Categories
Uncategorized

The Shutdown Decision And Permanent COVID-19 Job Losses

The shutdown decision is a fundamental economic principle. A firm should continue to operate if it can generate sufficient revenue to cover its variable costs. A firm should shut down if it didn’t make at least enough revenue to meet its variable costs. Because of government restrictions put in place to reduce the spread of COVID-19, whole swathes of the economy need to shutdown.

Many politicians are talking about the bridge to the other side. Unfortunately, many businesses have already decided to shut down. Some did not even engage with the possible support avenues because they knew there was no chance the bank would lend them more money or their landlord cut them some slack on their lease obligations.  

The evidence of this is in the enormous unemployment claim numbers around the world. The queues outside social security offices are happening even in countries where a wage subsidy policy now exists because of COVID-19. I don’t think the blame game is helpful at this point, but some empathy with people who are the collateral damage from the public health actions exists.

The public health crisis itself is playing out differently in each country. It’s not clear yet what the real impact of COVID-19 will be – modelling is uncertain, and each country will have its factors that either make their outcomes worse or better. It is silly to think that the only problem here is the health crisis. The social consequences of a 2nd Great Depression due to the sudden stop of economic activity will be just as awful for the world.

A simple thought experiment can help us understand the likely decisions of business owners. If revenue has gone to zero, for an unknown period, there are several ways to pay costs that are still being incurred by the business. It can use its cash reserves, borrow more from the bank, raise more equity from shareholders or use government support packages.

Every business owner will know what their break-even point is. They will also be acutely aware of their ability to support the business. If they have a year’s worth of bills in the business cheque account, this isn’t an issue for them. They will be fine, assuming there is a resumption of regular economic activity on the other side of the bridge.

However, if they are already running a low cash balance or using debt to meet operating expenses, they will not be able to proceed with zero revenue for longer than a month or two. Putting businesses into hibernation doesn’t work because every contractual arrangement they have entered into has to be put into hibernation on reasonable terms at the same time.

The recent drop in asset prices due to uncertainty around COVID-19 impacts and already recognised economic losses such as travel and hospitality shutting down, mean that the fair value of any small business is lower. There are unlikely to be any buyers at present. Incurring too much debt through a crisis impairs the value of the company on the other side.

This reality is affecting large businesses too. Unlike the public sector, a private company can hit “hard limits” of what is possible. Resource constraints exist,  their bank will tell them they can’t borrow more, and the government will restrict their operations. Their employees may choose to quit instead of coming into work and being put at risk. Their landlord will refuse to cut a deal on rent.

This health crisis is a society-wide coordination problem. Without the government imposing a lockdown on all, the decentralised decision-making of many actors leads to businesses putting people at risk because other companies in their industry are still operating, so they feel like they have to as well.  It’s crazy.

One of the issues with specific bailouts is that at this stage of the collapse, it’s likely putting good money after bad. Equity owners and debt owners receive a risk premium to incur risk. If every time a crisis occurs, they get bailed out, with no consequences, the people don’t like it.

The irony is that if people thought the response of populism to the Global Financial Crisis and its fallout was terrible, just wait until the second wave of populism and nationalism arrives after a global pandemic accelerated by the free movement of people and goods across borders.

It will be even worse when banks and large corporations get bailouts when at the same time, many households can’t access welfare. The losses will be borne by those who are unable to negotiate their bailouts with their creditors and landlords because they don’t owe them enough. Because of the uncertainty, many businesses will merely shut down because their balance sheets can’t sustain six months of no revenue.

The government is trying its best under considerable uncertainty. The lesson of this particular crisis so far is that looking to the government for financial support in an emergency is a dangerous path to take. On the other side of the bridge, expect a lot of debt aversion and laser focus on lean operating models where only the critical expenditures to deliver value to customers happen.

The current operating model for many businesses has grown over time to include a lot of unnecessary expenditure. There will be a focus on crucial value streams – what is the bare minimum required to deliver an excellent experience for customers? Product and service catalogues will need to be simplified. Entire categories will disappear because they will seem frivolous in more austere times.

Many firms are already replaying their GFC playbook. This playbook means cancelling projects, standing down staff, offboarding contractors and consultants, and eliminating discretionary spending wherever they can.

Unfortunately, this is the last thing the economy needs. When businesses tighten their belts, the drop in demand from public health restrictions accelerates further. The carnage from further reductions in economic activity will be just as awful as the health crisis happening in the hospitals.

A pandemic of this nature is going to change our way of life for decades to come. The health and economic scarring will be worse than the Great Depression because other than those directly impacted by the GFC, many in the developed countries have not known adversity on this scale their entire lives.

Hopefully, random acts of kindness and humanitarian response from governments to help their people in crisis can prevent a complete collapse of social order. This COVID-19 pandemic is a crisis on many fronts, and the worse the health crisis becomes, the worse everything else becomes. The other side of the bridge mightn’t be one we want to cross in the end.

Categories
Uncategorized

The Industry Composition Changes From COVID-19 Fallout

The industry composition changes from the COVID-19 fallout will be enormous. The firms with the most robust operating models that deliver value without people needing to leave their homes will emerge in a dominant position. The firms that rely on in-person service delivery will struggle to rebuild their revenue once social distancing becomes a new way of life. The impact on households will be dark as many stores closing now will never reopen.

The rapid spread of COVID-19 and the accompanying public health restrictions have caused millions of job losses globally. The speed of the economic collapse of the entire industry sectors of tourism, air travel, retail, hospitality and personal services is unprecedented. Different countries have responded with varying policy responses to slow the spread of the virus.

