Rip-it-and-ship-it Versus Value-added

October 14 - 2014 - It’s a common concern that Northern Ontario is not developing industries that will add-value to raw mining and forestry materials before they are exported for use elsewhere. So, why can’t we build processing and manufacturing facilities and then sell the value-added products to the world?

Mike Moffatt puts it simply: “If there is a business case to do so, then absolutely [we can].”

The notion that there is a ‘business case’ to develop processing and manufacturing facilities embodies the concept of comparative advantage.

Northern Ontario’s primary industries exist because the region has an abundance of minerals in the ground and trees on the land that can be extracted and exported. Northern Ontario is endowed with natural resources that not everyone else has; this is what gives the region its comparative advantage in these industries.

On the other hand, it is not necessarily clear that the region has a comparative advantage in value-added forest and mining products – i.e., processing and manufacturing of raw materials. Since a processing facility can be located almost anywhere, there are many additional factors – over and above having raw materials nearby – that affect where Northern Ontario’s comparative advantage (or disadvantage) lie for value-added industries.

In fact, due to the increasingly global supply chains, “proximity to markets is no longer a comparative advantage for traditional manufacturing regions,” explains Moffatt. This is not particularly surprising given technological advancements in transportation and communications around the world.

Some of the additional factors that contribute to a region’s comparative advantage are determined at the national level, such as exchange rates, corporate taxes and recessions. Other factors are determined at the provincial and regional level, including labour costs, energy costs, workforce, productivity, capacity for innovation, private sector will, educational institutions and more. These are all factors that can affect the viability of a business or industry.

The key to success is to utilize your comparative advantage

Propping up a particular company, or a particular industry, that does not have a comparative advantage – for example, a wood processing facility that requires low-skilled labourers and high-levels of electricity – with public sector subsidies will not be sustainable over the long-term.

In terms of labour costs, the industry is in competition with others who have access to an abundant supply of low-skilled labour at a considerably lower wage rate. It’s difficult to compete with a jurisdiction who can get away with charging a fraction of a wage rate. Similarly, if a local facility requires a large amount of electricity to produce a value-added product then the industry/company is at a clear disadvantage given Northern Ontario’s relatively high price of electricity.

Suppose the government decided to subsidise (or “invest in”) this industry anyway. How would this play out? Any government intervention would ultimately have to result in the industry producing their good at a competitive market price, otherwise we can assume no one will purchase the product.

Achieving a competitive price for this value-added wood product that is being produced with high levels of electricity by low-skilled and relatively high-paid labourers can happen one of two ways. First, the government can subsidise the local wood processing facility’s higher wage and energy costs, making their business ‘viable,’ in the sense that the owner of the facility would see the returns had they operated in competing jurisdiction.

The other option is for the government to subsidise the primary extraction industry who is supplying the raw forest materials to the local wood processing facility. Given that the local facility is at a comparative disadvantage due to higher operating costs, they must receive the raw materials at a discount rate in order to remain competitive. Thus, the government would have to subsidise an extraction company the difference between the discount rate paid by a local value-added company and the market price paid by a foreign processing plant in order maintain the initial level of returns that made the primary industry viable.

Whether it is option one or two that is chosen, the end result is a pseudo-competitive industry being propped up by government funding, or in other words, taxpayers. In this sense, one could argue that the region’s comparative advantage is government subsidies. This is hardly a sustainable strategy.

So what value-added industries does Northern Ontario have a comparative advantage in?

This, unfortunately, is not immediately clear.

Northern Ontario faces large structural issues that are having an adverse effect on growth and opportunities in general. The region is facing an aging population, coupled with youth out-migration, resulting in a largely dormant total population. Overall employment growth has been mostly stagnant, and the private sector is facing difficulties expanding. Although there are some regions within Northern Ontario that show signs of growth, the general economy appears to be facing structural challenges.

Northern Ontario should spend less time putting money into individual companies, and more time identifying real opportunities and industries that are well-positioned for growth. Shifting investments into attracting youth and immigrants to the region and developing a high-skilled and technical labour force will set the region apart from competitors who dominate industries made up of low-skilled workers. This means building a strong education system with government and industry partners and less restrictive and more specialized apprenticeship programs. These strategies are broad, but necessary, given the challenges facing the region. ‘Creating jobs’ by pumping money into a few companies is a short-sighted goal that usually only last as long as the funding does.

Additionally, investing in research and development will help the region build much needed capacity for innovation. Electricity costs are high relative to many of the region’s competitors, both domestic and foreign. Innovation technologies that reduce electricity costs through productivity enhancements and/or alternative cheaper energy sources, such as natural gas, will be key for local industries to thrive. An example of this, as identified in one of our previous blog posts, is KWG Resources’ plan to develop a process that uses natural gas instead of electricity for smelting ore in the Ring of Fire.

The bottom line is that the question of whether to ‘rip-it-and-ship-it’ or ‘sell to a local value-added company’ isn’t as straightforward as it seems. The narrative for growth in Northern Ontario needs to shift away from short-term strategies for creating subsidised jobs in value-added industries and towards addressing the long-term structural challenges facing the region. Addressing the fundamental issues with a keen perspective on where our future opportunities lie will be crucial for long-term sustainable growth.

Authored by James Cuddy, Senior Policy Analyst with Northern Policy Institute

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