SEA Working Paper 00/14

Ethics and the economics of environmental care

Steven G.M. Schilizzi

Agricultural & Resource Economics, The University of Western Australia, Nedlands, WA 6907
Steven.Schilizzi@uwa.edu.au

Contents

1. Introduction

2. Trends in business management of the environment

2.1 A unique trend or different trends?
2.2 Environmental care: genuine or just apparent?

3. Explaining the trends: ethics or economics?

3.1 Factors invoked as explanations
3.2 Ethics and economics: two competing paradigms?

4. The ethical paradigm and the reality of economics

4.1 Ethics as an explanatory paradigm: why environmental commitment?
4.2 Ethics as a policy tool : the economics of ethics

5. The economic paradigm and the reality of ethics

5.1 Defining ethicality
5.2 Amorality: a focus of competitive equilibrium
5.3 "The tyranny of the bottom line"
5.4 Strategic accounting
5.5 Time preference and willingness-to-gamble: the ethics of economics

6. Implications for business decision making

6.1 Strategic stakeholder rationality: anticipating legitimate rights
6.2 Market governance and ‘ethical incentives’

7. Implications for public policy and social pressure

7.1 The role of government : direct versus indirect policies
7.2 Public intervention models : who does what best?
7.3 The role of civil ‘moralising’ forces

8. Conclusion

1. Introduction

For at least a couple of decades, in most industrialised countries, environmental care by business firms has ranked among the top policy priorities. An impressive amount of legislation, regulation and standards have been produced, not only by national governments but by international organisations. The legal context in which firms must operate has changed. Remarkably, firms have not only complied; many have shown initiative by over-complying, innovating, and taking on exemplary role models, though sometimes in the wake of an environmental disaster (Shell, Union Carbide). Analysts have come from different disciplines to try and understand this nascent co-operative spirit. At the same time, because such firms are still a minority, a large literature has emerged aimed at convincing the ‘dirty dogs’ that going green is good business (Holme & Watts, 2000). In most if not all cases, authors have relied on a strange mix of ethics and economics. Perusal of the literature, and of environmental reports posted on company web sites, leaves us rather perplexed. Why should business firms care for the environment if doing so reduces profits? Are there hidden benefits? Are disguised profits still the driving force, or are there genuinely ethical decisions being made out there? How are we to know? The purpose of this paper is to look for an answer to these questions for small operations like farms, building on what we may perceive to be happening in the corporate world.

The rest of this paper is structured as follows. Sections 2 and 3 identify the trends and examine how they can be explained. Sections 4 and 5 examine, one how ethical decisions cannot escape the reality of economics, and the other how economic decisions cannot escape the reality of ethics. Sections 6 and 7 examine the implications for business decision-making and for public policy. Section 8 concludes. A glossary at the end provides key definitions. Environmental management, involvement, care and commitment are all terms used in the text, the first being ethically most neutral and the last being most heavily laden.

2. Trends in business management of the environment

2.1 A unique trend or different trends?

As of the 1970s, the literature on environmental management by business firms has grown exponentially (Sullivan, 1992). Reports of actual business involvement followed, with a clear increase in the 1990s (Dallmeyer et al., 1998). This steady growth in environmental care has been matched by its unequal distribution. Not every firm in every industry and in every country has been involved to the same degree. Differences span the whole range from no involvement at all, with worsening environmental impacts, to highly committed and exemplary behaviour.

Clearly, the picture is not simple, but what do we mean when we say that firms have increased their environmental management commitments? What is the evidence, what are the indicators? Table 1 summarises a number of key indicators, along with some corresponding measurements. There are two difficulties here.

Table 1 : Some key indicators for assessing environmental involvement by individual firms.

The first is the choice of relevant indicators. Deciding which are representative of environmental commitment is problematic. Be as it may, for indicators in table 1, the trend in the OECD countries is clearly upward in the 1990s. Secondly, one may be adding apples and oranges. Some environmental reports, for instance are of high quality, high reliability and are very informative, whereas others have the opposite attributes, with propaganda being the real goal rather than information. Yet, the general trend is clear enough. Environmental management has been on the rise and is still rising, with ripple effects similar to technology adoption patterns. From large corporations in heavy industry in advanced economies, it is spreading into light industries and into services, into small but high tech firms, and increasingly into multinational firms even in less developed countries. Laggards tend to be firms facing financial difficulties, or operating in poor economies, or under corrupt governments. Though the general trend is clear, how genuine is it? Has environmental management anything to do with commitment?

