• Strategy
  • McKinsey & Co.

The Role of Regulation in Strategy

Companies have everything to gain from linking them.

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.

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