SP-INSIGHTS - Silverbergh Partners

Go to content

Main menu:

Insights
Commodity trading (1/2019)

Commodity trading value drivers 2019


Introduction
As we start into 2019, the hope is that the upcoming year will offer more trading opportunity than in the previous year. 2018 has been disappointing in terms of overall price development but did offer more trading opportunity by the end of the year. Can this positive sentiment be taken into 2019 and will it prevail throughout the year? What are the key value drivers to watch as the year matures?

Starting point
Looking back, some of the value drivers with a negative impact on trading activity and opoortunity we pointed out already in 2017 prevailed into the 2018 trading season incl. e.g. low volatility, narrow correlations, limited liquidity at the long tail.  Overall after a good start in the beginning of the year, commodity prices contracted over the 2018 trading period. By the end of the year, volatility picked up attracting more capital. As such, some market participants contempleted to ramp up their trading activity.  So, what can we expect from the 2019 trading season?
 
Trends to watch
In line with our overall value driver perception, we expect that political risks will play a more important role than in the past. Discontinuities in the political arena become more frequent and will leave their mark on trading markets. Will this be negative per se for trading activity? No, on the one hand, economic supply-demand fundamentals might be affected. On the other hand, this will also be a driver for volatility which creates trading opportunity.  If this is captured and if market participants ‘play their hand successfully’, it will offer the opportunity to capitalize the existing trading activity and hence renew the ‘license to trade’. This is a challenge several commodity trading market participants intend to resolve in 2019.
 
Independent of supply-demand fundamentals in different asset classes, overarching patterns are important to understand as they may leave their mark on a single market. As several markets are globally traded and USD denominated, the role of the US and the state of the demand side are of utmost importance.

 
  • Stimulating impact: From a global supply perspective, oil production increases. However contracting oil supply from individual suppliers e.g. Venezuela and Iran will contribute to higher prices. Additionally, the agreement of the OPEX+ countries to maintain the recently agreed quotas will add to price discipline. Spill over price effects into other commodity markets (e.g. softs and metals) might appear. Spiced with some geopolitical uncertainty e.g. LATAM, US-Russia-China and potentially new conflicts in Eastern Europe will add to price volatility. A weaker USD might also support stronger commodity prices. What would one have to believe in order to see this materializing? The US FED would need to keep interest rates at low levels (in order not to kill economic growth and put burden on the unemployment rate). Additionally, the US trade deficit would need to remain high without the possibility of a fast trade agreement e.g. with China (reducing the trade surplus). This stimulus can still take effect even though economic perspectives in China today are softer than expected last year. The Chinese economy slows down and order book effects in Chinas machinery industry can already be perceived.
 


  • Softening impact:  Trading market conditions however might remain challenging if global growth slows further. This might be the case if e.g. China has to further correct growth numbers downwards during 2019. Brexit negotiations might stall adding more uncertainty to the transition process with the result of slower international trade and consumption. Unresolved trade conflicts or additional trade hurdles (tariff & non-tariff) would support this outcome. On individual commodities like gas, oil, coal or palm oil regulatory interventions, revised political objectives or amended technical specifications might put pressure on current price levels. Additionally, supply-demand balances of fossil fuels in the energy supply portfolio e.g. fuels, coal will be impacted as sales of electric vehicles (EVs) increase. Premium automotive manufactures will launch several models in 2019/20 and will start volume production. Also, the build out of renewables will continue in line with public policy objectives internationally. On the contrary as there is a potential softening impact of this development on fossil fuels, this would substantiate a continued stimulus for some metals e.g. copper.

Summary
What do we conclude?  Challenges and opportunities are distributed slightly differently compared to the previous year. We perceive a riskier and more volatile politically induced economic macro environment. However, there are strong signs for somewhat attractive trading market conditions and prices in 2019.  Some instability might create additional trading opportunity rather than destroy a positive market sentiment.
 
Outlook
For some market participants, 2019 will be an important year as they have to proof that they can create value and can attract capital for trading purposes.
 
Either trading performance will increase, or decisions will need to be taken to re-allocate economic capital and review the trading footprint. As a result, some trading activities might be closed, sold or partnerships might be considered. These decisions will also be driven by the evolution of cost-income ratios (CIR), margins (which are tight today), a decreasing capital base and challenging conditions to re-finance respectively capitalize.
International policy trends & value management implications (3/2018)

GLOBAL SOLUTIONS 2018 - THE WORLD POLICY FORUM: Impressions and learnings for the value management agenda

Key discussion topics and themes are being revisited. Trends and their relevance for corporate leaders and a company´s value management agenda are pointed out.

 
Introduction
Global Solutions is a format established by the German Government during the German G20 presidency in 2017. Research based policy advice is provided by a research and policy network (T20) to G20 leaders as they prepare for negotiations in Argentina (2018) and Japan (2019). The summit was hosted in Berlin and was attended by policy experts, government representatives, multinational organisations, corporates and NGOs. We provide some impressions on key discussion topics and themes which are of relevance for a company’s value management agenda.

Key trends discussed …
Across several works streams, forums and panel discussions some views were broadly shared. Key international policy trends described below are not entirely independent.  However, they capture different aspects of the policy discussion today and provide angles how to identify risk exposure and risk mitigation.
 
  • Multilateralism: The believe that ‘multilateralism’ is a key value of international relations is shrinking.  Not only are perceived national interest in focus and isolationist policies spreading. Also, procedural standards, protocols and rituals in international relations are no longer taken as granted. Language and communication is eroding.  This has a destabilizing effect and is a mounting hurdle to balance conflicting objectives of nations and policy stakeholders.
  • Institutional stability:  Institutions can provide a balance to evolving conflicts as they offer a well-established platform and formats which have been accepted by member states.  From a a legal perspective, member states have entered into legal commitments. These commitments are binding and cannot be easily terminated unilaterally. However, several institutions have lost influence, are no longer effective as influential members have withdrawn their support. There are numerous examples. Almost all major international institutional frameworks or institutions are confronted with challenging questions regarding their legitimacy, validity or effectiveness: e.g. WTO, UN (and i.e. UNESCO), the NPT (Non-Proliferation Treaty) with Iran, the Kyoto Protocol, NATO, EU.
  • International financial framework: It is already conventional wisdom that in the next financial crisis we will face a ‘lack of instruments given current fiscal and monetary policies (QE: quantitative easing)’.  Additionally, some senior policy makers voice concerns that unlike in 2007/08 the mandate provided by the electorate to bail out financial institution last time will be lacking next time. This will also limit the solution space to cope with a next crisis.  


 
As a starting point for a potential crisis, mounting credit volumes esp. in the US were less of a concern.  The instability of the Italian banking system combined with a lack of convincing regulation and sliding fiscal discipline worries a broad range of experts.
 
From as fiscal perspective, taxation frameworks need to change. Personal and corporate income taxes linked to traditional industrial activities as a share of total tax revenue are expected to decrease.
 
  • Narratives: Narratives are slogans defining and describing the identity of social groups. There is wide spread agreement that these narratives are ‘increasingly influential and powerful’ changing identities, political realities and as a consequence policy frameworks. Nobel Prize laureate in Economics, Georg Akerlof, distinguished between ‘protector’ vs. ‘fulfilment narratives’. Examples of narratives are ‘Yes, we can …’, ‘America first’, or ‘Nobody cares about us’.  These narratives evolve quickly and spread fast also due to digital communication. Not only politicians but also business leaders are directly affected and need to decide how to react to or proactively address these narratives.
  • International trade regulation: Although recent events suggest that producer induced (protectionist) trade policies still rule trade policy making, the wide-spread opinion exists that this is changing. Consumer based trade policy regulation becomes more important.  Recent examples are data privacy rulings or international trade agreements like the Transatlantic Trade and Investment Partnership (TTIP) which have been significantly influenced by consumer opinion.
  • Digital policy framework: Surprisingly this has not really been a discussion topic during the summit. Other than data privacy which the EU recently regulated, and which impacts digital business models, policy stakeholders seem to struggle with understanding potential policy implications of ‘digital’.
 
As mentioned above briefly, the tax system will be affected. Other examples are standard processes in financial services, intellectual property rights exposed to additive manufacturing technologies e.g. 3D printing, security policies leveraging evolving digital security infrastructure and biometric information. In this area more work will be conducted.  

… suggest a less stable international policy environment going forward …
The expectation is that across almost all international policy trends, volatility (of potential outcomes and impacts) is increasing.
For ‘digital policy framework’, experts are undecided how this will evolve. Hence, there is a perceived uncertainty.
If agreements would be reached this would a new baseline but not a risk. Therefore, for this policy scheme unlike as for the other policy schemes, risk perception remains unchanged.
 