2.2 Environmental care: genuine or just apparent?

Private information, or that known only to the business manager, is pervasive when it comes to environmental impacts. Often, environmental care is self-proclaimed. One must distinguish, however, between lip service and self serve. Mere lip service is increasingly unprofitable, provided the market is sufficiently competitive and diversified: sooner rather than later, the firm’s real commitment is discovered (Owen, 1992). But in situations of monopoly, especially state monopoly, poor environmental performance may endure. On the other hand, a firm’s ‘spin doctors’ may use environmental achievements for public relations and advertising. In most cases where market forces are at play, there are strong incentives for firms to disclose information on environmental performance, once achieved. The upshot of this is that no disclosure creates for stakeholders the presumption that such achievements do not exist. Information has become an important driving factor.

Genuineness also suffers from lack of sufficient specification. It is not always clear, in some countries, what ‘organic produce’ should exactly mean for consumers.

These observations beg the question: what are the driving forces behind the general trend, and what are the counter-forces that prevent or slow down developments in certain areas? From the literature emerge two different views which have not, to date, been properly related.

3. Explaining the trends: ethics or economics?

3.1 Factors invoked as explanations

Several factors are invoked to explain environmental management by firms. The first is government regulations. Government authorities around the world, in particular in the OECD countries, have been tightening environmental legislation and imposing ever stricter controls and standards on business. Failure to do so has meant lawsuits, fines, and reduction of rights such as rights to clear vegetation or cut wood.

A second factor invoked is pressure from environmental activists, in conjunction or not with government agencies such as Environmental Protection Agencies. Pressure in this form translates into media campaigns that tarnish the image and reputation of a firm or a whole industry. Consumer reactions may follow, such as boycotts and loss of market share to competitors, and disaffected employees lead to absenteeism and loss of productivity. If customer trust and loyalty are jeopardised, not only current, but future markets are at stake.

Thirdly, where the market is sufficiently competitive and goods substitutable, consumers can put pressure directly through market mechanisms, if they value in any way environmental performance. The growth of organic agriculture is an example. In addition, modern businesses tend to have several activities. A good public image in one activity branch will carry across to other branches, while an environmental scandal in any one branch will bring down market shares in all the other branches. This creates an incentive to clean one’s act in all activity sectors.

Fourthly, financial markets are seen to play a role. Insurance companies will ask higher premiums if environmental liabilities, such as soil contamination, betray insufficient risk-averting investments. They can even refuse to insure altogether, forcing firms to costlier and sub-optimal insurance schemes (Dlugolecki, 1996). Financial institutions such as banks offer discounted interest rates to clients with good environmental performance. Firms, banks and insurance companies, if quoted on the stock market, are all subject to investors’ decisions. Investment funds increasingly discriminate between firms with good and poor environmental records, over and above their economic performance (Sparkes, 1995; Arganodoña, 1995).

Thus, several drivers appear involved: market forces, information effects, and government action. But what makes governments regulate business and impose stricter environmental standards? Why would investment funds discriminate between firms that perform well and those that perform poorly? Why do media campaigns have any real effect on consumers’ choices? Is it because people care or because they suffer the ills, or both? In short, how do ethics and economics share their influence?

3.2 Ethics and economics: two competing paradigms?

If, as many argue, it is good business to be ethical, is it ethical to be profitable?

First, we must clarify the conditions of ‘ethicality’ in relation to economics and profitability. Table 2a lays down the bare bones. This view is inspired by Harsanyi’s (1976) work. In quadrant A, decision makers are willing to increase their own private benefits while imposing increased social costs. In quadrant B, increasing one’s own benefits does not lead to increased social costs. In quadrant C, one is willing to incur net private costs in order to increase social benefits, presumably by a factor greater than one. The situation in quadrant A is commonly considered to carry unethical potential; we shall call that in quadrant B ‘amoral’, and that in quadrant C ‘hypermoral’. Note that ‘ethical’ and ‘moral’ are not used, as they must relate to a specific ethical system, which we do not specify here. Quadrant D appears pathological.

Table 2a : Ethics and economics with ex-ante benefits and costs.

