Dealing With Renewed Inflation

For several years inflation has been far below the long-term average, with the slow recovery from the previous financial crisis being the main cause of the lacklustre performance. In 2015-2016, low inflation even turned into deflation following a sharp fall in commodity prices. Currently, everyone seems to have got used to low inflation rates – the last time inflation in the Euro area was above 3% was over ten years ago, before the global financial crisis. This stable price environment was particularly welcome for port investment.

However, the tide may be turning: economic growth has been surprisingly strong and broad in 2017 and the outlook is positive. Inflation is edging up closer to the central banks’ targets and at some point wage growth will accelerate when unemployment drops even further. This will increase inflationary pressures.

Inflation is more and more being flagged as a significant event for 2018 this could be easily underestimated. Some economists are predicting a further boost to inflation when quantitative easing programmes are scheduled to be stopped in the EU and unwound in the US later this year.

This turnaround of financial conditions would impact port operators over the next few years, with operating and financing costs bearing the brunt. This means ports should be prepared for what this change in macro-economic conditions means for their terminals.

Rising rates

Higher interest rates will not only impact the borrowing costs of debt-financed ports but may also have a dampening effect on the level of merger and acquisition activity in the sector. Port transactions have been partly fuelled by high multiples following the low borrowing costs of the last few years. Rising inflation will also mean that port operators will have to worry about who will pick up the bill of the increased operating costs of the terminal.

In the past, higher costs were covered typically by a combination of relatively high demand growth together with tariff increases passed on to the port’s clients. However, since the previous period of higher inflation a decade ago, the ports and shipping industry has changed. Terminal operators are dealing with fewer and larger clients who consequently have more bargaining power.

There has also been a slowdown in the pace of trade growth as the GDP multipliers recorded have declined. Last, more and more ports have been privatised, resulting in increased market-driven competition. This has placed generally negative pressures on pricing. Careful attention should be paid to finding alternative ways of raising tariffs in order to prevent margins being eroded by increased inflation.

Hedge fund manager Roy Dalio once commented: “There are two main drivers of asset class return: inflation and growth.” The ability of a port operator to pass on tariff increases in line with inflation is one of the most important drivers of the value of a terminal.

Forecasting tariff increases is both complex and opaque and consequently always receives much less attention than demand forecasting. A wide variety of practices and procedures can be observed globally with different stakeholders influencing the tariffs. In addition, historic information is generally not easily available for some terminals; when it is publicly available, specific discount information per client or activity is generally not provided in sufficient detail.

The ability of a port to pass-on inflation is not only important for an operator, but also for the shipping lines and shippers using the facility. With low margins across the industry, investments in port infrastructure are scrutinised extensively. If for any reason a port’s ability to raise tariffs is limited, the result will be reduced investment in crucial port infrastructure. Insufficient port capacity or too low a quality of port infrastructure will cost more for an economy than set tariff increases in line with inflation.

Service quantification

Tariffs are currently largely fixed due to the prevailing regulatory and contractual regimes. In some countries, regulation of port tariffs is in place. In addition, the Terminal Service Agreements (TSAs) may fix the tariffs and may or may not have a clause directly linking tariffs to inflation indices.

Where there is open-market pricing there are more drivers for tariffs. However, negotiations to raise tariffs are often opaque and only data-driven to a limited extent. There are clear key drivers determining the ability to raise tariffs, the most important being operational service levels at the terminal and capacity-utilisation. Higher service levels and less available capacity make the liners more willing to pay a premium. In addition, the level of competition between terminals, regional supply-demand balances, and the quality of the infrastructure and landside connections will all influence the position.

Abundant data on a port’s performance now exists so tariff increases can be more and more quantitatively linked to the actual service levels in the port. Making the tariff-setting process more transparent and data-driven will not only help the terminals but also the lines. It will incentivise terminals to focus even more on delivering the service levels their clients are requiring. In return, shipping lines will (potentially) enjoy higher service levels at the terminal and increased investments in operational improvements.

Alternative methods

Traditional tariff increases are captured in TSAs and may be hard to adjust. However, there are ways around this to ensure a dynamic approach during the life of the TSA. Other industries, such as the airline industry, use much more dynamic and data-driven pricing systems. So what are the other ways forward?

Linking tariffs dynamically to service levels and regional competition measures will harmonise the interests of port operators and clients. Currently, there are bonus schedules being included in TSAs and other incentive payments, however these schedules can be much more extensive and more driven by performance measures. A dynamic pricing system will also be helpful for flattening out traffic peaks and troughs. A system with a price surge during busy times may be useful to spread traffic at the gates or at barge berths and thereby increase the capacity of the existing infrastructure.

Another approach is to directly pass-on price increases for particular operational cost components. For example, energy price inflation can be directly passed on to a client in a similar way to shipping lines passing this on via bunker adjustment factors (BAF). Another example of this is the application of exchange rate adjustments on tariffs as applied in some countries.

Port landlords should also be open to a dynamic system for lease fees. In the current economic environment, it is more difficult for terminal operators to obtain longer term offtake contracts and financing. Adjusting the durations and terms of the lease contract to match current economic conditions (and possibly ‘gainsharing’ arrangements between landlords and tenants) will allow more flexible terminal operations.

Upward potential

For several years price levels have been stable and interest rates low. But inflation is rising again and when it raises further will likely accelerate interest rates in its slipstream.

Some terminal projects have been financed and managed on the basis of a continuation of a low inflation environment. This is highly risky. The key driver of pricing in general and the ability to maintain prices in an inflationary environment are driven by regulatory and contractual issues.

Operational and economic conditions should be more taken into account in the pricing of terminals and also in feasibility and financing studies. It is essential to adopt a more comprehensive approach to these issues.

Tariffs can be linked to a larger extent to measurable service levels and operational performance indicators. Other industries such as the airline industry and the taxi industry provide useful examples of this. This will not only allow port operators to be rewarded for efficient operations, but will also ensure that shipping lines and importer/exporters will have long-term access to high quality infrastructure and higher service levels.

Preventing the erosion of margins by inflation is in the interest of both the entire maritime industry and of customers in the hinterland.

Source: PORTSTRATEGY