"CORPORATE RESPONSES TO ENVIRONMENTALCONCERNS"

by

H. Landis GABEL*and

Bernard SINCLAIR-DESGAGNE**

N° 92/42/EP

This working paper was published in the context of INSEAD's Management of Environmental ResourcesProgramme, an R&D partnership sponsored by: Ciba-Geigy, Danfoss, Otto Group and Sandoz AG.

* Professor of Economics and Management at INSEAD, Boulevard de Constance, Fontainebleau77305 Cedex, France.

** Associate Professor of Decision Sciences, at INSEAD, Boulevard de Constance, Fontainebleau77305 Cedex, France.

Printed at INSEAD,Fontainebleau, France

June 1992

CORPORATE RESPONSES TO ENVIRONMENTAL CONCERNS

H. Landis Gabel and Bernard Sinclair-Desgagné

INSEADBoulevard de Constance

77305 Fontainebleau CedexFrance

This chapter discusses several systems of incentives andcontrol that firms may use in order to improve theirmananagement of environmental resources and to facilitatecompliance with environmental regulation.

2

1. Introduction

Most environmental resources are allocated by managers within

firms. According to some recent studies by the United Nations, the

world's 500 largest companies are responsible for 70 percent of

world trade, 60 percent of foreign investment and 30 percent of

world gross domestic product. 1 Hence, as customers, communities,

private organizations and governments are becoming more sensitive

to environmental issues, there is increasing pressure on firms to

be environmentally careful. Firms are especially vulnerable

nowadays to stringent public policies, severe lawsuits, or wide-

spread customer boycotts which are likely to hit the environ-

mentally complacent; for the openning, integration, and globalisa-

tion of markets have greatly intensified competition. Concerned

with securing their profitability and long-terra viability, several

companies have then settled to make proactive, i.e. anticipatory as

opposed to reactive or mandated, investments in appropriate tech-

nologies and management systems. In the latter sphere, however,

although a wealth of individual experience and specific solutions

are available, there is a lack of overall environmental/economic

concepts covering all functions of a company and yielding concrete

recommendations for action.

The traditional literature in environmental economics adopts

a "black box" view of the firm. According to this view, a firm is

"Business sets guidelines for sustainable growth",International Herald Tribune, Monday, June 1, 1992, p. 18.

3

fully described by its production technology (or its cost function)

and its compétitive position on markets for inputs and outputs.

The manager's only task is to use this data to compute an activity

level which maximizes profit. All the information necessary to

perform such a calculation is available. Once the appropriate

activity level is found, it is automatically implemented. In other

words, what many see as the main challenges faced by a manager are

assumed away.

A recent approach rather sees the firm as a collection of

assets [see Moore (1992) and the references therein]. From this

viewpoint, the manager and the firm put at each other's disposai

some assets (e.g., the manager's skills and knowledge, the firm's

office spaces and computers) that they own. It matters to a

manager's actions who owns which asset. For example, a manager who

is given some discretion on the use of a valuable resource will

tend to drain that resource (milk the cow!) if its owner is the

firm or someone else. With the creation and diffusion of tradable

permits and markets for pollution rights, the environment is de

facto becoming an asset. A "property-right" view of the firm may

then lead to some concrete suggestions concerning the design of

contracts and the appropriate dispersion of environmental ownership

between firm members. We will conte back to this issue in section

3. This approach, however, has very little to say about coordina-

tion, hierarchy and delegation.

We have argued elsewhere [Gabel and Sinclair-Desgagné (1992)]

4

that when the environment matters one can fruitfully see the firm

as a network of agency relationships. The division of labor within

the firm implies the presence, explicit or implicit, of lines of

authority and communication linking firm members. Those who have

authority over others for the achievement of a given set of tasks

are called principals, their subordinates are called agents. A key

postulate is that a principal can but imperfectly and indirectly

monitor her agents' performance. This informational problem

characterizes agency relationships. One can see that in a multi-

divisional firm line managers are simultaneously principals for a

group of workers and agents for some upper-level executives. Most

firms are then truly fabrics of intertwined agencies. In the next

section we will consider several managerial systems from this

viewpoint.

