This reminds me of a post from 2013 which I would like to repeat here – it was originally posted on interest.co.nz here.

What to do about Tiwai Point

The eventual closure of the Tiwai Point aluminium smelter is an inevitability that needs to be embraced.

Although the smelter is said to produce some of the world’s purest aluminium, the reality is that aluminium buyers aren’t prepared to pay enough of a premium for Tiwai’s product to ensure the smelter’s long-term survival.

With this harsh reality in mind, this article considers the plight of the 800 odd employees who will face the prospect of lower incomes and the cost of searching for new jobs when shutdown day eventually comes.

Tiwai’s owners, Rio Tinto, announced last week that the smelter made a pre-tax loss of $91.5 million over the year to December 31. The company blamed the loss squarely on high spot electricity prices, combined with sharply lower aluminium prices.

However, the crux of the underlying problem runs deeper.

The reality is that Tiwai’s remote location and relatively expensive workforce mean that the smelter can’t compete with a glut of cheaper Chinese aluminium production.

Tiwai was only ever built in such a remote part of the world due to the availability of cheap hydro power, and it is only the continuation of preferential electricity pricing that is ensuring the smelter’s survival.

Even factoring in lower national electricity demand in the absence of the smelter, it is widely acknowledged that Meridian would earn a higher rate of return selling its generation on the open market.

Meridian’s electricity contract with Tiwai effectively boils down to a state-owned enterprise subsidising an industry. 

And Rio Tinto knows all of this.

After having unsuccessfully tried to wrangle a further discount out of Meridian, Rio Tinto seems resigned to the fact that the smelter is of little future value.

The company has written down the book value of Tiwai from $606.9 million to $14.8 million.  In financial terms, this valuation means that, even with preferential electricity pricing, Rio Tinto expects the smelter to do little better on average than breakeven.  

The effects of a shutdown

The effects of Tiwai’s closure on the national economy would be relatively contained.

After all, aluminium only accounts for just over 2% of New Zealand’s export earnings.

In the short-term, there would be a temporary hit to exports, but over the long-term the national economy would benefit from the redeployment of electricity and labour into industries which we are more internationally competitive.

However, the same cannot be said about the regional effects of the shutdown and the plight of Tiwai’s former workers. The closing of Tiwai would have profound effects on Southland’s economy and labour market.

The Southland economy would in all likelihood fall into a recession, and many of Tiwai’s former workers would face the prospect of a prolonged period of unemployment unless they moved, retrained, or were willing to accept lower paying employment.

A generation of workers in Southland’s labour market have become institutionalised in the Tiwai environment.

Subsidised power led to the creation of well-paid positions and accrual of skills that would not have otherwise been demanded by the wider labour market.

This artificial disjoint would leave some former Tiwai employees with a tricky transition into comparably paying employment should the smelter close. 

Parallels can be drawn between the current situation for Tiwai’s employees and car assembly workers left jobless in the late 1990s. Both industries flourished because of some form of government intervention.

Tiwai survives because of preferential power pricing, while New Zealand’s car assembly industry only ever existed due to sizeable import tariffs on cars.

Not surprisingly, when the government decided to withdraw these protective motor vehicle tariffs in 1998, domestic assembly plants could not compete with the price of imported vehicles and were forced to shut down.  These closures left thousands of car assembly workers jobless.

The case for transitioning assistance

As with Tiwai, many of these assembly workers had dedicated a large proportion of their working life to an industry whose labour demands were quite different to those of New Zealand’s broader labour market. However, despite this disjoint, additional support from the government to help with their transition into other employment was not forthcoming.  The government gave a mere $400,000 of funding for communities affected by car assembly job losses on top of normal social support and employment assistance.

I find this lack of additional support somewhat callous.

Car assembly workers had acquired a specific skillset on the understanding that society wanted to support the industry, as a result, the government’s decision to remove car industry tariffs essentially boiled down to changing an implicit social contract.

The government should have recognised its role in the problem and gone out of its way to assist these workers’ reintegration into the labour market. It was a change in government policies that undermined the value of the human capital these workers had developed – which suggests that as a matter of fairness, these workers should be compensated for that loss.

A similar changing of social contract is occurring at present in the case of the smelter.

If Meridian and the government continue to stonewall Rio Tinto’s attempts to get larger implicit power subsidies, then the government is effectively saying it no longer deems it important for society to support the smelter’s continuing operations.

To mitigate the consequences of this decision, the government’s focus should turn to the future welfare of the smelter’s 800 odd workers, who will face less lucrative employment prospects in the broader labour market.

After all, it was only because of government intervention that Tiwai’s employees acquired skills in the aluminium industry in the first place and it is now the government that is helping pull the rug out from under these people.

The least the government can do is recognise its role in the problem and ensure careful support is given to ease the transition of these people into other employment.

Imagine being able to print your own currency.

Click a button, add a few zeros and voila you’ve increased the money supply.

