Welcome to the next level

Professor Porter…
…we have time until five to eleven and not a minute longer. I am sorry, but I have an important meeting with a major pharmaceutical company.

Big companies, big ideas: I want to talk with you about nothing less than the reinvention of capitalism.
Good. That is an issue which has been at the center of my research for decades. Go ahead.

In January, you and Mark R. Kramer published a much discussed essay about a new understanding of capitalism. You show why and how companies can help to improve the economic and social conditions of society. Does Michael E. Porter, inventor of the value chain and leading management thinker, think that capitalism has failed?
I can reassure you that that would be the wrong conclusion. Capitalism is magical. It is the most powerful force for progress and by far the most powerful system that we know for creating value for society – especially economic value. In a market economy companies invent products and develop services for which the consumer is willing to pay more than the production has cost. Creating such economic value is a huge achievement. Most aspects of society are about the dividing the value created by the capitalist system: we tax and distribute it. And consumers use it for good purposes. Why should I object such a system?

I do not object it either. Nevertheless, many people look at business and its actors with great suspicion.
It is true that the reputation and legitimacy of business are as bad as rarely before in history. And this is exactly where my new research sets in. Many companies view of their value chain was too narrow. Because we have cultivated a narrow and purely economic understanding of capitalism, capitalism could not reach its ultimate potential. But we now have the chance to bring capitalism to the next level. We are experiencing a very important moment…

…critics of capitalism will argue, that this is merely rhetoric and that capitalism is a system which reduces all values to economic values.
This is nonsense. I often ask in my seminars the question: Who do we expect to solve gigantic problems such as housing for people with low income, food supply and health care? The government? NGOs? The government does not succeed in solving these problems, and the NGO sector has been a big disappointment. Who remains? The business sector is by far the biggest sector, and it has the greatest potential to achieve immediate impact. Do you know why there are companies that drive societal progress?

Because they are innovative.
That too. But above all, because the success of a company and societal progress are mutually dependent. Companies are not entities that exist in a bubble. They consist of employees and need functioning communities around them. Thus, it is pure self-interest that offers the incentive for companies to improve the economic and social conditions of their environment. And they act in fields related to their business and value chain. To give you an example: Nestlé consults farmers on how to improve growing crops, they guarantee bank loans and assist them in the procurement of fertilizers and pesticides. Other companies such as General Electric, Unilever, Whole Foods act on the same principle. I call this idea shared value …

…that sounds similar to my understanding of classical entrepreneurship as brought forward by Adam Smith…
…Indeed. It is still Adam Smith and the «invisible hand»: if man can pursue his own interests, he also serves the overall interest of society. But we need to understand the interest of a business more broadly than we have done before. This opens up new opportunities and business areas for companies. After all, it is still about competitive advantages. If a company wants to be successful, it has to create a value that is unique and meets the needs of customers. Shared value leads to many new strategies that we have not been considering so far. If companies use these opportunities, they will grow faster, produce products with higher customer acceptance and generate more profit. And it can also – and even fairly quickly – change the world and contribute to solving societal problems.

That sounds fantastic. The only problem is that many people see an inherent contradiction between the profit motive and the ability of a company to solve societal problems.
That’s right. Outside the business world there is a widespread notion that profit is created at the expense of a third party and is thus bad. If we go back to the first decades of the 20th century, we find a similar suspicion of the business world. In the U.S. we had the trusts, the cartels – and the economic crisis. After World War II, however, and well into the 1970s, we witnessed a long period of growth in the West with continuously rising prosperity. Business was highly respected – at least that was the case in the U.S., Europe was a bit different. In the 1980s, and mainly in the 1990s, we experienced a period of increasing concern and a renaissance of the old idea, saying that the success of businesses is at the expense of the environment and society.

Why has the perception changed? Are there real reasons for this decreased legitimacy or is it a phantasm?
I see three reasons. First, there were a lot of scandals that have tarnished the reputation of companies. Think of Enron and the meltdown of financial markets, from which a number of institutions have benefited. Second, there is the globalization: Its possibilities have created a harsh new reality. There was a time when Americans produced cars in America and were paid 50 to 60 dollars per hour. These high-wage jobs were protected because there was no other place where you could produce. But suddenly, companies can go to India or China and hire an engineer which they pay 10’000 instead of 150’000 dollars per year…

