Month: March 2015

CFA Society Chicago Book Club Discusses

Bust; Greece, the Euro, and the Sovereign Debt Crisis by Matthew Lynn

The CFA Society Chicago Book Club met on March 17 to discuss Greece and how the debt crisis came to be and the outlook going forward.  Matthew Lynn’s 2011 book, Bust; Greece, the Euro, and the Sovereign Debt Crisis was a fantastic read and encouraged a very in depth discussion.

Just two short years after the collapse of Lehman Brothers, Greece faced mounting debts resulting from easy borrowing driven by cheaper rates after arguably fiddling its way into the Euro in 2001.  The Euro was created in 1999 to promote three key components.  1) Promote open trade across European borders minimizing FX risk, 2) Initiate a more dynamic, prosperous, and innovative Europe, and 3) Provide price stability with the intention of competing with the USD as a global safe haven currency.  Interestingly, countries like Portugal and Greece with much poorer credit quality were able to borrow Euros as easy as Europe’s strongest country, or Germany.  By becoming part of the Euro, countries resulted in a loss of national sovereignty and could no longer devalue their way out of debt as they did in the past.  Nor could they target a lower currency to export their way to growth.

Understanding Greece involves taking a look at the country’s history.  There have been predominantly two Greek families in power post WWII.  Post WWII, Greece never modernized while the North became industrial powerhouses.  Greece has had to rely on shipping, tourism, and agriculture.  They never heavily targeted investing in manufacturing like the North.  Greece has defaulted on numerous occasions including 1826, 1843, 1860, and 1893.  In 1997, the Greek Central Bank had to raise rates from 10% to 150% to stop the currency from going into freefall.  When evaluating whether Greece was suitable for the Euro, Greece was initially denied in 1999 but by July 2000, supposedly inflation was down to 5% and the budget deficit was only 1% of GDP gaining Greece entrance into the Euro effective 1/1/2001.  Once Greece switched to the Euro, we saw the Greek economy create strong growth but rising trade and budget deficits.  With low rates and the ability to borrow, Greece was riding an illusion of prosperity.  The 2004 Olympics held in Athens was a giant cost to the country.  Millions were spent on new stadiums that unfortunately tend to collect dust once the games are over.  In September 2004, it was reported by the Greek government that the accounting was incorrect and the country should never have been in the Euro.  The EU did nothing about it.  Greece continued to not play by the rules running up a higher and higher budget deficit to GDP.  Tax evasion and bribery has been common corruption we have seen in the country.  The Greek Pension system certainly doesn’t help the deficit as the retirement age is significantly lower than that of countries in the North.  Unmarried woman for example receive their parents pension if they are unmarried which discourages employment.  The Euro was not meant to be a currency you joined to become a stronger country, it was meant to only include the strongest countries to ensure price stability.

It was not only Greece that was incentivized to borrow at the ultra low rates once joining the Euro.  We saw very similar issues in Portugal.  Spain’s borrowing fueled a real estate boom that resulted in high growth but with relatively low productive growth making Spain less competitive.  Ireland cut its corporate tax rate luring corporations from all over driving the per capita income to one of the highest in the world.  The lower ECB rates resulted in Ireland’s excessive borrowing and an artificial property boom.

Germany on the other hand was running a surplus while the Club Med countries were running deficits.  Postwar Germany is said to be an economic miracle.  West Germany had strong growth driven by a stable currency, low inflation, hard work, brilliant engineering, and a frugal mindset.  Germany was not in favor of the Euro given their strong stable currency.  Germans tend to live within their means and avoid borrowing and credit cards.  The culture of Germany includes saving, living within their means, manufacturing, and frugality.  This all seems to diverge from the cultures of the Club Med countries which has led to where we are today.

