This bulletin explains why it is essential for regulators in Australia to adopt financeability tests as standard practice whenever they make a regulatory determination, and to take the results of those tests seriously.Financeability tests are used by regulators in the UK to assess whether the revenues they allow a business to earn over a price control period will be sufficient to finance the business’s operations efficiently. These tests act as an early warning against a regulated business becoming financially constrained or insolvent—an outcome that ultimately harms consumers, or taxpayers, who may be called on to rescue a regulated business providing essential public services from collapse.
By contrast, in Australia, regulators have either refused to employ financeability tests or run them but only pay lip service to the results.
Thames Water is Britain’s largest water company, providing water and wastewater services to 15 million customers in London and the Thames Valley.
In late June 2023, alarming reports began to circulate that Thames Water was struggling to meet its debt obligations and may be on the brink of collapse. The crisis deepened as the CEO stepped down suddenly following criticisms about the company’s poor environmental performance and record leakage rates, and a new Chair was appointed hastily to regain control of the situation.
The UK Government and the water sector regulator, Ofwat, began drawing up rescue plans for Thames Water amidst fears that the company might become insolvent. The crisis ended when shareholders agreed to inject £750 million of equity capital into the business, to reduce its debt burden.
The media was quick to blame the financing decisions of the company’s private owners for its woes. Previous owners of Thames Water, including Australian bank Macquarie (dubbed the ‘vampire kangaroo’ by some in the British press), were accused of loading the business with excessive debt, while extracting huge dividends, leaving it unable to meet its financial obligations.
Thames Water is one of the most indebted water companies in Britain. At the time of the crisis, it had £16 billion of debt and a gearing ratio (the proportion of its assets that are financed with debt rather than equity) of around 80%. Ofwat noted that Thames Water (and some other companies) had “borrowed too much.”[1] This meant that the company faced large debt repayments.
The situation was worsened by the fact that nearly 60% of Thames Water’s debt was inflation-linked. That is, a significant portion of the interest Thames Water needed to pay was linked to the retail price index (RPI) measure of inflation. The RPI is similar to the consumer price index (CPI). However, it also includes mortgage interest payments, which makes it more sensitive to changes in interest rates. Hence, Thames Water’s interest bill grew significantly as inflation rose sharply over 2022 and 2023.
But the size of Thames Water’s debt obligations is only one part of the equation.
As a natural monopoly, the amount of revenue that Thames Water is allowed to earn is capped through periodic price controls by Ofwat.
A part of that revenue allowance is an amount to cover real interest payments. However, to the extent that a company holds inflation-linked debt, its actual interest bill in each year will be the sum of a base (real) rate plus outturn inflation that year.
Ofwat allows the regulatory asset base (RAB) of the businesses to grow each year in line with actual inflation. Recovery of this inflation-indexed RAB, over 50 years or more, provides the business with compensation for the inflation component of its interest costs.
Herein lies a problem: the business is contractually obliged to pay the entire interest bill every year. But, it will take decades to recover through regulated prices the inflation component of that bill. When inflation starts rising, the mismatch between the business’s regulated cash flows in each price control period and its interest obligations widens.
In short, Thames Water faced a perfect storm: a large pile of debt, rapidly rising interest repayments linked to inflation, and regulated revenues that were insufficient to cover these increasing costs. All of this added up to material risk of default on its debt obligations.
Ofwat has a statutory duty to:
“secure that companies...are able (in particular, by securing reasonable returns on their capital) to finance the proper carrying out of their functions.”[2]
If the annual revenue allowance set by Ofwat is insufficient to pay the business’s interest bill or to attract equity finance, the business will be unable to finance its activities properly or invest in assets. In these circumstances, the business would be unable to deliver services of proper quality to consumers.
Moreover, the financial collapse of essential service providers such as water companies, energy networks or communications firms can cause catastrophic disruptions and economic costs to consumers.
Recognising this, Ofwat and other UK regulators with similar financing duties have developed ‘financeability tests.’ These act as an early warning to detect whether the revenue allowances set by the regulator would be insufficient for an efficient business to remain financeable. If the tests show a likely deterioration in financeability, the regulator can adjust revenue allowances to avert the problem.
Ofwat sets revenue allowances based on a ‘benchmark’ business that uses debt to finance 60% of its assets and maintains a BBB+ credit rating.[3]
The purpose of Ofwat’s financeability test is to assess whether the revenue allowances set in this way are in fact sufficient to support that BBB+ rating at the benchmark 60% gearing. It is effectively a test of the internal consistency of the regulatory decision.
