Climate Conundrum

The phrase climate change often renders an image of melting icecaps, rising sea levels, and other environmental changes. The environmental dimension is just one part of it. Not quite perceived by many are the sweeping changes taking place in the world of business and politics in an effort to respond to climate change.

2007 saw the IPCC (inter governmental panel on climate change), headed by Dr. RK Pachauri give its verdict: the climate is changing and we ourselves are largely to blame. The question now is not whether to act or not, but how to respond to climate change in a sensible way. Climate issues rank high on the political agenda; needless to say comprise much of rhetoric. Quite obviously climate change and related regulatory reactions will have significant implications on the world economy.

According to the IPCC, general warming of the earth is almost certain, rainfall patterns will change, and heat waves will become more frequent. The weather gods will become more capricious and we may see more Katrinas and Ritas. On one hand extreme weather events will cause destruction to plant machinery and crops, while on the other planning of future events would become complicated due to increased uncertainty. These are the twin factors which would have economic significance.

The first repercussion is increased financing costs. Institutions which lend to weather exposed sectors like agriculture, would expect a higher premium for the increased risk they are taking. Industries which have to reckon heavy losses due to the vagaries of the weather would find it difficult to finance themselves. Secondly, governments can no longer afford to sit quiet on potential climate threats and will be forced to take regulatory actions. This will result in growing climate protection efforts, which will result in higher costs. Regulations which aim at improving parameters such as heating efficiency, insulation, and low carbon technology are likely to be put in place. On the brighter side, some industries like construction and renewable energy do benefit, the costs however trickle down to you and me. Finally, climate change has the potential to change consumer behaviour. Increased awareness is already reflected in consumers’ efforts to conserve energy and support reparation efforts.

The key challenges in tackling some of these economic ramifications are

• Funding climate related technological advances

• Reducing the costs of greenhouse gas emissions

• Distributing weather risks effectively

• Create monetary incentives for environment friendly behaviour

Keeping these in mind, a lattice work of instruments and strategies needs to be evolved to respond to climate change in a sensible way. With the help of suitable financial instruments, it is possible to create incentives for climate protection, fund climate protection strategies, and share unavoidable risks effectively.

Emissions’ trading is an effective tool to augment efficiency of climate protection efforts on a global level. The Kyoto Protocol regulates green house gases like carbon dioxide, methane, nitrous oxide, sulphur hexafluoride, and fluorocarbons. All these emissions are converted to carbon dioxide equivalents, and measured. These measured quantities are used to issue emission certificates.

The Kyoto Protocol and the auxiliary agreements describe diverse emission certificates. At the outset, a distinction is made between emission rights and emission credits from project based mechanisms. In the first case, there is a ration of emission rights, which can be traded among the emitters of greenhouse gases. This includes the EU allowances that are traded in the EU emissions trading system and the assigned amount units (AAUs) that are intended for international trading. In the second case, credits can be obtained from additional climate protection projects in third countries and used to meet their own reduction target. A distinction is made according to whether the projects are realised in another industrial country (Joint Implementation) or in a developing country (Clean Development Mechanism, CDM). Another option provided for in the Kyoto Protocol is the realisation of carbon-sink projects at home, for instance in the form of afforestation. This results in so-called removal units (RMUs). Finally, it is possible to generate tradable project-based credits in the form of verified emission reductions (VERs).

The emission of greenhouse gases is a global problem; however, emerging markets and developing countries have been exempted so far from the Kyoto Protocol’s quantitative reduction commitments. All else being equal, the capping of greenhouse gases can often be realised at much lower cost in emerging than in industrial countries. This is where the Kyoto Protocol’s project-based mechanisms kick in. They allow emission credits (CERs and ERUs) from additional climate protection projects in third countries to be credited to the own reduction target. However, to prevent the industrial nations from buying their way out of any reduction commitment at home, there are limits to how much can be credited to their own reduction targets.

The trading of carbon credits is a lucrative opportunity for Indian companies and India in general. Indian companies can develop their own CDMs and sell their carbon credits to developed nations which have specific reduction targets under the protocol. Carbon credits have made climate protection a viable business prospect. Thanks to carbon credits, climate protection need not be at the mercy of benevolence.