Some have focused on the banks and business. Others have focused on jobs and wage subsidies. Some have tried to balance a mixture of support across the economy. This human tragedy is a real-time policy experiment across countries where everyone can see the different outcomes of different ideological belief systems.

We are dealing with both a health and an economic crisis. It is juvenile to ignore that there are tradeoffs governments are making, whether we agree with them or not. There is some modelling behind their decisions to move from one level of restrictions to a higher level. One of the things politicians are responsible for is making the calls based on the advice they receive. That’s part of what modern Westminister democracy entails – outsourcing political judgment to politicians, supported by the public service.

One concerning aspect of the policy response so far is that the crisis has highlighted the weaknesses of many existing business models. Typically, a recession would lead to those businesses closing down as part of the normal business cycle of creative destruction. In this case, a rapid collapse in economic activity in some cases because of government decisions means that many businesses are closing well ahead of where they would have failed in the next economic downturn.

The rational response of many boards and senior executives has been to lobby the government to secure an industry-specific support or bailout package. Small businesses don’t have that option. The support offered to banks to extend lending terms or provide low-interest bridging finance for an indeterminate period looks good at first blush but doesn’t pass the real-world test.

The reason why many businesses won’t take on additional debt in a time of high uncertainty is that if their revenue has gone to zero, they are still incurring fixed costs. They will try and reduce as many of those fixed costs as possible, and may not have the cash to be able to top up wages for a wage subsidy or even let people take annual leave or sick leave for a month.

Hence, many layoffs and redundancies have happened already irrespective of whatever policy response the government has deployed. The likely announcement of a wage subsidy in Australia today is too late for all the people already lining up at Centrelink. In New Zealand, every second day, MBIE announces little tweaks to the wage subsidy in perhaps the best example of iterative policy implementation in the country’s history.

When it comes to identifying industry composition changes from COVID-19, strong balance sheets are a crucial factor. In the hospitality sector, a clearout of small businesses is likely, leaving many countries with national chains and franchises the last ones standing on the other side of the bridge. Unless retail landlords give rent holidays, lots of cafes, bars and restaurants will have no choice but to close down. Given that very few own their premises, the prospects for independently owned hospitality operators is bleak.

Because of the uncertainty of the COVID-19 pandemic, it’s unlikely many small business owners will take on more debt other than out of pure desperation. If you trace back the impact of zero revenue and work backwards to who loses, generally it is property owners and the banks. Their tenants may default, and their borrowers may default. This reality is how a health crisis becomes a financial crisis.

There are now three crises – health, economic, financial. All three are interlinked, but the primary focus of many governments has been the economic and financial crisis. The health crisis has had far less government money directed to it. There will be real-world consequences from this approach.

For example, the purchase of residential mortgage-backed securities by the central bank is a significant change in the expected behaviour of a central bank. If the central bank is becoming the entity holding the credit risk hot potato, what is the point of the banking sector? What was the justification of the enormous investment in higher regulatory standards since the Global Financial Crisis if a stress event of 1 month changes everything?

The US Federal Reserve mainly spent a decade doing and then trying to rewind quantitative easing. Now it is going full speed on quantitative easing again. How can you price risk responsibly in such an environment? There are enormous problems that will stem from the panicked responses to this crisis. Those who most need a bailout don’t have a hope of getting nearly as much as they may require through no fault of their own.

The impact of COVID-19 on the retail sector is another one to watch. With physical retail stores closed, and staff stood down, how likely is it that firms will reopen them on the other side of the bridge? Already, retail in Australia was struggling. Many firms will use this crisis as an opportunity to accelerate plans to reduce store numbers and increase online shopping share of their revenue.

Some will use the crisis to close underperforming brands or chains and exit onerous lease obligations wherever they can. The face of retail will never be the same again. The impact on major landlords such as shopping centres will be grave. In the USA, commercial mortgage-backed securities could be in deep trouble. How many rent payments will they receive on April 1? Many retail chains there have told their landlords they would not pay the rent for the duration of this crisis.

The most challenging impact so far is the people who have already lost work because of this crisis. Recessions are particularly brutal because a proportion of people who become unemployed in downturns never work again.

Many parts of the economy will “bounce back” from this crisis. However, lots of people will lose their lives due to COVID-19 complications, and many will have ongoing issues like lung scarring and respiratory problems. The human cost will be enormous, and the overall human tragedy will be higher if the economic situation keeps accelerating towards a global Great Depression.

Categories
Uncategorized

We Will Judge Businesses – ESG Risk And COVID-19

The rapidly escalating COVID-19 global pandemic is causing enormous pain for people affected by its spread. The rising death toll and number of cases around the world is growing exponentially, just as experts predicted it would earlier in the year. The different response of many countries is a real-time experiment with people’s lives. There couldn’t be a more tragic way for 2020 to have turned out so far.

We will judge businesses and their response to COVID-19. The good ones are doing what they can to do right by their customers, their employees, their suppliers and their communities. The not-so-good ones are using a public health crisis as a lobbying opportunity for industry-specific bailouts and carveouts that protect executive compensation in a time of mass layoffs. Many boards and senior executives still haven’t learned the lessons from the Global Financial Crisis – your social license to operate can be revoked at any time in this new political climate if you act up.

One of the lessons of the past few weeks is that many well-managed businesses have been able to deal with this crisis as good corporate citizens. They had strong balance sheets, clear business continuity plans invoked, and the right attitude towards their stakeholders. These businesses operated in industries where their margins enable them to invest in preparedness and do the type of work where they can send their staff to work from home with no issue.

