Regulatory risk is the possibility of a change in laid regulations that can affect security-related matters or even the entire industry. Companies must abide by regulatory and governmental bodies’ rules that oversee the concerned sector to avoid this. Therefore, a company needs to be concerned with any changes in regulations that can cause a rippling effect across an enterprise. These rules and regulations affect the company’s operations in numerous ways, like increased operations costs, legal and administrative hurdles, and restricting a company from carrying out business smoothly.

General Regulatory Guidelines Imposed on a Company

Governmental and several other regulatory bodies often impose new regulations or update the existing ones to ensure fair business. Some of the examples of regulatory changes that usually affect most of the companies and industries are:

1. Tariffs and trade policies: These policies regulate the international trade policies of a company. These regularly deal with the export and import of commercial goods. These policies also affect investors who willingly engage in foreign direct investments (FDI).
2. Tax policy reform: These reforms affect the bottom line for businesses and individual investors equally. Any change made to the income tax law directly impacts the respective parties’ income and may present a regulatory threat.
3. Minimum wage laws: Increasing the minimum wage bar is a significant risk in the industry, as it substantially impacts all businesses. This predominantly affects when hiring is performed in large numbers, especially of low-skilled labor. In particular, small businesses suffer more significant losses due to their inability to match up with the pay.
4. Mandatory leaves and sick days: Along with the above-mentioned regulations, changes to mandated vacation or sick days affect a company’s bottom line. They must give employees more time off. Providing employees with more vacation days will be less exhausted and more productive during office days. Stress-related issues are also alleviated with more holidays. By providing employees with sick days, office productivity also increases because employees keep illnesses out. Industry experts are continually considering the effects of this.

As is evident from all the above cases that present regulatory risks that directly affect a company’s reputation. In some of these cases, the effect is not readily observed, like mandatory vacation and sick days. Regulatory guidelines often benefit both the investors and the companies they invest in.

Companies are penalized for not complying with the regulatory changes. Businesses need to pay utmost attention to managing regulatory risks. This is done by ensuring compliance and diversification in all their operating strategies.

A Case Study on Management of Regulatory Risks — Canadian Lumber Industry

The Canadian lumber industry has faced challenges with regulatory risk for a very long time. Here we look at how Canfor Corporation was hit by regulatory changes and how it overcame this challenge.

Mentioned below are excerpts from Canfor Corporation’s (TSX: CFP) 2017 annual report. These excerpts aim to denote higher legal costs due to the Softwood Lumber Agreement’s expiry (SLA). It is a real-life example of a company and industry suffering from regulatory risk.

The significant drop observed in the periods of 2015-2016 is attributed mainly to three factors:

1. Harsh weather conditions: An extended period of icy weather conditions affected the entire lumber industry. Due to the cold conditions operating days were reduced, and also the production was lowered. The cold weather even led to an increase in natural gas and maintenance costs that affected logs’ transportation.

2. Expiry of Softwood Lumber Agreement: The expiry of the agreement caused uncertainties in the lumber agreement. The primary concern was if the additional costs could be passed on to consumers. If demand was reported to be strong enough, charges could be passed on as soon as the prices increased.

3. An infestation of mountain pine beetle: The mountain pine beetle (MPB) infestation was reported to plague the western Canadian lumber industry for almost a decade. The infestation significantly damaged the pine trees, lowering production and reducing the quality of products. The infestation’s effect on timber supply caused regulatory changes in the Allowable Annual Cut rate. This rate determines the permissible harvesting rate and also ensures sustainable harvesting in Canada. All these factors reduced the supply of timber and caused the closing of Canfor’s Quesnel sawmill.

This made it clear that regulatory risk and the associated uncertainties were reasons for the price drop observed between 2015 and 2016. Both of the companies faced significant threats in the form of potential duties and annual allowable cut-rate reductions.

Mitigation and Aftermath

Canfor Corporation adopted additional sawmills and harvesting rights to mitigate the regulatory risk posed by reducing AAC rates and the MPB infestation. They were unaffected by the MPB infestation or provinces, due to which their AAC rates increased. Canfor again closed down its Quesnel sawmill, which became unprofitable due to limited timber supply. Besides, Canfor continued acquiring and operating sawmills within the United States, where timber supply is not affected by MPB issues.

A firm price resurgence is seen in the following years after the expiry. This is primarily because of the high demand for Canadian lumber in the U.S. market. This huge demand has allowed Canadian lumber companies to pass on additional costs from countervailing and anti-dumping duties imposed on them at higher prices.

This showed that regulation changes could have varying outcomes that can either harm or benefit firms and their related securities.