The second class of members in our lattice is pretty simple - climate related investments. There is an investment theme evolving, which tries to demarcate sectors which profit from climate change, and sectors that don’t. Firms involved in renewable energy, companies offering solutions to adapting to climate change. Growing investor interest eventually reduces financing costs for these companies. It also gives a fillip to better capital allocation.

The third class is - a market for catastrophe and weather risks. Reinsurance is a typical example. Reinsurance is where insurance companies are insured by other insurers against mass catastrophes like tsunamis and hurricanes. It’s not significant in a country like India, but a big business in developed economies. Natural catastrophes are huge in terms of the volume of disaster, potentially affecting a whole region, this is where reinsurance helps. Another example would be cat bonds – a special purpose vehicle issues bonds which are used to fund contingency claims. This class of instruments enable efficient risk sharing. Many other members of the lattice are in the nascent stage of their genesis.

Of all the complex mechanisms to tackle climate change, carbon credits are the most relevant from the Indian perspective. Indian companies have already started to realise their potential, and are developing clean mechanisms. Carbon credits are increasingly being seen as supplementary products. There are trillions at stake to curb fossil fuel pollution, switch to clean energy.

Whether all these instruments are significant to climate protection is unclear. What is clear though is there is a lot of money involved. The future of all these treaties is uncertain. Bush’s successor may object to Kyoto protocol style of emission curbs. Though waning American hegemony is very much alive. While the countdown is on to save the planet, world leaders will bargain on treaties with monstrous complexities.

The gap between the need for action and political rhetoric is widening. Almost all global summits on climate change have been plagued by finger pointing. Who should foot the bill of climate change is still a nagging question. Uncertainties are a part and parcel of doing business.

Dog days for the dollar

The year of the rat certainly seems bleak for the American economy. The US economy seems to be in one of the worst crises in the recent times, and pundits are working hard to save the US economy from the brinks of recession. 2007 in many ways saw the beginning of the end of the übercurrency. At the beginning of the last century, the Great Britain pound had the status. The United States of America was just emerging then. The story of how USA became a leader is history and the US economy is now in a mess, with a consumption boom fuelled by borrowed money. The wheel of fortune has turned, and time is running out for the dollar. Here’s why.

Web 1.0 at it’s time was considered revolutionary. The late 1990s was characterized by frenzy over dot-com. It promised to take lesser mortals into the land of milk and honey. What followed was the busting of the dot-com bubble, taking the American stock exchanges through the doldrums. Alan Greenspan was at the helm of affairs in the Federal Reserve, and he promptly trimmed down the interest rates. Lower interest rates set in motion a consumption boom, which seemed to have set the economy right. The subtler ramifications though weren’t palpable until late 2006.

Dozens of interest rate cuts post dot-com and September 11^th had increased the money supply. Interest rates were slashed from 4.5% to 1% in two years[1]. Think of monetary supply as a string wound over a pulley. Too loose is of no use. Too tight and it will snap. Gradually the Fed took up the slack, but far slower than it had let it out. Monetary policy was too loose, and created the perfect conditions for the next bubble.

The growth of the US Economy post the dot-com bubble is interesting, and in hindsight is responsible in a way for the current turmoil. Lower interest rates meant borrowing was cheaper (cheap credit). This kicked off a quest for higher returns. Financial engineering was used, and the availability of advanced computers made, complex calculation easier. Diverse asset classes were combined to create financial instruments like collaterized debt obligations (CDOs). The risk was ‘measured’ using complex mathematical formulae. The methods were perceived to be sound because the mathematics was elegant. Pundits suffered the ‘man with a hammer syndrome’ – to the man with a hammer, every problem looks pretty much like a nail. This enabled banks to lend customers with poor credit rating.

Poor housing credit was shielded by innovative structures and rising home prices. This made credit cheaper. Loans to borrowers with poor credit history (subprime) accounted for almost 15% of all loans in 2006, that’s 1.2 trillion dollars.[2] Consequently home prices rose, leading to a consumption and investment boom, thus increasing the GDP. Subprime credit kept escalating to dangerous levels till August last year, when realization finally dawned. Much of the perils of the US Economy can be attributed to the subprime crisis, and more bad news is yet to come. The crisis has the potential to start of a dangerous chain reaction.