The situations relevant to our discussion are therefore A and C. In B, ethical ambiguity prevails, as there is no way of telling whether economics or ethics drive the decision. In A, pollution, habitat destruction and other such externalities impose social costs while producers maximise their profits. Situation C, by contrast, will witness polluters reducing their impact levels spontaneously and without legal or government exertion, or by over-complying with respect to existing minimal obligations.

In this framework, environmental care by business firms that fall into category B poses no immediate ethical problem. It is a case of "know where your benefits are". This presumes there are hidden costs and benefits, and the goal is then, by some mechanism, to reveal them, both to the firm and to its stakeholders. On the other hand, situations A and C represent genuinely ethical issues.

4. The ethical paradigm and the reality of economics

4.1 Ethics as an explanatory paradigm: why environmental commitment?

Why would ethics be called upon as an explanatory paradigm in the case of environmental care? Table 2a suggests that ethics works as a residual explanation when economics fails to account for the observed phenomena. Environmental care is explained as a type C situation. Firms have either had their arms twisted by government, or they have seriously taken on their ‘social responsibilities’. How is this reference to ethics to be interpreted?

Economics is based on utilitarian ethics, which is opposed to duty-based or deontological ethics. Utilitarianism and deontologism represent the major philosophical cleavage in contemporary ethics. How useful is this distinction for environmental care by business? The ‘residualist’ explanation of situation C may be interpreted in at least two ways. One reflects a sense of duty or obligation. The other interpretation is utilitarian. Managers are seen as maximising a complex utility function that includes both direct personal utility and others’ utility, but in a way that increasing others’ utility also increases one’s own utility (‘warm glow effect’, or ‘purchase of moral satisfaction’).

Conclusion: two diametrically opposed philosophies can be used to explain the same observed phenomena. This is because the dependent variables (representing environmental care) rely on unobservable independent variables. It is impossible, or at least very difficult, for an outside observer to know what the managers’ motivations were when they made their decisions. As a result, it is unclear what is gained by resorting to ethical explanations of environmental care. This is not to say that genuinely ethical commitments do not exist, but we cannot know from the outside how extensive they are. Resorting to ethics as an explanatory paradigm in order to fill in for economics does not seem a very effective strategy. Does ethics perform better as a policy tool?

4.2 Ethics as a policy tool : the economics of ethics

When relying on ethics as a policy tool, there are essentially two ‘means of action’: words and deeds. Words take the form of ‘ethical injunctions" and persuasion that use verbal auxiliaries such as ‘should’, ‘ought’ and ‘must’. Deeds take the form of preaching by example or role models. In our case, these can only be used by other business firms who wish to play a leading role in environmental management. All other stakeholders, including government, use verbal injunctions.

It is useful here to consider a principal-agent relationship. Whoever is trying to influence others is the principal, and whoever is the target is the agent. If both principal and agent share a common ethics, then ethical action by the principal is pointless. The differences will be in information and awareness or in perceiving differences in how to implement strategies. ‘Landcare’ programs are an example. If the agent and the principal are at the opposite ends of the ethical spectrum, the agent will not listen nor even want to listen. In both these extreme cases, ethics as a policy tool would appear, though for opposite reasons, to be pointless. What of the intermediate range?

The outcome sought by the principal is some kind of inner change in valuation standards by the agent who then is more likely to adopt the principal’s preferred line of action. Clearly, the more similar the values held by both, the easier it is for the principal to be effective. However, as a policy tool, words and ethics, although a low-cost solution, are targeted at those agents who share with the principal similar values and at the same time face low implementation costs. Agents falling into this category will typically be a small minority.

Whether as an explanatory paradigm or as a policy tool, ethics appears to be of limited effectiveness when applied to business decision making. As an explanatory paradigm, it falls prey to the unobservability of the variables needed to distinguish between duty-based ethics and utility-based ethics. This reduces the value of ethics filling in for economics when economic explanations fail. As a policy tool, ethics by means of words, though cost-effective, is likely to remain ineffective in changing others’ decision patterns. Ethics by means of example is either virtue driven, in which case it is unreliable as a policy tool, or it involves communicating the existence of economic side-benefits, which are more likely to be effective in changing other firms’ behaviour. Either way, although examples of genuine ethical commitment exist, ethics cannot escape the reality of economics. Purely unprofitable ethical behaviour must appear as a bonus and as the exception rather than the rule. It must be considered residually after economic explanations have failed.

But do economic explanations fail, and if so how?

