Regulating for innovation

Regulation can promote beneficial innovation where it addresses clear problems with markets. For example, where regulation internalises the cost of pollution, it will send firms scurrying to find new ways to avoid those costs. The resulting market in pollution abatement will underwrite technology development and innovation, and help reduce pollution. Where we are world leaders in such regulation, our firms stand to become world leaders in pollution abatement expertise – for they and the business ecosystem within which they operate will have first mover advantages.

But much of our current regulation is not like this.

The purpose of this article is to begin a discussion by illustrating some of the pitfalls of our current approach to regulation, and to suggest some building blocks towards a richer approach.

In addition to being flexible when it is introduced – or having what we could call ‘static flexibility’ – regulation should also be flexible in an ongoing sense. We might call this ‘dynamic flexibility.’ Mechanisms should exist to ensure that opportunities for optimising regulation are seized with alacrity. Today, despite twenty years of government policy directed towards improving regulatory performance, this is not the case.

Regulation, regulation review and dynamic flexibility

In contrast to many areas of economic reform, few would argue that we have solved the problem of regulatory flexibility. Indeed, while many talk about the ‘deregulation’ of Australia’s
economy over the past two decades, the bulk, complexity and compliance burden of regulation continues to grow.

There is wide agreement across the policy spectrum that the social objectives of regulation should be achieved in ways that maximise the operating flexibility of those who are regulated. Still, in addition to what we could call ‘static flexibility’, or maximising the flexibility of regulation when introduced, regulation should also be dynamically flexible. Like any complex system, regulation will not function well unless it is subject to the kind of continual improvement that good businesses so assiduously cultivate. Currently, few people would regard our regulatory system as dynamically flexible.

This is because in many respects, regulators are not keeping pace with the businesses they regulate. Over the last three decades, business has moved itself out of a ‘Taylorist’ mindset in which managers set policies from the top down, often in minute detail, for employees to follow. Regulation and regulation review agencies have yet to fully make this transition to ‘post-Taylorism’.

The existing policy of ‘minimum effective regulation’ has established regulatory ‘gatekeeping’ institutions to enforce a quality hurdle for all new regulation. Thus, the major focus of regulation review falls on regulation making, rather than on the continual improvement of regulatory systems. Though some emphasis is put on wholesale reviews of regulatory bodies, these are typically policy reviews from outside regulatory agencies, rather than ongoing attempts to optimise the performance of the regulation itself.

The result has been that regulatory systems are a model of unresponsiveness when it comes to the kind of (often small-scale) continuous improvement that is responsible for so much productivity growth in business.


Regulation and regulation

It appears that in the area of regulation, as in other areas of economic policy, we have come a long way since the early 1980s.

Twenty years ago, regulators were subject to parliamentary scrutiny – at least in principle though, in fact, not on the detail unless it created substantial controversy. They were also subject to general disciplines governing the behaviour of public agencies. But as regulation burgeoned, it was clear something was wrong.

Since 1986, when the then Prime Minister announced the policy of ‘minimum effective regulation’, every government at both state and federal levels has established a specific institution dedicated to a variety of worthwhile tasks.

At the Commonwealth level, the Office of Regulation Review (ORR) – recently renamed the Office of Best Practice Regulation (OBPR) – and equivalent bodies throughout the states seek to improve the quality of regulation. Their remit is to do so by ‘gatekeeping’ – to prevent bad regulation from being passed – and by educating regulators. The OBPR’s role is to make regulators aware of the economic aspects of regulation and, in particular, to inure them to a cost benefit framework in all their regulation.

And yet, in contrast to many areas of economic reform, few would argue that regulation review has improved outcomes greatly. Politicians are told of the excesses of over-regulation, and have put effort and resources into the establishment of institutions to deal with the issue. But regulation continues to mount, and much of it is more complex and costly than it needs to be.

Regulation as an exercise in sovereignty – the analogy with ‘Taylorism’

No matter from how far down the hierarchy of government it comes, regulation always remains in essence a form of sovereign command. Further, it is often promulgated to prevent some kind of perceived wrongdoing.

