How not to run utilities

Joseph Bazalgetter the Great Sewer
Joseph Bazalgette inspects the Great Sewer

Were the FT journalists consciously punning when they wrote this morning about Assured Guaranty (a US insurer reported to have more than $10 billion of exposure to some of the most indebted UK water utilities) “agreeing to provide liquidity facilities to Yorkshire Water”?

The long running problems with the financial management and governance of Britain’s water companies have come to a head with the crisis at Thames Water.  The company has been at the heart of allegations about releasing sewage into water courses.  The company is struggling with rising interest payments on $14 billion of debt.  Sarah Bentley, chief executive has resigned.  Along with the UK’s other water companies, who also face criticism for releasing untreated sewerage and collectively waste 20% through leaks of the water treated and ready for consumption, it faces public pressure for renationalisation.  This sentiment is shared by Conservative Party voters who, according to a YouGov poll last year, are 58% in favour of a return to public ownership.

Before delving into the questions about governance, funding and risk bearing on the water industry, it is important to note the context.  The water companies (and Thames Water in particular) operate a system that includes extensive very old and infrastructure (similar issues affect the UK’s railway system) that need maintaining, repairing and replacing, and face increasing demand from consumers and cope with the consequences of climate change – the paradoxical combination of longer periods of drought and increased frequency of incidences of torrential rain that exceeds the capacity of drains and sewers.  This is well illustrated by the Thames Tideway Tunnel project, the £4.3 billion, 16 mile long “super sewer” nearing completion to replace Victorian sewerage system built under the direction of Sir Joseph Bazalgette between 1861 and 1875 and intended to reduce the number of “Combined Sewer Overflow” discharges into the Thames in London from an average of 60 a year to fewer than five.

But who is to pay, who should be running the show, and who should bear the risk when things go wrong?  Ultimately the customer will pay, whether charges for domestic consumption are averaged out on a per household basis prior to water metering being rolled out or, as is now generally the case, based on the water you use (and is drained away on your behalf using water consumption as a proxy for sewerage generation)?  (In a country with bountiful rainfall, the public struggle to understand why they should pay for something that falls from the sky, without understanding what is involved in getting potable water to them).  When addressing the investment required for new reservoirs (noting that Portsmouth Water’s new reservoir in Havant will be the first in the past forty years despite at 21% growth in population) or schemes like the Thames Tideway Tunnel, capital needs to come from somewhere (whether from shareholder, lenders or government (either taxpayers or, more likely, investors in government debt, aka lenders) and then needs to be serviced until the cost can be recovered from the customer.

Since the regional water boards (responsible for both water supply and wastewater disposal – noting that thirteen smaller water supply only companies – generally former municipal businesses remain, albeit also now in private ownership), were privatised in 1989, they have geared up with substantial amounts of debt.  Critics allege that this has released cash to pay over £60 billion in dividends to investors since privatisation, almost half the sum invested addressing the leaks and the sewer overflow discharges and increasing capacity.  A further criticism of the companies is that the interest burden reduces the corporation tax paid by the water utilities, with the result that in 2021-2022 only South West Water reported a profit after tax, with Thames Water in the spotlight for losing £973 million.

Would nationalisation solve any of these problems?  As a member of a sailing club that opened in 1979 on one of severally new reservoirs to the west of London, I am a beneficiary of the investment in water supply capacity by the nationalised water industry prior to 1980.  I am not in a position to take a view on whether adequate maintenance or investment in distribution and disposal infrastructure took place prior to privatisation but I recall burst water mains and pollution of rivers and beaches in my childhood, so suspect that the nationalised industry underperformed on this count.   The industry today has an economic regulator, the Water Services Regulation Authority, and is policed by the Environment Agency, both of whom have their critics.  As Dieter Helm wrote in the Financial Times on 2nd July, the problems in the water industry demonstrate a prima facie case that the regulators have failed to use their powers adequately and that they should been given more teeth.  But the problems identified do not make the case for replacing regulated privately owned companies with stronger governaance with a system of direct accountability for the management to ministers and civil servants in Whitehall, and financial accountability – including for access to capital for investment – to HM Treasury?

Hidden in plain sight – what three statues can tell us about disability*

Disabled heroes
I have a disability and a history degree, but you don’t need either of these to know that the most iconic hero in British history was disabled. He stands on his column in Trafalgar Square with the result of two “occupational injuries” – the lack of an arm and blind in one eye – proudly displayed, as they are in all his portraits.

Our history is full of disabled heroes, known for their achievements and not defined by their disability.

Down at the other end of Whitehall is the statue to Winston Churchill, rarely recognised as disabled, but who suffered from a recurrent depressive condition that he described as his “black dog”. Unlike Nelson, Churchill’s disability was invisible and often glossed over, so you can’t blame the sculptor for not capturing it.