Small businesses are in a completely different situation. Already, non-compliance with regulation and community norms is an issue for small businesses. They are likely to be under-capitalised, trading on modest margins in highly competitive industries and aren’t going to have the balance sheet to “get to the other side of the bridge”.

Many small business owners will have looked at proposed support from their bank and wondered how on earth that helps them make lease payments and pay trade creditors. Many will have realised they can’t even last a month without revenue, and the rational course of action is to layoff their staff and close the business down.

Larger businesses not big enough to land a bailout will have moved fast to plan and execute redundancies and stand-downs. This fast decision making is because their cash flow pressures mean they can’t even wait a week because of how fragile their business model is to adverse external shocks.

There is a real-time example in New Zealand: Air New Zealand was able to secure a government loan with associated conditions, still stood down most of its people. Virgin Australia was not able to obtain any support, so is now consulting on closing its entire New Zealand operation.

There are many arguments from both sides – letting businesses close down isn’t the end of the world as long as there are strong social security supports for the people impacted. Because of the speed at which this crisis has developed, the welfare system in many countries is being overwhelmed. Lots of business owners have realised the uncertainty ahead and just pulled the trigger, likely without advice or engaging with any potential support avenues.

We will judge businesses by how they respond to this crisis. Already, some major corporations have shown their true colours and gone back on all of the ESG statements and claims they have made over the past few years. By re-running previous crisis playbooks, they are unlikely to have the goodwill of their stakeholders on the other side of the bridge. It’s already a difficult enough time for the world – doing the right thing is seemingly too hard for many. It’s great to see some businesses stepping up responsibly, they’re the ones who’ll survive.

Categories
Uncategorized

The COVID-19 Economic Depression

The pace at which the COVID-19 pandemic is spreading is exponential. This crisis is the greatest challenge faced since the end of World War 1. It is bigger than the Great Depression and the Global Financial Crisis. It is the COVID-19 economic depression.

The difference between a recession and a depression is that a recession is part of the business cycle. It will last a couple of months, perhaps even a year, but there is a view to the other side, and through belt-tightening and some restructuring here and there, most firms can make it to the other side.

An economic depression because of COVID-19 is very different. The scale of the shock to both the demand and supply side of the economy is enormous. There is a massive labour supply shock to the downside as well. The entire economy is facing considerable changes in demand and supply chain reliability in an unprecedented fashion.

When the public health advice and evidence so far is that reducing the growth rate of infection requires complete lockdown, the cost/benefit analysis becomes apparent at a high-level. If the number of those infections is in the millions and the potential death rate is in the hundreds of thousands, then spending tens of billions to avoid that outcome is worth it.

In Australia today, the queues around Centrelink offices show how rapidly the private sector has responded to the uncertainty. It doesn’t matter what support the government offered up to businesses – many made rational decisions when faced with zero revenue for an indeterminate period and laid people off immediately. Most of those business owners will be ruined financially within weeks just the same as their laid-off workers.

Because of the increase of casualisation and part-time work, many who have lost their job had no opportunity to build up an emergency fund. They are unlikely to have a cash cushion to survive this uncertainty because they never had enough hours of work in the first place.

The situation of anyone on a temporary visa is particularly dark. This fact will slowly become a humanitarian crisis for governments around the world – how do you respond when many can’t return home given travel bans and extortionate airfares? The response will be telling. This situation could break globalisation and free movement of people across borders for a generation.

The behaviour of many people over the past few weeks with their hoarding behaviour may be rational at an individual level but has caused new panic and hysteria that means strict law and order enforcement is the only path forward.

The Anglo countries, in particular, have many cultural traits that mean responding correctly to this sort of crisis is very difficult. In essence, the Bondi Beach crowds on the weekend mindlessly going about their weekend business without a care in the world about social distancing are a prime example of this individualist streak.

In regular times, these traits are a strength. When a pandemic with no vaccine is growing exponentially, they are deadly. There’s no surprise that Spring Break crowds in Miami were behaving similarly to Britons going out to pubs and Australians just going to the beach as usual. It’s the common law vs civil law difference.

The COVID-19 economic depression is moving so fast that following the public health guidelines and practising self-isolation for you and your family right now is the most practical and rational thing you could do. This suggestion applies even if your particular government hasn’t moved to a lockdown yet.

Categories
Uncategorized

Small Business Lending, ESG Risk And COVID19 Responses

The rise of the COVID-19 pandemic around the world is changing rapidly. Boards and senior executives will already have implemented business continuity plans across the globe. The growth of working from home for entire firms in some industries will be stress testing remote working capability. Any failures will quickly highlight the firms which haven’t taken these issues seriously as they fail to perform their contractual obligations.

Doing the right thing by customers, employees, suppliers and the community is the bare minimum required to maintain your social license to operate in a crisis. Doing the right thing doesn’t mean engaging in irrational levels of self-sacrifice. It does mean open and honest communication about the reality of what zero revenue coming in the door means for your operating model.

Many businesses will have already laid-off workers and attempted to sell off as much inventory on hand as possible. Many employees will be trying to work from home if they can. If they can’t, expect aggressive interrogation as to why that is the case.

Aside from visible frontline staff and a small number of critical physical-location-only roles, this crisis is highlighting how working from home could have been embraced years ago by many firms without issue. Imagine the economic loss from commuting time alone that is now starkly in focus for those who haven’t been able to work from home before.

Because of the enormous impact of revenue loss alone, many firms will take drastic measures. The risk of insolvent trading means that some directors may choose to shutter a firm instead of taking advantage of low-interest bridging finance from their bank. Their suppliers may already have cut off trade credit, and their employees have been let go or stood down.