Ofwat decided in its 2019 revenue determination for Thames Water that it needed to accelerate the recovery of costs by £125 million in order for a benchmark business in Thames Water’s circumstances to maintain a BBB+ rating at 60% gearing.
Thames Water argued that, even after bringing forward these allowed revenues, a benchmark business with 60% debt finance would be unable to finance the delivery of its statutory obligations or attract the required amount of equity finance. Ofwat did not accept Thames Water’s representations.
Ofwat also performed a separate test of ‘financial resilience’ based on Thames Water’s actual gearing (at the time) of 80%. Ofwat expressed concerns that Thames Water was very highly geared and noted the company should take steps to improve its financial resilience.
Under this two-pronged test:
Whereas Ofwat and Thames Water differed in their views about whether the regulatory allowance was sufficient to support financeability, there was strong agreement that consideration of financeability is a vital component of regulatory best practice.
By contrast, Australian regulators have been slow to embrace financeability tests. Regulators in Australia fall into three groups:
The Thames Water case provides a timely reminder that even the largest and most well-resourced regulated businesses can face serious risk of insolvency, which can be disastrous for consumers. Properly implemented financeability tests can avoid such outcomes. Therefore, it is important to consider:
It is in the long term interests of customers that an efficient provider of essential services is financeable, so that it can provide services desired by customers. This requires that regulated revenues are sufficient for an efficient business to meet its financial obligations as they fall due and to invest what is needed to deliver regulated services.
If regulated businesses cannot provide their services because they are financially constrained or insolvent, then customers or taxpayers will bear the cost. If the regulated business is financially constrained, it may be unable to make the investments needed to provide the level of service today or into the future that customers want. If a regulated business becomes insolvent, then it will likely be taxpayers that step in to ensure the essential services continue to be provided.
This is why financeability tests are a key part of best practice regulation. The purpose of a financeability test is to ensure that the revenue allowance is sufficient for an efficient business to meet its financial obligations over the forthcoming regulatory period.
The test should also allow the regulator to diagnose the source of the problem, so that appropriate corrective action can be taken.
Financeability problems can arise because:
The first is a case of internal inconsistency in the regulator’s process and is for the regulator to resolve. The second is a case of risky financing practices and is for the firm and its owners to resolve.
Regulated businesses should be free to depart from the regulatory benchmark if they choose. The business then keeps any benefits, and bears any costs, of such a departure. Neither the regulator nor consumers should be called on to immunise regulated businesses against bad outcomes arising from such decisions.
The Ofwat approach described above involves a two-part test:
A similar two-pronged test is applied by the NSW Independent Pricing and Regulatory Tribunal (IPART).
The source of any financeability concern can be identified more easily by using two separate tests:
There are almost no examples of Australian regulators taking action to address financeability concerns arising from their decisions to set inadequately low revenue allowances. Some regulators perform no test at all, so have no way to detect the existence of a problem. But, many that do perform financeability tests have chosen to take no action, even when the test has clearly identified a financeability problem.
It is important that regulators acknowledge the outcomes of their financeability tests, respond consistently and do not try to apply a narrative that seeks to ‘explain away’ a potential problem.
The most important financeability metric considered currently by rating agencies for Australian regulated energy and water businesses is the funds from operations to net debt (FFO/Net Debt) ratio
In IPART’s 2020 determination for Sydney Water, the FFO/Net Debt ratio fell below of the minimum 7.0% threshold specified in IPART’s benchmark test in every year of the regulatory period. This suggested strongly a failure of the benchmark test. IPART should have adjusted Sydney Water’s revenue to ensure an efficient, benchmark business could remain financeable.
However, IPART concluded that the failure of the test on the FFO/Net debt ratio did not indicate a problem. This is because, amongst other reasons, that ratio was expected to improve over the regulatory period towards the target ratio (from 6.6% in 2020-21 to 6.8% in 2023-24). However, it would remain below the required threshold in every year.[4]
According to IPART, there was no problem to fix because the failure of the test was forecast to become less severe over time.
In 2022, the AER undertook a major review of its methodology for setting the allowed rate of return for electricity and gas networks. As part of that review, the AER presented a simplified financeability test to assess the impact of its proposed methodology.
The AER’s test used the FFO/Net debt ratio as the sole metric and set a threshold of ≥7.0% for a ‘pass’.
The AER found that the FFO/Net debt ratio for 25% of the businesses fell below the threshold for a pass.
The AER concluded that there was no evidence of a financeability concern (at the industry level) under its proposed rate of return methodology because 75% of the firms appeared to pass the test.