Head 150 miles north-west and you find a statue that, remarkably, conveys no hint of another hero’s disability. In Stoke on Trent, outside the Wedgwood Museum, stands a statue of Josiah Wedgwood, possibly one of the greatest figures of the Industrial Revolution: entrepreneur, inventor, innovator, radical and anti-slave trade campaigner. Wedgwood had his lower leg amputated because of smallpox contracted as a child. The fact that contemporary portraits do not show his prosthesis may reflect a desire on his part to conceal his disability. But his disability meant that he couldn’t turn a kick wheel and follow the family trade as a potter himself, so directed his attention and his prodigious talent to reshaping the industry he worked in.

Disabled people don’t want to be defined by their disability. However, we do hope people make “reasonable adjustment” (to use the words enshrined in the 2010 Equality Act) to help us mitigate our disability so we can achieve and contribute to the best of our ability. For some of my colleagues in the Disabled NHS Directors’ Network (DNDN), it is a matter of ensuring that there is decent physical access in the shape of ramps and lifts. For others, it involves thinking carefully about lighting, legibility and document suitability for text to speech solutions. At the DNDN, we adopt the discipline of checking at the start of any meeting if anyone requires any adjustment.

For me, it is relatively easy. My hearing is impaired by tinnitus, taking the form of a high-pitched ringing or screeching that means that I can’t hear sibilants and hard consonants even with my hearing aids. It is genetic rather than the result of having played in a rock band, and I slightly resent that the tinnitus also experienced by my father and brother, both of whom served in the armed forces, generated an adjustment to their service pensions (paid out of my taxes) because it was diagnosed as the result of exposure to gunfire.

It helps if I can see your mouth when you speak (which means colleagues dropping their Covid masks when speaking and allowing me to choose where I sit in a meeting). In the endless round of Teams meetings, it helps if you turn your cameras on and the closed captioning facility is enabled. It also helps if you don’t mind me occasionally asking you to repeat what you have said as it is much safer than me having to guess. And finally, please don’t ask me to engage in a mindfulness session that involves sitting silently: I don’t hear silence and this sort of mindfulness session leaves me tormented by my tinnitus!

Kate Smyth, (non-executive director at Lancashire Teaching Hospitals Foundation Trust) and I established the Disabled NHS Directors’ Network in 2019 with multiple objectives. Not only did we want to provide mutual support and share experiences among NHS leaders with disabilities, but we wanted to support disabled people throughout the NHS, providing role models from people at board level to junior colleagues, increasing the representation of disabled people on boards, and raising standard of service provided to patients and services users with disabilities.

It has been an exciting time building the network, discovering colleagues with a very wide range of disabilities: sensory like mine, physically disabling, like those of Kate who is a wheelchair user as a result of multiple sclerosis, and her co-chair, Peter Reading (chief executive at North Lincolnshire and Goole Foundation Trust) who had polio as an infant, or relating to long-term mental health or neurodiversity.  It is also exciting that the NHS is at last “getting” disability as it feels that, for too long, it has been the poor relation among the Equality Act protected characteristics.

And, finally, as someone who spent the winter 1976/7 (ancient history for most people reading this) studying the life and career of Josiah Wedgwood, it is also exciting to have the excuse of Disability History month to celebrate one of Britain’s disabled heroes.

Lockdown reading: Piketty’s Capitalism and Ideology

The Year of Revolution - a clash of ideology Chartists meet on Kennington Common in 1848
Chartists meet on Kennington Common in 1848 – the year of the Communist Manifesto and “All things bright and beautiful”

I went into the first Covid-19 lockdown in March with three doorstep sized volumes to keep me going.

The 912 pages of Hilary Mantel’s Mirror and the Light were riveting, even if I knew from the outset that Thomas Cromwell’s career would come to an abrupt end at Tower Hill in 1540. The 1088 pages of David Abulafia’s magisterial The Boundless Sea kept me entertained as it opened my eyes, chapter by chapter, to the way that different parts of the world became progressively connected by maritime exploration, communication and trade.

I had started turning the 1041 pages of Thomas Piketty’s Capital and Ideology before restrictions started to be lifted in May but, despite finding some stimulating ideas in his opening account of the different sources of power of different parts of premodern society (which he describes as ternary or trifunctional, and have echoes in the Escondido Framework’s account of  the three currencies or sanctions), it was not until the re-imposition of lockdown (the UK government’s Tier 4 restrictions) that I finally completed it.

I admire much of what Piketty has done in Capital and Ideology.  His effort to document the movements in the shares of income and wealth between different groups in different societies throughout human history, and particularly the past century or so, is admirable and revealing.  It is possible to challenge some of his assumptions and definitions, but the picture he paints of the direction of the trends in material inequality are compelling.  I agree with his spin on Rawls’s maximin principle: “To the extent that income and wealth inequalities are the result of different aspirations and distinct life choices or permit improvement in the standards of living and expansion of the opportunities available to the disadvantaged, they may be considered just.”  (p.968).  His chapters on the increasing support of the “Brahmin” classes educated to degree level for parties of the left and the corresponding “Nativist” alignment of parties of the traditional right and “left-behind” communities are persuasive. But the book is far longer than it needs to be, many of its graphs add little, and he strays from the professorial scholarship of the economist/social scientist-turned-historian into an undergraduate level of prescription.