Compare this with the ‘command’ of management within a firm. In each case, the source of command generally has sufficient power to enforce its commands, or to find someone who will. Yet there is a powerful difference. While there will always be minimum standards of conduct within the firm, good managers will mostly focus on encouraging and motivating employees to perform at their best. Indeed, good managers will often not command at all. They understand that the firm they help guide is a complex adaptive system.

Good managers spend a lot of time trying to communicate corporate objectives to those they manage; they also seek to introduce systems to motivate employees, and to measure and reward their performance. When management does command, such commands will generally be both offered and understood as conditioned by their purposes. And good managers’ instructions will often invite employees to solve problems and to add their own unique knowledge from the ‘coalface’ to the ongoing task of improving the firm’s operations.

It wasn’t always this way. In the world envisaged early in the twentieth century by Frederick Winslow Taylor, the author of The Principles of Scientific Management, managers would scientifically design the workplace and then instruct workers on their tasks in minute detail.

In important respects, the transformation from Taylorism has yet to be fully made in the area of regulation. Policies are decided upon, with or without appropriate consultation, and then, in being promulgated, receive the imprimatur of the sovereign. Though the purpose of the regulation can be of some significance when lawyers are interpreting the meaning of the regulation, what is generally required from subjects of the regulation is compliance with its specific commands, not with their purposes – in other words, with the ‘letter’ rather than the ‘spirit’ of the law. Indeed, there is no requirement on regulators to specify the purpose of their regulation, and those purposes may not even be clear.

Table 1: Contrasting two production systems

Taylorism Post-Taylorism
Metaphor of Production System A mechanism designed by engineers A complex adaptive system
Role of Management Funding and empowering professionals to design or buy in machinery, products, work routines and work incentives Eliciting the expertise of all in the productive network (including outside the firm)
Richness of feedback, to guide production and continual improvement, high morale and ‘alignment’ of employees with firm objectives
Means of Productivity Growth Better management, and technology bought in or produced by internal R&D Organisational learning, through continual incremental improvement at all levels

In the early 1970s, the Robens report on occupational health and safety regulation in the UK was a watershed in regulation. It ‘blew the whistle’ on regulatory ‘Taylorism’. Robens argued that occupational health and safety regulation had become a mass of technical rules for workers to follow and inspectors to enforce that were so complex and ad hoc that they were often worse than useless. Not only were they not understood by workers, they undermined responsibility for safety throughout firms by inviting the impression that safety was imposed from outside the workplace.

Robens proposed the first attempt to move beyond what we are calling here ‘regulatory Taylorism’. Firms were to be given general duties of care for their employees’ occupational health and safety and they would discharge them by collaborating with their workforce in developing, documenting, implementing and improving auditable safety management systems.

The new style of regulation seeks to use its power of command in a way that is more analogous to good management – it seeks to encourage excellence at the same time as putting a floor, below which performance shall not fall. It seeks to draw out the expertise of the regulated in improving outcomes. And, at least in intention, it takes those it regulates as being in charge of complex adaptive systems which may change over time. It seeks to regulate to improve outcomes rather than specify processes.

Occupational health and safety regulators have sought to follow this approach with some success. There is also some evidence of this approach in some areas of environmental regulation.

Is regulation review Taylorist?

Another approach to the emerging regulatory morass was regulation review. It had its intellectual progeny amongst economic critics of regulation in the spirit of Adam Smith.

One could argue that Smithian sensibilities were revived by George Stigler’s pioneering studies of regulation in the 1950s and 1960s, which illustrated how often regulation failed to achieve its assumed objectives – for instance, of reducing monopoly prices to the optimal level. This school produced a powerful critique of the political economy of regulation. It showed how often regulation could be ‘captured’ and the public interest subverted by vested interests.