After just under a decade, once 2009 hit following the credit crisis, we began to see the negative impacts of the excessive borrowing of peripheral Europe.  We saw downgrades from S&P and Fitch in late 2009.  Stocks in Greece began to fall, yields spiked, and bailout discussions began.  Germany did not want to bailout Greece.  The No Bailout Treaty of the EU also stated that each member state was responsible for its own public finances which was a precondition for long term growth in Europe.  From the end of 09 through May 2010, much debate and meetings took place to resolve the European sovereign debt crisis.  To protect the Euro, Merkel ended up compromising breaking the No Bailout Treaty and coming together with the IMF to bailout Greece, Portugal, and Spain among others in the trillion Euro bailout.  This resulted in the ECB for the first time buying government bonds helping to lower rates and increase prices to stabilize the Club Med countries.  Austerity programs across the Club Med countries were initiated and confidence was restored in the Euro.  Government salaries were frozen and social programs were cut.  Italy was forced to cut wages or suffer stagnation.  The question remaining was, did the EU and IMF provide a cure, a short term fix, or poison to the region?

It seems as though Greece has tended to follow the script of new government and new spending program, then falling GDP, austerity, and another EU bailout.  Excessive borrowing without investing in manufacturing led Greece to where it is today.  The author believes that once the moral hazard of providing bailout funds was initiated, the Euro was destined to fail.  He believes it was a major policy mistake to put politics in front of economics by creating a single European state.  He argues that bringing together the very strong economies of Germany and France with that of Greece, Ireland, and Portugal was a major mistake.  He argues that the markets should decide the outcome and it would have been better long term to let Greece go bust rather than provide a bail out.

Upcoming Book Club Schedule:

April 21, 2015: The Forgotten Depression: 1921: The Crash That Cured Itself by James Grant

May 19, 2015: How Latin America Weathered the Global Financial Crisis by Jose De Gregorio

June 16, 2015: TBD

July 2015: TBD

Aug. 2015: TBD (NOTE: Those who attend the Aug Book Club meeting will receive a free copy of Superpower: Three Choices for America’s Role in the World by Ian Bremmer. This is his new book and was released May 2015.)

Sept. 2015: Superpower: Three Choices for America’s Role in the World by Ian Bremmer

Sign up for a future book club event.


Climate and Energy Policy: What do Americans Want?

Consider, for example, the fact that President Barak Obama’s Administration has been reviewing Transcanda’s Keystone XL Pipeline project for more than six years. And, Amy Harder of The Wall Street Journal recently reported that this delay has emboldened resistance to at least 10 other oil and natural gas pipeline projects across North America representing $40 billion of investment. (See “Protests Slow Pipeline Projects Across U.S., Canada – Anti-Keystone XL Fight Emboldens Resistance to At Least 10 Other Projects.” The Wall Street Journal 9 Dec. 2014)

In addition, opposition to the Yucca Mountain Nuclear Waste Repository in Nevada and to the proposed Cape Wind generation facility off the coast Massachusetts illustrate how very long and costly delays to energy infrastructure projects can be. Some refer to this process of building public support for energy infrastructure projects as gaining “social license.” (Read more about social license and energy infrastructure here: Energy Investing: US-Canada Energy Summit).

In this environment, it’s essential for energy producers, developers, utilities, regulators and legislators to have a clear understanding of how consumers, and voters, actually think about difficult energy choices.

Fortunately, new research by Dr. Stephen Ansolabehere, Professor of Government at Harvard University, and Dr. David M. Konisky, Associate Professor of Public Policy at Georgetown University, provides rich insights into how—and how not—to develop energy, environmental and climate policy in their book Cheap and Clean: How Americans think about Energy in the Age of Global Warming.

Hats off to EPIC

Before we begin, I’d like to thank Dr. Michael Greenstone, Director – Energy Policy Institute at Chicago (EPIC), Milton Friedman Professor of Economics at the University of Chicago, for bringing Dr. Ansolabehere to Chicago recently for an engaging presentation on his research—rife with audience participation and discussion. I’d also like to thank Dr. Ansolabehere for the use of several slides and exhibits below.

EPIC is a collaborative energy institute of the University of Chicago’s Social Sciences Division, Harris School of Public Policy and Booth School of Business. I’ve found the EPIC Seminar Series of lectures and Symposia to be remarkable opportunities to gain direct access to some of the world’s leading thinkers on energy, economics and the environment.

