Dr. Michael Mainelli, and Ian Harris, The Z/Yen Group
[A version of this article originally appeared in Spectra (Winter 2004) pages 16-18.]
Tragedies of the Commons
The public sector acts, often simultaneously, as manager, regulator and steward for a variety of technological, natural and operational public assets, all within a politically-charged environment. Society expects more and more from the public sector, but the means used to impose societal expectations are crude, either feeble recommendations or daunting legal and regulatory mechanisms. There are disasters galore in management of public assets and services – health, education, transportation or the environment, just to get you warmed up – all showing that the power to impose does not necessarily come with the wisdom of what to impose. Untrammelled power leads simultaneously to the frontiers of despotism and the borders of ignorance, leading critics to demand a return to raw market forces.
Hardin  reified the “tragedy of the commons” using a number of topics, such as pollution and overpopulation, to illustrate his point that we needed to submit to “mutual coercion” on our activities in former areas of freedom such as waste disposal or breeding. Hardin’s influential paper has polarised subsequent debate. At one extreme of the debate, public assets must be publicly governed. Coercion via government is a natural enforcement mechanism. At the other extreme, only by allocating property rights over formerly public assets will people care enough, in their own selfish interest, to defend and maintain assets. Old battle lines - socialism or capitalism?
As the public sector struggles to manage common assets, increasing expectations of better “governance” has led to a deluge of public organization initiatives on countless topics. Departmental and agency CEOs, COOs, board directors, or governing council members manage by memo … “all staff must at all times…”. Robertson  points to both the enormous number of Corporate Social Responsibility (CSR) issues and the lack of appropriate management response. Henderson  argues forcefully that the burden of CSR on organisations is harming organisations and society. While the increasing burden of CSR may be a sign of an affluent society moving towards a risk society, i.e., one which has moved from relations based on production to relations based on risk [Beck, 1992], nevertheless the public sector also “has a job to do”.
The above may seem like a whinge about social responsibility and the inevitable laws, regulations and procedures that seem to result – the tragedy of commons management. Far from it. The public sector increasingly strains against its own multitudinous responses to public expectations of visible governance. The post-modern societal problem is how post-modern public and private organizations can adhere to social goals while still adding value.
Not Just a Public Affair
In today’s world, what prevents public sector managers from managing public assets? It has become clearer and clearer over time that public asset management problems are particularly exacerbated by two characteristics common to resource management:
the degree of uncertainty: uncertainty stems from a large number of unknown quantities, difficulties with measurement and poor tools for handling uncertainty. How can we estimate predicted changes? How do we model decisions under uncertainty? How do we help agents manage assets under uncertainty? How can we determine what political threat will drive priorities?
the complexity and holistic nature of managing sustainable assets: no part of the problem can be isolated and solved in isolation. Asset values affect economic returns affect investment affect politics affect communities affect compliance affect asset values, etc.
What’s needed is a system of making choices that combines complex parameters into as few relevant variables as possible. Financial decision theory has attempted to put finance forward, with some success, as a meta-decision framework for organizations, encompassing alternative financing and debt/equity trade-offs (Capital Asset Pricing Model), shareholder value added (hurdle rates, risk-adjusted return on capital), time cost of money (Net Present Value) and volatility (risk/reward options). Finance provides a single “currency” for corporate decisions made using these tools. Can this financial model be reconciled with social responsibility decisions? Only if societal risks are taken into account.
Risk/reward management is an increasingly common, albeit still emergent, approach to managing systems that have large degrees of uncertainty and complex underlying systems [Mainelli, 2003]. Risk/reward approaches are used in industries ranging from shipping through to health, from aerospace to brownfield land in both the public and private sectors. Risk/reward approaches involve a variety of mechanisms, none of which are, in isolation, new. Common mechanisms include tradable asset markets, option pricing, insurance, risk managers and long-term asset indemnification. Risk/reward mechanisms mesh nicely with existing financial decision-making tools.
Risk/Reward Management – A Synthesis
“Risk/reward management applies organisational knowledge to make better decisions about risk and reward through market pricing and capital charges.”
The popularity of risk/reward management is due to the high impact some simple ideas and tools provide. A risk perspective allows everything - costs, variances, flexibility, complex contracts, quality measures – to be defined as a financial impact. Risk is intimately related to quality – are activities “fit for purpose”? Risk managers are found in diverse environments and roles, e.g. health & safety, insurance, project management, credit risk, business continuity or quality. A key trick is to balance risk with reward, typically by pricing risk within managers’ bottom line profits and, therefore, their bonuses. The essence of enterprise risk/reward management is that organizations change culture by changing choices using an internal risk market that shares knowledge and alters capital charges, through:
strategic risk valuation: encouraging organisations to look at all risks, not just financial ones, and forcing boards to see total risk and initiative costs;
“premia” and “claims” management: showing managers the financial implications and results of risks while also reducing external insurance costs;
notifications and investigations: actively reporting and investigating ‘near misses’ as well as claims and incidents in order to learn;
sharing best practice: using information on risks gained from notifications and investigations and comparisons that permit line managers to learn from each other;
external comparators: providing comparative information on risk management from links with external markets, e.g. reinsurers, bond rates, benchmarking databases;
alignment with compensation: managers see the effects of managing risk in their own rewards, e.g. reducing risks reduces premia increases profit increases compensation.