The rapid deterioration of consumer spending will present a grave challenge for some firms: do they place orders with suppliers? Do they risk increasing any debt they already have? Do they need to consider administration immediately? Is appointing a liquidator necessary to preserve value left in the business on the other side of the pandemic?

 These are not easy questions. It is easy to criticise from the sidelines the discussions going on around the kitchen table boardrooms of small businesses, the boardrooms of major corporations and the management committees of the big banks.

We don’t know what the other side of the bridge looks like at the moment. We don’t know how long the slowdown of economic activity will last. This situation means it is precarious to take on additional debt or keep paying high monthly expenses and run down cash and short-term investment balances for an unknown duration of time.

A firm can raise either debt or equity finance. If raising debt finance is too risky, then raising equity finance through a rights issue can increase the cash available to ride out the pandemic. For some firms, their industry sector is now too risky, and fund managers may have no interest in participating in a rights issue. But at the right price, equity finance can be found somewhere.

 If a firm is raising debt finance, they may already be able to draw down lines of credit or commitments their bankers have made to them to assist in meeting operating expenses. Firms still have to reduce their monthly bills, including payroll and payments to suppliers.

There is a wave of restructuring and business model simplification coming to Australia and New Zealand as a result of COVID19. Firms will still need to spend money on critical regulatory and technology projects. They may need to accelerate transformation plans that reduce labour costs and adjust their operating model, so there is less reliance on any suppliers unable to perform during this crisis.

Because of the decentralised nature of the capitalist society we live in, coordinated action at the industry level to protect a particular industry is a risk for government and central banks. This crisis can’t be an excuse to bail out shareholders. Shareholders are paid to bear equity risk through capital gains, dividends, debt reduction, and share buybacks.

Already, much central bank intervention is protecting the banks and non-bank lenders, with modest flow-through guarantees to the employees laid off already due to a collapse in revenue. The scale of the economic slowdown still doesn’t seem to be appreciated by policymakers.

It doesn’t matter to a small business owner if they have lower interest rates or access to cheap financing if their revenue has gone to zero dollars a day. Why would they borrow under such uncertainty? Under company law, are they a prudent director if they take on more debt and risk trading while insolvent?

The need for independent legal and accounting advice before entering into any of these bank-championed arrangements is clear. The need for independent financial advice for business owners thinking about what to do under the circumstances is clear. The last thing the economy needs is hundreds of thousands of small businesses entering into zombie loans that will eventually break the banking system unless the central banks fully underwrite the loans, hence begging the question of why have a banking sector at all?

The flow-on effect of so many small businesses facing revenue collapse will be in the property sector. What is the present value of future cash flows from an apartment building full of casual workers renting? If there is a mortgage against that property, what is the likelihood of impairment within months? What is the plan for mortgage enforcement and tenancy law enforcement?

This thought process may sound extreme, but the jobless claims in the United States look like they will increase 10-fold in less than a week. How is this going to be any different in Australia and New Zealand? Unemployment could be over 10% in weeks.

There are high numbers of casual workers, part-time workers and full-time workers on modest incomes who already may have suffered from not getting as many hours as they want and now find themselves out of work?

The government and central bank are facing a crisis they have never seen before. Here are some of the critical factors:

  • A novel virus with unknown factors and rapid global spread
  • A supply shock in China
  • A demand shock in China
  • A demand shock ex-China
  • A supply shock ex-China
  • A financial market decline
  • A credit market crunch
  • Fast government and private sector decisions made under considerable uncertainty

These factors are a recipe for a very tough recession. The pass-through of interest rate savings to small business owners is cool. Until you start realising that many of the small businesses affected may not even have debt! They do have fixed costs though – their leases, their committed bills, their payrolls. It doesn’t matter if you save $2000 a month on your loan repayments when you still have a $10,000 a month lease payment to make! This situation would not be uncommon for, say, a café operating in the CBD.

There is so much uncertainty that firms stopping hiring and laying people off now makes rational sense as many only have cash reserves to last a short period. However, the societal impact of how fast this is happening while at the same time an exponentially growing pandemic caseload is stressing the public health system and people are hoarding toilet paper will change our society for quite some time.

Categories
Uncategorized

The Economic Impact of COVID-19 On Australia And New Zealand

The economic impact of the COVID-19 pandemic on Australia and New Zealand is going to be enormous. The governments of both countries have already announced substantial support packages, the central banks are easing monetary policy on a vast scale, and the private sector has begun to make enormous changes in how they do business.

The scale of the impact from a public health perspective is enormous. Everyone apart from essential workers self-isolating is going to happen within weeks. Many experts suggest it should already be in place, and some businesses able to offer working from home have already embraced it. For businesses, this is a massive health and safety issue. Your people should not come into the office unless they have to.

For frontline workers, enormous focus on deep cleaning and provision of appropriate safety equipment is the bare minimum you should be providing. If a business is making no revenue, it needs to cut its costs. It no longer matters if there are contracts involved. Fixed expenses will go down.

The advice from public health officials is always changing. However, the impact of social distancing and self-isolation means that the hospitality and tourism sectors are now over. For the duration of these restrictions industries in deep trouble include aviation, most non-essential retail, and any discretionary or entertainment spending.

What this crisis and the response is highlighting is the fragility of the current economic order. Casual workers, households and small businesses are now the unprepared shock absorbers of risk in the system. The rapid deterioration in asset prices around the world represents a rational reaction to uncertainty over what the present value of those future cash flows is under these economic circumstances.