… but with differening potential impact over time
Short- and long-term impact: Most importantly decreasing ‘multilateralism’ is already impacting international relations, economies and businesses today. The expectation is that this will also have long-term consequences on several policy areas. Businesses are exposed to several policy areas beyond trade policies.
 
Latent medium- to long-term impact: Some policy trends are widely discussed but have not exhibited broader short-term impacts yet. However, the assessment on their risk realizations varies from ‘respect’ to ‘fatalism’.  ‘It is not a question that these risks will materialize it is more a question when this will happen …’. In this category are ‘Institutional stability’ and ‘International financial framework’.
 
Short-term risk with the potential to stabilize long-term: In this area are two policy trends. ‘International trade regulation’ is a key trend for which almost on a weekly basis risk realization can be perceived. Knock-on effects between different stakeholders and across different policy areas (outside trade policies) lead to a challenging situation framing and evaluating the risk. The hope remains that stability can be reached. A ‘new equilibrium’ however might look different from today´s situation.  New alliances of stakeholders, new policy frameworks and new institutions might evolve over time most likely in the context of new geopolitical realities and security frameworks.
 
‘Digital policy framework’ is associated with risks as not much has been agreed to date (e.g. cross-border autonomous mobility). If, however ‘digital’ becomes more a reality framed as policies rather than a concept the expectation is that risk perception will decrease.
 
Outlook
In the recent past, some industries have experienced already quite some realization of these risks within the key policy schemes mentioned above. Industries most impacted are e.g. financial services, commodities, agriculture, manufacturing/ automotive.
Some of the above-mentioned sectors can adjust in some areas. But that takes time and comes at a cost. They have faced immediate revenue losses (but also increases) as a result of international policy conflicts and adjustments.
If infrastructure sectors or long-term infrastructure like investments are impacted, corrections ‘after the fact’ are even more expensive and much more difficult to achieve.
 
Therefore, it is important to realize that the nature of international relations is changing and that businesses must cope with this new reality. As the ‘new normal’ will be less stable, businesses are well advised to take a more active role to integrate international policy induced volatility into their business rationales.  
 
This might imply, adjusting the portfolio mix of businesses or recalibrating an international value chain and manufacturing footprint.
Supporting activities might also be considered e.g. operational risk mitigation, hedging or forward sales, tighter cash flow management and treasury as well as targeted insurance protection (e.g. for exports).
REPRINT: The Future of Transportation - EXECUTIVE BRIEFING 2018 (2/2018)

The evolution of SMART transportation infrastructure

 
The digitization of the transportation sector will result in more comfort, convenience, and safety to users. On the other hand, stakes for EPC contractors, operators, and investors are rising. SMART transportation infrastructure relies on digital business models which are explorative and potentially volatile. Different types of operating models are being explored. The use of electronics and software implies new maintenance requirements and costs.  The regulatory framework is not set yet but is evolving over time.  Managing risk and volatility of this new asset class is central to future success. If this is achieved, additional private financing will be made available, closing today´s funding gap.

(COMPLETE ARTICLE: PLEASE DOWNLOAD BY CLICKING ON THE LINK TO THE RIGHT)
Raw materials sourcing (1/2018)

Increasing bottom line contribution …

Raw materials sourcing of FMCG/CPG companies, and in particular soft commodities sourcing has been challenged by market conditions.  Price volatility has been high, financial markets have been somewhat illiquid complicating hedging activities.  Accounting guidelines have been restrictive.
 
Sourcing practices are advancing, and markets continue to mature. Hence, it could be worthwhile to review raw material procurement program and close potential value leakages.

Performance pressure is increasing
FMCG and CPG companies are under increasing pressure.  It is much harder to ensure top line growth and profitability compared to previous years.
 
  • Market conditions are becoming fiercer and premiums of branded goods are under pressure
  • Portfolio restructuring takes time and comes at a cost
  • Digital transformation requires management attention
  • The creation of online channels is difficult; some firms struggle to implement them successfully
 
These are some of the reasons which are frequently being discussed.
 
For several FMCG and CPG firms’ raw materials and especially soft commodities are an important cost component. Could raw materials sourcing contribute more strongly to bottom line profitability?

Today, value leakage in commodity sourcing is significant
In several firms physical procurement rationales dominate commodities sourcing practices. Some markets have however developed into traded markets with significant volatility. Additionally, several markets are USD denominated and hence add currency exposure. Financial markets are not as developed as the underlying physical markets. Therefore, financial hedging opportunities are limited.
 
The influence on company profitability can be significant.  A key issue is also a lack of synchronization between sales, manufacturing and sourcing.  This is influenced by different dynamics in raw materials markets and product markets.




How can these differences be bridged and how can an agile organisation contribute to make amendments to the system to deal with e.g. seasonality, weather influences, competitive pressure, changing demand patterns?

Procurement practices are being upgraded
Companies are exploring a broad range of value levers to improve bottom-line profitability.  In this effort, commodity sourcing practices are moving into the focus. A few value levers companies experiment with are …
 
  • Hiring of commodity traders to manage commodity procurement operations
  • Accounting treatment of hedges (in IFRS and FASB)
  • Timing of shipments
  • Market timing respectively over- and under-hedging to contribute profitability
 
Strengthening raw materials procurement practices …
Some of the above activities might be justified. Experience shows that in some instances isolated initiatives could backfire and achieve the opposite.  In this case the value leakage increases.
 
It is very important that the procurement activities are closely integrated into the company’s overall financial and operating framework.  In several companies this integration can be improved.
 
It needs to be ensured that there is clarity of the respective value levers and roles and responsibilities to manage these value levers.
 
The raw materials value management framework guides the review of current practices as well as the comparison with adequate practices of other organisations.  A comparison would also need to reflect the business model employed. Otherwise any comparison would be flawed and would lead to misinterpretations.
 
The business model is embedded into a strategic rationale which is assigned to raw materials procurement.
 
  • According to which pattern is the procurement function supposed to source volumes?
  • Which degrees of freedom to amend/ change procurement volumes and patterns exist?
  • How is the procurement functions performance being measured and assessed?
  • Which functions interfere with procurement activities?



 
… will contribute to higher company earnings and enterprise value
Strengthening the raw materials functions set up will improve bottom line profitability and stability of earnings.  A more sustainable company performance will directly translate into a higher enterprise value.
Coal marketing & trading (5/2017)

Metallurgical coal: 'From Dusk Till Dawn ...'
 
A few pressing questions are evolving after a period of low met coal prices and recent price spikes: ‘How will tomorrow`s met coal prices develop? What will be the key drivers for future prices?’  This report discusses a market outlook into 2021. Potential implications for market participants are explored.

This report investigates the price development in the metallurgical coking coal market. It details the key levers for this development and assesses the likelihood of future development. The evolution of the met coal market is expressed in some distinct scenarios, with the underlying drivers for the respective developments discussed. Implications for different groups of market participants are highlighted as well.
 
The report is based on the analysis of future supply-demand economics and the behaviour of market participants. The evolution of physical and financial wholesale and trading markets has been assessed in the context of the past evolution of other commodity wholesale and trading markets. Expectations of market participants and their view of the evolution of met coal markets have been reflected in this assessment.

In previous years, met coal prices have softened …
Met coal prices have been decreasing for quite some time.
  • Before 2014: Price spikes of more than USD 300/t could be perceived (Q2/2011)
  • Early 2014: Prices decreased below USD 150/t (PLV, FOB Australia) coming down from more than USD 200/t
  • Q2/2015: Prices decreased below USD 100/t, staying below that mark for about 12 months
 
There has been a correlation between iron ore prices and met coal prices. Iron ore demand has been growing driving met coal demand but the demand growth rate has been declining. In 2014, demand started to plateau due to stabilizing demand in Asia.  This had an impact on met coal prices. Met coal prices consolidated. Given declining profitability in the mining sector, mining companies started to reduce met coal production capacity. As a result, production economics of the intramarginal mines stabilized.

 
… but more recently prices have recovered …
 Before 2016, marginal costs of production had been in the USD 130/t range. As mining companies restructured, high cost US met coal production capacities diminished. Therefore, the supply curve flattened. Marginal costs of production went down to USD 100/t.
 
However, supply constraints caused price increases. Chinese domestic production stalled. Logistics bottlenecks occurred and Australia faced production shortages as weather-related events lead to termination of some operations.
 
  • Q2 2016: Prices increased continuously above USD 100/t and above USD 150/t in Q3/2016
  • Q1/2017: Prices increased to more than USD 300/t. As such, it took 6 years to reach the same price levels as in Q2/2011
 
This is a very attractive price environment for producers and steel mills with integrated mining and steel positions.