Piketty’s underlying thesis is that “no human society can live without an ideology can live without an ideology to make sense of its inequalities.”  I didn’t need to read 1041 pages to recognise this: growing up in a churchgoing family, I remember singing the third verse of “All Things Bright and Beautiful”

The rich man in his castle,
The poor man at his gate,
God made them, high and lowly,
And ordered their estate.

These days, it is generally omitted!

It may or not be a coincidence that Mrs Cecil F Alexander wrote these words in 1848, the “Year of Revolutions”, in which Marx and Engels also wrote The Communist Manifesto.  Piketty chooses to reformulate the opening words of its first chapter “The history of all hitherto existing society is the history of class struggles” as “The history of all hitherto existing society is the history of the struggle of ideologies and the quest for justice.”

There is something in Piketty’s thesis about the relationship between the ideas that prevail at any point in time and the organisation of society and its impact on the distribution of wealth and income.  It may be that I started out as a historian whereas has come to history by way of economics, but I find that he oversimplifies to sustain his argument.  Ideas ebb and flow and they can influence behaviours, but this is not the same thing as saying that they determine behaviours.  He falls into the trap of assuming that the behaviours that are generally ascribed to “capitalism” are the product of the past few centuries.

He frequently quotes Karl Polanyi with approval, who was even more blinkered in this respect, regarding capitalism as an entirely modern phenomenon.  Peter Acton has undermined Moses Finlay’s thesis that the ancient economy was shaped by considerations of status and civic ideology rather than rational economic considerations, demonstrating in Poiesis: Manufacturing in Classical Athens demonstrates that the commercial decisions of Athenians “were for the most part…consistent with today’s understanding of good (rational, profit-maximising) business practice[1]. It does not require a 21st century reading of the biblical parable of the talents to see that the notion of investing for a return was established by the time the Christian gospels were written.  And Abulafia’s The Boundless Sea, contains plenty of evidence for the commercial underpinning of the development of maritime trade over many centuries.  One of the primary shortcomings in Polanyi’s approach was that set very specific conditions around anything that he would define as a market and, by framing his argument in this way, created a platform for his dismissal of the longstanding heritage of commercial activity.  It is as though Polanyi, and to a lesser extent Piketty, seek to dismiss market mechanisms and their place in human societies on the basis that, prior to Adam Smith and his successor, the conditions assumed in classical economics had neither been articulated nor did they prevail.

Essentially, it is not that Piketty is wrong, but his case is overstated and needs reframing.  It is not that ideology determines the form of economic organisation, but it helps shape relationship between the parties.  In Escondido Framework terms, the prevailing ideological frameworks will influence the attitudes and trade-offs made by parties in their relationships with each other at market interfaces.  For example, a religious ordained prohibition on usury does not undermine the human behavioural drivers for gratification today over gratification tomorrow and discounting for risk (although these can be culturally influenced), but historically has resulted in work-arounds (eg Islamic finance) or lending being undertaken by a community less constrained by the prohibition.  Certain activities, as in caste based societies, may be undertaken by tightly defined social groups, with implications for the commercial terms on which these activities take place.  But this is not the preserve of caste societies: while the boundaries may be less clearly defined and not religiously ordained, even in contemporary society there is an intergenerational stickiness in occupations and values, traditions and attitudes acquired in childhood shape occupational choices and behaviours.

So, two cheers for Picketty for the underlying thesis.  And, in due recognition of his own disclaimer in his concluding chapters, he has set out to provoke further debate and provide the foundation for further scholarship rather than provide the definitive answer

However, where I find Capital and Ideology most flawed in when Piketty moves from diagnosis to prescription.  In particular, his leap from describing to the increasing inequality in economic outcome for the richest few percent compared to the poorer mass of the population to concluding that all would be solved by appointing worker representatives to corporate boards highlights the danger of straying too far from your own area of expertise.

The inequality that Piketty documents arises from the endowments that we start out with in life (geography, genetics, family wealth, upbringing, education) and our life choices and chances (too many possibilities to enumerate).  These will shape whether we end up with investable wealth (the impact of this on equality is thoroughly documented in his earlier work: Capital in the 21st Century) and whether we end up in positions in which we have market power and are able to extract economic rent, which has arisen most egregiously in recent years for executive directors of large companies as a result of shortcomings in corporate governance.  Addressing inequality arising from our endowments needs primarily to be by “levelling up” in terms of investment in education and social support, particularly in early years, and widening opportunities, but in relation to inherited wealth is a proper area for taxation.  Addressing inequality arising from investable wealth is also clearly an issue for taxation and also needs international solutions, but is a complex matter not least because of the risk of creating perverse incentives and unintended outcomes.  Taxation has its place in addressing inequalities in income, but as with addressing issues surrounding taxation of wealth and wealth transfer, is also fraught with difficulty.  Piketty raises these issues quite correctly.