About the Research

Ansolabehere and Konisky explain that, for decades, public opinion research on energy has been highly fragmented and episodic. The prior research often focused on the latest crisis—highlighting short-term events like oil spills, nuclear accidents and gas price spikes. As a result, “the emphasis on such episodes has made public opinion about energy seem fleeting, fractured and lacking in any rationale” (363). Furthermore, prior research typically asked about only one form of energy in isolation from other choices. The authors explain that pollsters and analysts must instead think systematically to really understand public opinion about energy in a meaningful way. Systematic thinking about energy asks questions like:

“What are the main sources of energy, and what are the public’s attitudes toward each one? What are the key attributes of each energy source, how do people view each energy source according to those attributes, and how important are each of the attributes in explaining what people want?” (578).

In my opinion, the really exciting thing about Ansolabehere and Konisky’s new research is that it has tracked these types of questions for more than a decade to see what the public wants the energy sector to look like and how public preferences have changed (578).

Their methodology utilized the MIT/Harvard Energy Surveys to gather information from 2002 to 2013 and then, based on the data, identified, quantified and explained the factors that really drive public opinion for various fuels such as coal, natural gas, nuclear, oil, hydro, solar and wind by developing a variety of multiple regression models. In addition, they also evaluated public opinion on different climate policies including regulatory caps, cap and trade and carbon taxes.

The regression models are fully described in the book and the appendix contains the summary statistics of the models including the coefficients, standard errors, significance levels and correlations.

Energy Choices

The first thing to understand is that we consume electricity, transportation, and heat, not coal, nuclear or solar power. In short, the authors explain that people value the qualities or attributes of the power they use and not the fuel itself. This means that people really want energy that is inexpensive, dependable, and safe—and it’s these attributes that really drive public opinion (62).

Having said that, the authors paint a picture of US public opinion about the energy sources used to generate electricity. As shown in the graph below, Americans want less reliance on coal and oil as illustrated by the large portions of pink (reduce use of fuel) and red (not use at all) throughout the time series (2002 to 2013). Second, Americans want to keep natural gas and nuclear power as they are, or increase them somewhat—with natural gas having the edge between the two.Third, Americans want to substantially increase the use of “alternative fuels” such as solar and wind as illustrated by the large portions of green (increase use) across the series (171).

In addition, Ansolabehere and Konisky report that very few American’s are pure conservationists who want to use less of every energy source (582). And very few want an “all of the above” energy strategy as often cited by the Obama administration (173).

So what’s the big idea?

“People have clear, stable opinions about the energy future that they would like to see in the United States. They know what sort of power plants they would like to see developed, and they know why. There is a simple, unifying structure to public opinion about energy, and that is the desire to have an energy system that simultaneously reduces environmental harms and economic costs” (363).

Economic Costs and Environmental Harms

Well, we’ve just seen what people want. But why do they want what they want? And are their perceptions about energy supported by accurate information? Ansolabehere and Konisky conclude that a “Consumer Model” best describes what people want from energy and energy policy. In short, people think about energy like they would any other consumer good.

The authors explain that in the Consumer Model, “an individual’s opinion about the use of various fuels and the direction of public policy depends on two key factors or attributes of energy—the economic cost (the private good) and the environmental cost (the public good)” (580). In fact, they found that between 75 and 80 percent of the variation in support for different fuels was explained by these two factors and while there can be other factors—they are of secondary importance (362). Survey respondents were then asked how expensive they thought electricity from each of these different fuels sources is and how harmful each method of generating electricity is to the environment.

In terms of costs (above), people generally got the cost of coal and natural gas as less expensive than nuclear and oil correct. However, the public incorrectly believes that solar and wind power are much less expensive than coal, natural gas, nuclear power and oil (246).

When informed of the true costs of electricity from solar and wind power, they found significant decreases in support for these fuels and increases in support for fossil fuels (411). Americans still wanted to significantly expand use of these fuels but their support was more tempered. So, Ansolabehere and Konisky remind us that public support for a fuel source does not mean that people ignore economic costs of the fuel in judging a public policy to increase the use of that fuel (389).