Of course, this ignored the fact that a quarter of the industry had failed the regulator’s own test.[5]
Not adjusting regulatory decisions in response to a failure of the benchmark financeability test and instead narrating away the outcome is as good as having no test at all.
The regulatory response to a financeability problem should properly address the underlying cause of the problem. Without addressing the cause, remedial actions may be misdirected, leading to inefficient outcomes.
If the financeability problem was caused by the business taking imprudent or risky financing decisions (e.g., by gearing up more than the benchmark level), it should not fall to consumers to ‘bail out’ the business for those poor decisions. That would impose unnecessary costs on consumers and create poor incentives for the business to avoid bad financing decisions in future.
However, if the financeability problem was caused by the regulatory allowance being set too low for a efficient business to remain financeable, then the regulator, not shareholders, should fix the problem.
IPART has made this distinction clear:
“If the source of the concern is that prices are too low even for a benchmark efficient business, we think the appropriate remedy is to review our pricing decision. In essence, this step would involve correcting a regulatory error. The financeability test could help identify any such error by applying additional information that may not have been available in the building block model used to set prices.
If the source of the concern is that prices are adequate for a benchmark efficient business but too low for the actual business because its owners have been imprudent or inefficient, there are appropriate remedies. The owners could reduce the business’s level of debt by injecting more equity, accept a lower than market rate of return on their equity, or both. It is an important principle that an inefficient business should not be rewarded for its imprudent decisions at the expense of customers.”[6]
The best way to diagnose the source of a financeability problem is to apply a two-pronged test of the sort used by IPART and Ofwat. Because the benchmark test assumes that the regulated business always finances itself efficiently and prudently, the only explanation for a failure of that test would be a regulatory error that requires correction.
Even when a test is structured correctly, it will only be useful if it accurately reflects the financial flows of an efficient benchmark business. If the thresholds for passing the test are set unrealistically low, then genuine financeability tests will go undiagnosed and uncorrected.
For example, when running its benchmark test, IPART assumes that businesses faces real, rather than nominal, debt obligations. But, in reality, companies in Australia issue nominal debt and therefore must pay nominal interest expenses.
Assuming that an efficient regulated business faces lower (i.e., real) interest expenses than it in fact does makes IPART’s benchmark test too easy to pass. Hence, the test is prone to ‘false negatives’—i.e., conclusions that there is no financeability problem, when there is one.
These examples show that regulators in Australia either do not apply financeability tests at all, or if they do, typically find reasons not to fix a problem identified by their own financeability tests.
The Thames Water example is a reminder that regulated businesses can face serious financeability problems.
Ofwat concluded at the last price control that Thames Water needed an uplift in allowed revenues of £125 million to support an efficient credit rating, at an efficient level of gearing. The crisis that Thames Water faced would probably have been worse than it was, had Ofwat adopted the approach that Australian regulators follow and ignored the results of its own financeability analysis.
Because regulated businesses deliver essential services, it is consumers that suffer if these businesses become insolvent or financially constrained. In the case of insolvency, taxpayers may also be called upon to rescue the business from collapse.
Therefore, regulators in Australia should view financeability tests as an essential part of best practice and incorporate them as a standard feature into their revenue setting processes.
A good framework for regulatory financeability tests should:
If the cause is imprudent or risky financing decisions by the business, it should be left to investors to deal with. However, a failure of a benchmark test indicates that the problem is a regulatory one. In these situations, the regulator should take action to fix the problem, rather than explain it away or shift the onus on shareholders.
A two-pronged test allows regulators to pinpoint the cause of the problem and ensure that tailored action is taken.
Regulators should take the outcomes of these tests seriously and not dismiss a clear failure of the test by simply assuming that their regulatory decision is adequate.
To find out more about how we advise on regulatory issues and financeability, pricing reviews, and more, please reach out to our team.
[1] Ofwat, Thames, debt and water sector finance, 24 July 2023. [2] UK Legistation, Water Industry Act 1991, section 2(2A)(c). [3] Ofwat, PR19 determinations: Thames Water final determination, December 2019. [4] IPART, Review of prices for Sydney Water from 1 July 2020, Final Report, June 2020, p 178. [5] AER, Draft rate of return instrument, Explanatory statement, June 2022, p. 24. [6] IPART, Review of our financeability test, Issues paper, May 2018, p. 32
Frontier Economics Pty Ltd is a member of the Frontier Economics network, and is headquartered in Australia with a subsidiary company, Frontier Economics Pte Ltd in Singapore. Our fellow network member, Frontier Economics Ltd, is headquartered in the United Kingdom. The companies are independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Pty Ltd.
