The Role of Regulation in Strategy

For companies in many nations, regulatory policy increasingly shapes the structure and conduct of industries and sets in motion major shifts in economic value. In network industries such as airlines, electricity, railways, and telecommunications, as well as in banking, pharmaceuticals, retailing, and many other businesses, regulation is the single biggest uncertainty affecting capital expenditure decisions, corporate image, and risk management.

In the electric-power industry, for example, the smallest price revisions can have a dramatic impact on corporate profits. So can the structural transformations, brought on by liberalization, that have created new markets for independent power producers and retailers. In pharmaceuticals, new U.S. Medicare rules are forcing drug companies to rethink their product and pricing strategies; in the food industry, pressure to regulate fast-food advertising aimed at children is influencing the marketing strategies of producers, retailers, and restaurant chains.

In many respects, regulation reflects an explicit, formal contract between business and society. Even in the absence of laws and regulations, informal agreements may call upon companies to meet certain social responsibilities. As the food industry is learning, the failure to fulfill these obligations — or new ones created by a change in society's needs or priorities — can propel a shift from self-regulation toward explicit rules. Societies form regulations through an ongoing negotiating process that seeks to reconcile the often conflicting objectives of governments and stakeholders (such as companies, consumers, unions, and environmental organizations), many of which have considerable influence. Successfully navigating this process can allow companies not only to manage regulatory risk but also to shape their industries and to create potential opportunities for themselves.

Despite the increasing importance of regulation, many businesses, even in heavily regulated industries, treat regulatory strategy as more art than science. Many lobby and conduct public relations on an ad hoc basis without the benefit of hard facts or a clear understanding of the trade-offs; others adopt a fatalistic or confrontational approach to industry regulators. Many companies, focused as they are on next quarter's earnings, view regulatory issues as a longer-term challenge that will either go away on its own or be dealt with in the future. Moreover, most companies tend to make regulatory management the domain of specialists — lawyers, technical experts, and public-relations people — who, essential though they are, almost always lack a holistic view of how regulation affects corporate strategy.

Companies struggle with their responses to regulatory challenges for several reasons. First, the issues are often extremely complex and interdependent. Moreover, when deciding on a regulatory stance, companies must consider complicated trade-offs between maximizing profits and broader social and economic factors while at the same time taking into account the interests of a number of stakeholders. Finally, the job is made no easier by constant uncertainty about future regulatory changes — uncertainty exacerbated by tensions among stakeholders and by unforeseen events, such as the emergence of disruptive technologies, rapidly evolving social trends, natural disasters, and changes in governments.

Companies can overcome these obstacles by making regulation a core element of strategy. Doing so requires a deep knowledge of the economic, social, and strategic impact of regulation, an understanding of other stakeholders so that coalitions can be built to support a chosen regulatory strategy, and a new organizational approach that puts regulation on the agenda of the CEO and the top team.

The Value at Stake
The impact of regulation and regulators is evident in many industries (Exhibit 1).

• Power. The implementation of the Kyoto Protocol is beginning to reshape energy markets around the world. In the European Union alone, a cap-and-trade scheme to meet targets for greenhouse gas emissions has created a multibillion-euro market for the certificates that allow a company to emit a certain amount of carbon dioxide. This system has reshaped the incentives for electricity production as generators switch from coal-burning to natural gas-fired plants to achieve lower levels of carbon dioxide emissions, for example. The strategic landscape is being redrawn as a result.

More recently, high oil prices and the destruction wrought by hurricanes in the United States have highlighted the role that regulation has played in constraining refining capacity there during the past 20 years. This new reality will almost surely cause regulators to reevaluate these constraints, as well as alternative energy sources.

• Food. With the rate of obesity increasing rapidly in many developed countries, the food industry is facing a sea change, from what had been a set of implicit contracts with society to more explicit regulatory remedies and to questions of legal liability. The EU Commission is demanding that the European food industry stop advertising junk food to children and improve the labeling of products or face new legislation. Calls to ban vending machines that sell soft drinks or junk food in schools have been heard from California to France to the United Kingdom, where a measure of this sort is slated to take effect next September. Initiatives like these, and the debate at large, may also create opportunities for smaller players — to produce healthier food and position themselves as an alternative to the market leaders, for example.

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