The task of reconciling ethics and economics vexes managers today. That challenge must be met, says this Ivey professor, who urges managers to find and occupy the space where economic and ethical activities overlap. Not only does this middle ground exist, she says, but activities undertaken in this space are likely to generate a source of long-term, stable profits and result in a higher level of employee, shareholder, and corporate well-being.

Economics or ethics?

There are countless examples of firms that have broken the law to serve their self interests. The examples roll off our tongues like the names of wornout celebrities: Enron, Worldcom, Tyco, Martha Stewart, Hollinger, Parmalat, and Nortel. Almost every day, the business pages report another story of company insiders trying to profit through corporate malfeasance. Many of us do not know the details of the wrongdoings; we just know that the key actors face criminal prosecution. That these firms and certain officers have acted irresponsibly and illegally is never disputed.

But the stories about corporate villains are not only about law breakers. They also include the subtle misdemeanors which blur the lines between right and wrong — wholesale layoffs, under-secured pension plans, poor labour conditions, and inflated statements about financial performance. These issues dog even our most esteemed corporations, such as Microsoft, General Motors, and Royal-Dutch Shell. The stories are often presented as ‘corporate efficiencies’ or ‘just doing business.’ Yet, these insidious issues can cause more damage because they are widespread and widely accepted. They also drive to the heart of a longstanding debate in business-the one between ethics and economics.

Essentially, there are two sides to the debate. The economic argument is that corporations are responsible only to shareholders. If corporate activities do not maximize profits, then the company is not acting responsibly. The ethics argument states that the corporation is an institution formed to ultimately improve society. If corporate activities do not enhance social well-being, then the company is not acting responsibly.

The debate illustrates the tug-of-war between people and profits (see Exhibit 1). On the one hand, social programs come at an economic cost and firms should not engage in activities that do not have a clear return. On the other hand, economic returns create social costs.

In this article, I describe this tension in more detail and then demonstrate why the debate is flawed. Each side flings mud at the other in an effort to make its own side look better. However, this ‘either-or’ approach polarizes the discussion and distracts attention from the space where economics and ethics converge, and where potential solutions exist.

This overlapping space is not the compromise position. It is a completely tenable position that uses business models that meet both economic and ethical objectives simultaneously. New corporate policies, procedures, and programs are able to secure economic returns while serving society-a position to which most organizational members would like to subscribe. I argue that the overlapping space is not found by recasting ethical issues in economic terms or in disregarding economic models, but rather in marrying social processes to economic ones, so that responsible decisions are both socially and fiscally responsible.

This middle ground is not merely a theoretical space — many organizations occupy it already. They are often unsung heroes. These firms practice good governance, not because they are compelled to do so, or because they expect to shout about their stellar reputation. They do it because the folks that manage the organization see no other alternative. For them, responsibility has a fiscal and a social dimension. Their strategic alternatives are not defined only by all they can do; they are also limited by what they will not do. These are companies, such as Tembec, Home Depot, and TransCanada Pipelines, that have found practical solutions for very practical problems.

The Economic Value Argument

The role of businesses is to create value for economic prosperity.

Corporations are efficient forms for organizing and allocating resources to create economic value. They allow groups of people to raise capital efficiently in order to supply goods and services. Capital markets allow firms to borrow debt from financial institutions and sell equity to arms-length investors. These capital markets are sufficiently flexible to meet the various needs of lenders, owners, and managers. Revenues generated through corporate value-creation activities are distributed as wages, salaries and other forms of remuneration to employees, and management and dividends to shareholders, or they are reinvested in the business. If this economic wealth is distributed equitably, then social well-being will be assured. Employees will receive a share of the profits of the business commensurate with their efforts, and shareholders will receive a fair return on their investment. Firms will manage social issues by internalizing their externalities, that is, by ensuring that those parties affected negatively by their operations are compensated fairly. Governments will be able to provide social services from their business tax revenues. Ultimately, all of society will benefit from the value-creation activities of corporations.

Institutional structures in most capitalist countries reinforce this economic argument. Corporate law in most countries dictates that corporations must act in the best interest of their owners, the shareholders. And in the short-term, shareholder interests are best served when profits are maximized. Business success is evaluated on the basis of financial measures of profit, such as return on investment, assets, sales, and equity. This view has been enshrined in the public mindset and in almost all corporate documentation. The first of the Canadian Coalition for Good Governance’s seven objectives is “ensuring that all public corporations have highly qualified boards of directors who understand that they are accountable only to the shareholders in the carrying out of their fiduciary duties.“

But…

Economic arguments assume the existence of perfectly competitive markets in which consumers and producers behave rationally in order to maximize utility and profits. In a perfect market, goods and services flow openly, there are no transaction costs, entry and exit is free, and producers and consumers possess complete information about the price, physical characteristics, and availability of each commodity.