At the International Institute of Communication’s Telecommunications and Media Forum, Sydney 2023 our Economist Warwick Davis joined a panel on competition issues in the sectors and commented on proposed merger reforms in Australia and the United States. He suggested that the Australian Competition and Consumer Commission (ACCC)’s proposed reforms for processes and legal tests for merger clearance will be contentious but seem more likely to produce economic benefits than the proposed changes to merger guidelines in the United States. This note explains the reasons for his view.
Competition authorities in many parts of the world are steering the debate on mergers towards sterner enforcement. The recently released details of proposed changes to merger enforcement in Australia and the United States show that competition authorities are on quite different paths to achieve that goal.
In Australia, details of the ACCC’s proposals for merger reform, as provided to Australian Treasury in March 2023, were recently released under Freedom of Information laws.[1]
The US Department of Justice and Federal Trade Commission (the Agencies) issued new draft merger Guidelines[2] for comment in July 2023. As in Australia, merger guidelines do not have the status of law, but they have been influential in US court merger proceedings.
The proposed changes are different, but they are both reactions to similar concerns – perceived harms from increasing market concentration that have not been prevented by merger laws and/or enforcement practices:
There is growing evidence to support the view that Australian markets are becoming more concentrated…It is important that Australia’s merger regime is effective in preventing increases in concentration before they occur.[3]
and:
[In the United States] Empirical research…has documented rising consolidation, declining competition, and a resulting assortment of economic ills and risks.[4]
The Agencies’ draft Guidelines have undergone a substantial change in form and substance from earlier versions.[5] The draft Guidelines show the Agencies’ desire to simplify the analysis of mergers that increase concentration or occur in concentrated markets, tied where possible to legal precedent. The FTC Chair has stated the draft Guidelines do not rely on “a formalistic set of theories” but “seek to understand the practical ways that firms compete, exert control, or block rivals”, and offer several ways to analyse transactions.[6]
The draft Guidelines have 13 specific guidelines that address analytical frameworks and specific challenges relating to serial acquisitions (creeping acquisitions in Australian parlance), buyer power in labour markets, platform markets and minority interests. This includes a return (in Guideline 1) to a stricter application of the ‘rebuttal presumption’ of market concentration that was first developed by the Supreme Court in 1961[7], and the introduction (in Guideline 6) of a rebuttable presumption in the case of vertical mergers, where a market share of more than 50% is involved.[8]
The changes from the 2010 version of the Guidelines on the significance of increasing market concentration are stark, as highlighted in Table 1. The thresholds at which the rebuttable presumption is engaged are reduced: in rough terms, a 6 to 5 merger of equally sized firms would now be subject to the rebuttable presumption while under the 2010 version it would not. For reference, the current ACCC Merger Guidelines approach (2017) is also highlighted, but these thresholds do not create rebuttable presumptions but instead provide an indication of the likelihood of concerns being raised.
Table 1: Changes in treatment of market concentration, US DOJ/FTC Merger Guidelines
Source: US Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines, August 19, 2010, draft Guidelines, p. 6, ACCC Merger Guidelines, 2017.
The ACCC also has expressed concern with increasing market concentration. But the ACCC’s proposed reforms do not specifically focus on elevating market concentration to a more central role in merger analysis. Rather, the key elements of the ACCC’s reform proposals include:
We have previously suggested that the ACCC’s proposed changes to the process by which mergers are assessed, including formal merger clearance, are worthy of serious consideration. The changes would address defects in the current informal clearance regime and adjudication processes, particularly by empowering the ACCC to be the principal decision-maker and increasing the transparency of its decisions.
On the added measures, the proposed ACCC reforms are better for not aiming directly at market concentration, albeit that concentration will remain a significant element of merger investigations. This is for two reasons:
The ACCC’s proposed changes to the section 50 legal test are likely to have a significant impact on the chance of contentious mergers being proposed and approved. Mergers that have uncertain effects would be more likely to be blocked than under the current system.
One framework through which to view the proposed changes is whether they minimise the total costs of decision-making errors:
Compared with the existing legal test, the ACCC’s proposed changes will reduce errors of the first kind while increasing errors of the second kind. Both kinds of errors are relevant: while errors of the first kind harm consumers directly, blocking mergers that are pro-competitive will also harm consumers.[11] Undoubtedly, the balance of errors is complex to assess and we expect further debate over whether the proposed change restores or upsets the right balance.