But addressing inequality arising from market power and the ability to extract economic rent is a proper matter for better corporate governance and regulation to address market failure.  Piketty fails to recognise the role of market failure and consequently the need to address this, and also the problem of the increasing ability of corporate management (and some of the services that support them), to extract economic rent (ironically, at least in part, at the expense of the owners of investible wealth), and that this is purpose behind the need for reform of corporate governance.  His own prescription, worker representation on boards, is not the solution for reasons that I have argued elsewhere.  Rather, and this comes back to his underlying thesis around ideology, there is a need to widen the understanding about the proper purpose of the company (the core of the Escondido Framework), and an improved understanding of the role of boards in serving them.

[1] Acton P (2014) Poiesis: Manufacturing in Classical Athens. New York: Oxford University Press

Understanding Apple’s implausible explanation

Apple logo






Apple has just announced that it will reduce the commission it charges smaller developers (those who earned less than $1 million last year through the App Store) from 30% to 15%.

As someone with an advisory role and financial interest in just such a business for the past ten years, the explanation provided by Apple’s CEO, Tim Cook, has a hollow ring:

“Small businesses are the backbone of our global economy and the beating heart of innovation and opportunity in communities around the world. We’re launching this program to help small business owners write the next chapter of creativity and prosperity on the App Store, and to build the kind of quality apps our customers love.  The App Store has been an engine of economic growth like none other, creating millions of new jobs and a pathway to entrepreneurship accessible to anyone with a great idea. Our new program carries that progress forward — helping developers fund their small businesses, take risks on new ideas, expand their teams, and continue to make apps that enrich people’s lives.”

The suggestion that this is a natural evolution and being done out of the goodness of Apple’s corporate heart is implausible at best.  The small businesses that rely on the App Store to reach iPhone customer have been “the backbone of the global economy and beating heart of innovation and opportunity” throughout the iPhone’s existence and have put up with being fleeced.  The entrepreneurs have funded their businesses, taken risks on new ideas, expanded their teams and made apps that enrich people’s lives without any help from the black shirts* formerly of Infinity Loop, now Apple Park.

The likely explanation is provided by the threat of action from the European Commission, which opened an investigation into Apple’s anti-competitive behaviour in June, and potentially from the US, with Congressional hearings into the monopolistic conduct of the tech giants later in the summer.  This is an illustration of the strategic solution space available to a company being reduced by the prospect of regulatory intervention.

In parallel with this reduction in the price charged to its small customers for using the App Store, Apple revealed at the Congressional hearings something about the shape of the market interface between the App Store and the “customers” who sell through it when it disclosed that it had agreed a 15% commission with Amazon for in-app charges within the Prime Video app.

The interesting question is what happens next.  Apple has had to cave in to the threat of another web behemoth flexing its market power and potential to lobby against it.  It has accepted, so far in part only with the new deal for smaller developers, the political reality of the forces gathering against its abuse of its power over a large slice of the market for apps on mobile phones.  What of the middle-sized App Store developer customers?  How long will it take Apple to develop an implausible but face-saving formulation to explain why it has reduced their commissions too?  Or will it try to tough it out until competition authorities around the world run out of patience and take Apple, and potentially some of the other tech giants, apart in the way they did to the US rail and oil industry over a century ago?

* for the avoidance of doubt, this is a reference to the sartorial style of the late Steve Jobs and his successors and not a comment on either their conduct or politics.

Investors and consumers both need good sustainability reporting

Sustainable fashion? (Financial Times)
Sustainable fashion? (Financial Times)

The FT has been carrying stories for the past two weeks about improving the quality of information provided by companies to their investors on the environmental impact of their activities and the sustainability of their businesses in the face of climate change.  It may just be a coincidence, or it may be a conscious decision of the editorial board, but the Fashion Editor writes in “Life and the Arts” section of the Weekend FT on the same subject under the headline “Sustainable fashion? There’s no such thing”

On 5th November, Erkki Liikanen, Chair of the IFRS Foundation Trustees, delivered the keynote speech at the UNCTAD Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting, introducing the Trustees’ Consultation Paper on Sustainability Reporting.

On 9th November, Rishi Sunak, Chancellor of the Exchequer, delivered a speech to the House of Commons on financial services.  In the course of setting out his plans for supporting the City at the end of the transition period as the UK leaves the EU and plans to launch a Sovereign Green Bond, he declared:

“We’re announcing the UK’s intention to mandate climate disclosures by large companies and financial institutions across our economy, by 2025.

“Going further than recommended by the Taskforce on Climate-related Financial Disclosures.

“And the first G20 country to do so.

“We’re implementing a new ‘green taxonomy’, robustly classifying what we mean by ‘green’ to help firms and investors better understand the impact of their investments on the environment.”

On 10th November, the Financial Reporting Council launched its Statement on Non-Financial Reporting Frameworks, opening with the preamble:

“Climate change is one of the defining issues of our time and, by its nature, material to companies’ long-term success. Boards have a responsibility to consider their impact on the environment and the likely consequences of any business decisions in the long-term. Our 2020 review of climate-related considerations in corporate reporting and auditing found that boards and companies, auditors, professional associations, regulators and standard-setters need to do more.”

before recommending that companies should try to report “against the Task Force on Climate-related Financial Disclosures’ (TCFD) 11 recommended disclosures and, with reference to their sector, using the Sustainability Accounting Standards Board (SASB) metrics” and setting out its own plans over the medium term to help “companies to achieve reporting under TCFD and SASB that meets the needs of investors”.

