The Scouting Report: Financial Regulation
Risk-assessment processes typically expose only the most direct threats facing a company and neglect indirect ones that can have an equal or greater impact.
October 2015 | by Robert Harris
The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the economy can set off chain reactions in areas that may seem completely unrelated. In fact, risk managers and other executives fail to anticipate the effects, both negative and positive, of events that occur routinely throughout the business cycle. Their impact can be substantial—often, much more substantial than it seems initially.
What can companies do to prepare themselves? True, there’s no easy formula for anticipating the way risk cascades through a company or an economy. But we’ve found that executives who systematically examine the way risks propagate across the whole value chain—including competitors, suppliers, distribution channels, and customers—can foresee and prepare for second-order effects more successfully.
Effects on a Company’s Risk Profile
Risk cascades are particularly useful to help assess the full impact of a major risk on a company’s economics. Exploring how that risk propagates through the value chain can help management think through—imperfectly, of course—what might change fundamentally when some element in the business environment does.
To illustrate, let’s examine how the risk posed by new carbon regulations might affect the aluminum industry. Aluminum producers would be directly exposed to such regulations because the electrolysis used to extract aluminum from ore generates carbon. They're also indirectly exposed to risk from carbon because the suppliers of the electrical power needed for electrolysis generate it too. The carbon footprint can be calculated easily and its economic cost penalty determined by extrapolation from different regulatory scenarios and the underlying carbon price assumptions. This cost penalty would of course depend on the carbon efficiency of the production process and the fuel used to generate power (hydropower, for instance, is more carbon efficient than power from coal).
In general, large industrial companies believe they are “carbon short” in the financial sense—their profits get squeezed when carbon prices increase. Is that always true? A different story emerges from a closer look at the supply chain, which stiffer carbon regulations would change in many different ways. The cost of key raw materials, such as calcined petroleum coke and caustic soda, would increase, along with logistics costs and therefore geographic premiums. The US Midwest market premium, for example, reflects the cost of delivering a ton of aluminum to the region, where demand vastly exceeds local supply. Not all competitors in the industry would be affected alike: this effect favors smelters located close to the US Midwest, because they could then pocket the higher premium. Some suppliers might even benefit from their geographic position.
Moreover, in a carbon-constrained, tightly regulated world, aluminum becomes a material of choice to build lighter, more fuel-efficient cars. Since automobile manufacturing is one of the largest end markets for aluminum, carbon regulation could substantially accelerate demand, thus helping to support healthy margins and attractive new development projects. Clearly, a high carbon price would enhance aluminum’s value proposition—positive news for the industry.
Finally, carbon regulations would affect not only a particular company but also its competitors, changing the economics of the business. For commodity industries, the cash cost of marginal producers sets a floor price. In a world where carbon output has a price, the cost structure of different smelters would depend on their carbon intensity (such as the amount of carbon emitted per ton of aluminum produced) and local carbon regulations. It’s possible to show how any regulatory scenario could influence the aluminum cost curve. In nearly all the plausible scenarios, the curve steepens and the floor price of aluminum therefore increases. For most industry participants, especially very carbon-efficient ones (such as those producing aluminum with hydropower), a meaningful margin expansion could be expected.
A simple risk analysis suggested that one of our clients would be carbon short and that its profits would therefore decrease under new carbon regulations. But a more extensive view of the way carbon risk cascades through the industry value chain shows that this company would actually be carbon long: as carbon prices increase, the company benefits economically thanks to its high carbon efficiency, its desirable geographic location (proximity to the US Midwest), and the potential added demand for aluminum.