Other proposals to structural merger factors seem more likely to be positive. The proposals focusing on accumulation of market power address long-standing concerns about creeping acquisitions but avoid placing increased weight on market concentration thresholds. This leaves more room for nuance in the merger analysis.
The ACCC’s proposals are a serious attempt to improve the processes and outcomes of merger reviews. Although the ACCC may be concerned about market concentration, it is helpful that the ACCC has not looked to tie its proposals directly to that concern – as is being pursued in the United States. While further debate on changes to the legal test is justified, we expect the ACCC’s proposed changes have reasonable prospects of improving competition and economic welfare.
[1] https://www.accc.gov.au/system/files/foi_disclosure_documents/ACCC%20FOI%20Request%20100067-2022-2023%20-%20Document%201_0.pdf (ACCC proposals)
[2] https://www.ftc.gov/news-events/news/press-releases/2023/07/ftc-doj-seek-comment-draft-merger-guidelines
[3] ACCC proposals, pp. 4-5.
[4] Remarks of FTC Chair Lina M. Khan, Economic Club of New York, July 24, 2023, p.3.
[5] The Agencies have amended the guidelines several times since the first guidelines were released in 1968, including in 1982, 1984, 1992, 1997, 2010, and 2020.
[6] Remarks of Chair Lina M. Khan, Economic Club of New York, July 24, 2023, p.2.
[7] United States v. Philadelphia Nat. Bank, 374 US 321, 363 (1961).
[8] Draft Guidelines, p. 17: “If the foreclosure share is above 50 percent, that factor alone is a sufficient basis to conclude that the effect of the merger may be to substantially lessen competition, subject to any rebuttal evidence.”
[9] ACCC proposals, p. 11.
[10] For example, in oligopoly settings, common market features such as cost asymmetry between firms or economies of scale can reverse the standard intuition that increasing concentration reduces economic performance.
[11] The ACCC suggests that the increased costs of errors will be borne by the merger parties rather than the public. That would only be true if the merger produced no efficiencies or did not otherwise benefit competition.
Frontier Economics Pty Ltd is a member of the Frontier Economics network, and is headquartered in Australia with a subsidiary company, Frontier Economics Pte Ltd in Singapore. Our fellow network member, Frontier Economics Ltd, is headquartered in the United Kingdom. The companies are independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Pty Ltd.
The Australian Competition and Consumer Commission has today released a consultation paper on NBN Co’s SAU variation. This follows NBN Co’s lodgement of the proposed variation in November 2022.
This latest proposal and consultation reflects further developments in NBN Co’s attempts to overhaul the existing SAU, accepted by the SAU in 2013, to reflect further developments in technology, increase certainty for access seekers on pricing, and move towards a more standard utility-style regulatory framework.
NBN Co’s proposed SAU variation follows a previous SAU variation, which NBN Co submitted in March and subsequently withdrew, and an extensive industry consultation process in 2021 to consider the future regulatory framework for the NBN.
NBN Co has also reinforced its preference to secure an outcome by early 2023 and allow it to develop new systems and prepare to implement a varied SAU on 1 July 2023.
NBN Co’s latest proposals are accompanied by two expert reports prepared by Frontier Economics:
Climate change impacts will continue to unfold across Australia with increasing severity in the years ahead. This will result in a set of complex and material financial implications for business. For Australian business to confidently rise to the challenge of systematically measuring, managing and mitigating risks and opportunities of climate change it will need a sound understanding of how climate change will most likely impact its finances. This Bulletin discusses Frontier Economics and Edge Environment’s approach to extending climate risk frameworks to build business cases for climate response against the inevitable, and potentially disorderly, climate transition ahead.
After centuries of relative climate stability, the world’s climate is changing. As average temperatures rise, acute hazards such as floods and fires and chronic hazards such as drought and sea level rise intensify. These hazards are categorised as the physical risks of climate change.
The frequency and severity of weather events in Australia is increasing and may further intensify as ecosystems are pushed beyond tipping points. Recent weather events in Australia such as the unprecedented rainfall and flooding in South-East Queensland, New South Wales and Victoria, extreme heat in Western Australia and the 2019–20 bushfires have resulted in highly significant financial losses for businesses and the communities they operate in.
Climate risk, however, remains an emerging discipline compared to other traditional risk areas. Climate risk management will necessarily grow in importance over coming years – recently, the Australian Prudential Regulation Authority (APRA) warned business around the need to prepare for “rapidly increasing expectations” on climate risk disclosure.