5. The economic paradigm and the reality of ethics

5.1 Defining ‘ethicality’

Table 2a defined what may be called ‘ethicality’. Ethicality is not morality. Morality is the conformity of behaviour to a reference value system. Ethicality is the congruence between private and social costs and benefits such that neither party imposes uncompensated costs on the other. Establishing ethicality first requires an allocation of legal rights and entitlements, particularly property rights; it then requires an estimation of the distribution of costs and benefits given the distribution of rights. The cost-benefit impacts of changing the distribution of rights is included. There is no presumption about who is right and who is wrong. ‘Ethicality’ is given a very specific technical sense, not to be given undue connotations.

Table 2a only considered expected costs and benefits without consideration for time lags and uncertainty. What if a manager expected to generate social benefits but things went wrong and profits were secured at the expense of environmental damage? Clearly, a corresponding ex-post table is needed. In table 2b, ex-post ethicality centres on compensation. This can operate both ways. If a firm, while generating its own profits, also generated social benefits, it can demand to be paid for them. The choice not to demand payment when the opportunity exists may be seen as ‘hypermoral’. If it imposed net costs on society, it may choose to compensate for the losses. The choice not to compensate may be seen as ‘unethical’. Actual compensation depends on the existing system of legal rights and entitlements, as well as on enforcement mechanisms.

Table 2b : Ethics and economics with ex-post benefits and costs.

Note: "Compensation" assumes satisfaction of all parties, and therefore an efficient resolution procedure based on freedom of consent.

This definition of ethicality depends crucially on the distinction between private and social costs and benefits. Clearly, the dividing line is relativistic and will depend on the context. The definition allows a range of behaviours to be identified. From the least to the most ‘ethical’, for any specific decision, we have:

1. Maximise private (net) benefits even when generating net social damages or costs
2. Maximise private benefits subject to the condition that social damages are avoided or compensated (the standard ‘amoral’ case)
3. Maximise social benefits or minimise social costs subject to securing a minimum amount of private benefits
4. Maximise social benefits or minimise social costs subject to the condition that private benefits are not reduced (they may be zero).
5. Accept losses in private benefits so as to generate social benefits or avoid social losses, subject to the condition that private losses are bounded by a survival constraint (the decision maker must stay in business)
6. Accept losses in private benefits so as to generate social benefits or avoid social losses, even at the cost of ceasing or changing activity. (This could be the case with farms in heavily salinised areas where farmers decided to plant trees then sell the farm to a forestry company).

5.2 Amorality: a focus of competitive equilibrium

‘Amoral’ situations are privileged in a competitive and well informed economy, that is, when markets are efficient (Brittan & Hamlin, 1995). ‘Hypermoral’ decision makers will be outcompeted, while the ‘unethical’ will end up suffering higher costs through lawsuits, loss of markets and loss of rights. In a perfectly competitive and transparent economy, all decision makers should gravitate towards situation B. Thus, striving for a competitive equilibrium is also an ethical endeavour, predicated on ‘amoral’ utility or profit maximisation. What happens when markets fail?

Following Koslowski (1992), ethics may be seen as a means to compensate for market failure. Market mechanisms can first be improved to create the right incentives, for example through new rights that can be traded. If such markets remain thin and ineffective, then non-market mechanisms are needed, such as information disclosure and regulation. Markets often fail because of high transaction costs. Ethical attitudes, by increasing confidence, reliability, loyalty and trust, lower these costs, increase the efficiency of the market and reduce the probability of failure (Wils, 1993).

5.3 "The tyranny of the bottom line"

Ethicality (not ethics) hinges on the relationship between private and social costs and benefits. Profitability hinges exclusively on private costs and benefits. Profits are benefits minus costs, but what benefits and what costs? Business has been portrayed as being subject to, and ethics falling prey to, "the tyranny of the bottom line". The question is, what bottom line?

There are two problems, choice and measurement, that are closely linked. One may decide to consider or discard specific costs and benefits because they are easy or hard to measure. So-called intangible costs may be unaccounted for, such as contingent liabilities, a typical cost from future environmental impacts. Government trust may not be included as an asset, although it greatly facilitates authorisations and licenses.