In terms of environmental harm, Ansolabehere and Konisky note that people have the relative harms about right. They correctly see coal and oil as having the most adverse environmental effects. Natural gas is seen as less harmful than these fuels but more harmful than hydro. Solar and wind power are correctly perceived to pose few environmental harms (259).

Importantly, people gave greater weight to environmental harm than to economic considerations in evaluating energy choices and policies. In fact, environmental harms were more than twice as important than economic costs as evidenced by larger coefficients in the regression models (290). So environmental harm is a strong predictor of energy preference. The policy implication of this finding suggests that the government should put, for example, $2 into clean coal for every $1 into research on cheap solar to be in line with the public’s relative preferences (361).

The public’s reaction to nuclear power appears strong and perhaps exaggerated (258). The authors conducted further research into nuclear power and found that two-thirds of the sample indicated they would support significant expansion of nuclear power “if there were a safe and effective way to deal with nuclear waste” (264).

Providing more information on environmental harms decreased support for coal, natural gas and oil and increased support for nuclear power (422). In addition, there was a substantial decrease in support for coal and an increase in support for alternative fuels, especially wind (432).

Interestingly, the research dispels conjecture that public perceptions about energy are explained by political or demographic differences among people. The authors found that it’s not political party or ideology, education, age or religion that really matters. Those factors are secondary. Rather, people think about energy through a common lens of cost and harms and then fit particular fuels into that framework. Then, the particular fuel defines the terms of the political debate (276).

Finally, economic cost and environmental harm were also found to be the most important factors that explain why people oppose the location of some sorts of power plants near their homes but not others—the not in my backyard (NIMBY) attitude (354).

Understanding the Trade-Offs

In order to effectively move climate and energy policy forward, we must recognize that there are real trade-offs between the economic costs and environmental harms of energy production. Today, no fuel exists that is both cheap and clean (593).

Based on data from Dr. Michael Greenstone and Dr. Adam Looney, the authors illustrate a “technology frontier” for new electric generation sources by plotting the “levelized” cost of generation against the social cost (environmental harm) for each fuel. The levelized cost is the present value, in real dollars, of the total costs of building and operating an electric generation plant over its financial life and duty cycle—presented in cents/Kwh (125).

Social costs are the hidden costs that consumers do not see on their electric bills. They arise from pollution caused by energy production that causes increased health care costs. For example, burning coal produces sulfur oxides, nitrogen oxides and particulates that contribute to the formation of smog (ground level ozone), acid rain and other pollution (lead, mercury, etc.). High levels of smog increase risk of cardiovascular disease, lung cancer, bronchitis, and asthma (110). Greenstone and Looney also estimate that the true social costs of fossil fuels (ignoring global warming) is about 75% more than we currently pay for energy (609).

As illustrated below, Ansolabehere and Konisky use existing coal-fired generation plants as the reference point since they are the least expensive (about 3 cents/kWh) but have the highest social costs from pollution and carbon emissions. New pulverized coal plants provide only a marginal reduction in social costs and are more expensive than new natural gas plants that provide significantly greater reductions in social costs. Solar, wind and nuclear power have significantly lower social costs. However, solar power costs about 17 cents/kWh more than coal while wind and nuclear are about 5 cents/kWh to 7 cents/kWh more respectively.

Bottom line, cleaner energy will cost more.

Global Warming

Today, the risks associated with global climate change (flooding in major cities, expansion of deserts, droughts, disruption of food supplies, etc.) are widely discussed by almost every national government in the world. The authors explain, “energy is back on the national agenda not because we have an energy crisis but because there is a risk of a looming global environmental disaster” (450).

The conundrum for public policy makers who realize the long-term implications of today’s energy choices is that although most Americans are concerned about global warming they don’t see it as the most important problem (“MIP”) facing the nation and have a low willingness to pay (“WTP”) to solve the problem. In short, the authors did not find climate concern to be a major driver of public opinion about energy (443).