However, asset prices going up or down doesn’t help households paying bills. The inflexibility of many contracts entered into by businesses or families will accelerate the economic fire we are experiencing. The relevant public health requirement of social distancing flies in the face of economic reality for many households. They simply cannot afford not to work, and their small business cannot afford to operate with $0 in revenue.

There are many ESG risks for firms here. How do they treat their employees? How do they treat their customers? How do they treat their suppliers? Doing the right thing is more important than ever. The behaviour of firms throughout this process will be under the microscope, and any poor decisions will be franchise destroying. All of the goodwill built up inside a brand or reputation can be damaged by making silly decisions like making people come into the office when they can work remotely.

The operating model impacts will be severe. Because of the fragility of many value chains, the reliance on outsourcing, and lack of investment in technology over many years, the inability of some firms to deliver on their contractual commitments after they implement their business continuity plans will become glaringly obvious.

Some companies are doing the right thing: everyone who can work from home already is, flexibility with customers and suppliers, and customers treated properly with credits or waivers offered due to radically changed circumstances.

Some companies are not doing the right thing: lobbying for taxpayer money when there are higher priorities, worrying about their particular industry when this is a societal issue, or treating the parties they have contractual relationships with inflexibly.

Boards and senior executives will need to think very carefully about the impact of their decisions on their communities. Their customers and employees aren’t silly – they know the implications are likely to be negative.

If there are six months of drastically lower economic activity, protecting essential capabilities ability to deliver key value streams on the other side of the slow down is an important consideration. For example, airlines need to preserve some ability to operate domestic flights and cargo freight.

The overall economic impact will be much higher than 10% of GDP. Unemployment will be more than 10% in Australia and New Zealand within months. Underemployment will be even worse because of the number of casuals now out of work and part-time workers who will never get more hours under these circumstances and could also have to take leave without pay to keep their jobs.

The unfortunate economic response from governments so far has been very much about business. This focus underestimates the economic impact of this crisis. The real issue is people being able to pay their bills. If hundreds of thousands of companies go to the wall, asset owners and lenders should be taking a hit. This reality means commercial landlords being flexible with their tenants and banks bending over backwards for their business and institutional customers will be necessary.

The pace of this economic slowdown is so fast that attempts to use fiscal and monetary stimulus during the midst of a public health crisis simply won’t be fast enough. The impact on people’s wellbeing will be devastating.

If you thought that the Great Depression-era generation had unusual attitudes about many things, the scars from the economic side of this crisis alone would last decades. Let alone the enormous changes in societal behaviour that will be required to flatten the curve.

Categories
Uncategorized

Sustainable Consumption, Production And ESG Risk

The transformation of our society that is called for by the UN Sustainable Development Goals is bold. Moving towards a circular economy where both production and consumption are sustainable is a crucial target to achieve by 2030. The ever-increasing expectations of the community on how private firms help make these outcomes are one of the ESG risk factors boards and senior executives need to manage.

Many firms can change their current operating model to improve energy efficiency, reduce environmental impact, reduce adverse social effects, and still deliver strong economic returns to shareholders. Understanding the breadth of your current operating model and continuing to drill down into the people, processes and technology across your entire value chain is a crucial part of understanding and managing these ESG risks appropriately.

The current consumption footprint of the global population is vastly unequal between countries. If developing countries consume at the average rate of developed countries, by 2050, we may need the equivalent of 3 planets to produce the level of natural resources required. It’s not explicit what assumptions around increasing technological efficiency sit around that number, but it is still a concern.

There are still boards and senior executives whose mindset has not adjusted to how they will need to change their business to make a positive impact on solving these societal issues. Making changes to your operating model to help address these issues and reduce ESG risks isn’t about veering out of the lane of private enterprise into politics – it’s about responding appropriately to changing community expectations around what a business has to do to maintain its social license to operate.

The Royal Commission into financial services in Australia provided a wakeup call to the financial services industry but was not that much of a surprise to many consumers. Many feel as if, after speaking to the hand for many years, the social risks inherent in many of the products that the banks, insurers and wealth providers sold, were exposed in case study after case study.

When you realise that the terms of reference were heavily restricted and that there are not only these risks around acting in the best interest of customers that need to be managed appropriately by doing the right thing by your customers, but there are many other environmental, social and governance risks that must be equally managed or removed from operating models in the financial services industry alone, the scope of the challenge for Australian business becomes apparent.

Boards and senior leaders need to revisit their social purpose – why does their business exist? When they have figured that out, there is a clear need to design their business strategy in line with responsible and ethical principles. The subsequent design and implementation of a new responsible operating model to deliver the outcomes to customers, shareholders, and the broader community of stakeholders, could be one of the defining make-or-break moments for your business in the coming decade.

It is amusing to read the “head-in-the-sand” commentary that is still coming out on climate change and ESG risk. Responsible investing isn’t going away, and if your firm participates in the capital markets, your cost of capital could be increased substantially over time if significant ESG risks are not remediated substantively.

One of the trends in corporate governance since the Global Financial Crisis has been a strong focus on risk management – have a risk appetite statement, have a risk management framework, implement a three lines of defence model, have robust internal and external audit, and have the board and senior executives sincerely across the details of the risks the business is running. The response so far of many large corporates indicates that the “risk bureaucracy” response to increasing regulatory demands means that ESG risk may be “press release managed” by many firms.

This approach may suffice in the short-run. However, institutional investors such as super funds, sovereign wealth funds, and pension funds are becoming even more demanding on these issues. It won’t be long until extensive operational due diligence on suppliers and customers up-and-down your value chain will be a standard part of their questioning.

