems that with recently implemented policies like the EU directive on non-financial disclosure, the future that Harden writes about in 1985 is becoming a reality.

Two concepts that Hardin introduced in Filters Against Folly show that you can use non-financial reporting as an opportunity to boost the competitive advantage of your organization.

Non-financial reporting to update your business strategy

A useful mental model in analyzing the business world is what Hardin calls the “Double C–Double P Game”, which stands for commonize costs and privatize profits. (Commonizing here means the spreading of the cost of an activity over a population no matter who profits from the cost. Privatizing means the profit from activities accrues to the company, and the company alone.) This model seems to be under attack with the increased attention of stakeholders to disclose which costs are commonized (e.g. land and water use, CO2 emissions, etc.) and which profits are privatized (see the discussion on the relationship between tax evasion and corporate social responsibility in The Economist).

Although the increased scrutiny of stakeholders can seem troublesome to many an organization in terms of increased effort to dig up information from every nook and cranny of operations, I see opportunities to actually use it for a renewed look at the company’s strategy and perceived competitive advantage.

There are numerous frameworks available to help an organization structure its non-financial reporting, these include ISO 26000, the United Nations Global Compact and the Global Reporting Initiative. Rather than just use these as reporting guidelines, a company can actually use these frameworks to understand where it may be losing ground in the “Double C–Double P Game”. You may ask yourself which topics need more attention because costs are becoming increasingly internalized, or how you can continue privatizing the profits of the operations you undertake. Social and environmental analysis might prove indispensable in effectively adjusting your business strategy to accommodate  a new business environment where your current business’s specific and carefully crafted “Double C-Double P Game” is losing ground.

Non-financial reporting to build better stakeholder relations

In addition to the benefit of building a strategy matched to the new business environment, there is a second opportunity in reporting on non-financial performance. If done well, a company might actually improve the relationship with all stakeholders by melding together what Hardin calls numeracy, literacy and ecolacy filters. Companies might be under attack from differing interest groups that are biased toward using one filter only. Literacy, for example, can do much harm if it is not accompanied by numeracy to put statements into perspective. Hardin explains:

There is no royal road to rationality. Whatever means we are tempted to use, we must be wary of the poetic approach. Rhetoric (..) may give one a wonderful “oceanic feeling” (to use Freud’s term), but this feeling is more likely to prevent than to facilitate advances in understanding. It is when ecological rhetoric is most beautiful that we must be most on our guard.

And, again about abusing literacy:

.. the wish to escape debate disguises itself under a multitude of verbal forms: infinity, non-negotiable, never, forever, irresistible, immovable, indubitable, and the recent variant “not meaningfully finite.” All these words have the effect of moving discussion out of the numerate realm, where it belongs, and into a wasteland of pure literacy, where counting and measuring are repudiated.

Of course, the company itself should also avoid vague words and terminology. One of the techniques proposed by Hardin to make clear what is actually meant, is operationalism:

Faced with conflicting views, the critical analyst asks, “What operations are implied by these statements?” Once the operations are made clear, difficulties usually evaporate.

After answering the question ‘What do thew words actually mean’ (i.e. literacy), Hardin further proposes to go beyond mere numbers to numeracy:

In spite of its name, numeracy is concerned with more than numbers. The relative size of quantifiable factors is often more important than their exact measures. The importance of scale effects can be appreciated with little actual measurement.

He gives an example where the numerate filter is a useful addition to the literate filter:

Dichotomies are favored over quantities. It is so comforting to divide polluting substances sharply into the categories of “safe” and “unsafe”. (..) Nature is silent. Nature does not tell us when “safe” slips over into “unsafe”; men and women, reasoning together, must legally define “unsafe”. (..)“Safe” and “unsafe” are literate distinctions; nature is numerate. Everything is dangerous at some level. Even molecular oxygen, essential to human life, becomes lethal as the concentration approaches 100 percent.

Finally, Hardin proposes to combine literacy and numeracy with ecolacy ‘to ferret out at least the major interconnections’. With ecolacy we ask the basic question “And then what?” to sort out what the unwanted consequences are ‘to grant a modicum of justification for the position of society’s nay-sayers’:

Excessive ecolacy can lead to conservatism of the most stultifying sort. For prudence’s sake, ecolacy must be combined with numeracy. Any action that we take – and inaction is a form of action – leads to some unwanted consequences. Prudence dictates that we compare the advantages and disadvantages of all proposed courses of action, choosing the one that, on balance, is quantitatively best.

By using non-financial reporting not as ‘just another report’, but as an actual effort to communicate through multiple lenses (i.e. literate, numerate and ecolate), I see huge opportunities in creating a more effective strategy, and better stakeholder relationships with fewer controversies.

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Successful Business and the Halo Effect

Being influenced in my thinking on business strategy and execution mostly by the work of Igor Ansoff (see Implanting Strategic Management), I have always wondered why business books like In Search of Excellence and Good to Great had such huge success. Ansoff stressed that business performance is highly dependent on the specific environment your business finds itself in at any given time. Consequently, he was very much against the notion of an ‘if you do this in any situation, it’ll always work’-approach as advocated by such business books.

So, following Ansoff, to me it seems that the prescriptive mantras for long-lasting high business performance are just not in sync with a situational or conditional approach (based on so-called turbulence levels of the business environment). Moreover, companies hailed as consistent high performers at one point in time, will sooner or later come crashing down. (As you may well ascertain when browsing through the companies listed as high performers in older business blockbusters.)

So, the question really is: what’s going on here? Are there really business laws (like laws in physics) that safeguard lasting high business performance? Or are these laws a mere fallacy?