Against this backdrop, forward looking businesses are taking steps to understand, quantify and manage their climate risk exposures.The good news is we have the tools to address urban heat: integrated planning of our natural and built environment covering blue, green, and grey infrastructure.
The Taskforce on Climate-related Financial Disclosures (TCFD) reporting framework has emerged as the global benchmark in climate risk reporting. It seeks to make businesses’ climate related disclosures comprehensive, consistent and transparent. TCFD enables effective investor analysis of a company’s demonstrated performance of incorporating climate related risks and opportunities into businesses’ risk management, strategic planning and decision making.
The TCFD was set up in 2017 by the Financial Stability Board – an international body of regulators, treasury officials and central banks – to provide voluntary recommendations on how business could voluntarily disclose the risks and opportunities from climate change (see Box 1).
The purpose of TCFD is to provide a framework for organisations to make consistent and transparent climate-related financial disclosures. The TCFD framework document provides the following overview of the types of disclosures that it recommends:
It is recommended that the business provides its disclosures in their public annual reporting.
Source: Recommendations of the Task Force on Climate-related Financial Disclosures
Since being first published in 2017, TCFD has been rapidly adopted by a broad range of organisations across the globe – the 2022 status report for TCFD points to TCFD “support” encompassing US$220 trillion of assets and US$26 trillion of combined company market capitalisation.
There is a trend towards mandating climate-related disclosures. Mandatory climate risk disclosures have been announced in jurisdictions including the UK, the EU, Hong Kong, Japan, Singapore and New Zealand. Significantly, the United States Securities and Exchange Commission has proposed rules to enhance climate-related risk disclosure drawing from the TCFD recommendations. Collectively, these actions will set norms and expectations for Australian businesses to develop their own disclosures.
In 2021 the New Zealand Government passed legislation mandating climate-related disclosures for around 200 financial entities. Further to impacting those covered by the introduction of this mandate, the move is widely expected to act as a catalyst for increased climate-related disclosures across businesses operating in the wider New Zealand economy.
While TCFD is ultimately intended to support more informed capital allocation by investors, it can also be an important tool for organisations to respond to the risks and opportunities of climate change.
For an approach to inform practical decision making it needs to provide climate-related impacts in financial terms:
Clearly this is a complex task, but it needn’t be daunting if we have the right tools and systematic approaches. Finding a solution requires assessing the changing climate exposure and vulnerabilities of an enterprise through time. A collaborative approach which brings together the key stakeholders across an enterprise provides the means to map the material climate impacts, their drivers and the likely financial consequences to the company. This collaborative approach also enables joint ownership of critical uncertainties to be addressed within business’ operations, financial reporting and data management. A structured approach is then required to cut through the uncertainty and deliver a clear path forward to adequately measure, manage and mitigate climate risks.
Frontier Economics and Edge Environment have partnered to combine our skills in financial analysis, ESG, risk management, climate science and sustainability to work through this complexity (see Box 2).
Edge Environment and Frontier Economics have worked across a broad range of climate risk and resilience projects, mostly within the property, infrastructure and government sectors. Together, this partnership provides a unique opportunity to better understand both financial risks and opportunities of climate change for Australian and New Zealand businesses.
Edge is a specialist sustainability services company focused on Asia-Pacific and the Americas. Its teams are based in Australia, New Zealand, the United States and Chile. Edge exists to help its clients create value from tackling one of world’s most fundamental challenges: creating truly sustainable economies and societies. Edge does this by combining science, strategy and storytelling in a way that gives clients the confidence to take ambitious action, and do well by doing good.
Source: Frontier Economics
Confident climate-risk decision making requires a multi-disciplinary approach, incorporating climate science and financial analysis. However, deep technical expertise alone is not sufficient.
There is also a need for broad buy-in and engagement from within and across an organisation in order to access information, form granular insights, identify key operational climate-related impacts and quantify financial consequence. Organisations are encouraged to systematically look beyond the acute and direct impact of extreme events but also to the aggregated impacts of chronic and indirect effects of climate extremes.
Even with all these elements, it can be difficult to know where to start a climate-related financial analysis.
A useful starting point in analysing climate-related risk and opportunities is to assess the impacts of recent extreme climate events – such as the Eastern Australia bushfires and drought of 2019-20 and the extreme rainfall of 2021-22 – on a business’ operations and related cashflows.
This “looking back to look forwards” approach provides multiple advantages. It allows the:
The logic mapping and notional financial consequences can then be tested and validated using actual operational and financial data to identify the impacts of recent extreme events.