 
… and have started to decline again
Since then prices have been declining. In September 2017, prices (PLV, FOB Australia) were still above USD 200/t. Prices CFR China dropped below USD 200/t.

Market participants are concerned about the future price environment and market conduct
Market participants are increasingly concerned with the market outlook.  Depending on how prices are expected to evolve, strategic decisions about future positioning in the market are impacted.
  • Ownership in production capacity  ̶  expansion vs. closure vs. acquisitions of equity coal positions
  • Establishment of marketing contracts and offtake agreements
  • Pricing of steel as input costs might change
  • Build-out of trading activity for prop trading and hedging activities
 
In the physical market, the demand side will gain importance
Unlike in the recent past, the market equilibrium will be increasingly influenced by demand side developments as supply constraints are removed. Future price evolutions can be expressed in scenarios characterized by underlying assumptions.
 
  • Base case: In this scenario, the supply-demand balance is stable. This is a solid basis for profit generation of miners.
    • Supply side: Australian production will recover. Supply constraints in China will be removed. After the 19th National Party Congress in October 2017, supply constraints will most likely be confirmed (but balanced in order to avoid GDP impact).
    • Demand side: Structurally, the demand composition will not change and demand will continue to grow.
    • Assessment: LIKELY ̶  Short-term, this scenario is in line with financial market expectations. Longer-term, the scenario is less certain and will depend on the evolution of monetary policies and the economic health of the global economy.
 
  • Low case: In this case, high prices today will stimulate production. Mines will open, productivity will increase, and demand will start to contract.
    • Supply side: Australian output will increase by more than 12 Mt by 2021.  New supply sources will develop as planned, e.g. in Mozambique and Indonesia.
    • Demand side: Chinese demand will be balanced. Demand for residential housing construction will be limited and shifted to support a further build-out of infrastructure developments. Indian import demand growth will slow.
    • Assessment: SOMEWHAT LIKELY ̶  The supply side might expand more strongly as opportunities arise, which would be in line with market conduct as experienced in the past.
 


 
  • High case: This case is characterized by overshooting prices as supply-demand will be out of balance.
    • Supply: Chinese domestic supply will be significantly constrained. Australian production capacity additions will enter the market as planned.  Domestic restrictions, met coal capacity additions and productivity increases will be more severe than anticipated today, e.g. labour. Today, total capacity additions are expected to be in the range 0f Mt 12 p.a. by 2021. They will not be reached. High cost US suppliers will increasingly act as swing suppliers as Australian production fails to meet demand.
    • Demand: Longer-term demand will increase due to the following influences: Urbanization will increase and steel intensity of global GDP will decline less than expected. Steel intensity in China will increase, African steel demand will pick up.  Modernization/relocation of Chinese steel mills will lead to higher seaborne import demand. Access to credit, especially in China and Japan, will remain unconstrained and hence construction activity will continue to grow.
    • Assessment: LESS LIKELY  ̶  The combination of significant supply and demand assumptions is probably less realistic.

  • Break out: This scenario is in line with the base case into 2018. As of 2019, prices might drop below the marginal cost of production of about USD 100/t.
    • Supply: Significant investments will be made and will foster additional supply. Productivity improvements will go beyond the expected rate. Australia will build out capacity beyond the Mt 12 p.a. by 2021. This would be more in line with productivity estimates around the 2014/15 timeframe. Mozambique will expand production beyond Mt 10 p.a. by 2021.
    • Demand: Demand will be contracting induced by central bank policies, access to credit, and/or Chinese demand regulations, especially in process industries and electricity generation. This will also affect mining and steel manufacturing. Indian demand will increase but will stay below expectations.
    • Assessment: SOMEWHAT LIKELY  ̶  Quantitative easing (QE) of monetary policies of central banks is phasing out. Access to credit and exchange rates might be impacted within a five-year timeframe.
 
There are some other influencing factors on met coal demand which might gain relevance to the end of the forecast period or after 2021.
  • Use of blast furnace vs. arc furnace (and use of scrap metal)
  • Traditional blast furnace vs. pulverized coal injection (PCI) may lead to increased demand of soft coals.  This would result in narrowing met coal price differentials (hard coals vs. soft coals)
  • Demand substitution, e.g. in automotive (aluminium substituted by steel)
  • Change in steel product mix, e.g. long vs. flat products (potentially influenced by Chinese regulation)

Across all scenarios, profitable production economics are expected
To summarize the evolution in the physical market, there are a few takeaways:
 
  1. Today´s high prices will not remain.  Over time they will come down to reach significantly lower levels much more in line with historic prices.
  2. Prices will stay above marginal costs of production until 2018/19 in all market scenarios. Only in the ‘Break out’ scenario will prices drop slightly below marginal cost. Only price setting mines will be challenged to earn their variable costs. All other mines will generate profits and (part of their) capital costs of mine expansion and productivity, increasing investments. However, as the supply curve flattens, the inherent profitability of intramarginal mines should decrease (as the producer surplus decreases).
  3. Very low prices are not expected. In 2015/16 prices were significantly below USD 100/t.   This situation is not expected to return.
  4. Price setting is expected to remain linked to spot prices. Although there are some efforts being made to squeeze out intermediaries, which in part has been successful, a broad return to quarterly contract prices is not expected. As prices have become transparent a fixed price regime would be associated with costs. A price differential between a fixed price contract and a spot market linked contract can be observed. The challenge with spot price linked contracts, however, is to deal with increased price volatility.
 
From today`s perspective, the next five years are expected to exhibit a higher and more stable price environment compared to the previous five years.

Financial markets are developing
Financial markets are developing. The Chicago Mercantile Exchange (CME) as well as the Singapore Exchange (SGX) are quite active in met coal trading and offer a range of products.  SGX just recently launched an options market. Over the counter markets (OTC) have become more liquid.
 
Chinese traded paper markets, however, have consolidated over time.  They are significantly influenced by the inflow of speculative capital.  Volatility is significant, owing to speculation and still limited daily trading volumes. This is a burden for price discovery and hence will prohibit a healthy accumulation of market liquidity, as forward sales and hedging activity are hindered. However, speculation is not a problem per se. Once there is more market liquidity and decreasing influence of speculation on market prices, speculators will contribute to robust market conditions as they provide additional liquidity and facilitate risk transfers.

Market participants might want to review their positioning to capture upside
Every market participant might want to establish a view how he is potentially impacted by future market conditions. He might also explore the evolving opportunity space.
 
  • Mining houses: Should the mining portfolio be reconfigured? How much capital should be devoted to mining extensions and greenfield developments vs. exploitation of existing brownfield operations? Should more flexibility be built into the portfolio to better cope with future price fluctuations?  How can miners offer steel mills price stability and what would be the business case associated with this?
  • Traders:  How should met coal offtake agreements be negotiated?  How should some of these met coal positions be sold-off into the market by providing price stability to met coal consumers and at the same time monetizing today’s high prices? How should cross-commodity plays be built out?
  • Steel mills: How should met coal (and iron ore) be bought going forward?  How should the commodity volatility be managed? How should financial hedging vs. other mitigation techniques be applied?
  • Professional investors: Is this an opportunity to seek more met coal (and iron ore) exposure?  If so, what would be the right mix of financial instruments, e.g. equity investments? Should individual investment opportunities or portfolio choices be revisited?
 
As several market participants have a positive perspective about the future market evolution they are already addressing some of the above questions.  There are still opportunities to be captured but positions are already being taken.
Blockchain SPECIAL

The evolution of 2nd generation crypto currencies

Crypto currencies (CC) are attracting increasing attention not only as payment instruments but also more recently as an investment asset class.  The underlying blockchain technology is moving into the mainstream enabling payment processes, efficient operating processes and identification procedures.  Hence, it is expected that for future transfer of financial assets, blockchain, and more specifically CCs, will gain significant importance. On the contrary however, doubts have been voiced more explicitly that given some structural deficiencies, crypto currencies fall short of traditional currencies and will not prevail as such.  Therefore, they may not substitute or even complement traditional currencies on a larger scale.
 
In this article, we will investigate the deficiencies of CCs today. Functionalities of traditional currencies are being revisited and discussed whether they apply to CCs as well.  Some suggestions will be provided how CCs could be further developed into more widely used ‘currencies’.  As such, CCs might become more competitive and relevant and as a result gain market share as a means of payment, as a store of value and as an investment asset class.

(COMPLETE ARTICLE: PLEASE DOWNLOAD BY CLICKING ON THE LINK TO THE RIGHT)

P2P energy networks (4/2017)

A win-win-situation to be monetized

These days, distributed energy solutions are very much discussed from a technical angle. They however have the potential to be the foundation for new business models and to take commercial customer relationships to new levels. We might see a closer integration of the energy industry with the financial services industry. For every market participant, there are significant potential gains in this development. It needs to be seen who will take the lead – incumbents, new entrants, investors or regulators.
 
