Despite the setbacks in Maui last month during the last ministerial meeting of the Trans-Pacific Partnership (TPP) many still believe that the negotiators will resolve all outstanding items so that an agreement can be signed by the end of 2015 and implemented in the Spring 2016. If so, the TPP will soon become more than an aspiration or fear, but a real time event that creates opportunities, as well as risk, for global companies.
The TPP: The Need for a Corporate Risk Strategy
A game changer such as the TPP thrusts corporate performance objectives in a bright light, where decisions will have to be made in an unpredictable and very fluid policy environment. Senior executives must manage their businesses in the face of these rapidly changing competitive challenges to ensure that the value of their enterprise is protected – if not enhanced – for investors, board members, and stakeholders. Indeed, part of managing their corporate-wide risk strategy is to focus on sustaining competitive advantages, optimizing the cost of emerging risks, and improving the overall business performance.
Because the TPP will undoubtedly alter how the imports of automobiles and automobile parts will have access to and qualify for preferential treatment within the TPP community, the agreement presents significant change for automotive companies with plant locations in North America. With a final TPP agreement looming, it is imperative that North American automotive executives take strategic aim now on what this agreement would mean for their business, both in terms of their access to the best supply chain, but also in terms of their longstanding business relationships with their own customers and auto assembly operations.
For the last 20 years, the North American auto sector business model has been built on North American Free Trade Agreement (NAFTA) regional content and corresponding interpretative rules — admittedly arcane and intellectually numbing – that have driven investment decisions, plant locations, supply partnerships, and preferential duty access. Although no one can predict with certainty all the details of the final TPP automotive rules and their interplay with any surviving NAFTA provisions, what is clear is that the rules will be different in many respects from the rules currently governing NAFTA transactions, especially for North American automotive companies. Particularly relevant, this dynamic is taking place as more and more automotive companies are expanding – or are considering expanding – their physical presence in Mexico, presumably basing those decisions on the existing NAFTA rules.
Accordingly, automotive executives must take stock now of the emerging risks as well as opportunities the TPP will present. This obligation should not be limited to compliance managers and customs brokers who focus on day-to-day trade issues– the changes proposed will reverberate throughout the company requiring executive action and strategic decisions by risk managers and senior executives in the finance, procurement, legal, and operations departments, among others.
The TPP and the Challenge to C-Suite Automotive Executives
Until recently, the automotive sector provisions in the TPP received little press or public attention. This changed last month when it was reported that the US and Japan had struck a deal in Maui regarding establishing regional value content (RVC) requirements at levels lower than imposed by the NAFTA. Not surprisingly, Canada and Mexico announced their opposition to this proposal. What has become evident is that whatever RVC and other requirements and conditions are ultimately included in the final TPP agreement, rules on which North America automotive companies have built their enterprises must now be dusted off and scrutinized anew under the new prism of the TPP.
As was the NAFTA, the TPP will be the game changer event for the automotive sector. In addition, given the various setbacks of trade negotiations for the TPP as well as others such as the WTO Doha Round, the final TPP text will likely be the framework for the international trade in auto and auto parts for the foreseeable future. One very influential member of the TPP, Japan, has made it clear that its primary goal within the TPP is to gain wider and deeper access for its auto parts industry in the US (and therefore North American) marketplace. If Japan succeeds, there will be cheaper auto parts competition as well as broader supplier choices for North American auto assembly operations.
For these reasons, senior executives should be taking stock of the various short and long term risks presented by the TPP as applied to their current business models and incorporate these risks into their own company’s enterprise-wide risk strategy. To do so, they will need to apply their own risk tolerance and recast assumptions based on what are “acceptable” to the company’s leadership and shareholders, which risks could be successfully and efficiently managed and which risks presented by new TPP rules should be avoided.
Being able to quickly identify the potential for inherent as well as systemic risks will give executives the advantage to take the “right risks” in a far more competitive landscape. To that end, company executives may want to put in place a corporate risk strategy that uses available in-house resources and expert counsel to identify and measure both the risks as well as opportunities the TPP presents to the company, its supply chain, and to its competitors.
