What is Regulatory Risk?
Regulatory risk is the risk that a change in regulations or legislation will affect a security, company, or industry. Companies must abide by regulations set by governing bodies that oversee their industry. Therefore, any change in regulations can cause a rippling effect across an industry.
Regulations can increase costs of operations, introduce legal and administrative hurdles, and sometimes even restrict a company from doing business.
Regulatory Risk from Regulatory Changes
Governmental and regulatory bodies often enact new regulations or update old ones. Here are some examples of regulatory changes that may affect companies or industries:
1. Tariffs and trade policies
Changes to international trade policies may affect companies that regularly export and import goods. They also affect investors that engage in foreign direct investments.
Investing in Chinese stocks is also restricted. Foreign investors have historically only been allowed to invest in ‘B shares’ that are denoted in USD. ‘A shares’, which are denoted in RMB, have typically been restricted to domestic investors. This was changed with an announcement that was made in July 2018.
In July 2018, China announced intentions to allow foreign individual investors access to A shares through domestic brokerages. In this case, the regulatory change was beneficial to individual investors.
2. Tax policy reform
Tax policy reforms can affect the bottom line for businesses and individual investors alike. Any change to income tax law directly affects the income being brought in by respective parties and may present new regulatory risk.
3. Minimum wage laws
Increases to minimum wage can be a critical source of regulatory risk, as they substantially impact businesses, especially if they hire large quantities of low-skilled labor. In particular, small businesses suffer greater losses due to their inability to access economies of scale.
4. Mandated vacation and sick days
Similar to the above examples, changes to mandated vacation or sick days affect a company’s bottom line as they are required to give employees more time off.
However, the opposite can be argued. By allowing employees to have more vacation days, they will be less burnt out and more productive during days in office. Stress-related issues can also be alleviated with more vacation days.
By allowing employees more sick days, office productivity may also increase because employees keep illnesses out of the office. The effects of this topic are continually being studied.
As you can see, many of the examples above can present regulatory risks that may directly affect a company’s bottom line. In some cases, the effect is not easily observable, such as with mandated vacation and sick days. Sometimes regulatory changes can benefit investors or companies.
Companies may be penalized if they do not comply with regulatory changes. It is important for businesses to pay attention to and manage regulatory risk by ensuring compliance and diversification in its operating strategies.
For example, in the case of diversification, a company can protect itself from trade policy changes with any one particular country by diversifying its market into multiple countries.
Financial institutions are often subject to regulations with regard to disclosure, investment strategies, and liquidity requirements.
For example, the alternative uptick rule was a rule passed by the United States Securities and Exchange Commission (SEC) in 2010 in efforts to preserve market stability and confidence. The rule ensures that a short sale order must be entered on an uptick (where the price of a security is higher than its previously traded price). It is invoked when a stock’s price drops more than 10% in one day and heavily affects how investors who take short positions invest.
Regulatory risk is an important consideration of strategy that is covered in CFI’s Corporate & Business Strategy course!
Case Study – Example of Regulatory Risk
The Canadian lumber industry has continually faced challenges with regulatory risk. Here we look at a case of how Canfor Corporation was affected by regulatory changes and how it overcame them.
Below is an excerpt from Canfor Corporation’s (TSX:CFP) 2017 annual report, denoting higher legal costs due to the expiry of the Softwood Lumber Agreement (SLA). This is an example of a company and industry suffering from regulatory risk.
Image sourced from Canfor Corporation’s 2017 Annual Report.
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Softwood Lumber Dispute
The Softwood Lumber Agreement was an agreement between Canada and the United States of America. This agreement was introduced in efforts to settle the longstanding softwood lumber dispute.
The core of the softwood lumber dispute is that the United States claims Canadian lumber is unfairly subsidized by provincial and federal governments. The U.S. claims that this subsidy allows Canadian exporters to beat U.S. market prices. As a result, the United States lumber industry has frequently petitioned the U.S. Department of Commerce (DoC) to impose countervailing and anti-dumping duties on Canadian imports of lumber.