Today, 14th November, the FT’s fashion editor writes about the dilemmas facing those of her readers who are concerned about the impact of their purchasing decisions.  She recognises that the best way to live a sustainable life is to buy less, but also that her readers want to find ways, while supplementing and refreshing their wardrobes, to plot their way through the “greenwash” claims of the fashion brands.  Both these consumers and some of the brands themselves want clearer and more reliable accreditation of products that come from supply chains that are, if not truly environmentally friendly, at least less environmental unfriendly.

Following up the themes in this article, I found a great piece written by Whitney Bauck in Fashionista, in April last year:

“If you’re aware that there are ethical issues baked into making clothes but don’t have time to do in-depth supply chain research every time you need a new pair of socks, there’s a good chance you’ve thought at some point: ‘If only someone could just tell me for sure if this brand is ethical or not.’

“You wouldn’t be alone in that desire. In years of writing about both sustainability and ethics, it’s a sentiment I’ve heard from fashion consumers a lot. While many people want to be more conscious with their consumption, they also wish it were easier to tell which brands are truly being kind to people and planet.

“If you fall into that category, there’s good news and bad news. The bad news is that a one-size-fits-all ethical fashion certification will probably never exist, partly because not everyone agrees on what qualifies as “ethical.” Should that word refer to job creation in impoverished communities or animal welfare? Should it mean making clothes from organic materials or recycled synthetic ones? Not every ethical fashion fan has the same standards or priorities, and that will always make a one-size-fits-all approach to ethical fashion certification difficult.”

I wrote in a blog post four years ago about the benefits that the team I led at WH Smith believed would arise from developing and selling green stationery ranges.  The issues described by Lauren Indvik in the FT are nothing new.  We faced similar challenges both in terms of selecting products and in terms demonstrating to our customers that buying these products would better than buying alternatives.

The challenges facing investors and consumers in taking environmental and other ethical considerations into account in what are otherwise commercial decisions are identical.  Both investors and consumers want the best information, to put into the mix with the other things that influence their decisions – the complex trade-offs of exposure to multiple risks, timing, and return for the investor, or look, feel, comfort, durability, after sales support and cost* for the consumer.

The similarity between these challenges is evidence for the symmetry in all businesses – investors are customers for investment opportunities presented by the company, in the same way that consumers are customers for products and, indeed, that employees are customers for the jobs that companies provide.  In an age when people – in their multiple roles as investors, consumers, and employees – want to invest in, buy from, and work for organisations that behave responsibly in relation to wider society and to the environment, they need reliable information to inform their decisions.

* and a host of other possible features depending on the product or service category

So, auditors can say “boo to a goose”

With their decision to resign as auditors to Boohoo after seven years, PwC’s partners have at last shown that they are willing to say boo to a goose.  Ditto those at Deloitte, who quit as auditors to EG, the petrol station operator that has agreed to relieve Walmart of Asda (albeit with a big slug of vendor finance).  And their colleagues at Grant Thornton who, prompted by a probe by the Belgian tax authority, decided that they had had enough of dealing with Mike Ashley at Fraser Group (better known as Sports Direct). And those at EY, who quit from auditing Finablr in May over weaknesses in corporate governance and links to troubled NMC Health.

This is welcome news, given that the Financial Reporting Council observed in November last year in its annual “Developments in Audit” publication:

“Audits are not consistently reaching the necessary, high standards required to provide confidence in financial reporting.

“A series of high-profile corporate failures has dented trust in the profession and highlighted the need for improvement……

“Our 2018/19 AQR inspections show auditors still struggle to challenge management sufficiently.”

The final point is nothing new.  I worked alongside one of the big firms in the early 1990s, undertaking a review of branch level financial controls (which were not as good as they should have been) in the largest chain in a quoted retail group.  I recall attending a meeting alongside the audit partner with the chief executive, a “strong personality”, and observed him forcefully objecting to proposals for qualifying the accounts.  I understand his reasons for doing so, and have in the past made a similar argument to an auditor to persuaded them that my organisation passed the “going concern” test.  However, the shocking aspect of this case was observing the chief executive drawing the commercial value of the advisory business attention of his company to the audit firm to the attention of the audit partner, that the subsequent audit opinion was not qualified, and that the company collapsed within six months.

Kate Burgess, writing in the FT today, suggests that the decision by PwC is a calculated commercial decision rather than motivated by principle.  She suggests that as the revelations about Boohoo’s employment practices emerged the reputational risk from being its auditor exceeded the value of the £389,000 annual fee income.  This may be harsh, but few in the audit profession can forget what the relationship to Enron (although it may have amounted to more than guilt by association) did to Arthur Anderson, and noting that EY’s partners must remain anxious about potential impact on the company of its involvement with Wirecard.

Irrespective of the motivation, the decision of audit firms to step back from working with clients who do not have adequate controls and who may well operate unethically can only be welcomed.  And even if progress can seem glacially slow, the action of regulators in trying raise standards must be welcomed too.