The energy market is still in a crisis mode.  However, investments into distributed energy generation are expected to be in the range of USD 200-300 BN per annum. Until now a centralized energy landscape has prevailed. Going forward, a more decentralized energy system might be a way out of today’s energy dilemma.
 
Different stakeholders would benefit from this development and some arguments will be presented why this would be the case.
 
  • Customers: Attractive, stable energy costs and a sustainable energy supply
  • Utilities: New solution business with attractive margin potential for incumbents as well as new entrants
  • Investors: New infrastructure like investment opportunities
  • Regulators: A more stable energy supply system

A more favourable market environment for decentralised energy solutions …
Decentralized energy solutions do exist for quite a while. In some markets e.g. Germany solar has become a quite sizable segment. New business models are evolving attracting significant investments e.g. Tesla, Northvolt, Vattenfall/ BMW i3 batteries …
 
This time, there are several reasons why decentralized energy solutions might take off and scale.
  • Grid parity has been reached as several renewable technologies have industrialized and are competitive from a cost perspective
  • Price spreads have narrowed significantly erasing fundamental margin potential for conventional centralized generation in wholesale markets (spark & dark spreads, location spreads, base/peak spreads)
  • Traditional generation has aged, is phasing out or is already scheduled for phase out (nuclear)
  • Large scale renewables projects or regulated midstream investment opportunities are less available
 
Additionally, new technologies are maturing and are becoming financially relevant.  

… and an accelerated technology development
From a centralized perspective, efforts have been underway to flex the energy system (e.g. gas-to-power). Flexibility in wholesale contracts has been very much exploited. Demand side management in retail markets has however not been very effective.
 
In the last few years’ efficient energy technologies have become commercially available also to end users (e.g. heating, CHP, solar).  Additionally, communication interfaces are being deployed through SMART meters enabling customer specific communication and pricing.  

Sufficient electricity storage capacity is still missing which would allow the balancing of increasing volatility from renewables (esp. wind but also solar). As battery prices are coming down also due to the evolution of e-mobility, more efficient decentralized energy solutions will become available to SME´s and retail customers. In 2017 an accelerated cost down of battery costs of another 35-40% driven by Chinese manufacturers is expected.

2nd generation decentralized solutions providers will reach profitability
The 1st generation of decentralized solutions providers was very much hardware driven. With further technology development, their business case will become more compelling.  
 
A 2nd generation of decentralized solutions providers has entered the scene. Beyond the hardware aspect they include other elements into their business model e.g. stronger operating expertise, financing, payment systems and/or peer-to-peer energy networks (P2P). The latter aims to balance deviating supply and demand patterns across the system. Settlement of imbalances might happen physically or financially. This constitutes decentralized market design.
 
Through technology, energy P2P networks might integrate with other P2P markets as well as with centrally organized wholesale markets. Each arrangement or structure will fulfil certain roles e.g. identification or market participants, administration of contracts, price discovery, settlement.
 
Dezentralied market design evolves across different sectors
In wholesale energy markets as in capital markets, market operators and exchanges are consolidating.  Major drivers are economies of scale and characteristics of natural monopolies. In some of these markets, market operators have started to experiment with technologies allowing them to identify market participants better and to administer trades more effectively and efficiently. Blockchain is being tested as a lever to improve effectiveness and efficiency and as one element of a future P2P energy solution.
 
In payments, also blockchain based approaches have been established.
 
E-mobility markets will be at the interface between mobility, energy and financial services. Payment solutions are required to also charge cars and to determine the identity of the user. As electric cars will not only withdraw electricity from the grid but also feedback into the grid at a later stage, SMART grid capabilities will evolve. In this new environment, the market rationale will transition from a technically dominated perspective of supply sources and demand sinks towards a user/customer centric perspective. Contributing to a balance/ imbalance in the system will be associated with a price and the customer will be priced/ rewarded accordingly. Today, some of the commercial mechanisms rely on statistical patterns (e.g. standardized load curves).  In the future, grid interactions will be individualized in line with specific demand/supply patterns.
 
Some implementation hurdles remain
As we are still in the early stages of the development, some implementation hurdles remain but are being addressed already.
 
  • Strategic ambition of incumbents: Incumbents are on their way to determine how to best balance legacy and new businesses. Some new businesses are not as profitable as the legacy business which leads to discussions whether new business models should be pursued.
  • Grid tariffs: Traditional grid tariff designs have not been developed with the idea that P2P balancing would be possible or that individual demand/supply patterns might matter. Depending on which grid levels are being used, grid costs are still substantial. Grid operators and regulators are aware of the issue and investigate options to potentially amend grid codes.  Further decreasing hardware prices might compensate this cost disadvantage.
  • Payments: A common standard would be favourable – currently, this is being driven by the e-mobility sector. Once established, it could also be utilized in stationary energy solutions.
  • Risk exposures: As more sizable implementation schemes have not been defined yet (given some of the implementation hurdles), risk exposures of such schemes have not been formalized. Once risks are identified, evaluated and formalized the investment case can be matched with a financing structure. If investor expectations are met, capital will be attracted.
 
As implementation hurdles are being removed, new value pools can be monetized.

Benefits for supply side market participants
  • Incumbents: There is the opportunity to transform the customer relationship if a standard supply contract is being replaced by a solutions contract.
    • There will be several margin components e.g. for hardware, financing, operations contract, backup power, broadband services …
    • The customer relationships will be more sticky as short notice contract cancelations will be less likely to happen
    • Upsell potentials for additional services might be investigated which are more dependent on customer insight, communication and financing offerings than just the supply of kWh or Joules.
    • Entering the market with decentralized energy solutions and scaling these can also be viewed as a defensive move prohibiting new entrants to break into the traditional supply business and to gain market share.
  • New entrants: A new business might be established as incumbents move slowly. Financing of the build out should be available if structured appropriately. In the past, hardware and ecosystem were significant entry barriers. Today, hardware is commercially available and competitiveness depends much more on which services are structured around the hardware. Experience from other sectors is therefore helpful to establish a customer value proposition e.g. telecom, finance, consumer goods.
  • Investors: New infrastructure like investments in a more competitive infrastructure market are available. Utility balance sheets are constrained and do not allow sizable funding. Record high capital inflow into today´s infrastructure market leads to reducing expected returns on investment. Therefore, this might be a new and attractive segment. Why is this the case?
    • It is in line with regulator ambitions to stimulate renewables build out.
    • It is more attractive than competing projects with funding needs. E.g. charging stations for e-cars exhibit more complexity. Technical standards are not clear yet (type of battery system and age of battery), uncertain adoption of new infrastructure, strategic risk of competing infrastructure, vandalism, …). For decentralized (P2P) energy solutions, several risk and value drivers can be determined upfront. The hardware (e.g. PV with battery) is a cash generating asset (if there is a lease or a loan).  Electricity prices can be defined upfront and hence there is no or limited outright or spread energy price exposure. Counterparty/ credit risk is highly diversified and in case there is a default the hardware could potentially be recovered.
  • Regulators: This is a fully privately financed scheme which allows to replace some centralized generation capacity.  Countries with aged or obsolete infrastructure would benefit most from adopting these schemes e.g. if there are high shares of old conventional generation (fossil and nuclear) or weak and congested grids.
 
The regulators might want to consider to which degree a new energy landscape is more stable and instrumental for the redistribution of externalities. Centralized generation (also renewables) exhibit some negative externalities (environmental damages, emissions, downstream infrastructure build out …). With the roll-out of decentralized units several externalities are being internalized. Also, the shut down costs would be cost neutral for the public. The question is whether this should be reflected in the regulatory framework resp. in an amended grid code providing more favourable conditions to decentralized units and/or decentralized (P2P) energy solutions.
 
Ambitions for a future market position need to be clarified
Now is the time to review the position each stakeholder aspires and will most likely have in the future energy landscape. Actions should be defined accordingly and aligned with the strategic and financial plan.
Innovation management (3/2017)

Digitalization vs. innovation management

Digitalization is one of the most frequently used business terms these days. But where will it take the company? Will it be better off at some time in the future or is it a gamble with an unclear outcome? Given the hype around some developments in the digital space, it is worth revisiting some of the developments and calibrating the approach to digitalization.
 
Digitalization is a key area of focus in many companies.  Indeed, the speed of technology development is enormous and every day new technology businesses enter the scene.  Let´s take a break and revisit this evolution.
 
