Financial and Economic Modelling for Business and ... · Financial and Economic Modelling for...

Financial and EconomicModelling for Businessand Government

Presentation to the ActuariesInstituteJune 2015

Craig Fenton

www.pwc.com.au

PwC

Presentation for today

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Our Approach

Discussion of Examples

2June 2015Financial and Economic Modelling for Business and Government

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Economic, Financial andCommercial advice topublic and private clients.

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Economic, Financial andCommercial advice topublic and private clients.

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PwC Australia…and me

Now

Joined PwC in 2000, with a focus on economic, financial andcommercial analysis and advice

Partner in the Australian firm, leading our

• Economics and Policy services nationally

• Government advisory services in Queensland

Before

Commercial, regulatory and economic advisory positions for bothCommonwealth and State Government organisations


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Our Approach


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A means to an end

• Project definition

• Client engagement

• Options definition

What is the‘question’?

• Qualitative or quantitative

• Data availability

• Model scoping

How is it best‘answered’?

• Build model

• Testing and review

• Analysis andreporting

Deliver andinterpret


Keep perspective

• Economic and financialmodels are tools to supportcritical business decisions.

• Before modelling:

- understand the ‘question’

- identify where quantitativeanalysis ‘fits in’

• During/after modelling:

- interpret in context

- be clear on the limitations

• Rarely a standalonedeliverable

PwC

Models to suit a client’s requirements

Demand Modelling

Investment RiskAssessments

Commercial andFinancing Options

Economic and FinancialFeasibility

Investment Prioritisation

Operational or PolicyDecisions

GeospatialEconomic Modelling

Pricing

ContractNegotiations

Procurement Processes

Modelstailored to

the businesschallenge


Investigation Implementation Support

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Let’s Discuss


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Model typeInvestment prioritisation

Demand Modelling







Pricing



Modelstailored to




PwC

Investment prioritisationOverview

Public resources are limited and always havealternative uses - a new project or policy meansreallocation of these resources. Governmentsmust determine if this re-allocation is likely tomake a net contribution to society.


Governmentclients orprojects

Private Sectorclients orprojects

Business Issue

Model Characteristics

• Pricing the intangible benefits of a project

• Accounting for uncertainty of outcomes, andforecasting future cash flows reasonably

• Discounting future costs and benefitsappropriately

• Ensuring all options to address issue areevaluated

Risks and Challenges

• Equity/distributional factors are irrelevant

• Focus is on marginal changes in markets forthe outcomes from a project/policy

• Need to ensure that the reallocation ofresources targets the problem not thesymptoms

− is traffic congestion due to insufficient capacity (engineering) or inefficient use(demand management)?

PwC

Investment prioritisationExample

South West Rail Link

High residential growth area in South WestSydney required transit improvements to link tothe city centre. Cost-benefit analysis modeldeveloped to evaluate four different options.


Project

Key Challenges Managed

A detailed model was developed to evaluate therelative merits of providing additional busservices, or combination of rail and roadinfrastructure.

Benefits modelled included:

• De-crowding, ambience and reduced standingtravel times

• Environmental benefits

• Increased workforce productivity

Modelling Task

• Broad literature review to identifyappropriate valuations of intangible benefits

• Consulted with multiple stakeholders todevelop an appropriate set of project options

• Scenario / simulation analysis undertaken tounderstand how model parameters affectranking of options

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Model typeEconomic and financial feasibility

Demand Modelling







Pricing



Modelstailored to




PwC

Economic and financial feasibilityOverview

Investigate alternative investment or policyoptions to estimate comparative:

• affordability / funding requirements

• financial performance

• economic impacts




• Need clear definition of alternative options orscenarios

• Require high levels of flexibility and‘sensitisation’

• Heavy dependence on forecasts

• Relatively low levels of detail

• Prefer ranges to ‘single point’ results

Business Issue


• Functionality requirements can change asoptions and scenarios ‘evolve’

• Preliminary model outcomes can ‘feedback’into revised options or scenarios

• Format and structure of key inputs oftenunclear until late in model development

• Avoiding undue reliance on quantitativeoutputs


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Economic and financial feasibilityExample

Gold Coast Rapid Transit Project

Develop a Business Case to compare value formoney of alternative options for improvingnorth-south public transport services on the GoldCoast.