The Reserve Bank can do it, and, believe it or not in a similar vein so too can Air New Zealand.

Our national carrier doesn’t have control over the New Zealand dollar, but it does control the supply of New Zealand’s second biggest currency – the Airpoints Dollar. 

Airpoints Dollars conform to the standard definition of a currency – they are a medium of exchange for goods and services, they can be used to store value through time, and they are a quotable unit of account.

Air New Zealand operates a fixed exchange rate policy for its currency, where one Airpoints Dollar can be redeemed for one New Zealand dollar worth of flights.

Furthermore, in addition to being a currency, the Airpoints Dollar loyalty scheme also adds to Air New Zealand’s bottom line.

Air New Zealand is the sole institution with the ultimate authority to issue the Airpoints Dollar currency and back-of-the-envelope calculations show that the value of the airline’s loyalty scheme could be around $400 million.

At first brush, this valuation of Air New Zealand’s money printing prowess may seem a little far-fetched, but bear with me. The remainder of this article outlines how I arrived at this rough valuation and describes how an airline can generate revenue from a loyalty scheme.

Valuing Air New Zealand’s Airpoints programme

Although Air New Zealand releases detailed information regarding the profitability of the various parts of its air operations, unfortunately our national carrier is somewhat cagier when it comes to its Airpoints loyalty scheme.

Air New Zealand chooses not to report on the profitability of its loyalty scheme, but the airline does regularly divulge the number of Airpoints members and how much these members’ outstanding balances are worth.

As at 30 June 2013, the Air New Zealand Airpoints programme had more than 1.4 million members, up 17% from a year earlier.  These members had outstanding Airpoints Dollar balances valued at $236 million (recorded as revenue in advance), compared to $234 million in June 2012.

This growth in outstanding balances appears modest, but bear in mind that the purchasing power of Airpoints Dollars was boosted over the past year by falling domestic airfare prices.  Using airfare price information from Statistics New Zealand and passenger numbers data from Air New Zealand, I estimate that the real purchasing power of the Airpoints Dollar money supply increased by just under 10% over the past year.

However, although it is interesting to understand how the supply of Airpoints Dollars to members has evolved recently, this information is still not enough to even crudely value how much the Airpoints scheme is worth to Air New Zealand.

In order to derive such a valuation, I need to have an idea of how much profit the loyalty programme generates.  With Air New Zealand not releasing such detailed profit information, I was forced to get an idea of potential profitability by looking across the Ditch at Qantas.

In the year to June 2013, Qantas’s loyalty scheme generated A$260 million of Qantas group’s A$372 million EBIT.

With the rumour mill abound that Qantas is set to sell off its successful frequent flyer scheme in an effort to raise cash and stabilise the airline’s balance sheet, some analysts have used these profit flows to value the Australian national carrier’s loyalty scheme at up to A$2.5billion.

Given that Qantas’s loyalty scheme has 9.4 million members, this valuation equates to a value of around A$265 per member.  If one assumes that Air New Zealand’s Airpoints programme is equally as profitable as Qantas’s loyalty scheme and has a similar profit outlook, then the same valuation multiple could also be applied to Air New Zealand’s 1.4 million Airpoints members.

This methodology would suggest that Air New Zealand’s Airpoints programme could be valued at just over $400 million. Not bad considering that the total market value of equity in Air New Zealand in its entirety currently sits at $1.8 billion.

How can a loyalty scheme be worth so much?

Many of you may wonder how a scheme that involves creating a currency out of thin air, that is redeemable for flights, can be worth so much.

To get to the heart of this issue, one must understand that, like Qantas’s loyalty scheme, Air New Zealand’s Airpoints programme generates profits in several key ways.

Firstly, the carrot of loyalty points earned by flying with Air New Zealand is a mechanism for attracting customers in the first place and retaining their loyalty.  Thus an Airpoints member will be more likely to purchase flights through Air New Zealand rather than competitors.

Secondly, Air New Zealand can also utilise its currency issuing authority to create additional Airpoints Dollars and sell them to third parties such as credit card companies, hotels, car rental firms, etc. These third parties can then use the offer of Airpoints Dollars as a way of attracting and retaining their own customers.

Other more minor sources of value for Air New Zealand are related to the length of time between when the Airpoints dollars are sold and when they are redeemed for flights. During this period, the airline has free use of the capital and can consequently reduce its funding costs.

Furthermore, there is also a subset of Airpoints members who fail to redeem their Airpoints Dollars before they expire. Air New Zealand can keep the cash received from issuing these particular Airpoints Dollars without ever having to provide a service in return.

Although the basic framework of Air New Zealand’s Airpoints programme is broadly similar to Qantas’s loyalty scheme, it would be difficult at present to come to more rigorous conclusions regarding value than I have outlined in this article.

However, if Qantas does indeed sell off its frequent flyer scheme then intense interest from the investing community may force Air New Zealand’s hand to divulge more detailed information regarding its Airpoints scheme in future sharemarket briefings.