The reader should be warned that we do not pretend here to

develop new results or to present another survey of the now

abundant literature on the economic theory of the firm. 2 Our

intention is rather to emphasize some existing propositions that we

deem useful for the implementation of corporate environmental

strategies, and to make some plausible conjectures that we hope

will stimulate further research in this area.

2 The interested reader may consult the existing surveys byHart and Holmstrom (1987), and Sappington (1991). For a stimulatingassessment, from a Coasian perspective, of the economic theory ofthe firm, see Williamson (1985). Milgrom and Roberts (1992)'s newbook also provide a lucid and extensive outlook of the field.

5

2. Systems of Corporate Incentives and Controls

Assume that for whatever reason, a firm's principal wants to

improve the firm's environmental performance. This could be

construed to imply reduced emissions into air or water, reduced

environmental damage done by the firm's products when used by

customers, or reduced risk of an environmental accident.

Characteristic of ail these goals is that they are expensive either

in money or time. Furthermore, the expense is easily identified

and it is in the present. Against it is set a benefit that is

difficult to observe and quantify, perhaps probabilistic, and often

realized in the future. The firm's principal wants improved

performance, but decisions that determine performance are made by

employees (agents) who are motivated by self-interest. The

principal, of course, controls the firm's rules of compensation and

punishment, and its technology of monitoring the agents' actions.

But monitoring is imperfect and costly. How can the principal

fashion the firm's systems of incentives and controls to optimize

its financial and environmental performance?

Below, we consider several well-known managerial systems which

are often mentioned by CEO's and public policy makers eager to

slow down environmental depletion and to reduce the risks of

environmental accidents. These systems are: the compensation

system, monitoring and audits of non-financial objectives, internai

pricing, horizontal task restructuring, centralization versus

decentralion of decision making, corporate sanctions, corporate

culture, and human resource management. This list is certainly not

6

exhaustive. It includes those managerial systems about which the

current knowledge of the economics of firms allows to make overall

and concrete, yet preliminary, recommendations.

2.1 The compensation system

In Gabel and Sinclair-Desgagné (1992), we explored the extent

to which an incentive-based compensation system could be used to

deal with the multi-task principal-agent problem. The model we

presented in that paper is one in which an agent allocates

constrained effort between two tasks. One task earns profit for

the firm (and income for the agent) and the other task reduces the

risk of an environmental accident. The principal wants to control

the agent's effort allocation, but that allocation is not

observable. All the principal can do is to infer the agent's

effort from some imperfect measure of performance. So in this

model, there is costless, imperfect, and indirect monitoring of the

variable of interest - the agent's allocation of effort. Should

the principal link the agent's compensation to the measure of

performance on environmental risk reduction?

What we found from the model is that when the agent's effort

constraint is not binding, then it is optimal for the principal to

use an incentive wage to reward performance on risk reduction.

Furthermore, the siope of the optimal performance-wage schedule for

a given task should be proportional to the relative accuracy of the

principal's measure of the agent's effort expended on that task.

In this model, monitoring accuracy is exogenous, but as noted

7

below, it may be possible to endogenize it.

If the agent's effort constraint were binding, then it may not

be efficient for the principal to pay an incentive wage based on

measured performance on environmental risk reduction. This rather

surprising result has an intuitive rationale. If the effort

constraint were binding, interaction between the principal and the

agent would be limited to risk sharing, but efficient risk sharing

requires that the marginal rates of substitution between the

various income levels be equal. This could only be achieved if the

wage schedule were invariant in the measure of risk reduction.

2.2 Quantification and monitoring of non-financial objectives

In the model described above, monitoring was costless, and its

accuracy was exogenous. In reality, any monitoring system is

costly, and if the principal were to spend more, he or she could

usually improve the system's accuracy. That is, accuracy can be

endogenized. Of interest is how the principal should make the

optimal joint decision on the level of monitoring of effort on the

non-financial environmental objective and the compensation for both

tasks. (Monitoring of financial performance is also important, but

one can assume that it is done irrespective of environmental

concerns.)

