Building & Construction Industry

Forecasts: Methodology This report was prepared for Master Builders Australia

14 May 2013

This report has been produced for Master Builders Australia (MBA) according to their terms of

reference for the project. Independent Economics makes no representations to, and accepts no

liability for, reliance on this report by any person or organisation other than MBA. Any person, other

than MBA who uses this report does so at their own risk and agrees to indemnify Independent

Economics for any loss or damage arising from such use.

Independent Economics is an independent provider of economic modelling services to support

economic policy analysis and forecasting. We are strongly committed to independent modelling that

provides robust analysis and real solutions to meet client needs. In Australia, we provide services to

government and industry, and we also provide services internationally.

© 2013 Econtech Pty Ltd trading as Independent Economics. All rights reserved.

Postal Address:

Independent Economics

PO Box 4129

KINGSTON ACT 2604

AUSTRALIA

Street Address:

Independent Economics

Unit 4

4 Kennedy Street

KINGSTON ACT 2604

AUSTRALIA

Phone: +61 2 6295 8884

Email: office@independenteconomics.com.au

Web-site: www.independenteconomics.com.au

Entity: Econtech Pty Ltd (ACN 056 645 197) trading as Independent Economics

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

Contents

Building and Construction Industry Forecasts................................................................................ 1

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

1

Building and Construction Industry Forecasts

Independent Economics (Independent) was engaged by Master Builders Australia to develop detailed

forecasts of construction activity (work done) at the national and state level. A Building and

Construction Industry Forecasting Model (Construction Model) was constructed by Independent to

provide these forecasts. This note provides an overview of the Construction Model.

Activity in the following construction types are forecast by the Construction Model.

residential construction

o house construction

o other residential building

o alterations and additions

non-residential building

o retail and wholesale trade building

o office

o transport and other commercial building

o industrial building (aggregation of factories, warehouse, agricultural and aquacultural

buildings and other industrial building)

o educational building

o health and aged care facilities construction

o entertainment and recreation construction

o accommodation construction

o other non-residential building

engineering construction;

o roads, highways and subdivisions construction

o bridges, railways and harbours construction

o electricity generation, transmission and pipelines construction

o water storage and supply, sewerage and drainage construction

o telecommunications construction

o heavy industry construction

o recreation and other engineering construction

The Construction Model is integrated with Independent Economics’ Macro-econometric model

(Macro Model) and uses inputs from Independent Economics’ Demographic model. The linkages

between these three models are shown in the diagram below. A discussion of each model follows the

diagram.

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

2

Building and Construction Industry Modelling Framework

Population by age by state

Demographic

Model

overseas migration

interstate migration

fertility rates

survival rates

Macro Model

World interest rates

World commodity prices

Industry labour productivity

Government policy variables

e.g tax rates and spending

Building & Construction

Model:

Approvals/Commencements

Approvals and

commencements by industry

Approvals and

Commencements by

detailed type Major projects

data

On-the-ground

information from

MBA

Building & Construction

activity by type by state

Building &

Construction Model:

Work Done

Working age population by age by state

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

3

Demographic model

The demographic model provides projections of the population by gender by single year of age for

each state and territory. The projections allows for the following assumptions.

Relatively low total fertility rate of 1.85. This is slightly above the rate projected five years

ago in the Australian Bureau of Statistics (ABS) series B projection, but slightly below the

rate observed in the intervening years.

Net overseas migration (NOM) is assumed to be constant at 200,000. This is mid-way

between the assumptions made in the ABS’ series A and series B population projections and

is just below the level in 2011-12.

Increase in longevity through a gradual improvement in survival rates over time.

Each state’s share of NOM is assumed to be its average share over the last 6 years.

Net interstate migration of individuals reflects each state’s average for the last six years. This

means that individuals are expected to move from New South Wales, South Australia,

Tasmania and Northern Territory to other states, particularly Queensland.

Independent Economics Macro-econometric Model

The all-new Independent macro-econometric model judiciously balances economic principles and

evidence from the historical data in capturing the broad workings of the Australian economy.

The key features of the Independent Macro-econometric model are:

forecasts on a quarter-by-quarter basis to a short-term and long-term horizon;

used with a detailed demographic model to allow for the economic effects of population

ageing in developing robust long-term projections;

strong data consistency for more accurate forecasting;

solid theoretical foundations for more robust policy analysis;

six industry sectors to better capture the macro-economic implications of industry

developments such as the mining boom;

fully-consistent, detailed projections for the eight states and territories from our satellite states

model;

an understanding of how the Reserve Bank pursues its inflation target in setting monetary

policy, taking into account developments in inflation, unemployment and the bond market;

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

4

modelling of consumer and investment behaviour that allows for the GFC;

a new approach to modelling household consumption that takes into account targets for asset

holdings based on labour income; and

allows for structural change in the labour market.

