Podcast: Brain Food for General Counsel

Transcript

Matthew Magee:

Hello and welcome to Brain Food for General Counsel, where we try to highlight the biggest challenges facing your company and how you might think about them. My name is Matthew Magee and I’m a journalist here at Pinsent Masons. Companies are always facing challenges but few business leaders will be able to remember a time when they were so serious or seemed to come simultaneously from so many different directions. There is no intrinsic connection between inflation, labour shortages, energy supply problems and trade barriers – except that businesses are having to cope with dramatic changes in these areas all at once. 

Trade is still unsettled in the UK and partly in Ireland and the rest of Europe in the aftermath of Brexit; near-full employment in western Europe is making it hard to attract and keep workers; gas supply is limited because of sanctions on Russia after its invasion of Ukraine, creating a knock-on price rise for all energy supplies, and a post-Covid spike in economic demand plus rising energy costs are causing inflation unprecedented in recent times. 

Most of these problems will affect most companies, and some will still be recovering from difficult times during two years of covid lockdowns, sending many into financial difficulty. We’re not going to pretend that our experts at Pinsent Masons can solve all these problems, but we have put together a special report with analysis, guidance and advice and thought it would be helpful to hear here from a few of our experts on how to think about and prepare for these challenges.

For UK companies and their trading partners the basic practicalities of trading have been in flux since the UK voted to leave the EU in 2016. A long, drawn out and still-incomplete process replacing the customs union with other ways of working has been followed by the intense disruption caused by lockdowns. Then as soon as factories, ports and shops could open again companies had to deal with the release of the intense pent-up demand of post-lockdown consumers. It all put intense pressure on supply chains, those increasingly long, complex and, it seems, fragile connections that now represent the central nervous system of the global economy. Clare Francis is an expert in commercial law and supply chains at Pinsent Masons, outlined the kind of shock that supply chains faced, and how companies initially reacted.

Clare Francis:

So I think over the past few years we've seen supply chains get hit by a number of different things, but all of them have some common features. They either significantly impact the demand side of the supply chain, and particularly with Covid we saw massive peaks in demand for certain products and drops in demand for others, or there's a shortage of the materials or labour that the supply chain ultimately need to fulfil whatever the demand is. And we've seen shortages of labour through Covid as well, with people being off sick or not being able to work because they're in isolation and then we've seen things like shortages of materials more latterly with things like the Ukraine war where it's meant that certain materials just have not been available to flow into the supply chain to fulfil their demand. So I think there are two major things that people learn about their supply chain, the first of those is that everyone does not necessarily reach for the contract in order to enforce it, you need a willing seller and a willing buyer and actually, there's a lot of collaboration in the market where those external forces are on the supply chains in order to find a solution together. And that's something people have talked about for a long time pre-Covid, but it kind of gave the burning platform for people to really focus on those areas and look at them in a different light about the importance of the relationship with the supply chain rather than being arm's length customer and supplier.

Matthew:

Part of the reason supply chains were so badly affected was that price had become in the recent pre pandemic years that be all and end all, resilience had been downgraded so networks became fragile, Clare says.

Clare:

Over the years, we've seen procurement have an increased focus within business, and that's driven costs down and cost out of the supply chain and made supply chains leaner and some of that has meant single sourcing in order to gain economies of scale. But actually taking a step back, there is a value proposition there. There is a certain price you pay to get resilience within your supply chain that helps you withstand the shocks that may come from external forces that are outside of your control, and a lot of companies looking again at their sourcing strategy and saying actually, how do we build that resilience into our supply chain and what is an acceptable price to pay? Rather than necessarily the cheapest price to pay for products.

Matthew:

Companies are paying attention to this at increasingly senior levels. Clare says that more senior managers are being drawn in to set a strategic agenda to govern procurement and supply, and she says that the actual values of companies are now being sent not just by earnings or market potential, but by the quality of their supply chain relationships.