As noted above, the proposed TPP RVC requirements are lower than the current NAFTA RVC rules. According to some TPP reports, the RVC level proposed is a low as 40 percent for vehicles. Other accounts of the US-Japan agreements have reported 55 percent as the prescribed RVC level, but still lower than the 62.5 percent value requirement imposed under the NAFTA. For automotive parts, the RVC figure consistently reported is 30 percent.
The US-Japan proposal makes perfect sense for these two countries. For Japanese automakers, it would allow them to continue to source from non-TPP countries, such as Taiwan. For US automotive companies, it provides more options for sourcing cheaper parts.
A number of reports have indicated, however, that the deal would not be good for Canadian and Mexican auto parts producers as it would reduce a competitive advantage in selling parts to automotive OEMs with plants in North America. Common sense also dictates the same conclusion, as “preference erosion” would seem to be the likely result – in other words, the negotiated advantages that Canadian and Mexican auto parts producers current enjoy under NAFTA could be wiped away by a TPP agreement that would extend the same benefits to at least nine other countries. There are also reports that there will be no form of automotive “tracing” in the TPP rules, which will complicate matters for North American producers that use tracing in their origin determinations. Less certain are whether other origin-defining mechanisms, such as averaging and accumulation, will be included in the final rules.
It remains to be seen what the final TPP automotive rules of origin will look like. Canada and Mexico are in the process of preparing counter proposals, which undoubtedly will include higher content levels. Timing of phase-out requirements could also serve as a tradeoff to permit the lower content requirements to prevail – the TPP is expected to have long phase-out periods for US automobile and trucks imports. A phase-out period for automotive parts and even the dismantling of Japan’s non-tariff barriers or the imposition of safeguards if Japan violates the TPP deal could conceivably be negotiating points or the subject of side agreements. What is clear from recent weeks is the US and Japan will impose pressure to keep future negotiations close to the original deal.
An Executive Primer on NAFTA Preferential Rules of Origin
It is critical to any regional or global trade agreement providing duty preferential treatment to imported goods that firm and transparent requirements ensure that only goods produced or manufactured by signatory countries receive favorable tariff treatment. The requirements must not be too restrictive so that meaningful production in a signatory country is not rewarded with duty preferential treatment when that good is imported into another signatory country. At the same time, the requirements must ensure that goods with inputs from non-signatory parties do not qualify for preferential treatment through minimal processing. For trade agreements, this balancing act is establishing workable and effective preferential rules of origin.
NAFTA Rules of Origin
Under the NAFTA rules of origin, goods containing imported materials will be deemed to be a product of a NAFTA country entitled to duty preference (today, zero duty treatment for all qualifying goods) if the production of that good in the NAFTA country accomplishes the requisite “transformation” of those materials. The requisite changes under NAFTA are established by product specific rules. The rules often involve comparing the tariff classification of the materials from non-NAFTA countries with the tariff classification of the finished good produced from those materials, which require no cost or value information. For many products, however, regional value content requirements also may be applied in addition to or in lieu of “tariff shift” rules.
In the NAFTA negotiations, the rules of origin received considerable attention because of concerns that Japanese and European companies would establish operations in Mexico in an effort to exploit the U.S. and Canadian markets. In establishing NAFTA rules of origin, the negotiators were instructed by their stakeholders to push for strict rules of origin – i.e., rules that would make it more difficult with non-NAFTA materials to qualify for duty preferential treatment. This was especially true for automotive goods.
NAFTA Automotive Rules of Origin – Regional Value Content and Unique Features
The NAFTA rules of origin on automotive products are one of the most complex and detailed rules of origin regime found in any of the current free trade agreements. The regional value content requirement must be determined in accordance with “net cost” principles, which involve producing and reviewing numerous accounting records, as well as special rules that apply specifically to the automotive sectors. Therefore, it is important to understand how automotive goods that currently qualify for NAFTA duty free treatment will be affected by the anticipated changes in the TPP, as well as those products to be developed in the future.