But the perfect market is an abstraction. Markets do not operate unfettered by regulation. The power between producers, employees, and consumers is not distributed evenly. Governments are not always able to redistribute economic wealth to ensure that all members of society have equal access to the resources and opportunities necessary to meet their needs. The richest 1% of the world (50 million people) receives as much income as the bottom 57% (2.7 billion people). Thirteen per cent of the world’s population is undernourished, even though, on average, the world produces sufficient food to meet everyone’s required daily caloric needs.

Negative externalities, such as noise, congestion, and pollution, impact those who have had no role in, nor consented to, the economic transaction. For example, greenhouse gas emissions are expected to increase the area affected by mosquito-spread diseases, raise sea-levels and inundate low-lying land areas, and reduce food productivity in tropical and sub-tropical regions of the world. Because the most critical resources in the world, such as water and air, cannot be priced sensibly, they are used and abused indiscriminately. The “tragedy of the commons,” described by G. Hardin in Science (December, 1968), demonstrates how market equilibrium theory breaks down for common property resources, such as ocean fisheries, common pasture lands, air, and groundwater supplies. Because no one owns the resource, producers consider fish stocks, (or air, water, or common land) to be free. Once a boat (capital) is purchased, fisheries will maximize their own profits by taking the largest catch possible. But by increasing the catch, each fishery reduces the fish population and increases the amount of capital and labour required to generate the same yield year over year. Economists tend to ignore these realities.

The Societal Value Argument

The role of business is to create value to improve and protect societal and environmental health.

There is also an ethical argument that says that firms are morally obliged to give back to the societies in which they exist. This responsibility arises for at least two reasons. First, firms are obliged to make a payment in kind for using society’s infrastructure, land, air, water, plants, and animals to generate profit. Second, they have a duty to reimburse society for the negative externalities their activities generate (e.g. noise, smell, congestion, toxic emissions, etc.). Corporations have been given the rights of an individual, and they have commensurate responsibilities. Just as it is a moral duty for individuals to contribute to the community in which they live, corporations are also obliged to contribute to their community through volunteering, charitable donations, sponsoring community and cultural events, and so forth.

Furthermore, the moral obligation of firms to be socially and environmentally responsible is greater than that of individuals, mainly because of the powerful role corporations play in society. Corporations own more infrastructure, physical capital, land, financial capital, and knowledge than governments, and they are the most powerful economic force in society today. As a result, they can significantly influence government policy, international trade, and the growth of national economies. Of the largest 100 economies in the world as measured by total output, 47 are transnational corporations (“An Agenda for Raising the Standards in Canada“, Democracy Watch, October 1994). Robert Monks, a successful author, investor, and activist, suggests that “…the heads of large corporations have more impact on your life and the lives of citizens around the world than the head of any country.“

In the ethical argument, the corporation’s moral obligations to society must be considered in all decisions.

But…

Even though ethical arguments are morally appealing, they do not apply well to the practical realities of modern western social and economic systems. First, the ethical argument lacks clear measures for evaluating the success or otherwise of socially valuable activities. It is difficult to compare one activity with another without a baseline measure of value. Very few social issues have these benchmarks. Is it more important for an organization to donate to the local hospital or to invest in alternative energy forms?

Second, firms have many stakeholders. Is a decision successful if all stakeholders are satisfied, or merely if their degree of dissatisfaction is minimized? Do some stakeholders take precedence over others? Which ones? Many businesses prioritize their activities, and find that they succeed in some areas, with some stakeholders, and are less successful in others. Does this make them irresponsible?

Third, socially or environmentally responsible business activities are voluntary (above and beyond regulatory standards), their effects are often very difficult to quantify, and they can be highly dependent on the personal views of an influential leader. For example, as owners, the creators of Ben and Jerry’s Ice Cream were able to embed social responsibility in to the organization’s values.

But when leadership changes, or in the face of economic pressure, the ethical argument provides a weak imperative for firms to continue to operate in this way, especially if there are short-term costs to doing so.

Finally, the legal entity of the corporation was created to allow resources to be jointly owned. Shareholders expect to earn an income on their capital. If they don’t they will move that capital elsewhere, or not invest it at all. If the purpose of the corporation shifts from one of efficient production to stakeholder satisfaction, then corporations cannot engage in the very act for which they were designed, ultimately compromising productivity and quality of life. Milton Friedman and other economists argue that corporations that divert resources from activities that generate profits for shareholders are unethical, irresponsible, and immoral.

Building Sustainable Value

I believe that the debate between ethicists and economists need not be polarized. In fact, the two arguments actually converge over time. In the longrun, unethical firms will likely lose their social license to operate, and unprofitable firms cannot create economic or social value. To survive in the longterm, businesses must capture sustainable value by finding, and operating in, the space where economic and ethical activities overlap.(see Exhibit 2). Not only does this middle ground exist, but activities undertaken in this space are likely to generate a source of long-term, stable profits and result in a higher level of employee, shareholder, and corporate wellbeing.