Project

• Multiple permutations of staging, corridorand design (e.g. station location) options

• Joint funding involvement of the Federal,State and Local governments, requiring

− consensus on scenarios and assumptions

− inconsistent analysis requirements

• Potential misinterpretation of key financialprinciples by analysis recipients


A highly flexible model was developed to forecastthe net financial cost to the QueenslandGovernment comparing:

• rapid bus vs. light rail infrastructure options

• alternative corridors

• scheduling of up to five project stages

• patronage and cost scenarios

• private delivery and financing options

Modelling Task

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Model typeCommercial and financing options

Demand Modelling







Pricing



Modelstailored to




PwC

Commercial and Financing OptionsOverview

Investigate options for the commercialstructuring and/or financing of an investment:

• ownership structure and responsibilities

• contractual / pricing arrangements

• debt and equity structures


• Close interaction with legal and tax advisers

• Requires ‘allocation’ of project-level forecastsbetween multiple investors / financiers

• Need clear definition of alternative options orscenarios

• Financing structures can be complex andbased on strict prioritisation of cash flow‘claims’

Business Issue


• Logic requirements can change as detailedtax, structuring or financing arrangementsare refined or redefined

• Require strong communication betweenmodel developer and parties definingcommercial and financing strategies

• Potential for high complexity (or error) wherethere is a high number of permutations ofpossible commercial / financing outcomes




PwC

Commercial and Financing OptionsExample

LNG Value Train

Support a client investigating optimisation ofvalue of gas reserves, through options forparticipation in an integrated LNG projectproposal.


Project

• ‘Dynamic’ modelling in an environment ofpreliminary project definition and optionsidentification

• Integrating upstream and midstreamelements of analysis

• Allocating value under different participationrates (ownership shares) for multiple assets

• Identifying gas monetisation (tax) points andallocation of historical ‘tax pools’


Develop models covering the full value chain ofan integrated Upstream – Midstream LNGproject to calculate:

• tariffs for access to third party infrastructure

• transfer prices for LNG plant and pipelinecomponents

• pricing for upstream gas and condensate

• JV participation rates in each component

• Government participation, taxes and levies

Modelling Task

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Model typeInvestment risk assessments

Demand Modelling







Pricing



Modelstailored to




PwC

Investment risk assessmentsOverview

Understand the probability of future outcomes incircumstances of risk or uncertainty, usingrelevant statistical measures (e.g. mean, mode,confidence intervals, etc).

Better understand and prioritise risks.




• Typically based on ‘unrisked’ models, orincluded as additional functionality

• Rely on Excel ‘add-ins’ such as “@Risk” or“Crystal Ball”

• Require definition of the probability ofuncertain events, and the distributions of riskimpacts

• Runs multiple (e.g. 10,000) randomisediterations for defined events

Business Issue


• Requires understanding of specialisedfunctions in Excel

• If risk or uncertainty cannot be reasonablydefined, analysis outcomes will be unreliable

• Ensuring appropriate interpretation ofstatistical results

• Extensive application in very large modelscan cause extended ‘run’ or iteration times


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Model typeDemand modelling

Demand Modelling







Pricing



Modelstailored to




PwC

Demand modellingOverview

Understand the drivers of demand for individualproducts and services, in order to:

• assess the effects of new taxes or tariffs, ormeasure responses to price changes

• prioritise product introduction

• forecast capital and operating expenditure


• Trade-off between model ‘richness’, and easeof computation, testing, and communicationto others.

• Although complex technical criteria areavailable to evaluate models, model selectionoften based on more subjective criteria.

• Demand drivers for the same product orservice may vary significantly betweenmarket segments.

Business Issue


• Data may not be available to estimate theideal theoretical model

− Not granular enough, or periodicity of the data is too infrequent

• Possible that strong statistical relationshipsbetween variables may not be identified

• A good fit to sample data may not guaranteeaccurate forecasts when fitting model to newdata




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Model typeProcurement processes

Demand Modelling







Pricing



Modelstailored to




PwC

Procurement processesOverview

Evaluate competing bids for the provision ofrequested services or assets

OR

Develop and submit bids for the provision ofrequested services or assets




• Focused on a lower number of project options

• Relatively high levels of detail, supporting‘firm’ pricing of services

• Based on detailed quotes, commitments,underwriting, etc

• Supported by detailed independent review

• Supports ‘contract close’ and ‘financial close’

• Tax structures and pro-forma accounts

Business Issue


• Models developed or evaluated in a ‘highpressure’ situation (e.g. time constraints)

• Errors can be ‘locked in’ through the biddingprocess

• Model output formats to align to precise bidinformation requirements

• Intellectual Property – models provided /received as part of submitted bid materials


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Procurement processesExample

Property Development - Brisbane

Financial and commercial advice for a biddersubmitting a competitive proposal to theQueensland Government for a major centralBrisbane property redevelopment.