NAFTA imposes a 62.5 percent of net cost requirement for passenger automobiles, light trucks, and their engines and transmissions, certain other vehicles, and automotive parts. This means that 62.5 percent of the net cost (certain items, such as profit are not included in net cost) must be attributable to U.S., Canadian, or Mexican production. As noted above, the content requirement under the new rules may be significantly lower, which is potentially good news for North American automotive producers, but will certainly increase competition for parts manufacturers from the non-NAFTA TPP countries.
One of the special features of the NAFTA content requirement applicable to automotive goods rumored to be excluded from the TPP is the concept known as “tracing.” Not all automotive components are subject to tracing – specific automotive parts are included in a “NAFTA tracing list” determined by the tariff classification of the automotive part. For those automotive parts on the tracing list, the value of any such component produced outside of North America will be included in the final non-NAFTA content of the value of automotive vehicles and parts subject to the tracing rules.
Conversely, because of how the NAFTA tracing rules works, many automobile and automotive parts producers located in North America currently benefit from the application of tracing. This is because the tracing rules allow certain automotive components that are produced outside of North America to be treated as originating from a NAFTA country for purposes of calculating regional value content. To the extent TPP does not incorporate tracing concepts in calculating regional value content, these companies should be addressing how the exclusion of tracing would affect the qualification status of their products under a TPP regime.
Producers of automotive goods in the US, Canada or Mexico also may elect to “average” their costs when calculating the regional value content requirement for NAFTA duty preference qualification purposes. Automotive goods producers that rely on some form of averaging may find these rules will change when TPP comes into play.
The complex rules described above, which over the NAFTA lifespan have been interwoven into the fabric of the North American auto industry, is the reason why senior leadership must take stock now of what the TPP portends for their companies. The ripple effect of a change in one or a number of these NAFTA rules might very well be felt throughout the corporate enterprise, potentially affecting its business relationships. An effective risk management system will yield strategic options – for both the “quick wins” as well as longer term objectives.
A Suggested Start - Identifying, Evaluating and Exploiting the Right Risks for Your Automotive Company
As with many emerging issues facing companies, the advent of TPP would suggest more of a risk-based approach than a compliance approach. For any effective risk model employed by the company, the first step would be to identify the particular risks (and opportunities) raised by the TPP. The Arent Fox Canada-US Cross Borders Business Affairs team recommends that automotive corporate risk managers take the following key action items:
- Foster collaboration among company executives on the key risks presented by the TPP.
- Provide expertise on how the TPP and NAFTA rules of origin differ for their particular enterprise and why.
- Assess the company’s current business model vis a vis the NAFTA and its current plant/supplier locations.
- Determine the actual scope of the company’s exposure or dependence on the current NAFTA rules.
- Evaluate the company’s ability to achieve its longer term goals within the new TPP framework.
- Identify potential new US import regulations and policies generated by the TPP, including new US trade enforcement regulations promulgated to implement the US obligations under the TPP.
Once these risks are identified, we recommend an enterprise risk management approach to apply these risks across the entire organization and lines of business. The objectives would be to:
- Best position the company in the new TPP environment to ensure the TPP risks are identified and effectively managed and exploited.
- Mitigate the risks that this new environment presents in comparison with the current business model.
- Identify the competitive landscape both within North America and throughout the TPP member community.
North American automotive parts manufacturers should be thinking broadly in terms of how their current business model will be affected by the negative risks the TPP is likely to create. Equally important will be how North American automotive companies will take advantage of the growth opportunities that the TPP is likely to present.
By getting a head start, parts manufacturers in North America stand to gain a competitive advantage so that when the final TPP agreement is implemented, all options, including their potential costs and benefits, will have been fully explored, considered, and evaluated both for themselves as well as their assembly customers. In this way forward-thinking automotive companies will be able to make best-informed decisions that will gain them the advantage in the uncertain years that lie ahead.