For example, in Gallup’s January 2012 poll, “two-thirds of Americans identified the economy as the nation’s most important problem, followed in order by dissatisfaction with government (15 percent), healthcare (6 percent), immigration (3 percent), education (3 percent)”. Typically, energy and environment do not rank highly compared to the economy and other problems (467).

Ansolabehere and Konisky found that the median amount people were willing to pay to “solve” global warming was only $5 per month ($60 per year) or about 5% of the typical monthly electric bill. And two dozen other studies, assessed by Johnson and Nemet, found the median amount to be $135 per year. In short, “most Americans don’t appear willing to make the trade off that many policy experts feel is required: substantially higher energy prices in order to substantially reduce carbon emissions” (483). The authors sense that Americans don’t want to pay more now to solve a future problem with no immediate health or environmental benefits for people living today (e.g. pay more, get nothing) (445).

Although nuclear power is widely recognized by climate scientists, economists, and others as a potentially important way to significantly reduce carbon emissions to address global warming the public doesn’t yet make that connection (334). Despite the fact that nuclear power has virtually no carbon emissions and offers the capacity to offset significant amounts of greenhouse gas. In addition, nuclear power provides more reliable electricity at a far lower price than solar or wind (286).

Ansolabehere and Konisky explain, “Nuclear power is the one non–fossil fuel that can be deployed quickly at an industrial scale to bend the carbon curve in our energy sector. Unlike wind and solar power, nuclear power does not suffer from either the intermittency or the transmissions problems that currently limit these sources, making it a useful way to generate baseload capacity” (335).

Surprisingly, Ansoblahere and Konisky found that people who were concerned about global warming were less, not more, likely to support nuclear power than those who were not concerned. And nuclear power was not alone. Except for solar power, they found no relationship between concern about climate change and support or opposition to the fuel (312). However, providing information about global warming seems to increase support for nuclear power (373). And what’s really interesting is that public attitudes for every fuel were local rather than global.

“Americans are more concerned about local pollution issues, including pollution of rivers, lakes, and reservoirs, air pollution, pollution of drinking water, and toxic waste contamination of soil and water. Even other global issues, such as ozone depletion and loss of tropical rain forests, weigh more heavily on the minds of most Americans than global warming” (470).

In other words, people mentally connect with perceived local environmental harms from air and water pollution and economic cost more than they do to global warming. Given these findings, how can climate and energy policy move forward?

Climate Policy

Ansolabehere and Konisky explain that the problem with our highly competitive electricity market is that it exerts strong downward pressure on prices but that the social costs associated with different fuels are not reflected in prices. As a result, the market fails to deliver cleaner energy.

“The electricity market fails, then, to allow people to “buy” cleaner water or cleaner air. There is pent-up demand for these attributes for fuels, and, hence, people give even greater weight to those attributes in public opinion polls, because that is the unmet demand in the market” (508).

Certain government policies, like environmental regulations and fuel taxes, are designed to force firms to “internalize” the social costs that would otherwise not be seen on the consumers monthly electric or gas bill (17). Ansolabehere and Konisky reviewed numerous public opinion polls, from 2007 to 2012, on three commonly discussed policies designed to address climate change. These three polices are:

  1. Regulate carbon emissions (Regulatory Cap) – Either directly through a cap or limit on carbon emissions from manufacturing, industry and consumers or indirectly through renewable fuel standards that require a minimum amount of electricity come from noncarbon emitting sources. Notably, 30 state legislatures and electorates have adopted renewable portfolio standards (576).
  2. Create a market for emissions (Cap and Trade) – A system of tradable carbon emission permits issued by the government up to a total limit on all emissions (a cap). Generally thought to be more economically efficient than a “one-size fits all” regulatory cap because firms with a low marginal cost of reducing carbon emissions would have an incentive to further reduce emissions and trade them while firms with a high marginal cost to reduce emissions could efficiently buy permits instead of facing costly restrictions. (See Regional Greenhouse Gas Initiative (RGGI) of 9 Northeast and Mid-Atlantic states)
  3. Tax emissions (Carbon Tax) – A direct tax on the production or consumption of coal, natural gas and oil in order to discourage use of fuels that emit carbon into the atmoshpere and to encourage use of fuels that do not. A simple and direct method of adjusting the price of each energy source to reflect its social costs (524).