Intuitively, monitoring would enter the principal's utility

function as a cost along with the contingent wage. The principal

would maximize over the two control variables - the wage and the

expenditure on monitoring. The agent's utility function would be

8

unchanged.

The benefit to the principal of a greater expenditure on

monitoring is that it would improve the accuracy of his or her

inference of the agent's effort on environmental risk reduction.

With more precision here, the principal should increase the slope

of the performance-wage gradient. This would shift more of the

risk of an environmental accident to the agent, and the agent would

adjust by dedicating more effort to that activity, ceteris paribus.

A further benefit of greater expenditure on monitoring is that

it would improve the principal's assessment of whether the effort

constraint on the agent were binding. As explained above, the

choice of a salary system depends on this assessment. Once the

quality of monitoring is endogenized, then a linkage can be modeled

between the cost of monitoring and the cost of a mistaken salary

system.

The most obvious manifestation of this corporate policy

approach is environmental auditing. Environmental audits are

becoming common in large companies in exposed industries like

chemicals. One aspect of audits is invariably the quantification

of the environmental effects of a firm's operations - a necessary

condition for an effective incentive wage. And whereas surveys of

management practice 3 do not suggest that many companies formally

link compensation to the results of environmental audits, there is

3 See Flaherty and Rappaport (1991), The Economist (1990),the United Nations Environmental Programme (1990), Mckinsey andCompany (1991), the International Chamber of Commerce (1991),Business International (1990).

9

reason to believe that de facto links exist, nonetheless. As it

was expressed in The Economist (1990): "[Audits] allow chief

executives to set goals for subsidiaries: get your reported

emissions down to such-and-such level, or lose a bit of your

bonus."

2.3 Internai Pricing

An alternative approach to assigning a single agent multiple

tasks, including a non-financial one, is for the principal to try

to correct the firm's system of accounting prices to reflect their

implicit values to the firm. With a logic analogous to that of

Pigouvian taxes [Pigou (1920)] and decentralized decision making in

a market, if the firm were to internalize ail externalities to the

agent that are borne by the principal, then decentralized decision

making within the firm would again be optimal to the principal.

How could this be done?

Note that this problem is similar to, but not precisely the

same as, the familiar transfer pricing problem. The transfer

pricing problem is commonly portrayed as one of finding the price

for inter-unit trade that cornes closest to inducing an efficient

level of that trade. Presuming no exogenously available reference

price, the challenge is to design an incentive mechanism to tease

the correct price out of those in the firm who know it.

The problem we describe here is again one of getting correct

intra-firm prices, but there is no prima facie argument that

individuals know the correct price but have an incentive to conceal

10

it. Rather, the principal must construct truly unknown prices (or

their expected values) from data that are costly to collect. This

is often an explicit objective of environmental audits.

There are many cases in which companies have attempted to

improve their environmental performance via this means. Three

examples will be noted here. A European chemical producer has

attempted to identify all environmental costs allocated to its

overhead accounts and then to shift those costs to the products or

processes that truly generate them. For example, legal fees

incurred or expected and insurance premia are charged to specific

profit and loss production centers or products. With altered

product margins caused by additional charges against environ-

mentally malevolent products, sales managers' incentives to sell

environmentally benign substitutes increase.

Another example appeared some years ago in the U.S. steel

industry. When a policy to allow intra-firm emissions trading

replaced command and control policies (as an experiment in the

early 1980s), Armco Steel calculated the shadow price of its

particulate effluents and charged its many facilities with the use

value of emission rights. Reoptimization earned the company a

saving of $50 million [Bodily and Gabel (1982)].

A final example of the spirit of this corporate policy is the

effort several European automobile producers including Mercedes and

Volvo have undertaken to design models with an assumption that

their makers will be responsible for repossessing the cars at the

end of their lifetimes. With the costs of recovery, remanufac-

11

turing, recycling, or ultimate disposai imposed on design teams,

the cars should emerge at least somewhat less environmentally

pernicious.