  • Importance of digital businesses created so far: As of today, 4 of the top 5 global companies in terms of market cap are digital companies – Apple, Alphabet, Microsoft and Amazon. Together they have a market cap of USD 2,2 TR. On the 6th rank Facebook follows with a market cap of USD 397 BN (1 March 2017).
  • Investments into digitalization: As of 2019 USD 2.1 TR will be invested into digitalization (IDC)

As digital company market values soar, corporations launch digitalization strategies and drive individual digitalization initiatives forward. Without any doubt, several of these programs will deliver what they were tasked to achieve. Even if this is the case and targets set by senior management will be achieved, will the company be better off afterwards?
 
Some surveys draw the distinction between digital innovation leaders and their high profitability and digital laggards with low profitability. But how about the other companies which are neither leaders not laggards but which try to identify their approach to digital which is best suited for them?

Digitalization is not a goal but an enabler to achieve goals
A significant part of the digitalization discussion is flawed.  It is not a goal to be digital but it should be a result of achieving a better value proposition for the customer and as a consequence enterprise value.  Hence, numerous digitalization discussions start from a wrong departure point.
 
More fundamentally what really matters is the companies approach to innovation management and the innovations. The stakeholders are
  • Customers: How does the company ensure a better customer value proposition and customer experience.  This can be further broken down into contributing items and measured accordingly e.g. relative price, product/service quality, response time, lead time to delivery, lifecycle costs.
  • Employees:  How can corporate innovations enable and support the individual as well as organisational units to better contribute to the customer value proposition and improve the efficiency and effectiveness of the operating model.

The solution to some of these challenges is not necessarily a digital approach but might be one. Additionally, a digital solution might even facilitate a step change making a conventional solution or approach redundant.



 
Innovating in a no-linear and non-deterministic market environment
It is important to understand that digital solutions need to be fit for purpose. These types of solutions will require iterations to have them established. Additional iterations are required to keep them up to date and in line with evolving requirements.
 
It would be a misconception to assume that senior management puts out an order and the organisation delivers.

On the other hand, there are companies which get involved with digital and which approach the topic very much with a linear top down thinking.  What might be the setbacks? Initiatives might be created which can internally be sold as progress but which lack market traction as they miss out on an improved customer value proposition. What are examples of such programs?
 
  • App creation: This nicely paints a picture of an innovative organisation. It is mainly used for communication purposes (which could also be done through other channels) and does not leverage technology for customer engagement
  • Development of new proprietary technology environments: A new technology environment is established and ideally additional partners are signed on.  The main line of thought is that ´the winner will take it all´.  The customer could not care less – his main problem is not a lack of a technology environment but a lack of a common standard which jeopardizes the interoperability e.g. in IOT.
  • In-house developments: In-house developments in a lot of cases take time and are costly.  A `not invented-here syndrome´ is not uncommon.  Being more pragmatic and rational to consider partnerships and acquisition to complement in-house initiatives would be a benefit for the innovation agenda.
Old-world linear top down thinking needs to be overcome. But how should that work?

Human interaction drives innovation
In order to innovate and potentially digitize and digitalize, (informal) human interaction is absolutely key. Solutions aspired are complex and cannot be fully specified upfront. But what are the ingredients for such a set up?
 
  • Decide on fit for purpose organisational structure – Organisational structure and organisational conduct need to be determined up front.  Is the innovation quite fundamental, a segregation from the legacy organisation should be contemplated. At a later stage, different organisational units could be integrated again. In case incremental or business process innovation is being pursued, this could take place in the legacy organisation.
  • Create an innovation friendly culture – This is more easily said but much more difficult to achieve. Key is an interactive work environment and the ability to communicate freely vertically as well as horizontally.
  • Enable risk taking and allow failure Traditional organisations sanction failure and hence individual risk taking is undermined. To assume that innovation comes without risks and failure is another misconception. Failure needs to be possible. However, management obligation would be to establish a process which contains risk taking and defines an institutional approach how the organisation will learn from mistakes. In technology companies this is done through stage gating in R&D processes with clearly defined milestones linked to economic considerations.
  • Link innovation goals to strategic aims of the company Applying a lifecycle rationale to business activities allows to distinguish generically between three different type of businesses a) old contracting legacy business b) mature core business c) growing innovative business (with the expectation to significantly contribute to the future revenue stream). Especially b) and c) demand innovation.  For a mature core business (b), process innovations are important to cash out over a long period of time. For a growing innovative business (c) a range of innovations is required – typically, product/ service innovation, manufacturing and production technology as well as go-to-market innovation and customer acquisition.  In all these cases, digital solutions might help to improve on all the performance dimensions e.g. quality, costs and speed. For a growing innovative business, the degrees of freedom are significant and the opportunity exist to innovate the entire value chain.

 

Digitalization needs to be embedded into an innovation management approach
What are the learnings?
  • Innovation management is risk and opportunity management typically in a risk averse corporate environment: As any other corporate activity, innovations need to take place in a given well defined budget framework. Within this budget, they need to deliver results. Earlier we discussed briefly how this is done by technology companies. In the start-up context Eric Ries (The Lean Startup) emphasises this aspect as well but uses a slightly different language. He talks about `innovation controlling` and the need to `pivot` once the innovation plan and innovation progress deviate. It means that new solutions need to be found to further progress the business and to avoid that the innovation and business building activity stalls.
  • Digitalization initiatives need to be embedded into an innovation management approach: Digitalization is no substitute for a innovation management approach and vice versa. Digitalization should follow the innovation agenda which again is aligned with the strategic and financial plan. Additionally, digitalization is sometimes confused with digitization – both are quite similar terms but are not the same.  Digitization stresses the technical aspects to move a business into the digital sphere, business dimensions are not really considered.
  • Digitalization requires creativity which needs to be governed through the innovation management agenda and framework: Digitalization initiatives in some companies fall short of this requirement. Therefore, important aspects to make the digitalization initiative successful are not defined.  Communication channels and cooperation models in the organisation are not defined. Conflicts of interest and incentives as set out in the performance management process prevail. This undermines human interaction which again is the basis for collaboration across organisational hurdles and fosters creativity.
Political risk (2/2017)

Coming to grips with political risk

In the past, the concept of political risk has been somewhat obscure.  Applications with relevance for day-to-day management have not been entirely clear. However, political events in early 2017 have fuelled the conviction that political risk is entering the global agenda again.  Risk management instruments as established in the past require sharpening and need to be  integrated into management routine.

 
Political risk or geopolitical risk is of increasing concern.  From a Western perspective, we have experienced peace and increasing wealth in recent decades.  Political risk has been basically discussed in the context of developing countries. As such, this has been of limited practical relevance for day-to-day management.  Shifting political preferences can be perceived in all global regions. Two major events have caused a debate which political risks we will need to face in the future.
 
  • The European perspective – Brexit: The UK vote to leave the EU has come unexpected.  There is a fear that in 2017 the EU might further disintegrate in the light of upcoming elections and fiscal instability.
  • The US perspective – Presidential elections: The victory of the Republican candidate had not been expected by the polls.
 
The new president is not only rolling out his domestic agenda. Other global regions are learning that the new US administration continuously adds new TOPs to global agenda.
So, is this covered by today´s understanding what political risk is? Are the tools available to add political risk to the management agenda?

 
Well established political and country risk landscape
Yes, there are surveys and tools which capture political risks.
 
  • Country risk ratings capture political risk on a country level.  These are meant to inform investment decision making covering dimensions like legal stability, capital movements and default risk. These ratings provide little information about how businesses might be exposed to the evolving political risk and how these could be mitigated. Examples are e.g. Financial Times, Association for Financial Professionals, EIU, Euromoney, World Economic Forum.
  • Risk inventory in companies covers some aspects of political risk but certainly not the dimensions of the evolving political risk landscape.  Risks in the risk inventory typically follow a geographic structure. Some political risks in the general discussions are somewhat generic and are difficult to handle in a specific company context e.g. `failing states`, `armoured conflicts`.
 
But a new class of political risks is evolving which can be summarized as `decreasing political consent`.  


`Decreasing political consent` - the evolving political risk
In Europe, new evolving political movements can be observed. Public opinion is shifting away from established political players. Consequently, new alliances and priorities are possible. Although economic well-being has increased across the board, social and geographic disparities are mounting.  The new US administration is putting established policy areas to the test.  It is quite articulate about potential future policy changes.
 