 

Value

It does not require a crystal ball to see how economics and ethics can converge to create insustainable value. Long-term thinking is an obvious risk management strategy. Through the power of social movements, facilitated by technology and globalization, stakeholders who are weak or disenfranchised today can be powerful tomorrow. Firms with a long-term view build greater resilience to these changes by responding to, and often preempting, these social challenges. As a result, they build trust and loyalty with employees, customers, and the community, which, in turn, create long-term, financial rewards. A longer time horizon widens the pool of possible alternative projects and keeps open options that would otherwise be rejected out-of-hand because they do not meet short-term revenue hurdles.

However, the fluidity of most capital markets keeps most firms focused on the shortterm. Investors can buy or sell pieces of the corporation relatively quickly and cheaply. Consequently, firms are under pressure to report these measures more often. Investors and analysts then scrutinize the firm’s performance, with the tiniest hint of weakness often compromising investor confidence in the company. A falling share price over several quarters puts the jobs of senior managers at risk, and a weak share price opens up the firm to takeover or divestiture.

Social Processes require Social Processes

It may appear all-but impossible to find the overlapping space in the short-run. But the answer is quite simple. Social issues require social processes. Social processes include stakeholder engagement, community participation, and employee involvement in decision-making. By investing in these processes, the firm:

• creates buy-in for strategic decisions, smoothing out the process of securing licenses to operate
• identifies problems and risks before they escalate into crises that can delay or derail a project
• uncovers innovative and creative ideas and solutions that appeal to the broadest group of stakeholders and are less likely to be compromised by changing legislation or public opinions.

Social processes identify critical social issues, eliminate strategic options that are not sustainable, and legitimize a set of social criteria that influence strategic decisions. The economic decision-making framework remains intact, but by implementing these processes, managers ensure that social issues are addressed throughout the organization, not merely at the top or the bottom. Social processes become an integral part of the economic decisionmaking framework, and stop being an appendage of it.

Active and Up-Front Stakeholder Engagement

Firms build sustainable value by actively engaging stakeholders in the decision-making process, and by doing it earlier rather than later. Here is an illustration. In 1997, the Ontario government embarked on an extensive public consultation process to create a strategic plan for land use in Ontario’s forests. Activists demanded that more of Ontario’s forests be protected; forestry companies could not concede more land and stay in business. It was an archetypal economist-ethicist debate. The 242 compromisebased recommendations that came out of the Lands for Life process did not suit any of the involved parties. The stakeholders remained polarized and a ‘war in the woods’ between the forestry industry and environmentalists loomed.

Frank Dottori, the CEO of Tembec Inc., was concerned that Ontario was facing a confrontation similar to the one experienced in Clayquot Sound, British Columbia. Even if all parties agreed to the Lands for Life recommendations, the environmental issues would not be solved, the forestry industry would not remain viable for long, and the conflict would inevitably recur. So Dottori took a different approach — he staked out a position in the overlapping space. He met directly with environmentalists and together they uncovered a common set of objectives: setting aside some pristine forests for public recreation, protecting biodiversity, preserving certain unique ecological features, and maintaining a viable forestry industry. In focusing on the overlapping space, the two sides found the innovative solution they were looking for: the forestry companies would harvest treetops at reduced stumpage fees. In the end, almost all sides were satisfied: a greater percentage of forests were protected, Tembec remained profitable and secured greater certainty for its future operations, and the government appeared to have brokered an agreement.

This example demonstrates how stakeholder engagement can reveal new opportunities when debate is focused on finding the overlapping space between the economically viable solution and the ethically sensible one. Firms that build sustainable value see the consultation process as a useful tool for making decisions about complex social and environmental problems.

Most businesses recognize their obvious stakeholders — customers, neighbors, employees, and shareholders. A wider lens also takes in environmental groups, non-governmental organizations, suppliers, First Nation representatives, government agencies, regulators, municipal officials, local businesses, and others. There are many examples of how businesses engage with these stakeholders, from formal, ongoing community advisory panels, to informal personal relationships between company representatives and community advocates. The stakeholder consultation process is costly in terms of resources and time, especially when stakeholder groups are multiple and diverse. However, these short-term costs offer long-term rewards.

Community Participation and Involvement

Many firms free-up employees to volunteer in the local community. Some encourage managers to be involved on the boards of directors of non-profit organizations. Others sponsor activities that build community spirit, such as fundraising or sporting events. Community involvement helps employees identify with their employer and builds pride in the organization. Employees become important spokespersons for the company by showing what it does; these employees walk the companies’ talk. Community involvement also exposes employees to local social and environmental issues and helps them understand the impact of corporate activities on their proximate stakeholders. Finally, community participation imbues employees with a social purpose, making them more willing (and able) to raise social issues with their managers and leaders. By encouraging this interaction, corporations can identify common interests that will help achieve common goals.