Key features of the Macro Model which make it well suited for forecasting building and construction

activity are as follows.

The model separately identifies a firm’s demand for building and construction versus other

types of investment goods (such as machinery and equipment).

Approvals and commencements are used as the indicator of a firm’s demand for building and

construction investment. This leads to robust short term forecasts of construction activity

because approvals and commencements provide more timely information on building and

construction activity, compared to a National Accounts measure of construction investment.

The model captures the key factors which affect investment decisions by firms, such as the

cost of construction, returns on other assets, depreciation, and profitability.

The three points above are discussed, in turn, below.

There are two main capital goods in the economy, buildings and structures, and machinery and

equipment. The building and construction industry is responsible for supplying buildings and

structures while the manufacturing industry supplies machinery and equipment. The Macro Model

uses a sophisticated methodology to model the demand for each type of capital good in a particular

industry. Specifically, in each industry, the relative demand for these two types of capital goods

varies according to the relative price of the two goods and the substitutability in that industry between

buildings and structures and machinery and equipment. This allows the forecasts to capture more of

the behavioural response of firms when the cost of building and construction changes. For example,

when the relative cost of machinery and equipment to buildings and structures increases, firms would

tend to substitute away from investment in machinery and equipment towards investment in buildings

and structures, all other things being equal. This sophisticated approach would provide more robust

forecasts of building and construction activity, as demand for buildings and structures is explicitly

modelled at the broad industry level.

Approvals and commencements are used as the indicator of a firm’s demand for building and

construction investment. That is, the Macro model directly forecasts approvals and commencements

by industry using sound economic principles. Using approvals and commencements as an indicator,

instead of a National Accounts measure of building and construction investment, leads to robust short

term forecasts of construction activity. This is because approvals and commencements provide more

timely information on building and construction activity.

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

5

A Tobin’s Q approach is used to forecast approvals and commencements. Using Tobin’s Q allows the

model to capture the key factors which affect investment decisions by firms, such as the cost of

construction, returns on other assets, depreciation, and profitability. Specifically, it compares the

actual rate of return on investment to the required rate of return. The actual rate of return is

determined by industry profitability and building and construction costs. The required rate of return is

driven by depreciation, a risk premium and returns to other types of assets. Approvals and

commencements are above normal levels whenever the actual rate of return is higher than the required

rate of return. Similarly, approvals and commencements are below normal levels whenever the actual

rate of return is below the required rate of return.

Building and Construction Industry Forecasting Model

The Construction Model uses inputs from the Demographic Model and Macro Model to develop

forecasts of building and construction activity by type for each state and territory.

At the national level, it takes forecasts of approvals and commencements by industry from the Macro

Model and uses this to drive forecasts of approvals and commencements by detailed types. For

example, approvals in the ownership of dwellings industry are used to drive approvals for housing.

The more detailed forecasts of approvals and commencements by type are then used to drive forecasts

of work done by type.

A “top-down” approach is used to allocate national forecasts of construction approvals by type down

to the state level. First, a state’s share of national approvals for a particular construction type is

forecast. These shares are driven by the relative population size of the state and an industry

composition variable. For example, a state’s share of national housing approvals is influenced by the

state’s share of national working-age population. The industry composition variable captures the

extent to which industry conditions at the national level are relatively favourable or unfavourable for

the relative position of the state. For example, a high level of activity in the Mining sector at the

national level boosts the industry composition variable for the Mining-intensive states of Queensland

and Western Australia. In a Mining boom, these states are likely to require more than their usual

share of new building and construction infrastructure.

Once approvals by type have been forecast for each state, work done by type can then be forecast in

each state. This is done in a similar approach to that used at the national level, under which

movements in approvals gradually flow through to movements in work done based on historical

relationships.

Data Sources

The key data sources used to develop the construction activity forecasts are sourced from the

Australian Bureau of Statistics (ABS). The key publications used are as follows.

8752.0 Building Activity, Australia

8762.0 Engineering Construction Activity, Australia

Master Builders Australia Building and Construction Industry Forecasts: Methodology

14 May 2013

6

8731.0 Building Approvals, Australia

8782.0.65.001 Construction Activity: Chain Volume Measures, Australia

5204.0 Australian System of National Accounts (Annual publication)

5206.0 Australian System of National Accounts (Quarterly publication)