  • Global free trade – Free trade agreements are challenged and a revision of corporate taxes and customs regulation with the intention to foster domestic business activity are to be expected. The changes seem to be in line with the general WTO framework. However, the new trade policies might impact security frameworks e.g. in APAC the role of China. As a result, Europe as a trade partner for countries in the region might be elevated further.
  • International security framework – not only the Transatlantic Alliance is being questioned.  The new administration signals that it is willing to move away from the current frameworks in APAC and in the Middle East. These movements are paired with mixed signals threatening or appeasing rivals not ruling out sanctions or even interventions.
  • Stability of foreign relations and multilateral political agreements – Foreign relations in NA are being redefined. The policy framework regarding Russia and the Middle East is not clear yet but seems to be patchy and volatile. Europe will be affected whatever this framework will look like.  Current communications suggest that the role of the EU is viewed as an economic adversary rather than a construct which has secured peace in Europe for quite some time now.  Separation from the union is being supported (e.g. the Brexit).
  • Regulation of financial markets – The administration intends to review and change some of the financial market regulation which was created after the financial crisis. Indeed, there are good reasons to review the regulation and its effects.  Concentration of large banks has increased – this is the opposite what was intended with the regulations. As small and medium sized banks have been shaken out, loans provided to SMEs have decreased. On the other hand, international consent how to regulate financial markets and how to create a level playing field might be at stake. The Brexit will also leave its mark on financial market regulation with still uncertain outcome.

In the US and in Europe, the reason for a changed for a policy mix is routed in an increasing economic disparity.
Although some of these policy goals are controversial, also agreement to challenge established policy frameworks across thriving new political forces across regions and across the Atlantic can be observed.

Because of a changing policy environment, political risk becomes more relevant.

In Europe, political risk has become more important as well. Different elections will take place in 2017.  Most importantly presidential elections in France and Germany will influence how the EU will develop further.  Elections in Hungary and in some SEE countries will determine how stable the union is at its borders. Given increasing East-West tensions this will also have security implications.  
 
As the financial recovery of Greece does not develop as planned, the stability of Southern European countries is back on the agenda foremost Italy, Iberia and Cyprus. Immigration policies remain unaligned between the European partners.

The question is whether Europe will succeed to better form and execute common policy goals and hence strengthen the union or whether national interest will prevail increasing the likelihood of the union to further disintegrate.

Especially C-suit executives and boards are concerned that political risk might influence their financials significantly. Hence, they are convinced that their companies should prepare to mitigate political risks.

Observations on the evolving risk landscape
In early 2017 the signals are mixed.  The expectation that a change of the US administration would send equity markets downward, has not materialized. Quite the opposite has happened. Additionally, since the election, equity market volatility is low. So, is the debate about political risk overheated? We would argue that it is not.

The short-term market effects are driven by announcements of low US taxes compared with targeted expansionist government spent in a low oil price market environment.  These would also create a global stimulus.  

On the other hand, policy effects driven by political dissent as described above and to a degree sympathized with by political forces across global regions might have a contracting effect according to the economic rule book.

One should also be reminded that risk is not just the downside risk but also a potential upside. Maybe this is what we observe in early 2017.

Implications for the risk management approach
Clearly, country risk ratings provide political risk information in a highly-aggregated form.  As such, they are insufficient to provide guidance how to mitigate risks.  They need to be complemented by some explicit understanding which allows to link company operations to the risk perspective.
 
In the case of changing political forces and regulatory interventions, political aspirations need to be broken down into policy areas.
 
A good understanding of the solution space and trending within given policy areas allows to take a much more pragmatic approach to political risk management. Potential outcomes and implications for the company can be assessed.
 
Impacts for the company can be linked to functional and business areas.  Therefore, the financial impact of risk can be assessed.
  • Example 1: Sales – How will new US customs regulations or an amended tax scheme influence the companies top and bottom line? Will it lose some of the export markets due to political instability? To which degree does local regulation facilitate or protect market access?
  • Example 2: Global supply chain and manufacturing footprint – Are global supply chains stable?  Are they exposed to geopolitical frictions? Will changing taxation require to restructure them?
  • Example 3: Workforce – Will it be possible to continue to source the qualifications needed at an attractive price point?
  • Example 4: IP –  Is it possible to protect the property rights of the firm against private and public interference?
  • Example 5: Currencies – To which degree will the company be affected by politically induced changes of exchange rates and the oil price?  Can some trends be observed e.g. due to changes in monetary policies?
  • Example 6: Cyber – Beyond traditional cyber risk, will increased cyber activity by governments and secret services face an increasing threat for my company operations and financial interests?

Some tangible actions can be initiated
What initiatives should companies pursue to better manage political risk?
  1. Build out political risk landscape: Get a better understanding about how political intentions might translate into policies. Build an expectation about how different political stakeholders might behave
  2. Prioritise expected policy changes regarding potential impact on company: Concentrate on risks which have a high likelihood and relevance to the company (e.g. alignment with geographic company footprint); schedule reviews for risks currently being deprioritized
  3. Update risk inventory: Integrate new type of risks into the company’s risk register and evaluate the risks (likelihood and impact). Potentially amend parameterization of risk which are already in the current register (e.g. increased exchange rate volatility, corrected assumptions on GDP growth and interest rates)
  4. Discuss mitigation actions: Make mitigation actions part of the ongoing risk discussion and performance dialogue. Assess the benefit of proactive defensive strategic moves (e.g. lobbying, communication, rebalancing of operations)

And … don´t forget to cover the upside of political risk
As the risk inventory is being updated not only the downsides of risk should be looked at. Potential opportunities should be considered as well. Here are some examples.
 
As mentioned before, recent political developments have stimulated capital markets. This stimulus might continue to exist if US companies get more traction and benefit from the announced policy goals.
 
Banking in NA will most likely face more beneficial conditions compared to the previous years. The Brexit is already causing the relocation of financial services businesses to other European geographies. The trade between China and Europe has been growing and is expected to grow further especially if the US policy position on China and some of the APAC countries remains. In case we would face a further disintegration of the EU, countries deciding to leave the union might become more attractive as locations for production. Production costs might decrease due to the devaluation of the local currency or fiscal policy changes (if bilateral trade agreements will still soften the burden of leaving the union).  Today, this is not a very likely scenario because it contradicts the fundamental believes of the union.
 
However, the recent past has taught us that we live in a dynamic environment and that what seems unthinkable today should already be anticipated.

Infrastructure (1/2017)

Managing infrastructure investments

Capital markets continue to generate low and volatile returns. Therefore, institutional investors look for more opportunities to backfill their investment pipeline generating stable and attractive returns. Traditional regulated asset opportunities are limited and new opportunities need to be identified. On the other hand, strategic investors and the public sector are challenged to find new means of financing. New operating and partnership models to renew and expand public infrastructure need to be established. This is a win-win for both market sides if volatility and project risks are contained and stable financial results are achieved.

Infrastructure investment needs in the OECD are estimated to be in the range of USD 71 TR (3.5% of GDP) until 2030. This offers opportunities for strategic and institutional investors.
  • Strategic investors: There is opportunity to participate in asset investments. However, these types of investments have exhibited significant risks which have been underestimated.  Only to some degree these risks have been addressed in contractual structures.
  • Financial investors: In the broader investment community, there is still the believe that all infrastructure assets exhibit ‘more or less’ stable risk profiles. Unfortunately, this is not the case. There are very distinct asset risks as well as fundamental differences in the composition of market vs. political/ regulatory risk depending on the infrastructure asset class.
Some of these risks materialize already in the construction phase.
 
Cost overruns in infrastructure are substantial
An analysis of more than 1600 infrastructure projects reveals, that cost overruns in the construction phase are substantial.
 
  • Dams is the asset class with the most significant cost overruns.
  • Transportation network infrastructure with rail and BRT shows cost overruns to be at around 40% whereas roads score slightly better with overruns of about 24%.
  • Individual infrastructure projects finish the construction phase on average with a 30-40% cost overrun.
 


These figures show that infrastructure projects face a significant NPV impact from the very start. Taking them into a profitability zone during the asset lifecycle is quite challenging. Recent infrastructure projects could be quoted which finished the construction phase with cost overruns being multiples of the initially budgeted construction costs.  
 
What are other typical pitfalls which can be observed with infrastructure projects?
 
Typical pitfalls in infrastructure projects
Reviewing infrastructure projects which are currently in the planning and construction phase surfaces typical pitfalls
 
  • Governance structure is unclear; contracts are not transparent and risk ownership is not well defined
  • Project objectives defined are to narrow e.g. completion is not sufficiently linked to budget requirements; just costs of completion are considered but lifecycle costs are neglected
  • Revenue risks are not sufficiently considered; focus is on costs only
  • Asset life is overestimated but is a major driver as it will determine maintenance and replacement needs; different technical options might even allow extended operations at higher total costs but lower annualized costs
  • Regulatory and country risk are not sufficiently understood impacting the exposure to ‘market’ vs. ‘regulatory/political risk’
  • Organizational hurdles lead to limited institutionalization of learnings about asset performance which would otherwise contribute to increased profitability and stable financial infrastructure asset performance

 
Capturing value in the investment process
The above examples show, infrastructure project value might be impacted by value drivers beyond construction costs.  In a traditional investment processes these might not be sufficiently captured. Why is this the case? Infrastructure as an asset class demands some slightly different perspectives.  Assets are not as liquid as other type of investments, volatility for a specific investment might not be in line with peer group volatility (as it might exhibit one-off characteristics). Operational aspects might have a more severe impact in an individual investment decision compared to a liquid traded equity investment. Additionally - depending on the respective infrastructure asset class - market risk is complemented by political risk.  Some investors avoid this risk type, others explicitly seek regulatory/ political risk exposure.
 


