business man playing jenga

In a new report, Transforming World: The 2020s, Bank of America Merrill Lynch (BAML) analysts say: “We enter the next decade with interest rates at 5000-year lows, the largest asset bubble in history, a planet that is heating up, and a deflationary profile of debt, disruption and demographics. We will end it with nearly one billion people added to the world, a rapidly ageing population, up to 800 million people facing the threat of job automation, and the environment on the brink of catastrophic change.

“At the same time, three billion more people will be connected online and global data knowledge will be 32 times greater than today. The social, political and economic responses to these challenges, all heading to a boiling point this decade, will overhaul traditional paradigms.

“During the next 10 years, we should see increased automation, a global recession, unprecedented innovation, serious environmental challenges, the death of quantitative easing, tectonic shifts in demographics, and the end of globalisation.”

As the new decade heats up, here are eight big issues directors should keep their eyes on:

1) Climate change risks

Climate change is a recent, but significant, entrant on the risk register. Ignoring foreseeable climate-related risks could lead to a breach of directors’ duties, says Louise McCoach, special counsel at Gilbert + Tobin law firm.

She says directors need to consider the following risks.

  • Reputational risk — arguably the most damaging and least quantifiable risk, particularly if the company supports or engages in carbon intensive activities.
  • Stranded asset risk — companies with business models dependent on carbon-intensive activities will need to assess the risk to assets that could be devalued or written down. Even companies not directly involved in these activities will need to question the risks if they are, for example, financing mining projects or managing superannuation funds for such companies.
  • Physical risk — for companies at risk from floods, cyclones or fires, either directly or indirectly through a supply chain or distribution network. Also, would your workforce be impacted by such events?
  • Litigation risk — is there the possibility of your company being sued for loss or harm suffered because of its adverse impact on the environment?
  • Regulatory risk — the risk of new laws being introduced that impose compliance or economic burdens that could threaten your financial viability. Obtaining regulatory approvals for activities that have an environmental impact, such as mining licences, may be subject to longer timeframes, and rejections may become more frequent based on environmental concerns.

2) Trade turmoil

In the BAML report, analysts say the 1981–2016 era of unrestricted globalism is coming to an end, with the US/China trade war the first of many signs that the global flow of goods is being renegotiated.

“Bilateral trade battles (US/China, Japan/Korea, US/UK) are replacing multilateral frameworks (NAFTA, TPP) and some corporates are planning relocations of supply chains to regional allies. These tectonic shifts will likely lead to greater macroeconomic volatility.”

BAML’s analysts also expect countries to develop explicit national industrial policies and boost spending on research and development to foster local innovation, protect nascent industries and shield national champions from hostile foreign takeovers.

The US/China trade war is already hurting. In the International Monetary Fund’s (IMF) October World Economic Outlook report, it warned the trade conflict would cut 2019 global growth to its slowest pace since the global financial crisis (GFC) and could darken the outlook considerably if trade tensions remain unresolved.

“The weakness in growth is driven by a sharp deterioration in manufacturing activity and global trade, with higher tariffs and prolonged trade policy uncertainty damaging investment and demand for capital goods,” IMF chief economist Gita Gopinath said in an online blog.

Associate Professor Heng Wang, professor and co-director of the Herbert Smith Freehills China International Business and Economic Law Centre, UNSW Law, says another big risk is that the World Trade Organization’s (WTO) Appellate Body may not be able to work as it did before. It’s been hampered by the US Trump administration’s refusal to fill its vacancies for judges, leaving pending appeals in limbo.

With less trade disputes being addressed by the WTO, Wang believes more unilateral measures may be taken. “This could affect the global value chain as businesses may make adjustments to reduce the costs incurred,” he says. “But there could also be opportunities as it means businesses will need to plan their operations again carefully.”

As a medium-sized open economy, Australia relies on the WTO’s trade rules and enforcement mechanisms to provide certainty and underpin its network of free-trade agreements (FTA).

Wang advises boards to have a plan B if the trade turmoil continues. “It may be smart to identify and reap new opportunities arising from the trade turmoil when businesses and other stakeholders seek new pathways,” he says. “For instance, will any new opportunities arise from the new value chain? What are the opportunities when the value chain moves to new places or consists of new components?”

He says directors should also consider the Regional Comprehensive Economic Partnership (RCEP), a planned regional FTA among 16 countries including Australia. If concluded, it could bolster regional trade and investment.

BAML’s analysts believe the US/China trade war will transition into a tech war in the 2020s. “China’s strategy is to ensure 40 per cent of its mobile phone chips, 70 per cent of its industrial robots and 80 per cent of its renewable energy equipment is made in China by 2025. This China First strategy will be met head-on by an America First strategy.”

3) Natural disasters

Australia’s catastrophic bushfires are a reminder that directors should be considering disasters in their decision-making, says Mark Baker-Jones, special counsel on climate change at New Zealand law firm Simpson Grierson.