As deregulation has been embraced in many areas of the economy, the policy of ‘minimum effective regulation’ was adopted in Australia in 1986. A recent succinct statement of its philosophy
was offered by Gary Banks, the Chairman of the Productivity Commission (2003), as follows.

To be ‘good’, regulation must not only bring net benefits to society, it must also:

  • be the most effective way of addressing an identified problem; and
  • impose the least possible burden on those regulated and on the broader community.

Where one might say that Robens’ idea was directed towards moving regulation from Taylorist principles to post-Taylorist ones, ‘minimum effective regulation’ sought to constrain regulators to regulate as little as possible, consistent with still being effective. Regulatory ‘gatekeeping’ institutions were established to enforce a quality hurdle for all new regulation. Regulators were required to produce adequate cost-benefit analysis of the regulation they introduced in the form of ‘regulatory impact statements’ which were to be available to cabinet along with coordination comments by regulatory review agencies.

Clearly, ‘minimum effective regulation’ is a worthy goal. It would also be wrong to present Robens-style outcome based regulation as some antithesis to minimum effective regulation. Regulation review agencies themselves promote the idea that regulation should target outcomes rather than mandate processes.

Even so, in important respects, the policies of regulation review as we are practising them tend towards a Taylorist conception of regulation. The policy of minimum effective regulation
delivered by regulation review agencies regulates regulators – it puts in place specific requirements that regulators are required to comply with. And yet, those requirements relate to the process through which regulation is implemented, not to its outcomes. Regulation review is process regulation of regulators.

Also, regulation review agencies go through many of the dilemmas of regulatory agencies themselves. Should they see themselves as enforcers against errant regulation? Or should they seek to influence and educate those they regulate? Should they be public advocates for minimum effective regulation? Or would this undermine their influence with regulatory agencies?

The problem is that the conception of regulation itself and that of regulation review both subscribe to the principles that we have called ‘regulatory Taylorism’. The major focus of regulation review falls on regulation making, rather than on the continual improvement of regulatory systems. Though some emphasis is put on reviews of regulation, these are typically policy reviews from outside regulatory agencies rather than ongoing attempts to optimise the performance of regulation in achieving its objectives. Indeed, regulatory review arrangements can even impede the continual
improvement of regulation.

Table 2: Contrasting two approaches to regulation

Taylorism Post-Taylorism Regulatory Taylorism (Regulation Review)
Metaphor of Production System (regulatory system) A mechanism designed by engineers A complex adaptive system A mechanism designed by policy makers in consultation with stakeholders
Role of Management (regulators) Funding and empowering professionals to design or buy in machinery, products, work routines and work incentives Eliciting the expertise of all in the productive network (including those outside the firm)
Richness of feedback, to guide production and continual improvement, high morale and ‘alignment’ of employees with firm objectives
Analysing costs and benefits and resulting design of regulation
Means of Productivity Growth New Technology bought in or from internal R&D Organisational learning, through continual incremental improvement Reviews of regulation to find improvements

Regulating for excellence and innovation: Delegated regulatory

To encourage excellence, we should seek to relieve firms whose internal systems can demonstrate (and continue to demonstrate) their own excellence from more onerous obligations of general regulation. The Victorian Environmental Protection Act 1970, for example has an accredited licensee system that enables a firm able to show a high level of environmental performance to avoid prescriptive works approval and licensing requirements (Perton, 1997).

However, such programmes have had limited scope and have not had a major impact on regulation more generally. Often, excessive risk aversion is shown in setting such programmes up. The officials involved have little to gain from their success and a lot to lose from any failure or perceived failure.

Regulation typically seeks to vouchsafe some minimum standard of performance. Yet in doing so, not only does it do little to encourage adequate and good performers to do better, but its prescriptions sometimes actually impede the best performers. If we are interested in improving outcomes – for instance, improved satisfaction of customer needs or improved safety at work – we should be keen for improvement, not just where it is unsatisfactory, but wherever it can cost effectively be made. Regulators and legislators should therefore be encouraged to extend the range of prudent experimentation with alternative compliance mechanisms.

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