Deciding what the bottom line is also depends on the underlying objective function. Whose benefits are being sought? Are they long term or short term? Do they pertain to this particular activity only (e.g. the farm), or to all sources of income together (including off-farm income)? The concept of economic value added (EVA) has been proposed as a way to measure the change in the total capital value of the business and is an incentive to account for intangibles as well as long-term profits and risks (Grant, 1997). It also better represents the interests of all direct stakeholders, even if the decision to care for them is strategic and the equity owners’ value is still what is maximised. Accordingly, the definition of the bottom line is changed, and with it one of the key decision drivers

5.4 Strategic accounting : revealing otherwise hidden costs and liabilities

Through stakeholder reactions and changes in social capital, profits and the bottom line are affected. This involves economic feedback mechanisms. A firm’s decision that imposes costs on society is likely to backfire. The firm’s managers would be well advised to consider these backlashes in their accounting of expected costs and benefits. An unethical decision will induce public reactions that will reduce the private benefits initially expected. This is ‘strategic accounting’: the future is not conceived of as an uncontrollable state of nature, similar to the weather, but as a player with whom one can interact (Schaltegger & Müller, 1997). The obvious rationale here is that of game theory. The links between economics and game theory date back to Von Neumann and Morgenstern (1944), but what has game theory got to do with ethics? Reputation, building of trust, and consumer loyalty can all be modelled as dynamic games under uncertainty.

Financial accounting is not ‘objective’; it depends on perceptions of market and non-market feedback mechanisms (Bailey, 1996). These perceptions are determined by the strength of the feedback mechanisms, which in turn depends on stakeholders’ state of information. However, if potential backlashes are likely to reduce the bottom line, then it makes economic sense for the firm to invest in withholding and distorting information. Secrecy can itself be maximised by threatening those who risk giving the game away.

The nature of the feedback mechanisms determines how easily potential costs and benefits can be measured. Financial feedbacks are easiest and include insurers’ policies, investors’ choices, and banks’ willingness to lend. Market feedbacks are harder. They include consumer reactions, boycotts, and reactions from suppliers and customers. Finally, non-market feedbacks are hardest to account for. They include media campaigns, government backlash, community action, and employee resistance.

Valuing the impacts of such feedbacks seem to pose similar problems to non-market valuation. Efficient accounting and estimation techniques have not been developed. By internalising social costs they would reduce unethical decisions and allow firms to increase their social capital. But what if decision makers are willing to risk long term sanctions in order to secure short term benefits? Having dealt with perceptions of risk and timing, attitudes and preferences remain. Are discounting and risk-taking the last bastions of ethics?

5.5 Time preference and willingness-to-gamble: the ethics of economics

When we introduce time and uncertainty in table 2a, the boundaries between the different situations A, B and C blur into each other. One cannot dismiss questions such as:

• In pursuing short term profits at the expense of uncertain long term social costs, does one behave unethically? (E.g. greenhouse gas emissions, controlled radioactive waste).
• In accepting uncertain long term private costs for the sake of short term social benefits, does one behave in a genuinely ethical manner? (E.g. ecosystem preservation when development profits are highly risky).

Two factors are involved in these decisions: risk preference and discounting or, more precisely, time preference. Both are significant when considering stakeholders’ reactions to one’s decisions. If these are perceived to be uncertain or far in the future, they will not be accounted for. Because others’ welfare is at stake, time- and risk preference have ethical implications. Can these preferences be influenced and changed?

External actions of a coercive nature, such as regulation, have no influence. Inasmuch as risk perceptions (is it risky or not?) and risk attitudes (am I willing to risk?) are linked, an educational role revealing all the risks behind some decision may have some influence, though it is likely to be limited. On the other hand, pure time preference appears to be an irreducible, exogenous parameter. Its roots may lie in psychology or in ethics. If so, psychologists, moral philosophers or spiritual ministers may have an influence, but not the economist or the policy maker.

On the surface, unethical decisions appear as a lack of concern for others and as a lack of balance between private and social benefits. Deep within, a high rate of time preference and a high willingness-to-gamble seem to be lurking. In this sense, every time economic decisions incorporate time and risk preferences, an ethical attitude is defined.

6. Implications for business decision making

6.1 Strategic stakeholder rationality: anticipating legitimate rights

Even if equity owners, managers and lenders receive priority, accounting for total capital value will require a reckoning of other stakeholders’ reactions through all possible feedback mechanisms, including industrial action, consumer pressure, and government regulation. Accounting for all this creates an incentive to include long term profits and risks, even if the future is discounted and some gambles are taken. Then, although ethics are not excluded, most decisions will end up in the rationally amoral category. There will be a strong correlation between private profits and social benefits. The need for an ethics leading to situation C will be minimised. As seen in section 5.1, this assumes sufficient competition and transparency in economic transactions - conditions that ethical governments must support. This decision rationale may be called ‘strategic stakeholder rationality’. It leads to and is based on strategic accounting.