“Exactly what those considerations might be for a particular company will depend on a number of factors,” he says. “For example, if a company is a heavy carbon emitter, its directors should be thinking about whether the bushfires will cause investors to redirect investment to operations with less climate-related risks. “If a company is directly affected by the fires or is dependent on a supplier or purchaser that has been affected by the fires, then directors will be considering the risk of future bushfire events affecting supply and value chains.”

Andrew Korbel, a partner at Corrs Chambers Westgarth, says directors should also consider how climate change and the bushfires can affect demand for their products or services, and the physical and mental health of staff and their productivity. Also important is what type of philanthropic role the company can play and how it can support affected communities in which it operates.

Dr Nick Wood, an associate at climate specialist company Energetics, says directors should consider how their organisations can better prepare for bushfires as they do for, for example, cyclones. “Businesses know how to do this, but when it comes to bushfires, it’s a new scale of risk and a lot of people have been caught out.” Wood believes boards and management should sit down while memories are still fresh and review what worked during the fires, what didn’t and what needs to be done better next time.

Baker-Jones says directors should also examine if the bushfires will affect insurance costs or lead to more regulation. “There’s been a slow response so far in Australia at federal level, but this will change and as such, companies will be subject to an increase in regulation governing emissions and internalising adaptation costs. This could occur quickly, as it has in other countries, and will be transformative.”

Louise McCoach, special counsel at Gilbert + Tobin law firm, believes new opportunities can also be created from an increased focus on climate change, especially for companies that can successfully commercialise products or services which facilitate the global transition to a low carbon economy.

“Companies with strong sustainability credentials will be more attractive from a credit perspective, particularly for environmental, social and governance (ESG) investors or asset managers with ESG mandates,” she says.

 

McCoach adds that boards can avoid shareholder activism by successfully and proactively managing climate risks. “ESG issues are at the forefront of investor engagement and long activist campaigns in the US. Even in Australia, the 2019 AGM season saw eight of the ASX 50 face ESG-related activist shareholder resolutions.”

4) US political drama

With US President Donald Trump unlikely to be removed from office despite impeachment proceedings, his focus is expected to swing back to the US election and especially the US economy.

Professor Simon Jackman, CEO of the United States Studies Centre at the University of Sydney, says, “Trump would dearly like, as any president running for re-election would, to ask that ‘Ronald Reagan question’ — that is, are you better off than four years ago? If yes, then vote for me!”

However, Dr Bryce Wakefield, national executive director of the Australian Institute of International Affairs, says we shouldn’t count on old trade policies returning if Trump is not re-elected.

Whether it is Trump or Democrat frontrunners such as Bernie Sanders or Elizabeth Warren who win the election, Wakefield says it’s clear the US isn’t going back to its preference for the large multilateral FTAs, which have been its trade policy since the Clinton administration days.

“Warren, for example, might be just as hard — or even harder — on China, introducing factors that Trump doesn’t really care about, such as labour standards, climate change and human rights considerations, into trade negotiations,” he says. “Both Trump and the Democratic frontrunners also favour protecting US jobs from Chinese competition.”

So what sort of US will we have after Trump?

“Across the political spectrum in the US, patience has run out with China and there’s a lot of anger from the business community,” says Jackman. “Many parts of the US are fed up with China in a way that is hard for Australians to understand. Economically, China is a good news story for us. It buys more of our stuff than we consume of its stuff. We run a trade surplus largely based on commodity exports where intellectual property (IP) issues don’t typically arise.

“US businesses are more involved in services or high-technology. There’s a big difference in how they do business with China. Plus, there’s Washington’s unease about China’s rise as a strategic competitor to the US. If you put the two together and then add in qualms about China’s human rights, China doesn’t have a lot of friends in Washington or New York.”

Jackman adds the US view of China “is not a Donald Trump thing”. “Regardless of who’s chosen as US president next year, we’ll see much more hawkishness, vigilance and assertiveness towards China, particularly around IP and national security. That was going to happen anyway.”

Jackman also advises Australian boards not to get too distracted by all “the drama that is Donald Trump”.

“America is getting on with business,” he says. “It is a huge economy and remains a place where Australians like doing business. The rules of the road are quite transparent. It’s English-speaking. It’s easy to get your money in and your money out. The US is also a very diverse market. It has 50 states made up of many regions and markets. There are lots of different places to do business and grow businesses in the US. There’s also an awful lot of business to be done on a state and local government level. States compete heavily to attract business. There are a lot of opportunities and state capital projects.”

5) Brexit

 

Wakefield believes the UK will be the big loser from Brexit. “As a whole, the European Union (EU) will suffer, too. However, there will be, and there already are, some winners. Many financial institutions and other companies based in London and elsewhere in the UK will move to cities on the continent. About 100 companies have already moved to Amsterdam, in the Netherlands, for example.

