In the summer of 2012, the worst drought for 80 years devastated the US corn harvest. By the following February, markets for ethanol markets – of which US is a major producer and corn a major feedstock – had spiked in anticipation of a huge shortfall in corn, unexpectedly pushing up the price of biodiesel. Corn supplies hit a 17-year-low in August 2013, reversing the trade flows such that Brazil and the Southern US states are instead supplying the world’s corn belt to meet demand from local ethanol factories.
Poultry farmers found themselves priced out of the market and had to find alternative sources for feed. Yet only a few months later corn futures had fallen to half their historic high in 2012, following news of a record harvest across the US midwest in 2013. Market volatility, energy and food-supply risk are all linked to corn supply. The price of corn has even been linked to an increased risk of food riots, due to its strong influence across the Food and Agriculture Organisation of the United Nation’s (FAO) food price index.
The impacts of such unexpected events for business can be huge. Three quarters of the food on US supermarket shelves contains corn in some form, and corn derivatives are ingredients for products as diverse as batteries, glue and bioethanol. Rising prices of the commodity threatens profit margins for any product containing corn, and shortages of supply may make it difficult to produce these goods in the first place.
Changing Risk Complexity
Anticipating and responding to risks is business as usual for all sectors. While the above example is for corn, it is just one of many that one could choose from any agricultural commodity. This industry is no stranger to dealing with the risks of supply-chain disruption, both man-made (such as export restrictions) and natural (such as flooding and drought). What is changing is the complexity of the risks, their interdependence with other risks and the wide-reaching, contagious impact they have.
The other major factor set to exacerbate supply chain risk is climate change. Often overlooked, climate change adds to complexity. It amplifies or alters existing risks, for example raw material availability (such as water and energy) or transport disruption due to extreme weather events. The resulting shocks on the global supply chain can be severe and persistent.
These shocks have broad impacts across food commodity markets – the table below provides an example of how these markets have been affected by climate risk in recent years:
The impacts of these risks are set to grow as climate change risk increases in coming years. The latest update from the Intergovernmental Panel on Climate Change (IPCC) is that the global mean temperature has already increased by 0.85ºC above pre-industrial levels, and future food security is recognised as a key risk from climate change. We can also look at estimates of global insured losses from major extreme weather events. In the last two decades losses have increased markedly, averaging tens of billions of dollars annually.
Each year, government representatives from around the world meet at the UN Framework Convention on Climate Change (UNFCCC). They have agreed to limit the average global temperature rise to 2ºC, and identified actions to mitigate and adapt to climate change. In spite of these efforts, carbon emissions have continued to rise. Can we really limit the temperature increase to 2ºC? PwC’s Low Carbon Economy Index suggest that, based on current progress, this is ‘improbable’; if current emission trends continue, we will have blown the carbon budget for the entire century by 2034, or 66 years early.
The World Bank predicts we are on track for a 4ºC warmer world within the century. As an example, this means drought-affected areas would increase from 15.4% of global cropland today to around 44% by 2100, most severely impacting the US, Southern Europe, Southern Africa and Southeast Asia.
So what action should be taken to deal with the risks presented by climate change? To start with, gaining an understanding of the risks is key.
For example PwC recently undertook a
climate risk analysis
for a major UK supermarket chain’s global fresh produce line. Using a vulnerability-based model, we were able to look at – presently and in the future – how climate variables (temperature, water, humidity, wind, cloud cover, sunshine) affect the growing conditions required for fruit and vegetable production, against the context of wider business risks (for example political, tariffs, land rights and infrastructure). From this analysis, the supermarket gained a deeper understanding of the specific climate and non-climate risks associated with sourcing fresh produce from particular locations, with a value at risk (VaR) calculation to help quantify strategic priorities.
The supermarket can now identify vulnerable sourcing countries and develop adaptation strategies for high-risk fresh produce items. These strategies will vary according to the commercial importance of the sourcing location compared to the level and nature of the climate risks it faces. For example, if a sourcing location is commercially important but has a high level of climate risk, then the strategy may focus on mitigating risk.
This could include providing support for ‘climate-smart agriculture’ – i.e. improving agricultural practices, which strengthens the resilience of farms to climate change. Experiences with these types of practices have proven very important when dealing with storm events and excess precipitation – watershed management have increased Peru’s potato yield from 850kg to 3,933 kilogram per hectare (kg/ha).
Food commodity procurement is becoming more complex because of the combination of risks associated with physical sourcing described above, with the financial risks from fluctuating commodity prices. As food pricing provisions become more complex within procurement contracts, companies are faced with an increased set of risks to manage.
In response, companies are looking to join the physical procurement process with the financial risk management process in order to manage these risks together. Data analytics embedded in risk management systems are also being used to help identify areas of improvement such as stock keeping unit (SKU) level margin management and working capital management across a product portfolio. In future, it will be critical for treasury and procurement teams to work together to manage the physical and financial risks associated with commodity procurement.
We have been witness to a series of significant security events recently around payment execution, from Leoni in Germany through to ABB in South Korea and SWIFT in Bangladesh to name a few of the major headlines.
The revised Payment Services Directive regulation, regarded as one of the most disruptive in Europe’s financial services sector, will begin to make an impact on January 13, 2018.
The cost of compliance efforts for banks has increased exponentially in recent years. This is especially true for those banks that are active in the global trade finance domain, where the overwhelming expectation is for compliance requirements to become even more complex, strict and challenging over time.
This year promises to further the regulatory compliance burden imposed on financial institutions. How are firms in the sector responding to the challenge?