This approach also clearly highlights any data gaps which limit the extent to which financial consequences can be isolated – providing insight to improve risk management systems.
This baseline analysis has standalone value as it provides a snapshot of the resilience of an organisation to recent climate change events which can be linked back to materiality thresholds in a firm’s enterprise risk framework. It is also vital in building a foundation for robust and defensible scenario analyses of the likely impacts of future climate extremes on an enterprise. It can be used to inform forward looking analysis of climate change impacts, which considers both cash flow and asset valuation risks and opportunities.
The approach taken by Frontier Economics and Edge Environment focusses on undertaking robust, transparent and actionable analysis. For example, we focus first on the short-term (to 2025) before extending analyses further into the future. A short-term lens reduces uncertainty and allows organisations to home in on impacts which require urgent action. It also allows for extensions such as cost-benefit analysis to support investment decisions around certain interventions.
Building the business case to confidently make decisions about managing your organisations climate risk is a journey – come and talk to us about getting started.
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Once thought of as purely an environmental issue, climate change is now recognised as a major threat to economies and financial markets around the world. As a result, public and private sector organisations are being asked to provide public disclosures of how current and future climate risks will impact their operations.
Recognising the increased need for climate change impact reporting with a greater focus on financial analysis, Frontier Economics and sustainability services consultancy Edge Environment are very excited to be partnering with each other to offer clients advice that combines in-depth environmental expertise underpinned by solid economic analysis and modelling.
“The requirements for climate disclosure reporting have been increasing around the world in recent years. We have seen climate change shift from being primary an environmental or “green” issue to one with legal, governance and financial implications” said Dr Mark Siebentritt, Edge’s Commercial Director and one of its climate risk analysis experts.
“We are seeing many of our clients step up their analysis of climate risk. This is in response to commentary by financial regulators in Australia about the need for companies to address what is now regarded as a foreseeable and material risk. Change is also coming through international markets with some countries like England and New Zealand headed toward mandatory climate risk disclosure reporting.”
One of the key challenges of climate risk disclosure reporting aligned to frameworks like the Taskforce on Climate Related Financial Disclosures (TCFD), is the need to better understand the financial implications of climate change.
“The impacts of climate change on the financial statements of an organisation is complex. Companies can find it challenging to do this as there are many drivers that need consideration. For example, take the impact of extreme heat on a property portfolio. You first need to understand the risk of such extreme weather in different climate change scenarios. Then you need to understand the physical impacts of extreme heat, this may include increased energy costs, damage to the property and even consideration of whether the property is unhospitable in extreme heat. Finally, you need to place a financial value on these physical impacts. Climate risk specialists and financial experts working together can give companies these insights” said Ben Mason, economist at Frontier Economics.
“A key risk companies are often interested in is around energy supply transitioning to renewables and the impacts on energy prices. We have energy network models and have provided shadow carbon price advice to various clients.”
Building on our expertise in TCFD reporting, Frontier Economics is expanding into ESG related advice more broadly. Ensuring decisions are based on sound and rigorous economics is critical for companies navigating this complex area.
Background
Edge Environment and Frontier Economics have worked across a broad range of climate risk projects, including within the property, infrastructure and government sectors. Together, this partnership provides a unique opportunity to better understand both financial risks and opportunities for Australian and New Zealand businesses.
About Edge Environment
Edge is a specialist sustainability advisory company focused on Asia-Pacific and the Americas. Its teams are based in Australia, New Zealand, the United States and Chile. Edge exists to help its clients create value from tackling one of world’s most fundamental challenges: creating truly sustainable economies and societies. Edge does this by combining science, strategy and storytelling in a way that gives our clients the confidence to take ambitious action, and do well by doing good.
About Frontier Economics
For more than twenty years, Frontier Economics has contributed sound economics to many important debates and decisions in Australia, New Zealand and the Asia-Pacific. Governments, regulators and businesses use our economic advice to inform policy development, market design, regulation and investment. Frontier Economics prides itself on delivering quality, independent economic input that can lead to better decisions and better outcomes for our clients.
The Supreme Court of Queensland today dismissed the legal action brought by Wilmar Sugar (a large miller) against Queensland Sugar Ltd (a co-operative that has the role of marketing the Queensland export sugar crop). QSL's approach was to lock in prices via futures contracts during the season based on crop forecasts provided to it by millers. Heavy rain in one season resulted in a shortfall relative to futures commitments that resulted in a loss.