 

“Brexit has already accelerated a push by the EU to conclude FTAs around the world, including with Australia,” he says. Although barred from official negotiations until Brexit, Wakefield says the UK will be looking to seal a FTA quickly with Australia as a model case. “If it can’t negotiate with Australia, with which it has so much in common, then what chance does it have with countries more culturally and linguistically different?” he says. However, Wakefield warns there may be roadblocks to a smooth deal.

“UK trade negotiators will be busy attempting to hash out post-Brexit UK-EU and UK-US deals, for example, both of which are obviously far more important to the UK than any deal with Australia,” he says. “Some sectors of the Australian economy may well want the government to prioritise a deal with the UK over the EU. It’s probably easier for certain agricultural producers, such as winemakers, to gain an advantage in Britain than in Europe as the result of a FTA.

“Nevertheless, we are in uncharted territory here. Post-Brexit investment into the UK is likely to be sluggish and consumer demand is likely to slump.” Wakefield advises Australian boards to examine the opportunities a FTA with the EU can offer rather than just assuming the door to trade with the UK will open wide for Australia.

6) Chinese tensions

Australia’s relationship with China is complicated, says Jackman. It’s not only because Australia’s biggest political ally, the US, is engaged in a trade war with its most important trading partner. Tensions have been brewing in many areas, including claims of foreign interference and spying, a ban on Huawei 5G equipment, China’s growing influence in the Pacific, suspected cyberattacks, and human rights abuses in Xinjiang.

“There’s been a reappraisal of China by the Australian government, but not as much by the business community,” says Jackman. “China is also trying show Australia that it’s not too happy with some of the things we are doing from a national security point of view.”

Jackman believes China’s crackdown on Hong Kong protestors is also an issue. “Many Australian firms have an exposure to Hong Kong. For Australian businesses, Hong Kong is the stepping stone into the Chinese market.”

He says the Hong Kong situation shows the world China is a very difficult place to do business in. But it’s also likely to benefit Singapore, and perhaps Australia, in a smaller way. “For example, Sydney or Melbourne may look increasingly attractive as a regional base for your operations.”

7) A rising governance bar

Australian directors will no doubt be asking themselves some crucial governance questions in 2020 as the fallout continues from a barrage of royal commissions and inquiries. At present, there are reviews into aged care, the corporate criminal responsibility regime and the regulation of auditing, among others. However, the banking Royal Commission and the Inquiry under the Charitable Fundraising Act into the NSW State Branch of the RSL (the Bergin Inquiry) have already provided directors with much to chew on when it comes to culture.

John Keeves, a partner at lawyers Johnson Winter & Slattery, believes the biggest messages for directors from these are:

  • Good governance really matters. “It’s not just a box-ticking exercise. Or more correctly, poor governance can lead to extraordinarily bad outcomes,” he says.
  • Non-financial risks can have some pretty serious financial consequences. They need to be managed differently from financial risks. “The possibility of making more money does not justify unethical or unlawful conduct.”
  • Conduct your business as if every decision could be written about on the front page of newspapers or social media equivalent.

Directors should be up to date with the 4th edition of the Australian Securities Exchange (ASX) Corporate Governance Principles and Recommendations, which takes effect for a listed entity's first full financial year commencing on or after 1 January 2020.

In particular, Jonathan Casson, a partner at Holman Webb Lawyers, points to principal three, which encourages listed entities to focus on the organisation’s culture of “acting lawfully, ethically and responsibly” and to consider a range of stakeholders beyond just shareholders. In addition, listed entities should also articulate and disclose their values and have policies for whistleblowers, as well as for anti-bribery and corruption. Casson adds: “Boards should be conscious of the stronger level of cooperation for enforcement between the Australian Prudential Regulation Authority and Australian Securities and Investments Commission, and their new policy of ‘why not litigate?’.

“And there should be an increased focus on an entity's ethical obligations — especially, but not only in the financial sector – and an awareness of the changes in the Corporations Act regarding criminal liability, and the definition of ‘dishonest’.”

8) IFRS16

The IFRS16 international finance reporting standard removes the distinction between finance and operating leases, requiring almost all leases to be recognised on the balance sheet.

It is effective for periods beginning on or after 1 January 2019, meaning that for many Australian entities, the changes will be effective for 30 June 2020 year-ends. According to the International Accounting Standards Board, it will affect an estimated US$2 trillion in the leased assets of listed companies using IFRS or US GAAP. “IFRS16 is one of the most fundamental changes to how many companies finance their businesses,” says Mark Arnold, a finance transformation partner at Deloitte Australia. “Many companies underestimate its impact on their key debt ratios, as well as the time and effort required to gather and interpret their lease inventories.” Sean Rugers, a partner at PwC Australia, says boards should be considering how IFRS16 could affect their broader business operations. “The leasing standard can have a material impact on many financial reporting measures, such as net debt and EBITDA, which are often used as key ratios for things such as banking covenants, credit ratings, management bonuses and merger and acquisition earn-out ratios.”