Clare:

Some more resilient suppliers will have diversity in their manufacturing operations, potentially across more than one country, in particular to withstand those kind of natural disaster shocks. A more resilient supplier we've also found is one that has better relationships with its customers because it will then help the customer find solutions rather than just hide. The more resilient suppliers will have greater levels of innovation within their management workforce to look at the workarounds and find alternative things, which means ultimately customers are looking for something fundamentally different in their suppliers and not just looking at the specification of the product and the price, but actually what does our overall holistic proposition look like, and what would the business continuity plan be? What would be the resilience within that supplier if things do go wrong? Which brings a whole another light to how we’re looking at how you source the materials you need to operate your business.

So we're seeing more of that where businesses are purchasing other businesses that they are looking at the resilience of supply chain as part of the due diligence process. There's a number of different ways going around that some people have a kind of scoring matrix and others will look at it on a more anecdotal basis, but fundamentally, they're looking at: do I have exclusive relationships or is there more than one supplier of a critical product and where we have suppliers? Where are they based and does that give you a natural hedge against this shocks that may come in the supply chain? That gives us a good view as to whether, when you've bought the business, the value is preserved, or you're potentially at risk of some massive supply chain shock on day one which would harm the value of the business.

Matthew:

Energy supply in pricing is one of the issues causing most concern for businesses, particularly those in the northern hemisphere as we hit winter. The impact is likely to be most severe for those for whom energy is a major input cost, such as manufacturers and those in the hospitality and retail industries. The effects of this are highly nationally specific but as energy experts, Ronan Lamb and then Murdo Maclean explain you don't need to be a direct consumer of Russian gas to be affected. We still use gas as a baseload and the price of gas affects the price of all electricity.

Ronan Lambe:

We've done very well on the one hand too develop a lot of renewable generation pretty quickly. As you as you increase the amount of renewables on the network, the role of baseload electricity, its importance almost increases because ultimately you need an ability to turn on another source of generation if the wind's not blowing or the sun's not shining. In the UK at the moment the source of generation we use for that predominantly is gas because it can react quite quickly.

Murdo Maclean:

I think what's brought this issue to the fore in recent months is the impact that events elsewhere, ie in Ukraine, have had on the price that consumers pay here. The reality is that at the moment the UK is hardly relying at all on gas sourced from Russia, but the fact that the major the European economies, gas is a worldwide market, and that causes the price to go up and the way the generation mix is configured in this country pretty much all of the time you need some gas at the margin. While that state of affairs continues the market price of gas across the globe is going to have an impact.

Matthew:

Different governments have different approaches to tackling this. In the UK, the government is trying to address the fact that the costs of a MW of wind power has risen along with the cost of gas, because the price is set by the most expensive element hitting power networks.

Murdo:

The government are therefore saying this this looks a bit odd because most of the time poor consumers got electricity prices linked to the worldwide price of gas, but if you actually look at the average production cost of all UK generators is far, far below that gas determined price. Renewables assets by and large they cost an awful lot to build, but actually to run them, they cost pretty much nothing because the wind is free, the sun is free and around the edges, you will have some resource and personnel there, but it's completely negligible. Whereas with gas plants it's exactly the opposite. They cost very little to build modern gas plant, but they cost a hell of a lot to run. So that has led government to think well can we look at ways of delinking the price of electricity from the price of gas pipes is to split the market into two markets. The first market would be in broad terms renewables and the other is the on demand market, which the way the system is at the moment, that's basically gas. So the idea would be that the first market, what they call the as available market, the price there would be delinked from gas consumers would pay less because they're shielded from those hikes in world gas prices. If we had that market structure at the moment, the issues we're reading about in the press would be a footnote rather than headline news.

Matthew:

But while charging different prices for different kinds of power would make businesses and consumers happy, Roland warns that it risks undermining exactly the kind of future investment that would win us off imported hydrocarbon derived energy in the long term.

Ronan:

It is causing people developing new projects to pause for thought, so if you're developing a new project in the UK at the moment, this is definitely causing you to pause and consider. The challenge at the moment is, you don't know exactly how much money you can make from your project. That obviously causes you difficulties in assessing and making decisions around procuring that project. So if you don't know how much money you're going to make from your project, can you agree to enter into a contract with the turbine supplier to buy the turbines because that's a fixed price and you need to know that you will get sufficient returns to be able to pay that, and one would hope it's temporary, but until we see details like the limits or the cap that's going to be placed, and I've seen this last week. Developers or off-takers of power finding themselves in a situation where they just can't really progress their deals at the moment on until further certainty arrives.