Frontier Economics advised the lawyers acting for QSL. Frontier's report explained that QSL's stated and agreed role was not to manage volume risk, but to maximise prices. It also demonstrated that the analysis presented by Wilmar was based on an economic framework that was inappropriate in the circumstances, and that the results were almost entirely driven by two historical data points that were unlikely to be repeated due to structural changes that had occurred in the industry. Frontier Economics chairman Stephen Gray, and Professor of Financial Economics at the University of Queensland, gave evidence in the Supreme Court. His evidence was well-received by the judge who noted that he found Professor Gray to be an ‘impressive witness’. QSL has indicated it will seek compensation for costs associated with Wilmar’s legal action.
Frontier Economics regularly provides economic advice and analysis in legal disputes, including those regarding financial instruments and quantification of damages or loss.
The Australian offices of Frontier Economics will be closed from 5pm Monday 24 December 2018 and will re-open at 9am on Wednesday 2 January 2019.
The Singapore office of Frontier Economics will be closed for the public holidays of Tuesday 25 December 2018 and Tuesday 1 January 2019.
We wish you all a Merry Christmas and hope you enjoy the festivities of the holiday season.
The Singapore office of Frontier Economics has moved. Our new office offers us greater flexibility for growth and additional features to support our work.
“Frontier’s presence in Singapore continues to expand and we are excited to have worked with many new clients as well as longstanding clients on new matters and in new jurisdictions across the Asia-Pacific region. Our new office will provide a larger platform to support our continued growth in Singapore and beyond” says Frontier (Asia-Pacific) director James Allan.
From our base in Singapore, Frontier Economics is fully committed to providing independent, high quality economic advice across the region.
Frontier Economics can now be found at:
60 Anson Road
Level 17, WeWork
Singapore 079914
Tel: +65 9450 5627
Justice Jonathan Beach of the Federal Court of Australia today handed down his judgment in the case brought by Australian Securities and Investments Commission (ASIC) against Westpac.
ASIC had brought proceedings against ANZ, NAB and Westpac for attempting to fiddle the Bank Bill Swap Rate (BBSW) by artificial trading. ASIC alleged that the fiddling was aimed at pushing the rate in a direction that would enable the bank to gain in contracts which had to be settled contingent upon the rate of that particular day. ANZ and NAB settled with ASIC; but Westpac continued to fight. Justice Beach found that Westpac had acted unconscionably on four occasions.
Frontier Economics advised ASIC during the course of the litigation.
Frontier Economics director Jason Hall is presenting today at the Australasian Finance and Banking Conference in Sydney. Jason will be explaining some recent work estimating the market value of imputation credits, outlined below.
Imputation tax credits are the credit an investor gets with a dividend for corporate tax already paid in Australia. The imputation system has been around for 30 years and there is still no consensus about how much the credits are worth. This is an issue because credits are not separately traded. You either get a credit with a dividend, or you don't, and only Australian resident investors get a cash flow benefit from the credits. For example, they are not useful for U.S. investors.
This creates a problem. As an Australian you get a large cash flow benefit from receiving a credit and if it was only Australians buying Australian-listed shares, you would pay more for a share that gives you a credit than a share which doesn't. But the international investors don't care about the credits. So when you have a market with Australian and international investors, it is an open question about how much higher the share price is if the company pays dividends that are accompanied by a tax credit.
It is considered important amongst regulators and regulated entities because the regulator makes an estimate about the value of the credits. The higher the assumed value of the credits by the regulator, the lower the revenue stream the regulated entity is allowed to earn. So the estimation of this single parameter affects the aggregate revenue stream of regulated entities by hundreds of millions of dollars.
The paper, co-authored by Stephen Gray, allows us to estimate the market value of imputation credits. We developed a novel technique that allows us to jointly estimate the value of cash dividends and credits (recall that it is hard to separately value them because credits are not traded). Our technique involves making an assumption about the distribution of error terms in regression analysis and then generating thousands of simulated samples in order to estimate confidence intervals.
Further, our research method has applications amongst any empirical analysis in which two of the explanatory variables are correlated. For example, suppose you were measuring the relationship between running times, testosterone and gender. There is correlation between testosterone and gender (if you code males = 1 and females = 0 there will be positive correlation between testosterone and gender); or suppose you were measuring the relationship between consumers' willingness to buy a train ticket as a function of (1) income and (2) distance to the CBD - people living close to the CBD have, on average, higher income so there will be negative correlation between income and distance. Our method has applications to those cases.
Click here to access the PowerPoint presentation (17 mins duration) and a transcript. (Please open the audio PowerPoint presentation as a slide show: the audio should automatically play).
The full research paper is available here.