Loan defaults by subprime borrowers have already happened – chain initiation. Credit standards inevitably need to be tightened, EMIs will increase as interest rates reset upwards. Apart from increasing the number of unsold homes, it will increase defaults (the chain initiating step). Now unsold homes cause housing prices decline. No one buys when prices are set to decline, so investment in housing declines. Recalling that poor credit was shielded by rising home prices, it is easy to see that falling home prices takes you back to the first step. Jobs are lost due to both declining housing prices and falling investment in housing. This leads to lower consumption, and the GDP growth slows. Wow!

The subprime crisis can’t be rubbished as a mere housing crisis considering that the US housing market accounts 20% of world GDP, and 60% of US GDP. Secondly it is also a banking crisis – a crisis of liquidity and a crisis of collateral. It has been each of these and also a crisis of central banking. Central banks were very much present at the genesis, as asset prices swell and credit markets hypertrophied. What was spectacular in America was the ability of a large number of subprime borrowers – those with poor records – to take out mortgages and buy homes, lured by cheap credit and the delusion that home price could only go up.

Authority: “Credit and asset-price booms can leave an awful lot of wreckage behind them. The casualty list after America’s housing crash includes: an overhang of unsold property; a huge fall in construction; the risk of weakening consumer spending as house prices falls; a trail of bankruptcies; big write-downs among the investment banks; and the unprecedented seizing up of some financial markets on both sides of the Atlantic” - The Economist

If we seek to examine, if the actions of the Fed after the crisis are going to do anything to help, the picture seems dismal. Not so long ago, the Fed announced a rate cut, ripples were felt here and the Sensex sure did respond with a smart gain. It’s hard to fathom how it’s going to help solve the crisis. Lower interest rates were one of the contributing factors for the crisis.

Then there was an American version of populism. Mr President’s office decided to keep initial teaser rates frozen for a ‘certain’ category of subprime borrowers. Firstly that’s akin to heralding “it’s ok if you default, the government will bail you out”. Secondly the idea spells trouble for lenders, and they will factor the risk of freezing in the future, leading to higher interest rates. The idea was to prevent homes from going into immediate foreclosure that would accelerate price declines, but law of nature says that ‘what has gone up by irrational exuberance has to come down’.

There was also a plan of providing low interest loans to holders of mortgage backed securities – the banks. This however is the wrong sort of protection, and a misplaced idea to bail out the banks. Such a measure would have been necessary if the banks were suffering from insolvency, but the problem is one of liquidity. This actually amounts to increasing the money supply – a causal factor of inflation. The housing bubble was a symptom of inflation. So it’s hard to see how inflation can be tackled with more inflation.

The newly created credit will help borrowing by institutions at low interest rates, and help investing at higher yielding currencies like the INR. Something similar happened in Japan and was christened the “Yen Carry Trade”, looks like it’s going to happen in America. The correct thing to do would have been raise interest rates, and curb money supply. This would have created a bigger crisis at that time, but would have averted serious future problems. The Fed in my opinion just lacked the conviction to put its foot down and take bold actions.

It looks like the outlook for the American and the world economy is bleak, but there is a silver lining. We can hope that the emerging markets like China and India will come to the rescue by growing at a rapid rate. Global economies are highly intertwined, so if the Asian juggernaut keeps rolling, it could be America’s aspirin. However this also means that Asian dependency on America is reducing, and the world would soon need the dollar less.

India can thrive on this chaos. The turmoil in the debt market and the US economy, would slowly lead to the easing of oil prices. The rupee is rising so imports will become cheaper. There will be a global realignment of currency which would benefit India. The slowdown in US will begin to script a domestic consumption story. India may actually benefit after a small transition period.

It’s too simplistic to conclude that the Fed did all the wrong things. Instead all moments of choice were catch-22 situations. What would have happened if the Fed reacted differently is anybody’s guess. My hunch is that the American economy would recover after a slowdown without going into a recession. However, one thing is clear – the dollar’s hegemony is shaking.

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[1] http://www.federalreserve.gov/releases/h15/

[2] http://www.responsiblelending.org/pdfs/CRL-foreclosure-rprt-1-8.pdf