Rio Tinto’s dynamiting of the Juukan Gorge: Jean-Sebastien Jacques’s solution-space implodes

Juukan Gorge caves after Rio Tinto dynamiting
Juukan Gorge caves after Rio Tinto dynamiting

What better illustration could there be of the Escondido Framework approach to understanding ESG investing described in last week’s blog than the defenestration of Rio Tinto’s chief executive, Jean-Sebastien Jacques, by the company’s shareholders?[1]

In relation to the distinction made in last week’s article between the impact of regulation on the solution space available to executive teams, one of the interesting aspects of the dynamiting of Juukan Gorge and the two rock shelters is that the company had previously negotiated native title agreements with the Puutu Kunti Kurrama and Pinikura people, giving it rights to mine the area and had also secured regulatory approval.  In Escondido Framework terms, as illustrated in last week’s blog post, the company thought that it was operating within the solution space defined by the market transaction with the owners of the land and that the regulatory market interface had not reduced the solution space available to the company.

However, the executives had failed to appreciate the sensitivities of the company’s investors to such an egregious violation of the heritage of not only the indigenous population but humankind as a whole.

Perhaps the board and executive team at Rio Tinto paid too much attention to the likelihood that investors in mining stocks are already a self-selected group that is less sensitive to ESG considerations than the investment market overall.

It matters little whether the response of the investors whose pressure on the board finally persuaded chairman Simon Thompson (who previously had insisted that Rio Tinto would not fire Mr Jacques) was a reflection of the potential for the scandal to increase future regulatory pressure on the industry, or a concern for the response of the upstream investors in their funds, or the consciences of fund management executives themselves being pricked by comparisons between the dynamiting of the caves with the actions of the Taliban blowing up the Bamyam Buddhas in 2001.

Either way, the shape of the investment market interface was sufficiently different to that perceived by Mr Jacques and his colleagues for them to have placed themselves, not temporarily but at a personal level permanently, outside the solution space available to them.

[1] For anyone who missed the story, Rio Tinto blew up two 46,000-year-old Aboriginal rock shelters in Western Australia, offending not only the Australia aboriginal community for whom the sites were sacred but also a wider public sensitive to an ancient archeological heritage. Initially the board decided to withhold bonuses for the executives involved, but has now decided that Mr Jacques should go (albeit not until early next year and without any further financial penalties)

Understanding ESG investment

The Financial Times has published a flurry of articles and the occasional letter about ESG (Environmental, Social and Governance) investing recently.

For example, Geeta Aiyer, president of Boston Common Asset Management, was the subject of a profile on 29th August.  This followed the success of Boston Common and other investors to secure the change of name of the Washington Red Skins American Football team by applying pressure on FedEx, the logistics company which sponsors the team’s stadium.

On 1st September the paper published an article about write-downs at BP and Shell in response to “scores of asset managers who have doggedly pressed the oil companies to set targets to reduce carbon emissions and recognise the financial impact climate change could have on their operations” .  The article cites a number of leading fund managers who comment on the “explosion” in ESG investing.  It also notes the role of regulation in changing perspectives, citing the requirement now placed on pension fund managers in the UK take sustainability issues into account in their investment decisions and the impact of the EU’s sustainable finance package which will, from March 2021, push asset managers to incorporate ESG risks in their decision making.

A day later, on 2nd September, the FT published an article by Chuku Umuna, former Labour business spokesman and now lead for ESG with Edelman, the public relations consultancy, arguing that  “a company’s ability to manage ESG factors is widely viewed as a proxy for prudent risk management, and with good reason”, citing work by Société Générale on the impact of ESG-related controversies that found that “in two-thirds of cases a company’s stock experienced sustained underperformance, trailing peers over the course of the following two years.”

A few months earlier, on 9th July, Gillian Tett wrote an article that opened by observing that the major ESG indices in the US and in Asia had outperformed the equivalent all share indices in terms of the financial returns to shareholders and cited a report from BlackRock making the same case, not only in the past year but also in 2015/16 and in 2018.  BlackRock put this down to two primary reasons: the momentum created by ESG investors pushing up prices as they seek to acquire these stock for their clients and beneficiaries; and the value to companies seeking to improve their ESG ratings the scrutiny to which they subject their supply chains and employee practices and the consequent benefits that arise to their businesses.

Does the Escondido Framework approach to understanding organisations help us understand what is going on?

The Escondido Framework approach to looking at the firm is described in detail elsewhere.  In essence, it explains that firms exist as a virtual space defined by their market interface with the suppliers of capital, labour, suppliers of goods and services, and customers, plus others whose needs may need to be satisfied, such as government or the wider community who implicitly or explicitly provide the firm with a license to do business.  Their survival depends on creating value through the efficiency of their internal operations for there to be such a space.  Where the firm places itself within the space will determine the distribution of economic rent to the stakeholders, how much may retained by the executive management, and how is available for reinvestment either in assets or long term relationships with one of more sets of stakeholders.  As the market interfaces changes – through changes in supply and demand, competition, or the trade-offs made by the other parties to the markets place exchange – the virtual space (which can also be considered as the solution space available to the management team) may expand or contract (increasing or reducing the range of options, strategies and potential profitability available).