These polls found dramatically more public support for a regulatory approach to limit emissions than for the other policies. First, there was about 75% to 80% support for a regulatory cap on carbon. Notably, the public wants a regulatory approach to limit emissions even though many economists believe that cap and trade would be a more efficient policy. Second, cap and trade received between 45% to 55% support. Third, carbon taxes were supported by only 25% to 45% of respondents depending on the level of the tax. Although taxes are efficient they can be politically unpleasant (528). However, public support rose to 40% for “revenue-neutral” carbon taxes which are tied to an equivalent reduction in federal income and payroll taxes (564).

Seeking to further explain this phenomenon, Ansolabehere and Konisky identified the correlations between the three regulatory policies, concern for global warming and the environmental and economic attributes of energy as shown below.

Global Warming Concern (Green) – The green portion of each bar explains the amount of predicted support for each climate policy that’s associated with a concern for global warming. Notice that the baseline support associated with a concern for global warming is relatively high–about 30% for Regulatory Caps and Cap and Trade and about 22% for a Carbon Tax.

Environmental and Economic Attributes – The purple, red, blue and yellow components illustrate how the predicted support for each policy is influenced by those who also see the connection with the environmental harms (purple) and economic costs (red) of traditional fuels as well as the environmental benefits (blue) and economic costs (yellow) of alternative fuels. Notice that these attributes of energy production dramatically added 50% of support for Regulatory Caps (now at 80%) but only about 20% to Cap and Trade.

The political implications of these findings are huge. In short, concern for global warming alone is not enough to drive climate legislation. Furthermore, a simple regulatory approach appears to be the politically expedient solution. The authors go on to illustrate the nexus between their research and two key pieces of legislation.

First, The American Clean Energy and Security Act (Waxman-Markey bill), which passed the House in 2009 but failed to pass the Senate, proposed a national system of tradable carbon allowances (cap and trade). It was almost entirely viewed as about global warming and this may have been the political error. The sponsors failed to make a connection between reductions in local environmental harms and climate policy. However, their opponents successfully emphasized the economic cost of the legislation (603). Case in point, concern for global warming alone was not enough to carry the day.

Second, California passed the Global Warming Solutions Act in 2006, also known as AB (Assembly Bill) 32, which created a cap and trade system. Subsequently, Proposition 23 was put forth to postpone implementation of AB 32. However, opponents of Proposition 23 successfully emphasized the environmental and health damages of coal and oil, which the voters understood, and it was defeated. They rarely even mentioned global warming (606). Today, AB 32 is regarded as the most aggressive piece of climate legislation ever adopted by an American legislature (494). Here, climate legislation was driven by local environmental concerns.

“It takes more than just concern about global warming to win support of a majority of the public for climate policy. The political fate of various climate policies depends primarily on the other half of the equation—how the public thinks about energy” (567).

Environmental Policy + Energy Policy = Climate Policy

Ansolabehere and Konisky conclude that we should stop thinking narrowly about climate policy as just climate policy. Instead, they suggest that climate issues should be viewed more broadly from the perspective of energy and the environment.This strategy would seek to develop policies that simultaneously achieve immediate environmental and energy goals and long-term climate goals (573).

For example, the authors suggest aggressively targeting the co-pollutants of carbon such as particulates, sulfur and mercury that present immediate and localized health risks. By reducing the use of fuels with the highest concentrations of these pollutants progress can be made on immediate health risks (573). In this way, progress is made on the local pollution issues as well as on the long-term climate issue. Dr. Ansolabehere goes on to suggest, “mercury and soot regulations might do more to help the US meet its climate goals than a 25 cent gas tax and would be politically easier to sustain.”

This appears to be a very logical strategy based on the research findings. Ansolabehere and Konisky have found considerable public support for regulatory policies like U.S. EPA caps on carbon emissions and renewable portfolio standards. And they’ve found that on questions of immediate environmental regulation public opinion approaches a consensus (or at least a majority) large enough for the government to act (575).