Large corporations, particularly multi-national manufacturers and energy firms, have evolved very sophisticated internal risk markets. So, while these organisations are as complex to command as many economies, they have evolved internal risk markets for direct insurances, pollution risk, terrorism or political risk. These risk/reward management systems allow managers to manage by relating risk decisions back to the key performance measure, financial returns. A classic public sector riposte is that financial returns are often irrelevant. However, much public sector management hinges already on financial systems. The trick is to translate risk into existing financial measures and systems. Frankly, it’s not that easy for the private sector either.
Governing the Commons
Risk is an increasingly popular theme in public sector management resulting in some sensible, albeit basic, statements such as “Principles for Managing Risk to the Public” [Cabinet Office, 2002] which sets out five criteria:
- openness and transparency;
- proportionality and consistency;
For the most part, public sector risk initiatives are qualitative and paper-intensive. Government wants civil servants to be “risk aware”, but is handing out more slowly the financial information needed to manage risk. It’s a bit like asking staff to be “cost aware” but not giving them a basic financial system that tells them actual costs.
Nevertheless, the UK government has successfully experimented with a few market-based approaches to risk in the UK, for instance Pool Re for terrorism reinsurance or the Clinical Negligence Scheme for Trusts in the NHS. In both cases, complex variables are reduced to insurance-style charges that managers can understand and incorporate into financial decision-making frameworks. Over time, managers make better-informed, day-to-day decisions about risk. Market-derived information can be incorporated in public sector management systems. Encouragingly, the public sector is exploring other combinations of markets, risk management and indemnification/insurance mechanisms to handle a number of public asset issues from fisheries to health care to polluted public land.
One academic, Elinor Ostrom, has conducted empirical research on a number of long-term common-pool resource management systems such as agriculture, fishing, forestry and water. She points out that there are many, enduring, alternative approaches that are neither socialist “Leviathans” nor privatisation. She derives eight design principles for systems that successfully manage common-pool resources, viz: clearly defined boundaries, congruence between appropriation and provision rules and local conditions, collective-choice arrangements, monitoring, graduated sanctions, conflict-resolution mechanisms, recognition of rights to organize, and the use of nested enterprises. There is an intriguing overlap between Ostrom’s eight principles and the UK government’s five principles for managing risk. The most significant gap is that the UK government seems to downplay the need to incorporate clearly defined property rights, sanctions and mechanisms to handle conflict. The government is moving towards risk/reward management of many public assets, but has yet to recognize that carrots need sticks and systems need hard performance measures. If the government can go a bit further, perhaps there really is a third way between capitalism “red in tooth and claw” and the quagmire of formal socialism.
Choice is a 21st century theme. One person’s freedom to choose imposes costs on another. This is as true within organizations as within society. Organizations cannot ignore society’s demands for more sophisticated, yet paradoxically more simple, management systems united in a single, risk-incorporating “currency” of finance. If public sector managers operate within a risk/reward framework, then they can make informed, balanced choices. The challenge is designing these successful risk/reward frameworks in demanding public sector environments.
Beck, Ulrich, Risk Society: Towards A New Modernity, (Mark Ritter, translator) Sage Publications, 1992.
Cabinet Office Strategy Unit, “Risk: Improving Government’s Capability to Handle Risk and Uncertainty”, www.pm.gov.uk, November 2002.
Hardin, Garrett, “The Tragedy of the Commons”, Science, 162, pages 1243-1248, 1968.
Henderson, David, Misguided Virtue: False Notions of Corporate Social Responsibility, Hobart paper 142, Institute of Economic Affairs, London, 2001.
Mainelli, Michael, “The Consequences of Choice”, European Business Forum, Issue 13, pages 23-26, Community of European Management Schools and PricewaterhouseCoopers, 2003.
Ostrom, Elinor, Governing the Commons: The Evolution of Institutions for Collective Action, Cambridge University Press, 1990.
Robertson, Stephanie, Dilemmas in Competitiveness, Community and Citizenship, The London School of Economics and Political Science, August 2002.
Ian Harris leads Z/Yen’s Not-for-Profit sector practice. Ian specialises in strategic planning, systems design, rewards planning and organisational change. Not-for-Profit sector clients include government departments, agencies and NGOs such as Barnardo's, Cancer Research UK, British Heart Foundation, The Marine Stewardship Council, UNISON and The British Red Cross.
Michael and Ian’s humorous risk/reward management novel, “Clean Business Cuisine”, was published in 2000. It was a Sunday Times Book of the Week and Accountancy Age described it as “surprisingly funny considering it is written by a couple of accountants”.
Z/Yen Limited is a risk/reward management firm helping organisations make better choices. Z/Yen undertakes strategy, finance, systems, marketing and intelligence projects in a wide variety of fields (www.zyen.com), such as developing a risk/reward prediction engine, helping a global charity win a good governance award or benchmarking transaction costs across global investment banks.