The plethora of ESG ratings, disclosure, and evaluation approaches aren’t helping matters. So how do boards assure themselves that their firm is positioned ahead of the curve on these issues? Thinking deeply about what “ever-increasing” community expectations mean for your firm and the products and services it sells is a useful exercise. Increasingly, it means that outcomes for customers that would be outrageous from your perspective or even against your interpretation of contract law could soon be the default new expectation for that product line.

As an extreme thought example, the “slippery slope” outcomes from a heightened focus on ESG risk could see enormous changes in product design that need to be thought about today to enable your firm to maintain its product and service catalogue in the face of ever-increasing demands from stakeholders who you may never have imagined would have a voice in your boardroom or management committee.

The previous bare minimum of sustainability reporting is now having climate-related risk financial disclosures added to the checklist.  The catchup required by firms is analogous to that on AML/CTF risk which many buried their heads in the sand on until they saw that the penalties for non-compliance had teeth. I predict that over the next decade, large financial services firms that currently have to balance technology investments in customer experience against risk & compliance will face a third stream of required investments in ESG related projects that will cost some tens of millions of dollars a year.

From a business strategy perspective, turning the cost of managing ESG risk on its head and asking the question: “can our operating model be simplified to remove or reduce ESG risk by design”? will be a differentiator from your competitors. The rise of B Corporations is merely the start of this. Increasingly, entire value chains will be sustainability-focused, and revenue growth will not be possible if you can’t meet the vendor selection criteria that will exhaustively interrogate your business on its ability to comply and attest compliance around an ever-increasing number of ESG risks.

Boards and senior executives will need to consider the breadth of their operating model carefully. To manage ESG risk appropriately, bringing previously outsourced capabilities in-house may be required. Some firms could face having to redesign their entire production capability as it stands today because they have no chance of meeting institutional investor expectations under their current operating model. This change will present enormous opportunities for disruptors in capital-intensive industries.   

Categories
Uncategorized

Sustainable Cities, Social License To Operate And Managing ESG Risk

The UN Sustainable Development Goals are a useful high-level framework for benchmarking your firm’s sustainability impacts. The 17 goals include issues such as climate change, reducing inequality, improving access to clean water, and building global partnerships between the public sector, private sector and NGOs.

Many top global firms already use UN SDGs in their annual sustainability reporting. They have identified where they can make an impact, and taken steps to reduce any negative consequences from their activities worldwide. They are just one of the many sustainability reporting options available to boards and senior executives.

Goal 11 of the SDGs is about making cities inclusive, safe, resilient, and sustainable. I think this is one of the dark horse goals of the SDGs – cities are so critically important, and nearly every country in the developed world has problems with their cities let alone some of the issues developing countries have with some cities development.

Many people want to move to cities because that is where opportunity exists. For some countries, only one city will be able to offer the incomes and opportunities that people desire. Some firms may want to think about how locations work in their operating model. There may be opportunities to build partnerships with cities that can offer employees something different in lifestyle or work-life balance.

Because cities are always evolving every day because of individuals choices, there is only so much that firms can do to help build sustainable and resilient cities. Central planning and coordination aren’t always going to align with how people want to live in the real world. Deeply ingrained cultural preferences seem to reject density and better investment in public transport.

Boards and senior executives may choose to diversify their locations away from large cities. However, large cities are still where much of the skilled workers live and are available for work. Remote work has not nearly been as prevalent as the technology could make it. Face-to-face communication is still critical for business-to-business sales and relationship management, for example.

ESG risks when it comes to city sustainability and resiliency may emerge in a firm’s real estate portfolio. Disclosure of the environmental impact of office space, retail space, and industrial space you own or lease will be required. Because of the ever-increasing community expectations on sustainability in supply chains, other participants in your value chain will need to share this data with your sustainability team.

Board and senior executive considerations

Understanding your current operating model and the locations where your value chain takes place is a crucial requirement for understanding your firm’s ability to make a positive social impact on Goal 11 of the SDGs.

If you are currently operating a flexible operating model with a wide range of vendors performing essential outsourced functions to deliver outcomes for your customers, understanding how they understand and manage sustainability in their locations is critical.

One of the ESG issues I predict will increase in severity in the 2020s is a backlash against large corporations using partnerships with cities to extract unfair advantages or subsidies over competitors. Some companies even play cities off against each other to see how much they can obtain from the public sector.

This sort of corporate behaviour will increasingly be scrutinised and punished. When inequality is higher, and many large firms have an already shoddy reputation, taking advantage of ratepayer or taxpayer money will become more difficult. The use of partnerships with cities will need to be carefully thought through to manage any ESG risk. The use of robust governance procedures and probity around these arrangements will be necessary.

One particular problem for some firms will be how they respond if one of their locations is green, sustainable, or low-impact on the environment – but a significant part of their value chain is delivering a negative social impact for a particular city.

Finding yourself in this situation may be easier than in decades past. The need to revisit your purpose and business strategy in a highly competitive environment with increasingly strict guardrails on all forms of corporate decision making mean even making appropriate business decisions like closing down an unprofitable part of your business will leave you pilloried.

Politicians on the left have increasingly used the phrase “a just transition” when it comes to moving workers from sunset to sunrise industries over time. If predictions about rising automation and its impact on jobs eventuate, then firms will need to delicately manage the changes in their labour requirements to avoid controversy.

The assessment of the current operating model of your firm should include observations on the automation potential for different parts of your organisation. Streamlined and automated customer experiences mean that many frontline roles will reduce over time and increasingly, higher-skilled workers who never expected automation out of a job will be in the firing line.

