Thursday, June 3, 2010
Who Monitors the Monitors?
A growing flurry of criticisms has emerged of those organizations supposedly responsible for holding business accountable for their actions. The Minerals Management Service (MMS) has recently come under intense scrutiny as a regulatory body for not doing their job in ensuring that BP and other companies jump through the appropriate health, safety and environmental hoops to minimize catastrophes like the oil spill in the Gulf. Before the Obama Administration came on board, the Environmental Protection Agency (EPA) was consistently criticized for neglecting their job to protect the environment while the Securities Exchange Commission (SEC) was found to be completely clueless, not to mention distracted by porn, when they were consistently presented with damning evidence that the mortgage bond market might create one of the worst financial crises in history. Moody’s and Standard and Poor’s, two market-based bodies meant to protect investors by accurately rating bonds, were complicit in the financial crisis for rating garbage mortgage bonds Triple A’s – the highest possible rating. The Food and Drug Administration (FDA) has also been criticized for dropping the ball on the health effects of the food and drug sectors while, at the business level, boards of directors have been repeatedly chastised for failing to hold managers accountable to the owners of the firm. As many have asked, where were the boards of Enron, Goldman Sachs and Lehman Brothers in protecting shareholders from manager decisions?
Why do these monitoring bodies exist in the first place? The need for a firm to have a board of directors, for example, emerged because managers of large companies who typically have no ownership stake in the firm are not always motivated to make decisions in the best interests of the owners. As a result, boards were created to minimize agency problems by making sure that decisions are made with the interests of shareholders in mind. This same logic applies to society where monitoring bodies are required in situations where corporate interests are not aligned with society’s interests. Business' contribution to pollution, climate change, social inequity, disease, drought, the recent economic recession are all examples here. Often called negative externalities, these represent effects of a transaction between two parties on a third party who did not consent to the transaction. The third party is typically the public. Negative externalities are synonymous with market failures or instances where actions of business cause negative impacts on society. So, ultimately these monitoring bodies exist to reduce the occurrence of market failures.
So now why has there been such a dramatic failure in monitoring of the private sector? There are at least five reasons that I’ve come across in the last few months. First, there is growing evidence of a revolving door syndrome between government and the private sector. Nowhere is this more of a concern than in the food sector where a number of governmental officials responsible for the health and well-being of the American public have or have had huge stakes in the financial welfare of food companies like Monsanto, Cargill, and Archers Daniels Midland. Another example is the Bush Administration’s close ties with military contractors like Halliburton and Xe (formerly Blackwater) resulting in skepticism that military decisions are predicated on profit opportunities for these companies. So how can we expect these governing bodies to protect the public when their interests are inextricably tied to the company’s interests; interests that we know can lead to market failures?
Second and closely related to the first are the very cozy relationships between public officials and corporate managers where assessments are made perhaps less independently than they should be. These relationships likely softened the much needed public body push back and threat of penalty meant to balance the strong pressures companies face to reduce costs. These cozy relationships have been earmarked as one of the main reasons MMS overlooked the many shortcuts BP took in their oil wells. An investigation in the interaction between MMS and BP revealed that BP made an unprecedented number of requests that tweaked crucial aspects of the oil well’s design a week prior to the explosion on April 20th, 2010. MMS approved each request within only a few minutes of receiving them from BP. “Of the more than 2,200 wells that have been drilled in the Gulf since 2004, only 5% have had multiple permit revisions submitted to MMS within one calendar day”, according to a Wall Street Journal analysis of MMS records. The content of these revisions was related to the use of a single pipe which was much more cost efficient than the safer two-pipe system. BP wanted to use the single pipe all the way down the well shaft. Subsequent revisions were required because of BP’s miscalculations in what was already within the well and the width of the pipe they thought they could use. Whatever the issue under discussion, MMS is being criticized because their rapid response is suggestive of a lack of oversight that would typically be expected for what appeared to be rash and careless decisions on the part of the company.
Third are the incentive systems in place. One of the reasons why MMS was particularly negligent in the BP case was because their incentive system was based on the number of project approvals rather than any quality of environmental and safety assessment. This same problem was evident in the financial sector where S&P and Moody’s recognized that friendlier ratings of crappy bonds were associated with a greater guarantee of customer loyalty from the big investment firms like Goldman Sachs and Merrill Lynch.
