Can game theory save the world (or at least the environment)?

November 3, 2020
posted in
written by Ahmed Khan & Florian Haas

Environmentally sustainable business models are tricky things to put in place, right?

Action against climate change was a key theme not only at the World Economic Forum in Davos, with some monumental announcements like BlackRock becoming the latest signatory onto the Climate Action 100+ Pact stealing the headlines. On top of that, legislation such as the UK banning the sale of all non-zero emission vehicles from 2035 is helping to pave the way for businesses to transform their operations for a greener future…but environmentally sustainable business models are tricky things to put in place, right?

Well, when there’s large value to be found in Procurement, you could argue that a sustainable business model starts with a sustainable sourcing process. In fact, given that 19% of GDP in the EU’s public sector comes from Procurement activity (and upwards of 50% in some manufacturing functions of the private sector), it’s not unreasonable to think that a well-structured Procurement process has the power to achieve sustainable results, in both commercial and corporate social responsibility dimensions.

What is the challenge?

Creating a structured, incentive-focussed sourcing process, that considers both commercial and corporate social responsibility goals, can often lead to conflicting objectives. Here, a game-theoretical process can allow both of these targets to be met without either having a detrimental effect on the final sourcing decision. To demonstrate this, let’s look at a case study based on a past project, which we can use to see the impact of:

  • Precise determination/evaluation of goals
  • Method of evaluation of providers
  • Degree of commitment, both in structure and in tracking of targets

BrawnTek, an eCommerce business with a large customer base, was seeking a logistics provider to handle the delivery of their products (for the sake of confidentiality, all names and figures within this case study have been altered).

In designing the best process, they faced several challenges in balancing their goals:

There was the ‘good fit’ challenge to make sure the chosen provider had a solid business model, was functionally suitable, and offered a good quality service. There was the obvious ‘commercial’ challenge of sourcing at a competitive price. Lastly, the ‘corporate social responsibility’ challenge, where BrawnTek had to consider the environmental impact of their chosen provider meeting internal targets to minimise the company’s CO2 footprint; a practice any respectable business should be engaged in!

How can you solve it?

Generally speaking, in traditional sourcing processes, these challenges tend to be conflicting– what’s best for the environment might not be the best for BrawnTek’s sourcing budget. The solution? Assess the goals unambiguously, verifiably and monetarily so they can all be accounted for in the sourcing decision. Easier said than done, but certainly possible (we will give some examples below). In doing so, you deliver a state of efficient competition, leading to providers being incentivised to submit their best quotes, not just their cheapest. BrawnTek used this to induce providers to present offers compliant with the company’s social responsibility goals. Assuming innovation is incentivised and commitments are tracked (as well as rewarded), in the long-run this should also create a pool of providers that are reliably cooperative.

So how is a monetary assessment of goals done? Firstly, they need to be split into ‘compensable’ and ‘non-compensable’ targets; the former already being in monetary terms (not requiring a ‘scoring system’) and the latter being factors which cannot be immediately priced, e.g. a guarantee of safe working conditions. Here, we can use heuristics to assess the monetary value of the sustainability goals. BrawnTek used such a heuristic-based judgement to monetise the environmental impact of the candidate providers’ services.

Their 3-step assessment went as follows:

  1. The environmental impact of an average delivery in each provider’s fleet was determined by considering two relevant factors:
    a) Vehicle expected miles per gallon (mpg); vehicles with lower mpg scores would consume greater volumes of fuel over a given route.
    b) Use of environmentally friendly packaging; providers using a greater proportion of recycled or recyclable materials were viewed to use better practices in their services.
  2. Target values were set for (a) and (b), against which the average vehicle/service across a provider’s fleet would be judged.
  3. For failing to meet the targets of (a) and (b), a monetary penalty was attributed to the assessment of the provider. Similarly, a monetary bonus was attributed if the provider could provide solutions which surpassed the targets set.
    a) Vehicle expected miles per gallon (mpg): the bonus/penalty mechanism needed to quantify the monetary value of the extra CO2 pollution per mpg above the target. Several different factors contributed to the final value for deviations from target, with intrinsic motivations, marketing considerations, loss of reputation and a potential decrease in sales being just a few of them.
    – In some cases, there were other methods for monetary assessment, e.g. a price established by CO2 emissions trading. However, at the time of the case-study, a free market for emissions certificates was not yet established, meaning a market price could not be determined.
    b) Use of environmentally friendly packaging: the bonus/penalty mechanism needed to quantify the monetary value of the adverse environmental impact from using packaging with a lower recycled/recyclable material composition. The final value for deviations from target was determined by taking the weighted average of the CO2 emissions impact per kg from production of the materials used in the packaging proposals and assigning a monetary figure to it in a similar logic to (a) above.

Using this bonus/penalty system, BrawnTek could account for all of their targets alongside the commercial prices, leaving each provider with a condensed assessment on a singular “comparison price” (i.e. their quoted price adjusted by any applicable bonuses or penalties).

Whilst assessment of the recycled/recyclable material category was straightforward and easily verifiable, assessment of mpg on routes was done prospectively and would not be verifiable until a provider was chosen and started operations with BrawnTek. For this reason, as a part of the bonus/penalty system, providers were told they would also be fined if their real mpg results were worse than those which they had quoted their fleet was capable of achieving (in the spirit of an operational KPI).

How did the approach add value?

By being transparent with providers and demonstrating commitment to the process, BrawnTek introduced incentives for providers to quote based on their own true valuation of the business. The possibility of any future ‘back door’ negotiations was ruled out, for which providers typically hold back a little margin in anticipation; something hard to prevent in traditional sourcing processes!

We assisted BrawnTek in using a committed, multi-phase negotiation process specifically tailored to make best use of available competition. Given that the contract was awarded to the provider offering the best comparison price at the end of the process, which had already factored in the fuel efficiency and recycled/recyclable material elements of providers’ proposals, the overall negotiation results were equally influenced by BrawnTek’s focus on corporate social responsibility as they were by commercial pricing. Perhaps just as important was the educational force of the process, whereby allowing sustainable practices to have a tangible influence on the outcome, we actively encouraged the market to compete and improve in this area.

Using this game-theoretical process enabled BrawnTek to comprehensively account for environmentally friendly practices without deviating from picking the operationally best provider on a business case logic. Game theory gives businesses a tool to channel the innovative prowess of their service providers; it allows corporate social responsibility to take a seat at the high table, and we all know how important that is for our future!

Finally, economics can come to Greta Thunberg’s (and all our) rescue!

Title image by Marcin Jozwiak on Unsplash