The constraints on corporate decision making mean that a press release driven approach to thinking about your impact on a city you operate in won’t cut it. Genuine partnerships with employees, suppliers, local and regional government, and other stakeholders will need investment.

Boards and senior executives can consider the perception of location changes within cities as well. For some employees, a location change could be extremely disruptive to their lifestyle, for example, if both parents are working. A serious consideration of how many people won’t apply for new roles at the new location should be part of the business case in these situations.

ESG risk management is comprehensive, and when you are operating under resource constraints in a competitive environment, tradeoffs will be required. This shift means that most CEOs will have to go back to the drawing board and revisit the purpose of their organisation.

Once they’ve done that, a radical transformation of their strategy and the design and implementation of a responsible operating model that enables them to deliver value to a wide group of stakeholders will be part of the execution side of their role.

The identification and triage of ESG risk isn’t a checklist exercise. It’s part of the risk management framework and will need to be embedded in the culture of a firm if there is any chance of avoiding existential controversies that destroy your firm’s social license to operate.

There are many businesses in 2020 that will not survive until the end of the year because of their indifference to ESG risk, let alone through to the end of the decade. Rising community expectations from the corporate sector mean that directors will need to interrogate the board reporting they receive and ask tough questions carefully. They don’t want to end up in the witness box of the next Royal Commission.

Categories
Uncategorized

ESG Risk, Technology Risk And Reducing Inequality

One of the UN Sustainable Development Goals is about reducing inequality among and within countries. The UN SDGs are a high-level framework of 17 goals that the world can achieve by 2030. They are useful as a way of understanding your firm’s social impact and identifying how to change your operating model to reduce any adverse effects or enhance any positive ones.

ESG risk and reducing inequality may seem entirely unrelated. However, there are ever-increasing community and employee expectations when it comes to issues such as executive compensation, wage growth, sharing in productivity increases, and managing rising living costs.

The detailed sub-goals of Goal 10 are really about the developing world, and not the relative poverty issues in developed countries. Many countries cannot afford social protection policies and legislation that richer countries can. Some richer countries place high tariffs on goods exported from poorer countries which makes it more difficult for people in these countries to trade their way to higher living standards.

An example of the ESG risk in this space is the cost of migrant remittances. Hundreds of millions globally send billions every year back to relatives in their home country. Often, there are high fees associated with this and many global financial institutions have encountered a lot of issues ensuring AML/CTF compliance in this space.

Goal 10.C is quite sad – reducing the cost of remittances to no more than 3% by 2030 and eliminating remittance channels that cost more than 5% in transaction costs. The rise of startups in developed countries that enable you to send money overseas at wholesale FX rates when poor people are charged enormous premiums is definitely in the social risk category.

Product management and pricing decisions around FX or overseas transfers will be even more complicated over the next decade than they already are. It’s certainly an area that is being disrupted by firms with better technology and customer experience than the banks. People who are moving between developed countries or paying less for their overseas holiday shopping and dining out capture much of this benefit in reduced costs.

When researching this particular UN SDG, the issue of technology startups in developed countries coming up with great ways to solve problems that only work in developed countries became quite clear. Many amazing innovations will only work if you have a passport from an OECD country. There are still enormous increases in transaction monitoring capability required to change negative screening for entire countries that some financial institutions still feel the need to do because their technology is decades behind Silicon Valley.

The strength of the focus on risk and compliance over the past decade has led many boards to authorise investment in their technology platforms. But merely spending hundreds of millions of dollars on technology isn’t necessarily enough.

How many ESG risks are hiding in the legacy technology ecosystems of major financial institutions around the world? A target operating model for a risk function includes more than just the implementation of transaction monitoring software. The people, processes and systems all need to work to clear principles and deliver the right outcomes for a broad group of stakeholders.

The irony of the enormous spend on risk and compliance technology, particularly regarding regulatory and legislative compliance, is that it has provided many large firms with the right model for how they might need to prioritise investment in climate change risk reduction.

The problem for the customer experience is that if you already have a poor customer experience that will cost $X to fix, and now your bank needs to spend a further $X on more risk and compliance programmes of work, then very soon you start running into a point where the duplication of all of these technology investments across different companies becomes redundant.

The role of a board is to provide governance to an organisation, and this includes making tradeoffs between Project 1 and Project 2. The problem is that many of the loudest voices criticising their every move on ESG risk don’t exactly appreciate the concept of constrained resources. For many financial services firms, they will face a point where they need to consider their entire current operating model and seriously rethink their purpose and strategy.

What is the link between this and the central problem of reducing inequality among countries and within them? Well, previously, a firm could make tradeoffs inside its operating model transformation that included plays like outsourcing or radical restructuring. Now, every person with a Twitter account could set off a backlash for something as random as invoice payment times for SMEs.

The reporting on this issue in Australia has been great because nothing could demonstrate more clearly to a board and senior executives that the operational-level decisions inside their operating model are now fair game. ESG risks must now be fully understood and considered at the customer interaction level and the supplier interaction level.

A board that wants to obtain an independent assessment of its ESG risk and current operating model should consider what social license to operate means in the 2020s. A higher proportion of people will increasingly demand more and more of the private sector.

Unlike politicians, CEOs face the market test. Many are already far advanced in changing their firm’s way of doing business to differentiate themselves from competitors. Higher enterprise value is likely to accrue to firms that have low ESG risk relative to other investment opportunities. Protecting access to finance at all should now be a consideration of boards – one serious enough ESG controversy could see lines of credit cut, investment banks no longer willing to work with you on a debt issue, or even suspension from trading on an exchange.