Reuleaux Tetrahedron with labels

If a new external party intervenes, for example a government agency imposes regulation, the virtual space will be reduced correspondingly.  Indeed, even the threat of regulation will have the effect of reducing the space as the firm is likely to take the view that it cannot afford to provoke the regulator.

Impact of new regulation to reduce solution space
Impact of new regulation to reduce solution space

So what is going on with ESG investment?  ESG considerations have an impact on investment decisions in multiple ways.

Some investors will choose only to invest in businesses whose practices meet certain standards in terms of environmental and/or social responsibility and impact.  When I was trustee of a large medical charity, we initially had a relatively limited list of sectors that we guided our fund managers to avoid, but progressively widened the list to avoid those whose products were implicated in contributing to the ill-health we working to address.  Other charities have much wider exclusion lists, and many private individuals also choose to invest in ethical funds.  Such investors are making an explicit trade-off between such potential increased returns as may be available from investing in companies (eg defence, tobacco) that don’t satisfy their ethical criteria.

Other investors decide to invest in ESG funds and businesses that meet ESG criteria because they believe that companies that with sound governance, ethical approaches to the communities in which they operate and setting high standards in their supply chains, and responsible approaches to the environment will ultimately deliver higher long term returns and be sustainable. Such investors may also take the view that these approaches also represent good business.  Working in retail management as a merchandise director in the 1980s, I certainly took the view that being as environmentally responsible as possible was good business.  I led a team that decided to adopt policies towards sourcing products from sustainable raw materials, reducing packaging, and developing “green” product ranges making extensive use of recycled materials on the basis that it was good for the business.  It was good for our brand as it improved our standing with increasingly environmentally conscious customers.  It was good for our sales, since people appeared keen to buy less environmentally harmful alternatives.  It was also good for recruitment and retention of good staff, who seemed motivated (as I was) by working for a company that was trying to be environmentally responsible.

High standards of governance should also be appealing to investors, and the evidence is strong notwithstanding the mercurial successes of a few mavericks. As chair of a committee investing £200 million for the charity on which I was a trustee, I was attracted to Edinburgh based fund managers, Baillie Gifford, precisely because of the demands that it placed on the governance of their investee companies and its willingness to vote the shares it held for client like us to improve governance of the investee companies – and we were rewarded for our confidence in the approach by returns that consistently exceed the benchmarks for the fund.

If, as the flurry of FT articles suggests, there is an increasing appetite for ESG investing for whatever reason, the impact on companies is that (at least for the visually minded) the shape and precise orientation of their interface with the investment market will change reflecting either the trade-offs (in the case of the first type of investor described above) or the beliefs about the sustainability and long term returns  (in the case of the second type of investor).  The consequence of the appetite for ESG investing on companies is that those with business practices that align with the demands and expectations of ESG investors will face a slightly lower cost of capital and consequently increase the size of the solution space for the management teams when looking at their strategies.

George Schultz at 99

George Schultz (Hoover Institution
George Schultz (Hoover Institution)

Over forty years ago, I attended a four session seminar at the Graduate School of Business at Stanford with George Schultz, then moonlighting as a part-time professor while serving as President of Bechtel Corporation.  By that stage in his career he had already been a professor at MIT, dean of the Chicago University Graduate School of Business, and served in the US government as both Secretary of Labor and Secretary of the Treasury.  Two years later, the Economist’s leading article gave a warm welcome to his appointment as Ronald Reagan’s second Secretary of State, after the disastrous Alexander Haig when the Cold War showed dangerous signs of overheating.  The Economist reeled of a list of the world leaders with whom Schultz had built a close relationship over many years, which contributed the dialling down of threats to world peace during and following Schultz’s term of office.

Among the unexpected benefits of the Covid-19 pandemic has been the efforts of organisations to reach out to audiences with webcasts and webinars.  My Stanford connections mean that I am on a mailing list for the Hoover Institution where Schultz remains, at age 99, a senior fellow, and to judge by the unmissable half hour session on Monday evening, a very active one.

I recall being put down in 1980 by Schultz when I made a case, the details of which I have long forgotten, for government intervention of some sort and he responded arguing against the approach I’d suggested and made the case for the use of economic, and specifically market levers.  It was striking in this week’s interview how wide is the range of areas in which he now argues for intervention in relation to domestic policy, albeit still using economic levers,  and international co-operation to address the range of threats to the future of our society, not least climate change and inequality.

As one of the architects of détente in the 1980s, and more recently an advocate for continued international collaboration (arguing for example that Britain should remain in the European Union), it was no surprise that he contrasted both the current deterioration in the relations between the superpowers and the America First foreign policy of the Trump administration with the post World War 2 settlement.  He opened his talk by citing the vision both of those who gathered at Bretton Woods in July 1944 to establish a new international monetary and financial order and of the European leaders who met in Paris in 1951 to surrender sovereignty to establish the Europe Coal and Steel Community and thereby laid the foundations of the European Union.