It gets more complicated when we consider the difficulty in identifying appropriate incentive systems to reflect public welfare needs. There are so many confounding variables that it’s difficult to associate a reduction in health of the public, for example, to FDA decisions or the preservation of the environment to EPA decisions. So we resort to reducing down these grand objectives to measurable ones such as the number of foods certified or the number of coal projects evaluated. There are at least two problems with this. First, these reduced measures only represent a small part of the overall objective leading monitoring bodies to lose focus on the ends and over-achieve on the means. Second, companies have been very effective at finding loopholes or cracks in these measures, the result of which greatly hinders the overall objective despite the fact that they perform well on the measure.
Fourth, the same companies that need to be monitored are the ones either doing the monitoring or coming up with the approaches by which they are to be monitored. In some industries, companies have developed their own standards of monitoring to preempt government control while giving the impression that they are looking out for the best interests of the public. Processed food companies like Kellogg and PepsiCo developed the Smart Choices Program which was meant to create a third party that would independently certify processed foods so that consumers would have the luxury of looking for the certified checkmark rather than reading the lengthy ingredients list. The problem was that the companies were the ones determining the criteria for what was considered healthy and that the body they created was remunerated based on the number of products that they certified. So not only were the criteria flawed but the incentives used to apply these criteria were inappropriate. This is a particularly potent problem because food companies have strong incentives to maintain strong margins in an environment where unhealthy sugary ingredients and fortified foods provide low costs and higher revenues – the ‘perfect storm’ for a market failure. So we then have products like Fruit Loops receiving the Smart Choice seal and, hypothetically speaking, calcium fortified sawdust – if we were to brand such a product.
Finally, and most importantly, we might need to think about the broader historical context of the last 30 years to understand why monitoring bodies are failing in their jobs. Since the Reagan era, the West has undergone a dramatic movement towards neoliberalism where free market fundamentalists were given center stage for their advocacy in abolishing government intervention. This movement carried through the George H.W. Bush, Bill Clinton, and George W. Bush administrations. Over the course of these three decades, there was growing consensus that the free market will iron out any social, economic, and ecological issues on its own thus eliminating any need for government interference. Unfortunately we’re seeing the effects of this highly misguided ideology today. Over-reliance on the free market likely meant that key resources and control were removed from those regulatory agencies meant to monitor company decisions. Scales began to tip as the private sector developed strong depth in expertise that the public sector was unable match as monitors. As a result, quite ironically, companies began to be viewed as those best positioned to do the monitoring. Consider the following quotation from MMS in the oil and gas industry:
"The lessee or operator is in the best position to determine the environmental effects of its proposed activity based on whether the operation is routine or non-routine."
What is the point in having MMS if the monitoring body is essentially going to shift the monitoring role to those who are supposed to be monitored? While the Obama Administration is exploring criminal charges against BP, they are certainly weary of ticking them off to the point where they withdraw their efforts at stopping the leak. This is a pretty precarious position to be in because it symobolizes the incapacity of public bodies to heavily penalize companies when they've done something wrong. This is of course dangerous and likely one of the reasons why the auto and financial sectors were bailed out; government was too reliant on their presence in society.
With this lack of expertise, monitoring bodies not only struggle how to do the monitoring but also with when company behaviour should or shouldn’t be examined. There may also be instances where the behaviour of the private sector is so complicated that the public body couldn’t possibly foresee its detrimental effect until it is too late. This is precisely what happened with collateralized debt obligations (CDO) in the financial service industry. No monitoring body could have identified this as a problem in advance and no regulation would have prevented it from occurring until it was too late.
So what is this telling us? There is indeed a growing concern that the monitors are failing in their duties to keep companies in line. We’re also learning that free market fundamentalists likely had it wrong and that markets, left to their own devices, can wreak havoc on society. To what degree and in what way the pendulum swings back towards increased government intervention is likely going to be a hot topic in ensuing months. Is this simply a minor blip in society’s ability to keep corporations in line where we just need to make sure that we monitor the monitors or is this suggestive of a revisit of the relationship between business and government? Time will tell...