It was only recently that I came across a fascinating theory called the The Halo Effect by Phil Rosenzweig (the book with the same name was first published in 2006 with an updated version published in 2014). It tries to shed some light on the apparent attractiveness of a recipe for long-lasting business success. Rosenzweig argues that our thinking about business performance is shaped by a number of delusions:

For all their claims of scientific rigor, for all their lengthy descriptions of apparently solid and careful research, they [i.e. science in business books] operate mainly at the level of storytelling. They offer tales of inspiration that we find comforting and satisfying, but they’re based on shaky thinking. They’re deluded.

He goes on naming a number of delusions in our thinking about business performance. The pre-eminent delusion Rosenzweig names the Halo Effect:

[The Halo Effect is the] tendency to look at a company’s overall performance and make attributions about its culture, leadership, values, and more. In fact, many things we commonly claim drive company performance are simply attributions based on prior performance.

It’s not so much the result of conscious distortion as it is a natural human tendency to make judgments about things that are abstract and ambiguous on the basis of other things that are salient and seemingly objective. The Halo Effect is just too strong, the desire to tell a coherent story too great, the tendency to jump on bandwagons too appealing.

It turns out that most business blockbusters that tell you precisely which companies to mimic for success, suffer from the Halo Effect. Consequently, the companies that are given as examples in most business books (e.g. Xerox in In Search of Excellence, Fannie Mae in Good to Great; also see this article in The Economist) are not consistent high performers after all:

Yet for all their promises of exhaustive research, Collins and Porras [in Built to Last: Successful Habits of Visionary Companies] didn’t address a basic problem: the Halo Effect. Much of the data they gathered came from the business press, from books, and from company documents, all sources that are likely to contain Halos.

You would have been better off investing randomly than putting your money on Collins and Porra’s Visionary companies.

But why the appeal then? Why are these prescriptive books such a huge success? Time after time? The answer, Rosenzweig argues, is that we like stories:

Managers don’t usually care to wade through discussions about data validity and methodology and statistical models and probabilities. We prefer explanations that are definitive and offer clear implications for action. We like stories.

Now, there’s nothing wrong with stories, provided we understand that’s what we have before us. More insidious, however, are stories that are dressed up to look like science. They’re better described as pseudo-science.

And:

Readers, too, prefer clear stories. We don’t really want to hear about partial causation or incremental effects or threats to validity. And there’s a further problem compounding all of this. As Harvard psychologist Stephen Pinker observed, university departments don’t always represent meaningful divisions of knowledge. If you’re a professor of marketing, you care a lot about market orientation and customer focus, and there’s a natural tendency to want to demonstrate the importance of your specialty.

Does this mean that everything that is written about good business practices is just nonsense and everything might as well be left to chance? No:

Success is not random – but it is fleeting. Why? Because as described by the great Austrian economist Joseph Schumpeter, the basic force at work in capitalism is that of competition through innovation – whether of new products, or new services, or new ways of doing business. Where most economists of his day assumed that companies competed by offering lower process for similar goods and services, Schumpeter’s 1942 book, Capitalism, Socialism and Democracy, described the forces of competition in terms of innovation.

But the main point is that high performance is difficult to maintain, and the reason is simple: In a free market system, high profits tend to decline thanks to what one economist called “the erosive forces of imitation, competition, and expropriation.” Rivals copy the leader’s winning ways, new companies enter the market, consulting companies spread best practices, and employees move from company to company.

These findings show that performance is not random but persists over time, yet there is also a tendency to move toward the middle, a clear regression toward the mean. Competitive advantage is hard to sustain. Nothing recedes like success.

However, real science on business performance, as opposed to mere storytelling, is out there. But it might not make for such a good story:

Anita McGahan at Boston University and Michael Porter at Harvard Business School set out to determine how much of a business unit’s profits can be explained by the industry in which it competes, by the corporation it belongs to, and by the way it is managed. This last category, which they called “segment-specific effects,” covers just about everything we’ve talked about (…): a company’s customer orientation, its culture, its human resource systems, social responsibility, and so forth. Using data from thousands of U.S. companies from 1981 to 1994, McGahan and Porter found that “segment-specific effects” explained about 32 percent of a business unit’s performance. Just 32 percent. The rest was due to industry effects or corporate effects or was simply unexplained. So maybe all of the studies we’ve looked at make sense after all! It’s just that, as we suspected, their efforts overlap – they all explain the same 32 percent [italics mine]. Each study claims to have isolated an important driver of performance, but only because of the Delusion of Single Explanations.

Rosenzweig stays clear from coming up with his own take on a recipe for long-lasting business success. However, understanding that strategy always involves taking risks, that links between input and outcomes are sketchy at best and that flawless execution (once you have made up your mind about your strategic direction) is needed at all times, can veritably be read as a good starting point for discussing your company’s performance. It also means you do not have to resort to the latest and newest four, five, or eight-point list promising the holy grail of ever-lasting high business performance.

So, what’s the very mundane advice that Rosenzweig has to offer to managers?

When it comes to managing a company for high performance, a wise manager knows: (1) Any good strategy involves risk. (2) If you think your strategy is foolproof, the fool may well be you. (3) Execution, too, is uncertain – what works in one company with one workforce may have different results elsewhere. (4) Chance often plays a greater role than we think, or than successful managers usually like to admit. (5) The link between input and outputs is tenuous. But when the die is cast, the best managers act as if chance is irrelevant – persistence and tenacity are everything.

Will all of this guarantee success? Of course not. But I suspect it will improve your chances of success, which is a more sensible goal to pursue.

If you want to read your management books more critically, the lessons drawn by Rosenzweig in The Halo Effect  might just be invaluable.

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