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Melbourne APEC Finance Quarterly Issue 4, August 2008 |
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Welcome to the newsletter of the Melbourne APEC Finance Centre. In this edition ANZ’s Gavin Murray provides pointers for businesses to consider following the Australian Government’s green paper on emissions trading; Westpac’s Huw McKay postulates on some of the positive and negative effects on economies of the continuing turmoil in credit markets, and Ivan St Clair, principal of Treasury Training Services examines the same topic but from a corporate finance viewpoint, plus insights from the MAFC directorate on Asia’s growing infrastructure requirements.
BUSINESS AND THE CARBON POLLUTION REDUCTION SCHEME - 10 THINGS YOU NEED TO KNOWGavin Murray is Head of Sustainability at ANZ
The Australian Government has released its Green Paper on the proposed design of an emissions trading scheme, the Carbon Pollution Reduction Scheme. The scheme’s objective is to provide a mechanism to achieve Australia’s greenhouse gas emissions goal of a 60 percent reduction by 2050. The scheme will have significant impacts on the way business manages and reports its carbon liability. The Government has confirmed its intention to implement the scheme in 2010, supporting the view that any delay will result in increased abatement costs in the future. Companies now need to consider the implications for their business and begin to prepare themselves for the potential effects of the scheme. We have outlined 10 key points for business to consider. 1. Regulating carbon emissions as pollution The scheme places a price on the six greenhouse gases that contribute to global warming. This will apply across our economy, not simply at the point of control. This represents a fundamental shift in Australia’s approach to environmental regulation and pollution reduction. While only heavy carbon emitters will be required to purchase permits, the price signals are designed to be felt across all sectors. This will affect every Australian business, regardless of whether the business is obliged to participate directly in the scheme. 2. Provides a market-based approach The scheme defines carbon pollution as an economic issue and provides economic instruments in response, to encourage the lowest cost abatement opportunities across the economy. Similar approaches have been used successfully to control pollution elsewhere, such as sulphur dioxide emissions in the USA, emissions trading in the EU and, closer to home, salinity levels in the New South Wales Hunter River system. 3. Compensating mechanisms will minimise volatility A range of mechanisms is proposed to minimise economic disruption in the scheme’s introductory stages. These include an initial price cap to reduce volatility, discounted allocation of permits for exposed industries, tax offsets, phased introductions of sectors such as agriculture, direct assistance to electricity generators and the ability to bank and borrow permits. Business should pay close attention to the effects of these transitional arrangements as they evolve. 4. New liabilities and costs for business The proposed scheme will introduce new costs to all companies regardless of whether or not they are large carbon emitters. Businesses will need to consider the most effective ways to reduce their exposure. For some companies this will involve purchasing permits, and for others the focus will be on resource efficiency. Opportunities to buy offsets will be limited. 5. Direct impacts for companies in ‘covered’ sectors Around 1,000 Australian companies operating in sectors covered by the scheme, including stationary energy, industrial processes, waste, fugitive emissions and transport, will be required to purchase the right to emit greenhouse gases. The point of obligation to acquire permits will vary depending on the sector and quantity of a company’s emissions. 6. Every Australian business will be affected The broad nature of the scheme ensures it will have implications for all Australian businesses, even if they are not directly liable or in a covered sector. Although companies outside of the covered sectors will not be required to purchase permits, they will be impacted by the scheme through price increases in a range of inputs from the covered sectors, such as electricity, gas, petrol and manufactured materials. Companies required to purchase permits will look to pass on these costs. Supply chain linkages and the potential impact of increased input costs should be analysed. 7. Energy efficiency presents a clear opportunity For both directly and indirectly affected companies, energy efficiency initiatives will likely be the most cost effective option. Energy efficiency will reduce carbon liabilities for directly affected companies, and reduce operating costs for indirectly affected companies. The Government is proposing a fund to provide capital for energy efficiency and low emissions technologies. 8. Assistance for trade-exposed companies The government has proposed an initial allocation of free and discounted permits to the most emissions intensive trade exposed (EITE) industries, such as metals processors and other heavy industrials, potentially up to 90 percent of their permit requirement. This assistance will be based on a sector average of emissions intensity. This has the potential to reward efficient companies (who require fewer permits) as they will receive the same free permit allocation as less efficient companies (who require more permits). This will create a new incentive for energy efficiency in these industries. 9. Price impacts may affect future sales The scheme contains a number of proposed measures to assist low and middle-income households to adjust to the flow-on price effects. Increased consumer awareness is likely to produce a trend in preference towards lower intensity products, and businesses can anticipate greater scrutiny over emission intensive goods and services. In addition, consumer confidence levels may be impacted by the introduction of the scheme, affecting consumer spending across all sectors. 10. Position yourself to be a winner The introduction of an emissions trading system represents a transformational shift for business, and the move to a low carbon economy will create winners and losers in all sectors of the economy. The opportunities for innovators and leaders are expected to be unprecedented, and forward thinking companies are already preparing their business for future success. Position yourself to take advantage of these market opportunities.