Although this is a simple look at internai pricing, at a more

subtle level, problems of impacted information and perverse

incentives may assert themselves. For example, if intra-firm

prices are "corrected" for costs incurred by the principal but

external to the agent, should the agent have the option to

subcontract work with other firms? One can assume that there are

external costs there, too, and that some of them may be borne by

the principal. Under these (reasonable) assumptions, it is clear

that questions of transfer pricing are not independent of questions

of organizational form. Those questions could range from centra-

lization vs. decentralization of decision making ail the way to

integration vs. specialization of the firm's activities. This

suggests the relevance of work such as that of Holmstrom and Tirole

(1991) which attempts to integrate transfer pricing and organiza-

tional form. These authors admit that their work is exploratory

and at this stage cannot of fer much by way of specific predictions,

but the questions it poses are relevant to environmental resource

management. How much flexibility do units in the firm have? Is

the opportunity cost of trading outside of the firm large or small?

Is monitoring of outside trading relations feasible, and if so,

how?

This is not an artificiel problem, and an example of it has

appeared in the oil industry. A diversified oil company could

12

burden its shipping division with the insurable and non-insurable

costs of many kinds that the corporation would expect to incur

should there be an oil spill. The intent would be to ensure a

correct incentive for the division to undertake risk minimizing

actions like operating vessels with double-bottomed hulls. But

once those costs were allocated, the division might decide to

subcontract some of its shipping (e.g., that in U.S. waters where

the legal liability for a spill is especially great) to small

independent firms protected by their limited liability. Should

this be permitted?

Precisely this question arose after the Exxon Valdez accident.

Seeing the enormity of Exxon's legal liability and loss of reputa-

tion, Shell Oil's transport division ceased commercial tanker

operations in U.S. waters and contracted it to small shippers

instead. Other oil companies reframed from following Shell's lead,

and presumably employed other control systems instead.

2.4 Horizontal task restructuring

Assigning different responsibilities to one agent with a

reward system designed to govern the allocation of his or her

effort is an organizational option discussed above. Another option

is to assign the different tasks to different agents and thus

obviate the problem of designing a reward system for allocating

effort. In essence, the amount of effort dedicated to the

different tasks is centralized with the principal who decides on

the number of agents assigned to each. But there is still the

13

problem of how to define the tasks and how to structure the

incentives for them.

Holmstrom and Milgrom (1991) explored the problem of task

assignment on the basis of a monitoring criterion. They concluded

that tasks which are easier to monitor and those which are harder

to monitor should be assigned to different agents with steep and

flat incentive compensation schemes, respectively. Since a

reasonable assumption in the present context is that monitoring

non-financial environmental tasks is inherently difficult, it would

follow that profit and loss objectives should be domain of a

specific agent with a flat salary. This match between monitoring

accuracy and compensation scheme is consistent with our results in

the multi-task problem.

It is also consistent with commonly observed business

practice. Often, firms have line managers with profit and loss

responsibility working under strong incentive salary plans based on

financial measures, while staff with responsibility for environ-

mental affairs have salaries decoupled from operating profit.

Under such an organizational arrangement, the staff may be respon-

sible for making capital investment decisions (with a budget

allocated centrally) intended to reduce environmental effluents (or

risks).

2.5 Centralization vs decentralization of decision making

The example above suggests that centralization of decision

making can be and is often used to control agents' behaviour. In

14

a paper focused on antitrust compliance but relevant as well to

compliance with environmental regulations, Beckenstein and Gabel

(1986) modeled a situation where agents' decisions were made with

uncertainty as to their legality and probability of prosecution.

In their model the principal has two alternative ways of

influencing the quality of those decisions. She may provide better

information to agents and monitor their decisions. Alternatively,

she may centralize decision haking, either by making decisions

personally or by imposing standard operating procedures (defined by

the principal) that would constrain the agents. Both of these

alternatives reduce the probability of unwittingly violating the

law (a type II error on the part of the firm), but their costs is

quite different. Information and monitoring entail explicit costs

while centralization of decision making or standardization of

procedures entail no explicit costs but raise the probability that

legitimate and profitable actions would not be taken (a type I

error). That is, information and monitoring reduce the probability

that agents make either error type while centralization of decision

making or standardized procedures reduce the probability of a type

II error while raising the probability of a type I error.

