Keeping it simple

Profile: Towngas

pg29-ho1-gif

The Hong Kong and China Gas Company, better known as Towngas, believes in taking a conservative and uncomplicated approach to its business, a philosophy that permeates its risk management strategy. Pamela Tang reports

Hong Kong-based utility Towngas has supplied natural gas to customers for 140 years, enjoying a healthy 65% of the Hong Kong residential market share and a significant foothold in mainland China through 33 joint ventures (JVs), which it is looking to expand further. In contrast to its growth plans, the company's risk-management policy tends towards the prudent and conservative.

Not surprisingly, then, Towngas shuns highly structured products, says chief financial officer John Ho. Indeed, the group's only derivative contracts are foreign exchange forwards, although Ho is keeping a close eye on interest rate swaps with the intention of entering the market when the time is right. But until then, he prefers a simple approach. "Highly structured products are complicated, because there are multiple elements like interest rates and different currencies," he says. "We feel (such contracts) would be difficult to wind down, and that's why it's better to just keep it simple."

Towngas buys naphtha, a liquid hydrocarbon mixture, which it 'cracks' - or refines - into natural gas. Since it makes these purchases in US dollars, it is exposed to forex risk, which it minimises by buying forward contracts when the spot rate drops below HK$7.75 to the US dollar. The Hong Kong dollar is pegged in a range of 7.75-7.85 to the US dollar. And although Ho says the risk right now is minimal, the move away from the fixed peg of HK$7.8 to $1 in 1998 did increase the group's risk.

Unlike many of its counterparts in competitive energy markets in, say, Europe and the US, Towngas does not need to hedge against unpredictable price fluctuations in naptha. The fuel cost variation adjustment policy introduced by the Hong Kong government in the 1970s following the oil crisis eliminates such risk by fixing the cost of naptha at $28 a barrel. Towngas passes on the difference as a surcharge when the cost exceeds that level and similarly returns rebates to consumers when the price drops. Ho does not foresee any changes to this policy in the short or medium term.

Towngas enjoys healthy profit and cashflow from its operations in Hong Kong - it reported HK$5.29 billion profit before tax on HK$9.35 billion in turnover for 2005 - but Ho acknowledges that the saturated market there no longer provides exciting growth.

More expansion, bigger risk

China, on the other hand, offers growth potential in spades. The company - which makes around 10% of its revenue from the mainland - made its first foray into China in 1994, when there was a lot more uncertainty over the economic climate, political landscape and exchange rate. At that time, Towngas required an additional premium on profit, says Ho - a certain percentage over the expected return - to compensate for possible risks.

But as the years have passed, there has been a significant dip in the risk associated with investing in China, says Ho. Political risk, for one, has arguably become a secondary consideration, as China grows in economic strength. The peaceful handover of power to the next generation of leaders, such as Hu Jintao and Wen Jiabao, is also in marked contrast to China's volatile political history.

Towngas' first-mover advantage has arguably paid off, and its JVs on the mainland stand it in good stead to capitalise on China's burgeoning growth of an estimated 9% a year. Ho expects a corresponding surge in energy demand of 5-6% from the commercial, industrial and residential sectors, as natural gas becomes progressively more available in China. Towngas also enjoys a fixed profit margin in the mainland, similar to the agreement it has with the Hong Kong government.

Such growth exposes the group to forex risk in China, and while Ho acknowledges that is beyond his control, he is confident the central government would appreciate the renminbi in controlled and systematic fashion, making it unlikely that the currency would see runaway value increases of 10% or more.

The fear was once that the renminbi would depreciate, but that has been proven unfounded with the currency's sustained increase. But in following Towngas' conservative policy, Ho has no immediate plans to use renminbi derivative contracts, even with the currency appreciating.

"It seems everyone has already forecast the upward swing in the renminbi - forward contracts have already been priced with a 4% premium, so we will stand to lose money if it doesn't increase by that amount," says Ho. "While we are very interested in investing the RMB7 billion we have earmarked for China, the only legal way is to buy forwards, which we do not see as the right position to adopt right now. I would rather wait and see."

Joint-venture risks

A problem unique to Towngas' operations in China is how to exert control and maintain risk policies over its JVs from its Hong Kong headquarters. For starters, Towngas only gives out the minimum capital necessary to these companies, which are required to submit detailed reports when they request funds.

To manage spare cash in its ventures, the group started to use a 'back-to-back' method to earn higher returns two years ago, which Ho says has been successful in reducing idle cash and reducing borrowing cost across its operations. If one of the joint ventures requires additional funds, rather than borrowing at market rate, another of Towngas' ventures will transfer the funds at a below-market rate of interest, but will still earn higher interest on the loan than it would otherwise get from a bank.

Towngas also faces interest rate risk from its borrowings, which totalled HK$8.2 billion as of December 31 with a floating interest rate, although it does not use derivatives in this area.

The borrowings include a HK$3 billion syndicated loan that Towngas plans to use to enhance its capital structure and facilitate business development, especially in China. While this is a departure from the group's history of not having significant debt, Ho says it helps improve capital efficiency. "You need certain borrowings to run the capital structure more efficiently, and certain equity and debt to have the appropriate gearing ratio," he says. "To have some debt is a good thing because it reduces the total cost of capital to make it more efficient."

A holistic picture of Towngas' risk appetite emerges when you consider the group's healthy gearing ratio of 30-35%, says Ho, who adds that this makes the loan considerably less significant. The ratio was set by the group's treasury committee, comprising all executive directors - Ho included - and tasked with identifying, evaluating and managing financial risk.

Towngas' strong balance sheet has given it bargaining power with lenders, which was demonstrated when the company got an attractive interest rate of Hong Kong interbank offered rate plus 22.8 basis points - which Ho says is the lowest any commercial entity received in Hong Kong in 2005 - on the HK$3 billion loan. This translates into an effective interest rate of about 4.5%, which Towngas is prepared to swap into a fixed rate when the time is right. Ho says that should happen when interest rates - which he believes have hit the ceiling - fall.

"Obviously if you have debt from about four years ago," he adds, "it would be wise to swap that into a fixed rate, but we were in the cash position at that time and did not have debt until this year."

For Towngas, it seems, being careful does not equate to being risk-averse. What it does mean is having a thorough understanding of the benefits and risk that accompany any venture, and only entering the fray when the best opportunity presents itself.

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe

You are currently unable to copy this content. Please contact info@risk.net to find out more.

Stemming the tide of rising FX settlement risk

As the trading of emerging markets currencies gathers pace and broader uncertainty sweeps across financial markets, CLS is exploring alternative services designed to mitigate settlement risk for the FX market

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here