What of unborn generations, animal and plant communities, or even subdued minority groups who have no right of say? Unless today’s empowered decision makers adopt a genuinely ethical stance, these ‘unempowered’ stakeholders will be discounted out of the picture. In fact, large sections of the current population are concerned and care for ‘those who cannot speak for themselves’. We may consider these carers as ‘second-order stakeholders’. Their utility depends on how they see the welfare of first-order stakeholders affected. This will motivate them to react to decisions they see as unsatisfactory. Firms must then reckon with second-order stakeholders, even if only the first-order seem to be involved.

6.2 Harnessing market governance for ‘ethical incentives’

We can now make better sense of the explanatory factors listed in section 3.1. Those related to financial markets are summarised in table 3 which highlights the underlying drivers. These drivers together make up the financial market governance system. Each individually can provide an ‘ethical incentive’. Items in columns provide incentives for items in rows (see examples under table 3). Following section 5.2, if competition is strong and information evenly shared, market forces will spontaneously tune the level of these drivers so as to achieve ‘amoral’ behaviour (type B in table 2a). The incentives are ‘ethical’ to the extent that they discourage unethical (type A) behaviour. Information asymmetry, monopoly, and other forms of market failure will not achieve ‘amorality’: unethically oriented firms will be free to rip society off. Failure of market governance calls for other forms of governance (section 7).

Table 3 : Harnessing market governance for ethical incentives

Note: Column provides the incentive for row.

• Firms in 1^st column provide incentives to banks by being creditworthy, to insurers by being insurable at a reasonable price, to investors by being viable in the long term.
• Banks in 2^nd column provide incentives to firms by varying interest rates and offering special services, and to investors by providing financial investment alternatives.
• Insurers in 3^rd column provide incentives to firms, banks and investors by varying risk premiums and insurable items, or by refusing to provide insurance.
• Insurers in 4^th column provide incentives to all other economic agents by buying and selling shares and driving stock values up or down.
• On the diagonals competition provides most of the incentives, but so does inter-firm (supplier-customer) contracting, by the specification of restrictive clauses (e.g. disposal of packaging and used products).

Books on environmental management and business ethics are replete with case studies showing how shareholders and the market have hammered unethical and ‘dirty’ firms. Exxon’s management of the Valdez oil spill crisis appeared unethical to stakeholders: its share prices plummeted, customers destroyed their Exxon credit cards, and the company paid $2 billion in cleanup, another billion in compensation, and still had $3bn extra in liabilities (Hartley, 1993). There also exist strong correlations between ethical-environmental performance and stock market value. The ethically sensitive Domini 400 Social Index has generally done better than the Standards & Poor 500 Index (Blumberg et al., 1996; Cohen et al., 1997).

The business sphere, mainly through market mechanisms, has been able to develop ‘ethical incentives’. This is a remarkable achievement, but not one that could have been achieved spontaneously. Without the ethical concerns of consumers and voters, the market would have done nothing. As for governments, spurred by voters, their legislative and regulatory roles have been instrumental.

7. Implications for public policy and social pressure

7.1 The role of government : direct versus indirect policies

When market governance fails to discourage unethical behaviour, it is up to an ethical government to step in. Because of its position of power, government can intervene directly, by regulation, incentives or ‘suasion’ (table 4, left column). A major drawback to this approach is information asymmetry: business knows best when it comes to environmental management. Different firms have different technologies, cost structures, and impacts, all of which are poorly known by government. Direct intervention can then fail to be cost-effective. This is an incentive for government to explore indirect intervention (right column in table 4). The focus is on enhancing the efficiency of the governance system. It can do this by generating ethical incentives and feedback controls. This approach can lead to several types of action.

Table 4 : Direct and indirect government intervention policies

(*) See table 3 for more details on how market governance can be improved.