As an example of a standard operating procedure that can be

construed as reducing type II errors while raising type I errors,

a European firm in the agrochemical business has established a

policy that sales of specified pesticides would not be made to

markets (which are listed) where the company cannot be assured that

they are used safely.

15

Beckenstein and Gabel also showed that the choice between the

two alternatives (and consequently the probability of violations

and the cost of any level of compliance) depends, among other

things, on the policy approach of the enforcement agency (or the

actions of civil litigants). The enforcement agency's policy

variables include the size of fines and (with civil litigants) the

enforcement "vigor". More vigorous enforcement results in more

convictions but more acquittals as well.

Comparative static analysis demonstrated that an increase in

fines or in the likelihood that a violation would be prosecuted

prompt the principal to increase both monitoring and centraliza-

tion of decision making. But if a combination of federal and civil

actions raised the likelihood of spurious as well as of legitimate

suits, the principal would adapt by reducing monitoring and

increasing centralization of decision making.

2.6 Corporate sanctions of agents for non-performance

Segerson and Tietenberg (1991) used a principal-agent model to

analyze the issue of corporate vs. individual legal sanctions for

violations of environmental laws. A related issue which we address

here is that of corporate-imposed sanctions for agents guilty of

violating company environmental policy (presumably, whether or not

the violation caused environmental damage).

It is common for companies that are exposed to the risk of

environmental liability to attempt to shift some of it to the

employees whose negligent actions may incur that liability. This

16

can be done by threatening dismissal, for example, or by stating in

the employment contact that legal aid and the indemnification of

fines would be denied to any employee found personally liable for

an environmental accident.

In the context of a model, liability cost functions dependent

on the damage caused or the seriousness of the breach of company

policy would have to be specified for both principal and agent and

then subtracted from the respective utility functions. Furthermore,

a conditional probability of an environmental accident given the

agent's action would also have to be specified.

2.7 Corporate culture

Companies can and do place great emphasis on corporate

"culture". In a recent article, Kreps (1990) defined corporate

culture as a focal point in a noisy reputation game. Corporate

reputation might influence the agent's utility function, or it

might protect the company from harsh penalties in the event of an

environmental accident. Also, in the presence of ambiguity, a

focal point might indicate the type of inference the principal

might draw from his or her observation of the agent's behaviour.

If one were to ask the principals themselves what purpose was

served by an emphasis on corporate culture, be it conveyed by

policy statements, by direct communications from the principal to

the agents or the community, or any other means, the answer is

often that it is intended to convince agents of the principal's

sincerity. That is, it is intended to demonstrate a credible

17

commitment on the part of the principal to sustain the policies put

in place to control the agents. In traditional principal-agent

theory, the agents are not assumed to be skeptical, but in the

environmental arena in large companies, such skepticism is a

reality, widely commented on by agents and the public.

2.8 Human resource management

In addition to making their technology and their physical

capital more gentle to the environment, companies may also invest

in "greening" their human capital. In a recent book Winter (1988)

describes several means used earlier by some firms in order to

enhance their employees' ability to cope with growing environmental

pressure. These means, which altogether became known as the Winter

Model, include staff motivation and in-house training, selective

promotions and recruitment, appropriate working conditions, and

even environmental counselling for employees' households.

Employees will be interested in their firm's environmental

performance if they are themselves environmentally concerned or if

they have a stake in the company's future. The former is enhanced

through environmental in-house training, the latter through in-

house training in general. Clearly, focused discussions with

peers, case studies, business simulations, and speeches by

respected executives or academics can contribute to increase an

employee's environmental awareness. In-house training also

generally contributes to develop firm-specifichuman capital, i.e.,

skills and knowledge that are valuable only in the context of the

18

given firm, as opposed to general-purpose human capital, which

involves skills and knowledge that are relevant for several other

employers. Employees with firm-specific human capital are more

reluctant to leave the firm, because outside of it this capital is

useless; they are therefore more prone to establish a long-term

relationship with their current employer.