…which is a deterministic view of things: If a job is being outsourced to China, this is done at the expense of the American worker in Detroit. In a dynamic economy there will be new jobs in new industries…
…but that is how globalization is generally perceived. The global economy is, of course, not a zero sum game. Nevertheless, globalization has led to unprecedented opportunities for arbitrage, i.e. taking advantage of price differences in human capital. The reality of globalization has created a fundamental challenge for developed high-wage economies, which primarily affects low-wage earners. The highly skilled workers in the U.S. or Germany are doing very well. They benefit from globalization and they have the opportunity to supply their work force around the world. That is, however, not true for the socio-economic middle, whose jobs have long been protected. The reality of globalization has led to tremendous tensions. This leads to the third reason: the economy has so far failed to capitalize on solutions for social problems. I began to realize 25 years ago that socially and environmentally sustainable long-term measures are profitable. Back then, many people laughed and said that the environment is an externality. That was short-sighted.

Internalizing externalities and long-term thinking: That sounds reminiscent of the entrepreneurship of patrons who are aware that the long-term success of their business depends on their social and economic environment. Is your idea of creating shared value about incorporating the ideal type of the sustainable-minded entrepreneur into the DNA of a company or a corporation?
We have to be careful. There is much confusion what shared value is really about. Central is the idea of fully understanding the value chain of your company. We’re not talking about the general notion of sustainability. An example: a company that reduces its use of natural resources is creating shared value. Because it reduces costs, it is more profitable. At the same time it preserves the environment. Shared value is not about personal values. It is not about business ethics or philanthropy. It is rather about being profitable by finding creative, entrepreneurial and innovative approaches. Decisive is: creating shared value is in the self-interest of a company. The force of dedicated entrepreneurship, which is motivated by self-interest, is more powerful than any other force we can mobilize. The business community just has to understand that we can address social problems with entrepreneurship.

Milton Friedman said: «The only social responsibility of a corporation is to increase its profits.»
Milton Friedman’s definition is often misinterpreted, and it has led to the idea that businesses should stay away from social issues and care only about conventional economics. A company is, of course, accountable to its owners, but the question is what holistic return they want to achieve. Companies can focus on social issues and capitalize them, such as WaterHealth International, which provides clean water to millions of people in India and elsewhere. I am convinced that we will have a very active dialogue on the global level over the next five to ten years. The feedback I receive from the business world is enormous. That makes me optimistic. Last week, we had an event here in Boston attended by 50 of the world’s leading companies. We discussed how you can create shared value and how to implement this strategy in practice. That made me realize once again: the possibilities to bring about a change in the coming years are enormous. It is perhaps difficult for outsiders, but believe me, the business community is ready for new ideas.

A company must be able to afford long-term considerations and the internalization of externalities. Is shared value thus a privilege of market leaders and family businesses?
The question of time horizon is indeed very important. Family businesses have an advantage because their ownership structure fosters long-term thinking. It allows them to use the strategic opportunities that arise from creating shared value. To cite two examples: MARS and Cargill have both embraced this principle…

…but why should stock -listed companies follow that example? What are their incentives to think over the long-term in the era of the «quarterly capitalism»?
There is no doubt, the question of the time horizon is a challenge to the capitalist system. Corporations can improve. Yesterday, I was in a meeting with a major listed company. Their representatives talked about how they have reduced their consumption of energy, water and packaging material with a three-year program. They have invested 30 million US dollars. And they save every year 16 million. After less than two years, their investment pays off. In short: One does not necessarily think in terms of decades. Such measures can have a positive effect on the balance sheet within a short time.

A company that wants to create shared value depends on the long-term trust from its owners. However, shareholders and investors are often looking for a profit these days…
The shorter the time horizon on the financial markets, the bigger the chance that there is a conflict between short-term profit and long-term value. But this problem is not the end of the road. Even in the era of short-termism, there are many opportunities for companies to create shared value.

How can we expand the time horizon of investors?
That is a central question: How can we counteract the growing institutionalization on financial markets? How can we counteract the principal-agent problem? The low transaction costs encourage rapid trading in financial markets. My proposal is that investors pay lower capital gains taxes if they hold an investment for more than five years.

Before you have to hurry away: What will happen to capitalism in 30 years if the idea of shared value will not be implemented on a large scale?
If companies do not create shared value on a wide basis, we will have a smaller global economy, less growth opportunities for companies, and a lack of support for business by politics and the public. Many people will feel that businesses have to be more strongly regulated. Such approaches could entail poor regulations, which make it more difficult for companies to be efficient and productive. However, that will not happen if we use the opportunity. We are in the midst of a transformation which we are just beginning to understand.

Michael E. Porter is the Bishop William Lawrence University Professor at the Harvard Business School and director of the Institute for Strategy and Competitiveness.