During establishing an asset portfolio structure and scouting assets, it might be worthwhile to establish a view on value drivers which are acceptable for an investment (e.g. one might not be willing to enter certain regulatory or political risks).  
 
In the pre-investment evaluation, reviewing lifecycle costs and the revenue structure will shed some light on the stability of the business case.  In case potential issues are discovered, technical or contractual mitigation options might exist.
 
Value levers in operations should tie in with the business case established in the pre-investment stage. This allows to manage asset operations in line with the investment rationale.
 
At the end of the asset lifecycle, major overhauls or replacements are required.  It is important which ones should be conducted and how this links to the re-investment rationale or whether this extends the asset life.
 
Example ‘Portfolio structure and asset scouting’: In the absence of tangible infrastructure investment opportunities, an asset manager considered opportunities to invest into clean tech.  The questions raised was whether these opportunities would exhibit infrastructure like cash flow characteristics. In case they would deviate from infrastructure characteristics could a premium be monetized to compensate for a higher risk exposure?
 
Example ‘Pre-investment evaluation:’: A strategic investor considered to repower a fossil power plant in the UK.  The intention was to burn biomass and pocket Renewable Obligation Certificates (ROCs).  At that time, there was a political debate to change the ROC allocation mechanism. Additionally, as the ROCs are traded, analysis conveyed that a change in the allocation scheme would significantly impact the certificate market price. Thus, the investor decided to postpone the investment decision.
 
Example ‘Operations’: An investor reviewed the key value drivers of a major highway project.  The total traffic expected was in line with expectations. However, the mix of truck traffic vs. car traffic was off.  Truck traffic was much more substantial than car traffic. The good news was that this lead to higher revenues than expected. However, maintenance costs were much higher than expected and the forecasted lifetime of the asset was reduced significantly. The investor initiated several initiatives to bring profitability back in line with expectations.
 
Example ‘Reinvestment, closure, replacement’: A strategic investor considered to renew its fleet of power plants.  Therefore, the investment budget had to be defined.  Renewals, capacity additions and re-powerments had to be timed. Analysing investment needs and run time expectations conveyed that in some instances, moderate investments would be sufficient to modestly extend the asset life. For other assets, the risk that main components would break during an extended asset life were so significant that an asset life extending investment would not be justified.
 
Therefore, it is important to establish a perspective how project value might be impacted prior to committing to an investment project.  
 
A value perspective should be forward looking and hence apply predictive perspectives and methodology. Just extrapolating historic findings will not suffice.
 
Benefits of a volatility based financial perspective
The interconnectedness of global markets has increased.  Hence, linear planning is less relevant in today´s environment.  A volatility based financial perspective is necessary to gain insights into sensitivities and dependencies on key value drivers. Does this provide protection from value leakages in the future?  No – future market developments are still uncertain. But a sound understanding allows to manage assets for superior performance across the asset lifecycle. It also allows to better integrate a value view with an operations perspective.
 


Are perspectives of strategic and financial investor different? Yes, they are – strategic investors focus more on strategic and operational questions; financial investors focus more on financial asset characteristics.  However, going forward both perspectives require to be integrated further. If policy makers contribute their part to contain risk, more capital will flow into the sector opening new investment opportunities.
 
What are the benefits across the asset lifecycle?
 
  1. Portfolio structure and asset scouting: sound overall financial perspective, scouting action plan and investment priorities
  2. Pre-investment valuation: comparison of individual assets against investment concept, value decisions across time enabled, baseline for (future) performance management
  3. Operations: business case linked to operations, mitigation planning is enabled, prioritization of maintenance activities
  4. Re-investment, closure and replacement: holistic asset management view allows better (re-investment decision), feedback of historic operations data into finance function for better (future) asset operations
 
Applying a concise and stringent volatility based financial management rationale across the asset lifecycle will lead to better asset performance.  It will also allow to identify investment opportunities which might be not as obvious as others. In a constrained opportunity space this is an important strategic advantage.
Commodity trading (3/2016)
 
Back to operations …: Opportunities for 2016/17
 
Commodity trading revenues are still being challenged after a weak trading year 2015 and optimistic expectations for early 2016. Overall the outlook remains modest with markets still exhibiting signs of past investments, the correlation to a low oil price and weakening demand due to different reasons. As trading revenues are not expected to get back to previous levels medium term, some operational levers and opportunities might be considered.
              
Commodity trading revenues in 2015 were down compared to the previous year.  Attractive oil trading revenues could not compensate the overall contraction of the sector. Reuters estimates overall commodity trading returns of the 12 large investment banks to be 18 percent down to USD 5.6 BN. With some exceptions also trading houses are facing challenging conditions. An early 2016 recovery of prices expected by several risk investors and traders did not happen although volatility patterns could be monetized.

Challenging market situations to continue
Oil: Although the oil price impact on the supply-demand balance may seems exaggerated, a low price but volatile market conditions remain. An inflow of significant investment is needed to compensate natural oil production losses. Additionally, an increasing demand of 1-1.5 MMBD needs to be met. Whether this supply challenge will be met as well as a potential alignment of interests within OPEC will demine the future price environment.
 
Coal: Most recently, WoodMackenzie expects thermal coal consumption to be down 40% by 2035. This will have a significant impact also on market conduct.
 
Metals: Changing requirements and material innovation in manufacturing and automotive as well as slowing construction activity is impacting metals trading.  Strategic market participants are already acting on this trend.
 
Softs: Not only supply-demand patterns across the BRIC countries will influence future market conditions. China as a key driver of demand. It has cut commodity consumption due to a dim economic outlook as well as changing domestic demand profiles.  In softs however, demand remains high and supply positions have been established (e.g. in animal products).
 
Overall, difficult market conditions will remain.  Volatility in oil provides trading opportunities. Increasing oil prices driven by supply-demand measures might cause some relieve also impacting other commodity classes. However, interest rate policies of the Federal Reserve (FED) as well as additional quantitative monetary measures of the ECB might still be a burden on the commodity price environment.

Efficiency improvements in trading not exploited yet
Operational improvement levers have already been addressed by commodity traders elevating the efficiency challenge from the divisional agenda to the corporate level. To get to the next level of operational excellence will be more challenging as this requires process innovations potentially supported by technology.
 
Also FICC operations of large banks have made significant cuts. However, the focus has been on cutting front office costs. But improvement potentials at middle and back offices have not been addressed to a similar extent. Trader support ratios and cost income ratios (CIR) at large investment banks still remain high.  CIR are in the (high) seventies. Hence, JPMorgan estimates that at some large investment banks, costs at middle and back office need to be cut by 25-30% in order get the businesses back in line with post regulation RoE.

Middle and back office operations improvements
Operations should still be on the management agenda offering degrees of freedom not seen in the recent past. Here are some examples:
  • Continue operational improvements and also facilitate cross opco best practice sharing: Middle and back office operations continue to be an important lever.  Strengthening processes will allow to integrate with technology and will create a more resilient operating environment.
  • Integrate dispersed and increasing industrial operations into ops agenda: As processing activities and industrial operations have increased, including these into the operational efficiency agenda is even more important compared to the past. Realizing improvement potentials without risking operational stability is however tedious compared to creating additional trading revenue.
  • Improve mid and back office capabilities: Both activities should not only be viewed as cost positions but also as contributors to contain and manage risk exposure – not only market and credit risk but also operational risk. Given that banks need to restructure their FICC mid and back office operations – especially in Europe – allows to tap into a talent pool at attractive costs.
  • Review integration of financing/ treasury and tax management into ops agenda: Integrating trade finance activities and the international taxation framework into the ops agenda adds value and is of strategic importance these days. However, in order to ensure seamless execution, a corresponding operating framework needs to be put in place.

