SDA Professor Mario Vinzia, 01/12/2020
The previous article was about how value, risk and sustainability influence the choices made by the company,
now it is necessary to verify in reality if these three dimensions have equal roles within the decisions made by the management.
It is important to underline that it is not easy to find a good balance among the three dimensions described because:
- to guarantee a risk exposure consistent with the company’s risk appetite, it is necessary to mitigate or eliminate a series of risks, and this has a cost which corresponds to a benefit that cannot be easily estimated in terms of stabilizing the value creation path;
- Implementing initiatives in the field of sustainability in turn requires a cost, which corresponds to a benefit in terms of reputation and image, but also in terms of the market involving employees, customers, suppliers, financial institutions, investors, consumer associations, public bodies, opinion and media, … which return is neither immediate nor easily estimated.
All of this appears to have a negative impact on the ability to create a shareholder value. But this is not necessarily the case, because it is not a question of sustaining costs, but of making an investment that can generate future benefits. In other words, by giving up a portion of the profits in the short-term we create more value in the near future, precisely through investments.
Value, risk and sustainability: how much do they weigh on Management decision making?
If what is written is generally acceptable, it is necessary to try and understand if in the corporate decisions and behaviour the creation of value takes on a great importance, compared to the efficient risk management and sustainable choices.
To understand this, it may be useful to think about what the objectives assigned to the top management of a company may be. If there is a strong predominance of the value component over any other component, then the aforementioned gap could be wider than expected. In summary, the corporate incentive system is often the “litmus test” that reveals the actual corporate culture in relation to the three pillars mentioned above.
Lets’ take the current “Covid-19” pandemic situation as an example.
Think of a pharmaceutical company that has to develop a flu vaccine, the strain of the virus seems to be identified and is more aggressive in very poor countries. The shareholder can alternatively assign the following objectives to the top management:
- Develop a vaccine against the specific virus identified to minimize costs and maximise value.
- Develop a portfolio of vaccines against the strain of the virus to help prevent possible mutations of the gene of the virus and manage the risk of not having the right vaccine. The portfolio of vaccines would be made available only to those countries that were able to pay for it.
- Develop a portfolio of vaccines against the strain of the virus to help prevent possible mutations of the gene of the virus and manage the risk of not having the right vaccine. The portfolio of vaccines would be available to poor countries and a reasonable price.
It is clear that the first objective maximizes value because only one type of vaccine is developed, and the costs are therefore lower. The problem is that this is a risky choice, because if the virus mutates there is a high probability that the right vaccine will not be available.
The second objective does not maximize the value, because an entire vaccine portfolio is developed and costs are higher, but it reduces the risk of not having the right vaccine and unnecessary spending of money and time, as well as missing a market opportunity and the needs of people.
Precisely because developing a vaccine portfolio is more expensive, there may be a strong temptation to keep the price high, at least initially, to try to maximize the vaccine’s sales margins by supplying it primarily to richer countries. This would create more value, at least in the short-term, but it would make the vaccine unreachable for the poorest countries, resulting in damage and suffering for them. And this would be a corporate behaviour that could not be qualified as sustainable.
In conclusion, a strategic choice – to be reflected upon in the top management company incentive system – should take into account risk management (type 2) and, as far as possible, also sustainability (type 3).
If the type 1 prevails in the company, it would be easy to conclude that the statements on the company’s attention to risk and sustainability are perhaps a bit hasty.
Top management objectives in light of Risk management and Sustainability
If in this moment Italy – as other countries – decides to purchase the production of a vaccine in advance which validation period is still underway, it would incur an unnecessary cost in the case that the vaccine is not registered. This is considered as “Risk management“.
Returning to the corporate world, it is no coincidence that the supranational (OECD, European Community, …) and national (Consob and other supervisory bodies) are demanding that the top management be increasingly incentivized, measured and rewarded in relation to objectives that take into account risk management and sustainability and therefore not just the creation of value.
This is not surprising since the creation of value is now understood as value created in the long run; without risk governance and attention to sustainability, sustainable growth would remain just a mirage.
In the next article we will examine some examples of the remuneration policy of listed companies to understand how it is possible to effectively translate what is described here in a real-life situation.
Are you interested in learning more this topic?
Take part in the virtual arena where we will talk about “Risk Adjusted Performance Measures” on December 18th!
Find out how to define a planning and control system that knows how to combine risk-value-sustainability, assigning equal dignity to each of these three dimensions.
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