In a long-term agency relationship, salary and status-

enhancing promotions are a standard way to align the incentives of

agents properly. As Milgrom and Roberts (1992) argue,

Promotions from within have the advantage that theyresemble tournaments, which have three importantadvantages for providing incentives. First, tournamentsrequire only comparative, ordinal information about whodid better rather the much costlier cardinal informationabout how much better a party has performed than someabsolute standard. Second, even when the quality of eachperformance is separately and objectively measurable,relative performance evaluation may be a better basis forcompensation if common factors affect the performance ofall the participants. Third, because the bonus pool ina tournament is set in advance, the employer has noincentive to disparage or misrepresent the workers'performance in order to save having to pay performancebonuses (...). [pp. 383-384]

Ordinal information may be the only sort of knowledge available

when it cornes to assess the performance of two plant managers with

respect to long-term environmental risks and the prevention of

environmental accidents. One manager might be obviously more

careful than the other, but there is no way of assigning an

objective measurement to their respective contributions. Concerning

the promotion or the implementation of "green" innovations, on the

other hand, some numerical scales may exist (e.g., number of

patents obtained, amount of decrease in air or water emissions),

19

but similar, unobserved, market and organizational factors also

affect the plant managers' performance in these dimensions. Compar-

ative performance evaluation can be useful in this case for sorting

out those who do best. Finally, promotion decisions that take into

account a manager's environmental record allow the firm to make its

commitment towards "green" management explicit and credible.

Promotions from within, however, imply that recruitment occurs

only at the bottom. This rigidity is the price to pay for

maintaining the managers' motivation: their morale would probably

suffer if their career path within the firm was constantly crossed

over by outsiders. Compared to the benefit for a firm of having

more of its managers endorse its vital long-term interests, a

reduction of the pool of applicants for some higher-level position

might be innocuous. This is especially true if most of the habits,

skills and knowledge which have been acquired in a given position

are still relevant up the hierarchy. It is then the company's task

to of fer career paths where the acquisition and usage of skills are

cumulative.

Another way to augment a manager's ties with the firm is to

increase the value of the fringe benefits that the manager would

lose if he or she were to leave. Pleasant and healthy working

conditions, access to family counselling are among those firm-

specific benefits, which may also directly enhance an employee's

environmental awareness and his or her receptiveness to the

increasingly numerous policy statements about the environment.

20

3. Property rights and the firm

Tradable pollution permits have been allowed by US environ-

mental laws since 1978. But it is only with the Clean Air Act of

1990 that the idea of a market for pollution allowances has really

taken off. In May 1992, three US utility companies - the Wisconsin

Power & Light Company, the Tennessee Valley Authority, and the

Duquesne Light Company in Pittsburg - exchanged up to 35,000

allowances between each other.4

It is a well-known theorem that the creation of environmental

markets should lead to an efficient use of environmental resources.

The argument is that, if property rights for pollution (or clean

air) are clearly defined and enforced, then these rights, like

those attached to any standard good, will be traded between the

economic actors and will end up in the hands of the people -

ecologists or polluters - who value them most.

The fact that ownership of pollution allowances has incentive

properties for the agents within the owning firm is not as well

understood, however. Paraphrasing Hart and Moore (1990), imagine

that there are three parties - a principal, an agent, and a

consumer (representing the public in general) - with potential

access to two complementary assets - a machine and a pollution

permit. The agent who operates the machine may improve its

cleanliness at a cost Ca . This brings a benefit of 240 to the

4 "A market made out of muck", Financial Times, Wednesday,June 10, 1992, p. 10.