Operations agenda supports overall strategic objectives
What will be achieved if a stringent operations agenda is followed?
  • More attractive operating economics: Support ratios and support costs can be better understood and managed than in the past. Facilitating an internal exchange on operating economics and aligning these with the incentive system will lead to more attractive overall operating economics.
  • More resilient business model: Clarity on processes and transparency of middle/ back office operations is not only increasingly demanded by equity and debt investors. It will also contribute to the stability of the business model impacting risk adjusted returns.
  • Improved financing capabilities: As operational performance and effectiveness increase, financing capabilities will also be improved – a key strategic objective of commodity traders these days.
  • Better alignment of financial performance levers with business and operating model: A supply chain set up in line with treasury and taxation considerations is essential for global commodity trading businesses and contributes directly to the bottom line.
 
 
 
Risk management (2/2016)
 
Taking risk management to the next level …
                                            
Risk management at large corporates has evolved from a qualitative exercise and compliance effort into a quantitative discipline. Additionally, it has been better integrated into the daily management reality of businesses. Is this set up made to cope with future risk challenges? There might be some upgrades which should be considered …      

Risk management at large corporates has evolved significantly over the last few years.  It has moved out of the insurance and compliance corner. It is supported by quantitative methodologies and supports key strategic decisions like portfolio management and day-to-day business decisions.

Risk management – what has been achieved?
By applying these practices, functional gaps between the risk management function, strategy/ corporate development and finance are being bridged.  With the integration of a risk management perspective into the financial plan, performance can be measured and tracked in line with reporting cycles. A differentiation between business performance and external influences can be measured.  Timely management action and intervention within and not at the end of the reporting period is possible. Hence, an issue and value based management approach can be followed more easily. But is this sufficient to cope with future risk management challenges?

Observations on risk management challenges …
Two observations can be made when reviewing the characteristics of an evolving risk environment and talking to risk practitioners and senior management.
 
  • Evolving risk environment – ‘Disruptive risk events with potentially high impact have been quite frequent …’: The recent history has produced risk events which have come as a surprise.  Some of these have not been on the risk management agenda or have been underestimated.
    • ECB monetary policy: The change of monetary policy in the aftermath of the financial crisis has evolved from a risk to a reality impacting e.g. exchange rates, financing costs and availability of financing.  Additional surprises have paved the way … rather than moving back to normal, expansive monetary instruments have been introduced and are being discussed which have been off limits before.
    • Infections: Some years ago ‘pandemic’ was a new type of risk entering the risk inventory.  The fear has become real that an infection might spread globally with large scale lethal impact.  Since then, fears of spreading viruses have been on the agenda several times. Most recently there has been a debate about the Zika virus and the impact and threat it might have in the context of the 2016 Olympic games.
    • Cyber: This was considered to be a topic to be under control if a sound business continuity plan, IT set up and insurance coverage has been put in place. However, even intelligence agencies have been hacked. Most recently Apple´s operating system has been hacked enabling large scale access to user information and meta data, calls and messages. This has not considered to be a likely scenario given Apple´s focus on IT security.  One might imagine the damage a similar event might cause especially in a digital world in which industrial and personal devices get increasingly connected.  Maintaining resilience of commercial systems and public infrastructure is moving up on the priority list.
    • Terrorism: Terrorism has been a phenomenon which seemed to apply only to high risk global regions. Sadly, it has developed very quickly into a reality for modern societies with no recipe for an instant cure. Who would have thought this to be the case?
    • Oil price: Only in the recent months, the oil price has exhibited movements not expected previously.  In the beginning of 2016, risk investors lined up large sums of capital behind the conventional wisdom for the oil price development in Q1/2016. They were proven wrong.
 
This is just a selection of events and developments – more examples could be mentioned.
 
  • Internal risk management capability set – ‘Quantitative capabilities need to complemented by qualitative assessment expertise …’: Historically, companies where challenged to get quantitative risk management capabilities on board. These days it is becoming more eminent that quantifications also have their limitations.  Risk analysts and management might be blind sighted by an automatism how to look at risks.
 
But what needs to be done and how can these challenges be met?

Understanding risk and not only calculating it …
Risks need to be genuinely understood. Only this allows to also package them into an appropriate quantitative framework and interpret how they evolve over time.
 
A risk culture needs to be established throughout the organisation. The intention is not to avoid risks but to take calculated risk for profit and to be prepared for higher impact events. Potential starting points are …
 
  • @ risk management department level: The necessity of complex and extensive quantification exercises should be reviewed.  Quantification exercises might be balanced with (additional) qualitative risk assessment capabilities and capacities.  
  • @ business management level: Observations and impact assessments provided by risk management should be regular discussion topics at least in the context of planning cycles. In day-to-day management, they need to influence management action and initiatives.
 
So, the next level of risk management evolution is not a substantial one but rather a corrective one. Organizational challenges and implementation hurdles should however not be underestimated.
Digital transformation (1/2016)

The forgotten customer

Digitalization has become the new management buzzword. Companies have established digitalization initiatives, conducted digitalization strategies and have established digitalization departments. Is this sufficient to be successful in a transforming market environment? This article highlights some perspectives what companies should keep in mind as they head down the digital transformation path.
 
‚Digitalization’ has entered the top management agenda of nearly any larger corporation. Responsibilities have been defined and initiatives are under way. More frequently the question gets asked: ‘Are we heading into the right direction?

Customer perspective cut short in digitalization initatives
Analysing how digital initiatives are being set up in a lot of cases convey the following patterns:
 
  • Staff function: ‘Digital’ is in several cases organised as a staff function. The businesses tend to be on the side-lines rather than in the driver seat
  • Manufacturing and supply chain focus: Digital initiatives are focused on manufacturing and supply chain activities
  • Deployment of apps: Customer facing digital initiatives tend to focus on the development of ‘apps’. This may be delivered together with a proprietary technical standard
 
Is this appropriate? Where are potential white spots and will the digital initiatives ensure a stronger competitive position and value capture?

Recalibrating around competitive dimensions
‘Digital’ needs to address the whole value chain as technology offers the opportunity to be more effective and efficient with any activity. Also, interdependencies throughout the value chain need to be taken into account. But where should be the priority and what are the most pressing competitive dimensions?
 
  • Production cost?
  • Supply chain costs?
  • Complexity?
  • R&D and time to market?
  • Other?

Any of the above might be supported by a digital technology dimension and is part of an Industry 4.0 rationale to innovate the value chain.

Unique opportunity to build a true customer relationship
However, technology offers the opportunity to innovate the end-customer relationship or to establish one if it has not existed before. Information and transaction costs of establishing and maintaining a customer relationship are not as restrictive as this has been the case in the past.
 
  • Broad reach: Customers can be approached any time and in any geography with a customized message
  • Close interaction and automated operations: Through a well-structured interaction much more targeted messages can be sent and automation of routines is possible (e.g. chat bots). Behavioural patterns of customers can be captured and linked to buying rationales and timing
  • Communities can be leveraged to make relationships for customers more relevant: Peer-behaviour and referrals are relevant buying factors in a B2C relationship. In B2B relationships adjacent offerings can be positioned more prominently which are identified as an integrated value proposition (e.g. services, financial products)

What implications can be drawn for some industrial sectors?

Understanding the customer value proposition will change the delivery …
  • Electric devices, furniture and construction materials/components: These industries sold traditionally through wholesale channels and rely significantly on their sales network for customer intelligence. Now, for the first time these industries can establish end customer relationships and deploy commercial or technology platforms to make a bigger market impact
  • FMCG: For some large FMCG firms a 'charged' customer relationship has become already a reality. Social media is used to engage with communities proactively. Apps are used to nurture individual customer relationships and to impact brand loyalty
  • Financial services: As the sector is transforming it will reorganise around customer value. Costly distribution structures will no longer be required to interact with the customer, product innovations can be deployed much faster and at lower costs. Compliance with regulatory requirements can be tracked much more easily
  • Mobility: This is no longer just a pure hard ware or service play. Both plays are integrating. Lifestyle considerations become more important with regard to the pure transportation aspect

Especially in online-retail and online technology, the customer is in the center of the business model evolution. Strategic business model considerations meet explorative business model evolution cycles. As such not a deterministic marketing approach is followed. Explorative marketing is being pursued supported e.g. by big data analyses, machine learning, continuous price exploration and testing.

… and enable companies to maintain their relevance in the market
As the customer relationship 'gets charged', companies will be in better position to prove their relevance. This will be the basis for continued profitable growth. If this is not being addressed other market participants will challenge and take over the customer relationship over time.
New entrants are also quite active to develop new ground (e.g. Apple Pay, Uber, AmazonFresh, ShaveClub, Google Car). Technology should be employed driven by commercial requirements (and not the other way around).
Creating value through commercial platform rather than fragmenting the market with proprietary standards should be the leading thought for developing a customer value proposition. The latter will limit the benefits of developing commercial and technology networks (IoT) and hence will undermine the customer value proposition.
 
© Silverbergh Partners GmbH · 8700 Küsnacht ZH · Switzerland
Back to content | Back to main menu