The level of seriousness boards and senior executives have to take these issues is quite clear. They are skating on thin ice in a real-time communication world. Independent assessment of the ESG risks they face and the steps to take to mitigate, reduce, or eliminate them will be a top focus for 2020 and beyond.

Large transformation projects that have already started may require even larger investments or potentially cancellation and writedowns. The business strategy of a large financial institution is also facing severe risk in an ultra-low interest rate environment. A pandemic related recession could be on the cards in many countries.

When interest rates go down, eventually there is no choice but for net interest margins to go down. The subsequent pressure on high bank operating expense ratios increases ESG risk even further due to the short-term earnings pressure from many shareholders. What a fascinating era!

Categories
Uncategorized

Sustainable Infrastructure And ESG Risk Management

The UN Sustainable Development Goals are a useful high-level framework for business to use in assessing its negative or positive social impacts. Global partnerships between government, NGOs, and the private sector will be required to achieve them by 2030.

The rise of community expectations around climate change and other ESG risks means that boards and senior executives can no longer function in “press release” mode when it comes to sustainability initiatives.

The management of ESG risk is a crucial part of your risk management framework, and firms need to identify and manage both quantitative and qualitative risks. The excuse that it is difficult to quantify some ESG risks will not cut it with stakeholders over the coming decade.

Institutional and retail investors will increasingly expect rapid and decisive responses to controversies, including the immediate resignation of directors and senior executives. “Riding out” the storm of displeasure will be very difficult given the increasing volume in the media on these issues.

One of the important considerations when thinking about sustainability reporting and the achievement of the UN SDGs by 2030, is that innovation and profitability in the private sector is a crucial success factor.

Many businesses have the opportunity to assess their current operating model, identify where and how they can make a positive social impact, and move towards implementing a responsible operating model that delivers for a full group of stakeholders while still generating an appropriate level of profit.

Goal 9: Build resilient infrastructure, promote sustainable industrialisation and foster innovation

Goal 9 of the UN SDGs is about how essential investments in underlying infrastructure are to enabling sustainable development. Technological efficiency, energy-efficiency, and increased productivity enabled by investments in transport, energy, technology, healthcare, education, and irrigation will all help developed and developing countries alike in improving their standard of living.

A lack of necessary infrastructure in developing countries means that their people are at a clear disadvantage when it comes to ease of access to more markets to sell their products and services. Sustained employment growth will become more realistic for some countries once appropriate infrastructure investments are made and brought online.

Environmentally sound infrastructure development will help achieve other sustainability outcomes while providing lower environmental impacts from infrastructure development. Firms who operate in the infrastructure sector will be able to share their best practices with developing countries to enhance ecological efficiency for new projects.

For firms operating in developed countries, assisting in developing countries and providing technology investments where feasible can help accelerate sustainable development. For example, substantial investment in mobile phone networks in Africa has enabled a wave of entrepreneurship and innovation to take place in previously unconnected communities.

Board and Senior Executive Considerations

Boards and senior executives in other sectors may not think they can have any impact on this particular goal. However, UN SDGs are a broad church of targeted outcomes for a global society. One of the more effective ways that any business can make an impact on these goals indirectly related to your business is through due diligence and standards for your broader value chain.

The first exercise is a current operating model assessment that looks at your present purpose, strategy, and operating model. The outputs of this exercise can be mapped at a high-level to each of the 17 UN SDGs to provide input into the next activity.

The second exercise is mapping the current operating model outputs to each of the UN SDGs and identifying the positive or negative social impacts your business currently has. There may be somewhere there are none, there may be others where some substantial impact is possible.

The third exercise is taking the first two exercises into account and re-examining the purpose of the business. Why do you do what you do? Is your goal relevant in the 2020s? Are you a sunrise or a sunset business?

The fourth exercise is then revisiting the business strategy. Does it help or hinder the achievement of sustainability outcomes? Are there any products or services that need changes or closing down in light of changes in community expectations today or anticipated changes in community expectations tomorrow?

Once the current operating model, mapping exercise, purpose re-examination, and strategy re-examination are complete, a broad group of stakeholders should participate in the development of a responsible operating model.

The current trend in transformation is to speak of the target operating model; however, in the 2020s, it will be necessary to design and implement a responsible operating model. Sustainability outcomes must be incorporated into the design and planning stages of any transformation program. If they aren’t, they won’t be delivered.

One of the changes in thinking about ESG risk is that the business case is about the enterprise value of the business itself. Issues that even five years ago may not have merited a mention in a footnote to a presentation could now present themselves as existential crises for a board of directors.

Over the past decade, the cost of implementing appropriate systems and controls to manage compliance risk has been billions of dollars for the financial services sector. The coming decade will see a further increase in required technology and project expenditure to give boards and regulators assurance that a framework is in place and monitored actively at all levels of a business when it comes to ESG risk.

Other industries have faced similar costs, such as the impact of health & safety legislation on the construction sector. But no one would argue that making sure everyone goes home from a worksite at night is less important than making a profit at any cost. However, 30 years ago, those arguments were undoubtedly being made by some construction sector executives and boards.

Times have changed, and old attitudes towards ESG risk will need to be updated. The current economic environment globally, where the asset markets have boomed, and many companies rebounded from the Global Financial Crisis after brief tests in 2008 and 2009 of their operating model, means that the next downturn will provide an opportunity for deep introspection and consideration of what a responsible operating model needs to look like for a secure strategic position relative to your competitors in the coming decade.