The key to improve market governance is to use the profit motive in a socially beneficial way. Besides the traditional market corrections (anti-trust laws, competition policies, etc.), government can foster and fund research programs to improve, not only environmental technologies, but the consistency and reliability of business accounting systems, especially where contingent liabilities are involved. It can use legislative instruments to facilitate social empowerment mechanisms that can backfire when business acts unethically. It can secure entitlements, confirm existing rights and create new rights, and reduce transaction costs, in particular for legal procedures. These are all empowerment mechanisms.

In the environmental field, the advent of the concept of 'responsibility without fault' reflects legislative and juridical innovation (Anderson, 1998). The same can be said of the concept of ‘retroactive responsibility’, implemented in the American CERCLA system for the clean-up of contaminated soils. Suddenly, firms may be facing millions of dollars in liabilities for past industrial activity (LAAMS, 1991). Worse, if a company cannot meet the costs of its liabilities, its lenders and insurers will be held liable, a chain-reaction effect leading to the controversial ‘judgement proof’ issue (Pitchford, 1995).

In the realm of incentives, tradable pollution permits, tradable carbon credits and individual tradable fishing quotas are noteworthy institutional creations. There are prospects of tradable covenants on land to be protected; of conservation areas owned through shares traded on the stock market (see table 4). On the information side, requiring disclosure of environmental performance indicators acts to enhance economic feedback mechanisms. So do requiring or even recommending environmental audits by accredited third parties. The ‘PROPER’ environmental labelling system in Indonesia acts as a disclosure mechanism which sets into motion both market and non-market feedbacks.

7.2 Public intervention models : who does what best?

Ethics as a policy tool (section 4.2) seeks to influence others’ behaviour. On its own, it is unlikely to be very effective (table 5). What other tools are available? Ethical injunction and persuasion is part of a larger category known as suasion, which encompasses all communication using the jawbone, including information and education (Harnahan, 1997). The two other categories mainly use, respectively, legal force and money, or the profit motive (Foulon et al., 1999). The first underlies regulatory action while the second covers incentive policies. Table 4 shows examples of the three. Table 5 shows how cost-effective each type of policy will be depending on how ethical is the target population. For an ‘easy’ and docile target, who is already convinced the policy maker is right, suasion is least costly; for a ‘hard’ and unconvinced target, stringent regulation is needed, but enforcement costs will be high and an optimised mix of incentives, suasion and regulation should work best (table 6). Alternatively, a sequence may be used as in table 7. Each policy performs better on certain criteria than others (table 8). Table 9 shows that different stakeholders may each have a privileged role to play, even if all can use an optimised policy mix. The key criterion is cost-effectiveness.

Table 5 : Agent ethicality and policy cost-effectiveness

(*) Higher effectiveness will be more costly.

Table 6 : Synergistic policy combinations

Legend:

• 1^st (left) : primary motive
• 2^nd (top): correcting or add-on motive

Examples:

• Tradable rights / covenants are subject to restrictions
• Cross-compliance are conditional incentives
• Reputation modifies future benefits from business
• Bequest benefits increase time horizon of decisions
• Technical support fills knowledge gap for implementation
• Partnership agreements combine all three.

Table 7 : MacAulay’s Rules for Policy Formulation

Source: Symposium on ‘Using Economics to Value and Preserve the Environment’, Agricultural & Resource Economics, University of Western Australia, 25 May 1999.

Note: this list order reflects a bias towards ‘markets first’ policies. Table 7 suggests that other orderings are possible, e.g. starting with suasion to reduce subsequent implementation costs.

Table 8 : Pros and cons of each policy category with ‘amoral optimisers’

Notes:

1. Regulation will be socially equitable if it is designed to be so and is effective.
2. The value of incentive policies will be high if agents’ (opportunity) cost structures are low.

Table 9 : Who does what best (in terms of table 6)?

The World Bank (1999) has recently publicised what it calls ‘The New Model’ in environmental management, where government, markets and the community each have a role to play. Models pretty much respect the rankings in table 9. Taken together, these interventions define a governance system. The preferred system is one that will keep transaction costs low.

7.3 The role of civil ‘moralising’ forces

Non-governmental organisations also have their role to play (World Bank, undated). The work done by the International Standards Organisation on establishing the ISO 14000 norms is having both economic and environmental impacts (Harnahan, 1997). ISO 14000 certification and accreditation is now part of a company’s social capital, without which it may lose markets or fail to acquire new ones. The media have an ever-increasing role in diffusing information and for blowing the whistle. Active environmental groups will also increase the probability that unethical environmental behaviour is discovered, brought under the limelight, and held there until corrective action is taken. All this assumes that the general public cares for and values the environment, like any other public good. If this is not the case, then environmentally ethical individuals, deep ecologists and spiritual leaders, or religious groups, can step in. If the general public does not care, things will not happen.