STATE OF THE ECONOMYHuw McKay is Senior International Economist at Westpac
The world economy is looking more vulnerable than at any time since 2001. Each of the G3 economies is facing the likelihood that domestic demand will contract in at least one quarter this year. The outlook for emerging markets is less sombre, but downside risks to growth are rising, particularly in the smaller economies. Financial markets remain decidedly jumpy, as the credit crisis ‘celebrates’ its one-year anniversary with the financial de-leveraging process continuing apace. This is obviously an unusually difficult time to be making bold pronouncements about the future. For Australia, this backdrop is hardly benign. Yet, it is important to be clear that there are positive and negative forces operating on the Australian economy and in the global system more generally. The nature of the global expansion is a positive One of the key reasons for optimism, despite the ugly portents from the world’s financial hubs, is the stunning breadth of the current global expansion. In this cycle more countries than ever before have been drawn into the vortex of modern economic growth. That means there are more independently strong contributors to the bottom line of global demand expansion. Furthermore, the internal and external balance sheet deterioration that accompanied previous periods of emerging market ‘out-performance’ are not evident. Indeed, this group of countries could easily be growing significantly faster without the imposition of a binding external financing constraint. Today’s balance sheet problems are concentrated in the advanced nations, and that is where any global adjustment process will be felt most keenly. The emerging economies are a vital swing factor Rapid expansion in the emerging world has increased its marginal share of global output; resource and food demand; pollution generation and financial asset acquisition. Therefore, the health of the emerging world and the policy trajectories chosen within these countries, have become a central pillar of the global story. This theme really began to achieve relevance for Australia via the rising prices of our commodity export basket from the middle of 2003. The latest episode in this saga, the annual contracting round for iron ore and coal, has delivered a further astonishingly large boost for Australian income growth. As a consequence, there is likely to be a further round of fiscal largesse washing over the economy in 2009, bolstering the consumer at a time when relief is sorely needed. Australian domestic demand is at a critical juncture On this last point, there has been an extremely abrupt shift in the momentum of Australian domestic demand in the year to date. Consumer sentiment, as measured by Westpac and the Melbourne Institute, has recorded steep declines to levels not seen since the early 1990s downturn. High interest rates, haemorrhaging equity markets and record petrol prices are a nasty troika. Business sentiment has also shifted in a pessimistic direction in all the relevant surveys. Credit growth has decelerated rapidly, as both the demand and supply of funds have been squeezed. National house prices fell on average in the June quarter. Leading indicators of labour demand have rolled over, implying the unemployment rate will rise, albeit at a moderate pace. The forecasters who get closest to the mark (those not relying on off-setting errors of course) will have made the correct intuitive assessment regarding the balance of these contending forces. The Australian Central Bank can be expected to ease monetary policy The Reserve Bank of Australia has obviously been shaken by these developments, which have occurred in the wake of both a large increase in official interest rates in 2007 and early 2008, and a further unscheduled tightening of financial conditions precipitated by the credit crisis. Indications are that the Bank will seek to move to a less restrictive policy stance in relatively short order. That is despite a lofty inflation rate and labour scarcity. To be confident with this strategy the Bank must be applying a substantial discount to the impending terms of trade stimulus. The transmission of an income boost into final demand is conditioned by the mood of the time. Depressed consumers are more likely to save windfall gains than spend them, and businesses will invest only a fraction of their profits. A rise in the terms of trade is like a sown crop: one variable in a complex equation. The final realised yield from the sown seeds also depends upon the state of the weather and the fertility of the soil. Suffice to say that there are no firm indications at this early stage on this ‘final yield’. The RBA will be hoping for an ample but not excessively abundant crop. The RBA's strategy can be relied upon to partially shift the burden of real exchange rate appreciation away from the nominal Australian dollar and onto the relative price level.