Project

• Constrained development timeframes

• Commercial and financing structures notresolved until ‘test run’ phase of modelling

• Bid consortium participants with differinginvestment strategies

• Ambiguous financial informationrequirements in bid documentation

• Fully developed pro forma accounts includingdevelopment financing, GST accounts, etc


A flexible and detailed model was developedwithin a very constrained timeframe to supportanalysis of bid structuring and pricing options:

• multiple precinct urban design strategies

• different realisable property productoutcomes and pricing

• different JV ownership by development asset

• funding public realm (cross-subsidisation)

Modelling Task

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Model typeContract negotiations and support

Demand Modelling







Pricing



Modelstailored to




PwC

Contract negotiations and supportOverview

Understand the financial implications ofdifferent negotiating strategies or proposedclauses in legal agreements, such as:

• pricing structures

• penalty provisions

• termination payments


• Tailored to a specific project or commercialsituation

• Needs to precisely align with the financiallogic and methodology represented incontract provisions, or ‘heads of agreement’

• High transparency and capability forreconciliation to specific contract provisions

• May require capability to provide ‘workedexample’ outputs for contract materials

Business Issue


• Clearly aligning model formula structures todiscrete calculation steps reflected in contractmaterials (i.e. transparency)

• Identifying potential ambiguity in contractdrafting (i.e. should be no methodologyassumptions in the model)

• Model may be provided to contractingcounterparties to support understanding ofproposed commercial terms




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Model typePricing

Demand Modelling







Pricing



Modelstailored to




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Pricing modelsOverview

Calculate pricing or charges for services providedby a business or asset. For example:

• Regulated or ‘quasi-regulated’ infrastructure

• Cost recovery or sharing for joint ventures

• Transfer prices for non-arms length entities




• Based on specific pricing or chargingmethodologies (often contractual)

• Often reflects a mix of historical and forecastdata

• May have a relatively ‘long life’, to be used forregular pricing ‘resets’ or ‘true-ups’

• Often specified as being subject to disclosureto third party price/charge payers forindependent review or ‘audit’ rights

Business Issue


• Model methodology must precisely (andtransparently) reflect specified pricingmethodologies

• Can be relatively large and complex (e.g. forlarge regulated infrastructure projects)

• May be highly dependent on the applicationof capital asset pricing theory, and subject to‘academic challenges’

• Subject to scrutiny by third parties andgovernment regulators / taxation agencies


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Model typeGeospatial economic modelling

Demand Modelling







Pricing

Contract Negotiations


Modelstailored to




PwC

Geospatial Economic ModellingOverview

Decisions are being made for local regions usingstate-wide or industry-level data.

• Government agencies want to understandgaps between demand and supply of services.

• Businesses are deciding the location of theirnext stores


• Combines multiple data sets to generateholistic view of regions, including data across:

− Economic, demographic, labour force

− Retail, transport, industry and climate

• Provides spatially consistent data, resultsfrom granular regions sum to larger areas

• Consistent with ABS measurement andaccounting methodologies

Business Issue


• Requires detailed understanding ofgeographical mapping in data

• Technical expertise required across a range ofplatforms, e.g. data analysis, databases, GIS

• Managing significant volumes of data, e.g. 20industries, 2114 locations, 15 years of datafrom 5 data sources

• Incorporating revisions to ABS geographicalclassifications




PwC

Geospatial Economic ModellingExample

Ergon Energy peak demand modelling

Ergon’s state-wide peak demand forecastingmodel suggested growth was flat-lining inaggregate, and wanted to identify specific areasof growth in order to prioritise capitalinvestments.


Project

• Worked closely with Ergon econometriciansand GIS specialists to understand forecastingmethodology and map Ergon regions to ABSdata

• Calibrated uncertain Geospatial Economicmodel parameters based on theimprovements to peak demand model fit


Used PwC’s Geospatial Economic Model toallocate historic and forecast input data used inErgon’s state-wide peak demand model toindividual network regions.

Used these more detailed inputs to developregion-specific peak demand models to identifyhigh growth areas in the network.

Modelling Task

PwC

Model typeOperational and policy decisions

Demand Modelling







Pricing

Contract Negotiations


Modelstailored to




PwC

Operational and policy decisionsOverview

Support recurring or one-off business and policydecisions, such as

• cost of capital benchmarking

• business/asset valuation

• taxation or financial assistance programs


• Highly unique and tailored to a specificbusiness, policy or financial issue

• Less likely to have any clear commonality inmethodology between models of this type

• More likely to involve managing a ‘mix’ offorecast and historical data

• May have a relatively ‘long life’ where theissue to be assessed is recurring

Business Issue


• Ensuring consistency between data,particularly where ‘blending’ historical andforecast data

• Facilitating ‘roll forward’ of historical datawhere model management spans time

• Developing ‘reasonable’ methodologies forunstructured issues




Questions...

Contact:

Craig FentonPartner

+617 3257 [email protected]

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