Welcome to the October 2011 edition of The Director's Dilemma.
This newsletter provides case studies that have been written to help you to develop your judgement as a company director. The case studies are based upon real life; they focus on complex and challenging boardroom issues which can be resolved in a variety of ways. There is often no single 'correct' answer; just an answer that is more likely to work given the circumstances and personalities of the case.
Although these are real cases, the names and some circumstances have been altered to ensure anonymity. Each potential solution to the case study has different pros and cons for the individuals and companies concerned. Every month this newsletter presents an issue and several responses.
Consider: Which response would you choose and why?
Ella is chair of the board's strategy committee for a large government-owned utility business. The company is planning some necessary infrastructure which will have a life in use of approximately 50 years and which is needed to be available for the community within three years.
The industry regulator has just issued some new guidelines that, following a period of industry consultation, will become the basis for regulation in the future. They are very onerous. Industry participants are complaining and asking for the standard to be lowered but the regulator is very committed to the new standards this proposed regulation would set. The Government is supporting the regulator and the Opposition is saying that the new standards will stifle industry and would be repealed if they came into power.
The problem is that Ella's board needs to let contracts now or risk not having the infrastructure built in time. Building to meet the proposed standards will result in a costly asset that will not be able to cover its cost of capital if the standards are lowered: competing infrastructure could be developed to undercut the incumbent and the pricing regulators will not enforce a usage fee above market rates. Building to the existing standard could result in infrastructure that breaches the regulations when construction is complete. Waiting to see what the regulation is going to be before starting to build will not provide the infrastructure when it is needed.
Management is looking to the board for leadership on the issue.
What should Ella do?
Jay's Answer
Begin by quantifying the risk. If you proceed and get caught out, what will it cost to rectify? What are the chances of that happening? Multiply the two to quantify the value of the risk. Management then has some context in which to consider the decision.
Waiting is not really an option, since you say that meeting the deadline is then impossible. In this scenario I'd do a number of things. First, I'd look at the project plan and see if there's any opportunity to front-load activities that are common to both possible outcomes. That way construction can get underway immediately while the regulation is pending.
Second, I'd start planning for every possible scenario in order to reduce execution time later. Whether the regulation passes or not, whether you require emergency changes to the project or not, you just take the plan off the shelf and execute it. This is part of your risk mitigation and damage control.
Third is addressing further risk mitigation and damage control: work on lowering the cost of capital so any losses are minimized.
Fourth, try to insure the risk. Then you can proceed and have your risk covered if urgent demolition and reconstruction is required.
Fifth, hedge. If these tough regulations pass, will that increase the cost of energy, suppress profits in the energy sector, or have any other predictable economic effects? If so, you can hedge your risk by betting on them. That may generate enough extra income to get you over your hurdle rate for the project in the event the regulation passes unexpectedly.
Lastly, work with government through an experienced lobbyist. Politicians have an interest in the welfare of companies and the creation of jobs in their jurisdictions. Negotiation might be possible.
Jay Lebo is a Principal at Gravitas Business Architects, based in Toronto, Canada.
Julie's Answer
As a government-owned business Ella's company must deliver the policy outcomes of the government of the day. She should keep an eye on electoral cycles and alert the department if an election is likely to be called whilst the issue is out for tender or under determination prior to award.
The Chairman, with Ella's assistance, must keep both the portfolio and the treasury Ministers informed. It is important to let the Ministers know that the project will cost more if it is to meet the new regulations and that the project is viable but at a higher price for users. The Ministers must understand that the company will build to the higher standards as these are currently foreseen and likely to be implemented.
Ella should identify the cost difference of building to the current and proposed standards and ensure that the company can either generate the funds required to build the asset or gain a commitment from the current government that the shareholder will inject funds when they become necessary for investing in the project.
Ella should also investigate the availability of grant funds for companies to adjust to the new higher standards. She and/or an executive can liaise with the treasury department on this. The whole board should be kept informed.
Once Ella knows that her board can commit to the project without risk of taking the company towards insolvency then she should develop a full CapEx (capital expenditure) submission for board approval. This is too important for a committee to approve.
If a change of government lowers the regulatory standards, and hence the price and value in use, then the board will need to revalue the asset and charge a reasonable usage fee based upon the new value and a sensible depreciation/amortisation rate. The write down will affect profit in the year that it occurs and the incoming government must accept this.
Governments plan for the long term and are often more willing to invest in proving that new standards and better performance is possible.
Julie Garland McLellan is a specialist board consultant and practising non-executive director based in Sydney, Australia.
Tim's Answer
Many decisions are appropriately made through a process of informal deliberation around the board table. This is not one. The complexity of this type of decision would make it vulnerable to a range of individual cognitive biases on one hand and problems of group interaction on the other.
Leadership from the board in this case would consist in the requisitioning of a thorough decision analysis. A decision tree would map out the various options available at this time, the events which might change the situation, and the ways the business might respond. The relevant costs and probabilities and payoffs should be quantified and entered into the analysis. The analysis should incorporate the costs of any provisioning or insurance options.
Any such analysis would inevitably incorporate numerous forecasts or estimates. Most obviously, the analysis would have to consider the probability of the Opposition (a) becoming government, and (b) if in government, actually following through on its promise to repeal the new regulations. Such estimates should be sharpened through rigorous elicitation techniques of the kind developed at the Australian Centre for Excellence in Risk Analysis.
Since ineliminable uncertainties will remain, quantitative methods such as Bayesian analysis or Monte Carlo simulation can be used to determine the distribution of possible outcomes for each of its major options.
Properly conducted, such an analysis would provide the board with a rigorous foundation for selecting the most promising path.
Tim van Gelder is an associate at Melbourne Sustainable Society Institute and a Principal at Austhink.
Disclaimer
The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling. Names and some circumstances in the case study have been changed to ensure anonymity. Contributors to this newsletter comment in the context of their own jurisdiction; readers should check their local laws and regulations as they may be very different.
What's New
Second Edition of 'All Above Board' - On 19 October I shall be launching the second edition of All Above Board; Great Governance for the Government Sector at the Public Sector Governance Conference in Canberra. It has been a lot of work but I am thrilled with the improvements made over the sold-out first edition, and am hoping the second edition will sell as well as its predecessor. I'll report how it went in November.
Feedback on 'The Director's Dilemma' - I was particularly delighted to receive this feedback after last month's issue "Each edition you ask: "Which response would you choose and why?" It may be rhetorical but I am happy to answer. This month's responses were equally good and remarkably aligned. What a great scenario! It brought out the need for emotional intelligence and maturity in governance. It highlighted spiritual qualities of humility, compassion, frailty, gratitude, faithfulness in small things - not to mention horticultural analogies of planting, growing and blooming! Governance is not just science - it is relationships. Thank you for this helpful newsletter."
Please feel free to send in feedback and suggestions for future topics or to post a recommendation on my LinkedIn profile.
Book reviews - Finding books that meet the needs of directors and aspiring directors is no easy task. Here is my review of Alan Hargreaves' action-oriented book 'Recharge', available in kindle and hard-copy versions.
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Farewell until the next issue (due 1 November 2011). Enjoy governing your corporations; we are privileged to do what we do!