CREDIT CRUNCH ISSUES FOR CORPORATIONSIvan St Clair is a Director of Treasury Training Services Pty Ltd
The “credit crunch” crisis has come a long way in recent times. It was only 12 months ago that corporations were contemplating how the sub-prime crisis in offshore capital markets might affect financing in local markets. There was an acceptance that securitisation structures may not receive the investor support that they had historically enjoyed and corporations with new financing or debt rollovers would be faced with higher financing margins. However these issues were considered to be short term. One year on and we have seen billions of dollars written-off bank balance sheets overseas, regulators trying to deal with a systemic crisis in the global capital markets and some pundits questioning whether we are watching the demise of the US dollar as the global currency. We are now starting to comprehend the extent of the sub-prime crisis, and are feeling the impact on domestic and regional corporations. Financing margins have increased materially Clearly the most immediate area of impact is financing margins. Banks are now more constrained in the amounts they can borrow through the capital markets and the price they have to pay, and are therefore rationing credit accordingly. Corporations with a strong credit rating (which is necessarily backed by strong cash flows and low gearing), a transparent business model and strong banking relationships are still receiving funding support from their banks at “reasonable” margins. However banks are now pricing credit risk more “appropriately”. In some cases, financing margins are increasing by one percent p.a. and more. In the more extreme cases, banks require repayment. What should Corporations be doing Corporations need to ensure that their borrowing facilities cannot be repudiated and that they retain their previous financing margins for as long as possible. This involves:
When reviewing the facilities, remember that some banks may seek technicalities to repudiate existing agreements and increase their fees. The balance of power in the relationship between banks and their corporate customers has changed in favour of the banks (and is unlikely to change back for some time). Banks have a lot of pressure to lower their risk and increase profitability, hence the importance of corporations keeping their banks well informed. Develop alternative financing plans in the event that existing lenders have reduced appetite for your credit risk - this may involve either debt and/or equity. Ensure the alternative financing plans are well founded and time-bound i.e. set an amount and dead line for securing long term financing and stick to it. It will likely cost more than existing financing, but that reflects the prevailing price to reduce the probability of financial distress. Cash is king! The importance of cash retention will continue to increase. In the short-term expect suppliers and customers to manage their working capital (inventory, creditors and debtors) more aggressively than ever - at the expense of their trading counterparties. Those businesses not focussing on working capital management may find themselves financing their suppliers and customers. Long-term cash retention is also receiving increased focus. Some corporations (e.g. Starbucks and Don Smallgoods) have recently announced corporate contraction. For others, the increasing cost of energy in particular, combined with volatility in exchange rates and interest rates, may lead to increased corporate restructuring and in some cases, a restructuring of industries (can diesel fishing trawlers continue to compete with aqua-culture?). Risk-averse banks will not finance faltering business models so it will be incumbent on corporations to restructure quickly and retain cash wherever possible. Rate volatility is expected to remain high The sub-prime crisis is also indirectly impacting interest rates and foreign exchange rates. Short-term interest rates in the United States are being kept low to minimise the impact on borrowers generally. The reduced interest rates are a factor contributing to a lower USD. Whist we can’t be confident of any forecasts of absolute levels of interest rates and exchange rates, we can expect that volatility is likely to remain high as Central Banks grapple with the optimum setting of interest rates to minimise the risks of recession and inflation. During such volatile times, the importance of robust hedging programs to protect from adverse movements in interest rates, exchange rates and commodity prices becomes paramount. Some corporations may need to review their approach to hedging to ensure that it provides the required protection. Issues such as the use of knock-out and knock-in options may require re-visiting. The inclusion of mutual right-to-break clauses that have the effect of reducing the cost of long-dated derivatives, but give the counterparty the right to cancel, may also require a re-think if the hedging program is to be relied upon. Navigating the next one to two years We have not seen such adverse credit conditions since the early nineties. However the circumstances were different then and much of the corporate memory from that era has since moved on. To safely navigate the next one to two years, corporations will need to be:
CHALLENGES IN PROMOTING PUBLIC PRIVATE PARTERNSHIPS FOR INFRASTRUCTURE FINANCINGKen Waller is Director of the Melbourne APEC Finance Centre at Monash University