Pragmatism and Policy

I highly recommend Cheap and Clean: How Americans Think about Energy in the Age of Global Warming by Dr. Stephen Ansolabehere and Dr. David M. Konisky for their holistic and systematic analysis of how Americans really think about energy, environmental and climate policy.

It’s amazing to know that there is a basic consumer model that aptly describes public opinion on energy. It’s rational and apolitical. It weighs the trade-offs between economic costs and environmental harm and is primarily concerned about local issues.

After that, climate policy can be highly partisan. But this research should help policymakers in both government and industry develop the pragmatic solutions Americans want while simultaneously addressing long-term climate issues.

Ansolabehere and Konisky summarize their findings best by saying:

“Americans need to hear pragmatic solutions that fit with our approach to energy generally. We think about energy as consumers. We are motivated by the economic costs and local environmental harms, things we can see and feel and name. We need to think and act locally” (493).

Gaffney Signals End of Era; Provides Alternative Strategies for Fixed Income Investors

During a frigid Chicago lunch-hour in late February, Kathleen Gaffney, CFA, spoke to a room of CFA Chicago Society members and their guests at the Willis Tower’s Metropolitan Club about the prospects of fixed income investing and potential income generating strategies during the eventual rise in interest rates. Her overriding message was one of reassurance; “We’ve been here before.”

Gaffney, the lead portfolio manager for Eaton Vance’s multi-sector bond strategies, began her presentation by discussing today’s current ultra-low interest rate environment and the risks associated with a Fed decision to increase short-term rates in 2015, which she expects in June, lest the Fed risk being behind the curve. However, she was quick to give the Fed credit for current policies and actions, which Gaffney labeled “bridge-financing” until the private sector can provide the momentum to move the economy forward. As the U.S. leads the world into economic recovery, while other world economies toddle, Gaffney is not concerned about inflation or rising long-term rates. Her forecast for the yield on the 10-year Treasury bond is 4% by the end of 2015, although she admits her forecasts for the 10-year have been incorrect in the recent past.

Besides the obvious risks to bond values in a rising rate environment, Gaffney also noted that nearly none of the fixed income practitioners operating today have experienced the magnitude of the long-term rise in interest rates that preceded the cycle’s peak in 1984. Additionally, regulatory changes have reduced Wall Street’s ability to put their own capital to work, resulting in decreased valuation support, reduced liquidity and very swift corrections in high yield, emerging and equity markets.   The end of the era will require careful asset allocation and alternative strategies that seek to mimic fixed income returns, while minimizing interest rate risk.

Gaffney encouraged the audience of investors and advisors to enhance portfolio flexibility by thinking broadly about the various “levers” that can be pulled to generate investment returns, i.e. credit, country and currency. She likened taking interest rate risk in today’s rate environment to driving down a dead-end road at 80 mph.  Rather, with her expectation of a secular bull market in equities, fixed income investors may consider “high-quality” equities with good dividend yields that will provide additional return on positive market movements, according to Gaffney. She also suggested that investors consider equity sensitive convertible bonds to mimic the returns of high yield bonds, while minimizing interest rate risks. Floating rate bonds were also offered as a reasonable alternative. However, Gaffney noted that floating rate notes introduce an additional element of repayment risk if rates rise too high or too fast, which she does not expect. The current strong dollar also provides opportunities to benefit from the potential growth from product importers to the U.S. Additionally, Gaffney proffered an idea that countries working to implement long-term positive structural reforms, including Brazil and India, have the potential for enhancing portfolio returns. However, she cautioned investors regarding new issuances encouraging investors to increase due diligence levels for new market entrants.

Gaffney finished the luncheon session with a question and answer session that included audience inquiries regarding duration assignments, the potential for negative deposits rates and, among other things, the performance of the her managed portfolios if the 10-year yield does reach 4% in 2015.