21

consumer. Similarly, the principal may invest at a cost Cp in

monitoring the agent; this gives 240 to the consumer. Finally,

the consumer may also support at a cost Cc the R&D effort to curb

pollution and this yields another 240. Assume that the principal

owns the machine. The machine, however, cannot be used without the

pollution permit. Suppose first that this permit is owned by the

consumer. The principal and the consumer then need to negotiate

with each other. Assuming symmetric bargaining positions, each one

will act provided (240) > Cp and (240) > Cc respectively. The

agent, on the other hand, needs to negotiate with both the

principal and the consumer. Assuming again symmetric bargaining

positions, she will improve the machine if 1/2(240) > Ca . Suppose

now that the principal owns both the machine and the pollution

permit. The incentives of the principal and of the consumer do not

change; both will act provided (240) > Cp and 4(240) > Cc respec-

tively. But the agent now has to share only with the principal, so

she will improve the machine if (240) > Ca . Thus, the agent's

incentives are stronger when the principal owns the pollution

permit.5

This simple example illustrates that there is an important

link between market solutions to environmental problems and

corporate practices. A general result in this respect can be found

in Sinclair-Desgagné (1992). Large environmental markets are now

5 This is just a specialized form of the generalproposition that highly complementary assets should be ownedtogether. See Hart and Moore (1990).

22

just spreading, generating much enthusiasm and controversy. Their

design is still imperfect. It will improve as we understand better

the incentives created by the ownership of environmental assets.

4. Conclusion

Since the seminal works of Pigou (1920), environmental

economists have been preoccupied with the problem of market

failure. Similar concern has emerged more recently for the problem

of regulatory failure [see Baumol and Oates (1988), Tietenberg

(1990)]. It is our contention, and the message of this chapter,

that there is a third institution subject to systematic failure

with environmental implications. That institution is the business

firm. To this institution virtually no attention has been given by

environmental economists.

Most environmental resources, however, are allocated by

managers in firms. Even if the market prices of environmental

resources were corrected for all externalities, which is the

ultimate objective of market-based environmental policies, business

policy makers - the top executives of business firms - would still

have to fashion what might be special systems to govern decisions

of employees within their firms when the environnent is at issue.

This chapter discussed several systems of incentives and control to

correct or at least attenuate organizational failures within

business firms.

By organizational failures, we mean systematic deviations

between the objectives of the firm's principals and the actions of

23

their subordinates. This phenomenon has received renewed attention

lately, as recent studies reveal that resistance from middle

managers, and now indeed from top managers, are considered by

senior executives and board members to be the biggest obstacle to

the type of organizational and culture changes that companies need

to implement. 6 Companies are now increasingly looking for slick

ways to cope with growing environmental liability and accelerating

demand for environmentally responsible operations, strategies, and

products.

An important feature of organizational analysis, which is

often implicit in this chapter, is that managerial systems are

often complements, i.e., they fit together and may enhance or

jeopardize each other. For example, sections 2.1 and 2.2 above

explain that it may be optimal to accompany relatively more

accurate audits of a manager's environmental performance with

sharper compensation schemes. Section 2.3 outlines Holmstrom and

Tirole (1991)'s attempt to integrate transfer pricing and

organizational structure. Section 2.9 links promotion and

recruitment policies. As Milgrom and Roberts (1992) rightly

emphasize, "Evaluating complementarities - how the pieces of a

successful organization fit together and how they fit with a

company's strategy - is one of the most challenging and rewarding

parts of organizational analysis." [p.17; emphasis added]

Some managerial systems, such as incentive compensation,

6 "Top bosses find change is as good as a pest", FinancialTimes, Wednesday, June 10, 1992, p. 10.

24

internai pricing, task delegation and design, corporate culture, or

organizational structure must be implemented voluntarily by the

firms themselves. Others, such as environmental audits, corporate

sanctions, or policies concerning human resources can be mandated

by law. It is our view that effective and efficient public policy

in this regard must be predicated upon a more subtle understanding

of firms' compliance processes than the simplistic but traditional

"black box" view of neoclassical microeconomics. Only now is

research beginning to appear [e.g., Beckenstein and Gabel (1986),

Segerson and Tietenberg (1991), Sinclair-Desgagné (1992)1, that

takes enforcement policy behind the corporate veil to examine how

policy actions directed at firms and individuals prompt adaptive

behaviour.

25

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