8. Conclusion

So, is environmental care by business a matter of ethics or economics? A summary of our conclusions will help. First, there is ample evidence that business management of the environment has been and is on the rise. This is a case of private agents providing for what is mostly a public good. Although much of it is compliance to government regulation, and some of it is only lip-service, there is also ample evidence of over-compliance and proactive commitment. Both ethics and economics have been called upon to explain this trend and further encourage the laggards, but in a way that presumes that ethics and economics, though compatible, are conceptualised as exclusive. This oversimplification undermines the two paradigms both as explanatory and as policy tools.

Ethical explanations rely on unobservable variables, while economics fail to explain apparently unprofitable decisions. This is resolved by showing that profitability depends on economic feedback mechanisms. When strategically accounted for, ‘profits’ are redefined and most environmental decisions appear ‘profitable’. However, it seems that economics cannot account for individual time preference and willingness-to-gamble. These reflect purely ethical or psychological traits.

The answer to the question above is then something like: 90% economics, 10% ethics. Economics help avoid unethical decisions while ethics help provide a social bonus. A perfectly competitive and transparent economy can only achieve amoral behaviour that is neither ethical nor unethical. Even in this ideal case, ethics, "the cement of society" (Elster, 1989) can greatly reduce transaction costs and increase total welfare. Policy implications are that governments should minimise ‘unethical incentives’ by enhancing competitive market, finance and insurance mechanisms through institutional engineering (Eggertsson, 1990). Non-government instances can provide the ethical incentives that will generate a welfare bonus. However, this assumes government goodwill. The study of incentives for government to promote its own ethical behaviour is another study altogether.

As an historian summarised the remarkable development of Republican Rome, "a society that channels private benefits into social benefits and social costs into private costs is bound for success". This paper has tried to show that there is no reason why we cannot also achieve success when it comes to the environmental impacts of businesses, both large and small.

Glossary

Economic feedback : Social reaction to a decision such that it modifies the initial costs and benefits expected by the decision maker. An economic feedback may activate market or non-market mechanisms.

Ethical distribution of rights : Rights distributed in such a way that no stakeholder remains unsatisfied with his or her rights; such that no stakeholder believes his lot is ‘unfair’.

Ethical / unethical incentives : Incentives that foster ethical behaviour and discourage unethical behaviour. Incentives can be economic, social, or psychological.

Ethicality : Congruence between private and social costs and benefits, defined by the fact that neither the private nor the public decision maker imposes uncompensated costs on the other, once given a distribution of social rights.

Governance system : The network of interacting rules, norms and incentives that allow a social system to evolve smoothly and without structural breakdown.

Immoral : That which does not conform to a reference value system.

Indirect government intervention : Policies that increase the efficiency and effectiveness of the governance system, using regulation, incentives or suasion.

Institutional engineering (or management) : Creating, modifying or extinguishing rules, laws, rights, and organisations so as to achieve a specific social outcome.

Market governance : The interplay of different market incentives the effects of which do not conflict with each other. (It should be governments’ role to enhance market governance).

Morality : Conformity of behaviour to a reference value system.

Private (vs. social) costs and benefits : Costs and benefits as perceived by the decision-making body.

Social capital : For a private agent, the sum total of his economic assets in terms of political friendships, social networks, moral reputation, economic trustworthiness, etc., and their corresponding economic impacts and value.

Stakeholders : All those whose costs and benefits, utility or welfare, are changed by a decision.

2^nd-order stakeholders : Those whose benefits and costs, utility or welfare, are changed because other stakeholders, whom they care about, are affected. (E.g. people who care for subdued minority groups, future generations or non-human species are 2^nd-order stakeholders).

Strategic accounting : Including as private costs and benefits the possible financial consequences of external (social) costs and benefits, after feedback mechanisms enter into play.

Unethical : Seeking private gains at the cost of social losses.

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Citation: Schilizzi, S. (2000). Ethics and the economics of environmental care. (SEA Working Paper 00/014). http://www.general.uwa.edu.au/u/dpannell/dpap00014.htm

SEA News issue #8

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Copyright © 2000 Steven Schilizzi
Last revised: May 21, 2003.