The last APEC Finance Ministers' Joint Ministerial Statement noted that when supported by sound management and appropriate risk sharing, public-private infrastructure partnerships can lower operating costs and deliver a significant public benefit. More significantly, the statement noted the intersection with developing strong and liquid and diversified capital markets via infrastructure investment. Developing countries need economic and social infrastructure to transform their economies. And demand is at a level where governments alone cannot meet these needs through budget financing. Private sector resources need to be harnessed. But the prospect of participation in the delivery of infrastructure by the private sector is tempered by market limitations in the provision of capital to finance debt for major projects. Mobilising capital A system of well-structured financial intermediation acts as a driver of economic growth. It can help to manage fluctuations in capital flows and provides fixed-income investments opportunities. Many capital markets in some emerging economies are underdeveloped and financial intermediation is left to banks via the mobilisation of savings. Building a diversified, well capitalised, credit worthy and strong functioning investor base is a significant challenge for APEC. As economies develop and incomes rise, diversification of savings through the development of pension funds, insurance and investment funds, is being realised. These investments bring depth and liquidity to markets. With an appropriate regulatory framework to ensure accountability, transparency, disclosure and certainty for market participants, public and private sector investment in infrastructure can be harnessed. Bridging demand The ADB estimates the cost to provide the necessary infrastructure over the period 2006-2015 is USD 470 billion per year. The public sector will not be able to meet this demand alone. Australia provides a good example of the utilization of private funding in infrastructure development. Since the mid-1990s, private investment in Australian infrastructure has increased while public investment has declined. Consistent with this, issuance of non-government, long-term infrastructure debt has increased with listed funds totaling approximately AUD 35 billion in 2006. The introduction of compulsory superannuation has helped mobilize a massive savings pool, a proportion of which has contributed to infrastructure financing. Models to deliver infrastructure are often financed using Special Purpose Vehicles (SPVs). Capital is raised based on the projection of revenue streams from an infrastructure concession. The projections are used as collateral to raise capital through banks, or from capital markets in the form of bonds and equity. By transferring infrastructure assets to the private sector, the role of corporate debt and equity markets in financial intermediation in economies can be increased. Public offerings, private equity and indirect investment through investment funds can help mobilise long term capital. Class asset Infrastructure assets have special characteristics that make them an attractive investment. The long-term nature of infrastructure financing can match the yield needs of long-term savings in life insurance and pension funds. In APEC economies, high public and private savings rates should continue and thus contribute to the growth of pensions, public investment funds and superannuation products. This diversification and improved liquidity will provide capital markets with reliable sources of funds necessary to deliver the infrastructure Asia needs to develop and sustain its economic and social infrastructures and to improve its standards of living. A well developed sovereign debt market which establishes benchmark yield curves for other fixed-income instruments to be priced against is a critical component of the capital market structure. The World Bank has suggested that public private partnership infrastructure projects could help in the development of a de-facto benchmark yield curve, providing important key supporting market structures are in place. Major prerequisites Capital markets necessarily involve legal structures that uphold property rights which give private sector participants the assurances that any agreements are well defined and enforceable through a judicial system. Good governance regimes are critical to promote confidence by both governments and private sector investors and the community generally in the efficacy of public private infrastructure projects. A critical aspect of an infrastructure project is calculating demand that underpins the value of a project over the long run. Forecast demand and pricing analysis needs to reasonably reflect the future. This is not easy and the complexity of such assessments impacts on the role of contingencies in the financing agreement and on the adjustment measures that may be required over the life of a project. Governments may choose to provide various forms of assistance to the private sector in order to make projects commercially feasible. However governments must also be careful that any such assistance does not reduce the transfer of risk to the private sector that may compromise the defined value objectives of a given project. Governments may face significant fiscal risk if contingent liabilities arising from guarantees occur. In the current environment the tightening of global credit will impact on capital raisings for infrastructure. Lower risk investment grade projects have seen limited increases in the cost of capital. But new higher risk projects may need to turn to the banking sector for finance and this would tend to involve higher premiums than those charged in capital markets. Assessing the benefits Whilst there are always caveats, infrastructure delivery via public private partnerships represents a significant opportunity for emerging economies in the Asia-Pacific where demand is robust. There is little question that we will see a substantial growth in this model of financing in the period ahead. APEC can share knowledge and skills through capacity building initiatives to facilitate partnerships, help economies to build the necessary legal frameworks to provide contractual stability, and foster capital market development to finance infrastructure projects.
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