Annette Verschuren, President of Home Depot Canada, passionately supports her company’s community activities. In a speech to investment executives, Verschuren explained: “All we know is that regardless of how you slice it, it’s good business and adds value.” She believes that “corporate volunteerism may the single-most powerful untapped force for positive change in the world today.” It’s not about “corporate Canada,” she argues, it’s about “corporate Canadians” (December 13, 2002, www.conferenceboard.ca/GCSR/research/presentations/Verschuren_Pres.pdf). For Verschuren, these are not just words. She was instrumental in creating the Week of Service program, in which all Home Depot staff volunteer in their local communities. In the first year of the program, the program resulted in over 262,000 hours and 1,600 improvement projects in a single week in communities across the U.S., Canada, Mexico, and China (November, 2005, http://www.homedepot.com/HDUS/EN_US/corporate/about/corp_overview.shtml). Home Depot’s volunteerism programs boost employee morale and help reduce turnover, and benefit the community immensely. These programs are also opportunities for employees to interact with the community and other employees, and with customers, suppliers, and other business partners, sharing ideas and establishing valuable personal networks.

Community involvement is an opportunity to interact with key stakeholders, without calling specific meetings. It helps fill knowledge gaps that cannot be met through formal stakeholder consultation processes. Creating a thick and tight social fabric ensures that the firm is well-accepted and trusted as it pursues its value-creation activities.

Strategic Decision Making with Employees

Involving employees who must implement strategic decisions is a powerful mechanism for creating sustainable value. Encouraging internal debate, discussion, and dialogue will ensure that strategic options take account of the impact of the decision on the firm’s stakeholders. And social and environmental issues are best identified by the people whose daily activities are impacted by them.

Some practical examples of how businesses involve internal stakeholders are:

• including employees in formal, corporate planning processes
• passing decisions along a chain of subject matter experts who comment on the aspects of the decision that are relevant to their area of expertise or responsibility
• establishing ongoing or project-based, multifunctional decision teams.

TransCanada Pipelines uses cross-functional teams to improve the effectiveness of its strategic decisionmaking. Cross-functional teams are not decisionmaking bodies, but forums for vetting all strategic decisions. “We all come into the room with our various expertise and we rely on each other for that. But once it’s all on the table, we become a problemsolving unit,” explained Elizabeth Swanson, TransCanada’s Associate General Counsel. These teams consist of representatives from many functional areas, including members of the senior management team. Once they have explored an issue or proposal in detail, it is passed onto the executive leadership team for further vetting and final decision by the CEO or functional group head.

This process is not the most efficient way to make a decision, but its benefits are undeniable. For example, involving internal stakeholders not only exposes issues, but also gains buy-in and trust for decisions that will likely have a profound impact on their work lives. As well, including diverse employees in decision-making often leads to more innovative solutions to problems. Involving internal stakeholders requires a great deal of trust on both parties because almost every strategic decision results in some winners and losers. By involving those who are affected, solutions can be sought that minimize the impact on the losers, smoothing the implementation process.

Involving internal stakeholders also helps to break down the functional or departmental silos that are often erected in organizations. Doing so has been shown to lead to better knowledge management processes. Finally, looking for innovations from within, rather than relying on external consultants or competitor benchmarks, also protects corporate values from being diluted by outside perspectives. Businesses that involve multiple internal stakeholders in a multi-disciplinary, iterative decision-making process ensure and benefit from invigorated, innovative decision-making. This process of joint problem-solving allows alternatives to be carefully analysed, often resulting in innovations that would not have been previously recognised. It brings diverse perspectives to the table and facilitates debate about some of the “softer” corporate values, like corporate responsibility and integrity. This dialogue is important in allowing relevant social issues to surface.

Building Sustainable Value

Long term business performance will be enhanced if the concept of sustainable value is woven into all levels of decision-making.

The importance of building sustainable value is indisputable. How could we argue that the wellbeing of future generations is not important? As I argue in this article, there does not have to be a tradeoff between economics and ethics. The arguments have been unnecessarily polarized. There is a compelling business case for firms to operate in the overlapping space where activities are both financially profitable, and socially and environmentally responsible. In this middle ground,
firms reduce costs, mitigate risks, protect their reputations, stimulate innovation, and find new, sustainable sources of economic well-being. I made these arguments in a previous article in the Ivey Business Journal (November-December, 2001).

Many firms are already moving into this space by engaging their stakeholders, by leading with vision and powerful values, and by thinking long-term. While some companies continue to argue whether they have a role in creating social value, others are moving forward anyway — and getting well-ahead of the pack.

Acknowledgements: I would like to thank Merrilyn Earl and Tom Ewart for their assistance with this manuscript.