He presented a depressing outlook for the world, given the scale of the climate change crisis and the apparent lack of reason in the approach of too many world leaders.  However, I am not sure that I buy all the arguments that he made.  In particular, he argued that the ageing of the populations of North America, Europe, China and the more developed countries of Asian (and given the need for population decline to reduce pressure on the environment and address global warming, the inevitability of an ageing of the global population), create the potential for an end to economic growth and squeeze on living standards, which seemed to take little account of the potential for extending productive lives.

But, however interesting his view of the global outlook and whatever the pleasure for me of this trip down memory lane, what justifies including an account of Schultz’s webinar in this blog?  The “takeaway” is his account of the importance of personal relationships and human interaction.  It is clear from his anecdotes that his ability to rub along with people made a huge difference to the resolution of problems in the United States’ relationship with the rest of the world both when he was Treasury Secretary and, most critically, Secretary of State.  The Economist was right in 1982 to hail the appointment of this massively networked figure.  Interpersonal skills are important to the management of the interface between organisations, right up to the size of superpowers.  They are also critical to the effectiveness of internal operations.  In answer to a question about the dysfunctionality of US government and politics today, he observed that the key figures in both executive and legislative branches all lived in Washington for most of the year, and he would regularly meet over dinner with congressmen from both sides of the aisle, in contrast to the situation today.  A glimpse perhaps of the Dark Matter that makes organisations work?

My recollection from our encounters in 1980 is of a solidly build man in late middle age (at least from the perspective of a 24 year old) with a gravelly baritone, a contrast with the smaller man of today with a voice pitched an octave higher.  There is only so much we can do to hold back physical ageing, but it is inspiring to see that there is every reason for remaining engaged and committed to public debate.  Schultz’s recipe for a long and active life was revealed in answer to the final question addressed to him: “Don’t stop working on the things that interest you.”  There is no sign that George Schultz intends stopping soon.

How can technological change serve society through purposeful business?

This third session of the on-line British Academy Future of the Corporation – Purpose Summit was anchored in an interview with Satya Nadella, CEO of Microsoft and, as became clear, a living embodiment of the importance of purpose to business.

He conveyed a strong commitment to the resilience and survival of the corporation, and the place of purpose within this.  Early on, he stated “A company should not outlive its social purpose.  Its social contract should be sustained.”  His final remark, in response to a question about what he wanted to achieve at Microsoft, was that measure of the contribution of leaders to their companies was that they left them with the institutional strength to outlive them.  These two observations together add up to a compelling view of the role of the leader to ensure that the company’s purpose, in terms of what it provides to society at large, creates value for society.  By implication, strategy is about adapting to ensure that the company’s purpose continues to achieve this.

Nadella, in common with  Alan Pole of Unilever in an earlier, reflected on the importance of a company’s purpose in relation to meeting he challenges of the climate crisis and inequality.  He spoke of the need for economic growth, but that it needs to serve everyone, to be anchored in popular trust, and to be sustainable – “you can’t have growth and break the planet.”

Nadella spoke repeatedly about the need to earn and maintain the license to operate, a particular concern for the very largest technology companies.  They need to be more sophisticated in avoid the harm that is a consequence of their scale – not least to keep regulators and would be regulators off their backs.  He spoke of the need for companies like Microsoft look upstream of themselves and see what they can do to ensure that through an embedded culture and value system of their own they do what they can to shape their external environment so that “we can be customers of good stuff”.

He was asked whether the pressures of quarterly reporting imposed short term pressures on Microsoft and compromised its corporate purpose and own long term strategy.  He acknowledged that quarterly reporting was a constraint but only insofar as it forced the company to explain what it did and why. He explained that he had no difficulty, for example, justifying to his shareholders why Microsoft invested in local housing projects in Washington since the company need to support its wider workforce, not just highly paid software engineers but also people in blue collar service roles keeping the local economy operating.

Chair of the House of Commons Science and Technology Select Committee and former minister, Greg Clark, had to follow this tour de force.  He reflected on the how the Covid-19 pandemic had accelerated some technology trends such as video-conferencing but also commented on the degree to which the recent experience surrounding the popular responses to apps to tracking infected patients had highlighted the importance of face to face contact in service activities.

The third contributor to this session was Ngaire Woods, Dean of the Blatavnik School of Government at Oxford who focussed on the role of government in regulation and the limitation of self regulatory codes in prevent a “race to the bottom”.  It was apparent that her underlying thesis is that, notwithstanding the sense of purpose adopted by some business leaders, regulatory intervention is necessary  – citing as her example the need for Robert Peel to secure the legislation to ensure widespread adoption of the standards in factories that Robert Own had pioneered.  She also highlighted the need for appropriate regulation, in that the cheap solution is not always the best (using the example of the alternative approaches to preventing oil spills: the inexpensive solution of a fining system was ineffective whereas the policeable and expensive solution of requiring tankers to have a double skin has been highly effective).  In answer to questions later, she also argued that governments should be prepared to use their power as lenders of last resort in the pandemic to secure responsible and purposeful behaviour by business – an answer that unwittingly brought us full circle back the issue addressed by Nadella of the license to operate.