Matthew:

We can see then that companies are facing new and developing challenges in a number of areas. So does this mean that lots of businesses are going bust? Restructuring expert Steve Cottee says that the picture, in the UK at least, is muddied by the enormous amounts of financial support provided by the UK government during and after Covid lockdowns.

Steve Cottee:

We're emerging from a period post lockdown and the government support measures that were imposed as a result where we've had the lowest number of corporate insolvencies since records began in 1986, so it's a slightly perverse situation where everybody - because of high inflation, increased energy costs, consumers cutting back, concerns about the global economy, rising interest rates - expects there to be a large number of corporate failures, but we've emerged from a period post lock down where businesses have been protected like they haven't been previously and that has enabled poor businesses to continue to trade with furlough to pay their employees with bounce back loans and loans from their clearing banks to help them trade through lockdown and it's resulted in fewer insolvencies than we've ever experienced before.

Now we're gradually seeing that come to an end. So in recent months we've seen a high number of liquidations where smaller businesses have decided to go into liquidation because they haven't been able to pay their bounce back loans back and we're also starting to see a few more administrations since September and some evidence of distress in the corporate world that's still at historically low levels. So the big question for us in the restructuring world is will it be a rerun of the financial crisis in 2008 or 2009, or will it be more like 1997/1998 when we had Russian defaults and some stress in the market, but it didn't really translate in high corporate insolvency numbers. So we geared up and expecting to see a rush of companies heading for administration, but we're not yet seeing that in the numbers.

Matthew:

I asked Steve does that mean we're about to see a huge wave of insolvencies as companies that would otherwise not have survived go out of business as government support is withdrawn?

Steve:

It all happened at once. I mean in 2009/2010 we had over 4,000 administrations and now we'll get 1,200 a year. So we had at the time of financial crisis, sort of four times the level of insolvency administrations we've currently got. I don't think we're going to see corporate failures at that level, but undoubtedly we are going to see an increase. The question is, will it all come at once, will there be a domino effect, or will the banks be more supportive, will the debt funds step up, will HMRC step back and not present winding up petitions, will there be support for the businesses and forbearance again to enable businesses to continue to trade through this period? It all depends what happens in Ukraine, it all depends on the cost of energy, will inflation continue to remain high? There's quite a few unanswered questions, but I think the jury's out whether it's going to result in a wave of insolvencies. That's certainly the fear, but I'm not sure that will translate in practice.

Matthew:

If companies do find themselves in distress, then they will, Steve says, find that the environment is far more forgiving than it has been in past recessions. They should take full advantage of the support that's out there.

Steve:

We have got a slightly different market to what we had in 2008 and 2009 because we've got clearing banks who are now very willing to support their customers and for reputational reasons they are concerned and will not want to put businesses into administration and insolvency if that results in large numbers of redundancies for employees. So you've got more options as a borrower than you've had for a long time. You need those discussions with your stakeholders if you've got the right advisors around you, there may be tools to help facilitate that restructure and preserve the business. This is on the premise that there is a decent business underneath there. Then there are options now and more supportive stakeholders who, for reputational and political reasons, may not be looking to take the keys back, which is what the fear was at the last recession, I think. So there are cultural changes and economic changes in the restructuring world that mean wider, holistic restructurings are more achievable now and that's what a lot of people in the restructuring profession are working to achieve and that may result in less formal insolvencies, than we've had before.

Matthew:

As I said, we don't have all the answers, but hopefully that's given you a starting point for thinking about some of the more pressing issues facing you. Next time we'll have a much closer look at the vagaries of the modern supply chain when we investigate the age of the middleman economy.

Thanks for joining us for the latest Brain Food for General Counsel podcast. Now remember you can keep up with hour by hour, business law news coverage by the Outlaw reporting team at pinsentmasons.com. And don't forget to subscribe to us wherever you get your podcasts and if you've enjoyed this or past programmes, please do like and review them. It helps us to reach other people who might also be interested until next time goodbye.

Brain Food for General counsel was produced and presented by Matthew Magee for International professional services firm Pinsent Masons.