1996-2003 Softwood Lumber Agreement
The Softwood Lumber Agreement first came in place as a five-year trade agreement in 1996, scheduled to end April 2001. A consensus could not be reached to extend or renew the agreement. In April 2002, the U.S. DoC announced countervailing and anti-dumping duties. The result of this was a mass layoff of 15,000 British Columbian workers by February 2003. It is clear from this event that changes in trade policies have widespread effects on companies and industries.
2006-2015 Softwood Lumber Agreement
The next rendition of the Softwood Lumber Agreement came in 2006. The United States agreed to lift countervailing and anti-dumping duties so long as lumber prices stayed above a defined range. The agreement expired in October 2015 and was not renewed or replaced. In November 2016, the U.S. DoC initiated countervailing and anti-dumping investigations and named Canfor Corporation as a mandatory respondent.
Impact of the Expiry
As shown by the above excerpt from Canfor Corporation’s 2017 annual report, the expiry of the Softwood Lumber Agreement has a direct material effect on the bottom line of a company. Canfor incurred substantial legal costs in 2017 compared to 2016 as seen in the ‘Unallocated and Other’ line of this statement.
Additionally, the effect of the expiry can be observed in the stock price history of companies in the forestry industry. Below is the five-year stock price history (as of September 2018) of West Fraser Timber (TSX:WFT) and Canfor Corporation (TSX:CFP), the two largest lumber firms in Canada.
Image sourced from Toronto Stock Exchange official website.
The large dip seen in the periods of 2015-2016 can be attributed to three factors:
1. Softwood Lumber Agreement Expiry
The expiry of this agreement caused uncertainties for the lumber agreement. It was likely that the U.S. DoC would impose countervailing and anti-dumping duties. The primary concern was whether the additional costs from duties could be passed on to consumers. If demand was strong enough, costs could be passed on as price increases. If not, these costs could have caused some Canadian production to become unprofitable.
2. Extreme weather conditions
A period of extreme cold weather conditions affected the lumber industry as a whole. The cold conditions reduced operating days, lowering production. The cold weather also increased costs such as natural gas and maintenance costs and affected the transportation of logs.
3. Mountain pine beetle infestation
The mountain pine beetle (MPB) infestation plagued the western Canadian lumber industry for over a decade. The infestation damaged pine trees, lowering production and reducing the quality of products. In addition, the infestation’s effect on timber supply also caused regulatory changes in the Allowable Annual Cut (AAC) rate. The AAC rate determines the allowed harvesting rate to ensure sustainable harvesting in Canada. The above factors reduced supply and caused the closure of Canfor’s Quesnel sawmill.
It is clear here that regulatory risk and its associated uncertainties were a large factor in the price drop observed between 2015 and 2016. Both of the companies faced risk in the form of potential duties and Annual Allowable Cut rate reductions.
To mitigate the regulatory risk posed by the reduction in AAC rates and the MPB infestation, Canfor Corporation acquired additional sawmills and harvesting rights. They were in areas unaffected by the MPB infestation or areas which had their AAC rates increased. Canfor also closed down its Quesnel sawmill, which became unprofitable due to limited timber supply. In addition, Canfor continued to acquire and operate sawmills within the United States where timber supply is not affected by MPB issues.
The acquisitions of U.S. sawmills can also be considered a diversification strategy against the expiry of the Softwood Lumber Agreement. By owning more sawmills based in the United States, Canfor mitigates some of the effects of duties that may be imposed against them.
A strong price resurgence is seen in the following years after the expiry. This is largely due to the high demand for Canadian lumber from the U.S. housing market. This demand has allowed Canadian lumber firms to pass on the additional cost from countervailing and anti-dumping duties imposed on them in the form of higher prices.
This shows that regulation changes have varying outcomes that can harm or benefit firms and their corresponding securities.
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