Distinguished Speaker Series: Kathleen Gaffney, CFA, Co-Director of Diversified Fixed Income, Eaton Vance

The Distinguished Speaker Series featured Kathleen Gaffney, CFA, and Co-Director at Eaton Vance who focuses on fixed income. Eaton Vance is one of the oldest and most distinguished investment management firms in the United States.  Gaffney warned that the “end of the era” of low interest rates is at hand and that more volatility will be the result.

The increase in volatility is due to more than just the expected rise in interest rates.  Gaffney warns that the broker/dealer community has been hard hit by new capital rules that prevent them from holding large inventories of bonds.  Due to the global financial crisis of 2008-2009, this “shock absorber” has been taken away.  Gaffney stressed that moving capital will be difficult, leaving the market vulnerable to sharp corrections.

Gaffney stated that she is convinced that the credit markets are ripe for correction.  The FED’s actions will most likely impact short and intermediate term bonds the most.  If the FED does not begin to tighten in June, it will be accused of being behind the curve. She believes that the fundamentals in the United States are good and that once rate hikes begin; the resulting yield curve will resemble a “bear flattener” as short rates will rise faster than longer term rates.  Inflation will result when economies outside the US continue their economic recovery.

Gaffney is convinced that duration risk is the greatest risk facing the US bond market.  It is her position that US interest rates are too low and that the 10-year treasury yield will approach 4% by year-end.  She also believes that high-yield and investment grade corporate bonds are currently expensive. In this environment, as part of a multi-sector strategy, Gaffney utilizes dividend paying equity substitutes in her fixed income portfolio.

Gaffney purchases equities that yield between 1.5% and 3.0% at prices that are more reasonable than current bond prices.  These equities have yields that currently compare favorably to the 10-year treasury.  The equities market at this time also offers more liquidity than fixed income markets, and she is able to use up to 20% of her portfolio for equities.

In the brief question and answer period that followed Gaffney stated that she is an optimist and that strong GDP numbers which she expects in the near future will be a catalyst for rising interest rates.  She assigns a 0 duration to the equity positions she holds in her portfolio. It was interesting to hear how a multi-sector strategy allows her to include equities in the search for yield.

Sustainable Investing: Profit with a Purpose

The art of investing requires a broader skill set—more perceptive thinking, insight, intuition and even an awareness of psychology—things that Howard Marks, Co-Chairman of Oaktree Capital Management, refers to as “second-level thinking” in one of my favorite books on investing: The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor (46).

The purpose of this article is to stretch your second-level thinking skills. Specifically, we will explore how investors (private, institutional and asset managers) can make sustainable and responsible investment choices by carefully analyzing environmental, social and governance (ESG) issues within the investment decision-making process. In short, it’s about reducing risk and generating return while investing in firms that add value to society—producing profit with a sustainable purpose.

ESG for Alpha

On Feb. 19 CFA Society Chicago explored these issues at a conference entitled “ESG for Alpha” where top investment managers and institutional investors gathered to discuss the past, present and future of Sustainable, Responsible and Impact investing (SRI). As the conference title implies, a key question is whether ESG issues can be used to produce superior risk-adjusted returns (or alpha) that beat the market —but more on that later.

John Mirante, CFA, CPA, and Senior Relationship Manager, BMO Global Asset Management welcomed the audience and explained that there’s currently a plethora of terminology used to describe investments that take ESG issues into account including: sustainable investing, ethical investing, socially responsible investing, responsible investing, green investing and impact investing. While there are some distinctions between these terms they all generally emphasize two key factors (1) a long-term investment horizon and (2) ESG issues.

ESG Issues

Let’s start with the basics. Although there’s no “single list” of ESG issues, and not every issue fits neatly into just one category, we do have a general understanding of the major issues:

Environmental Issues: Carbon emissions, greenhouse gas emissions, climate change impact on company (risk exposures and opportunities), ecosystem change, facilities citing environmental risks, hazardous waste disposal and cleanup, pollution, renewable energy, resource depletion and toxic chemical use and disposal.

Source: CFA Institute, “Environmental, Social and Governance Factors at Listed Companies: A Manual for Investors” (May 2008).

Social Issues: Customer satisfaction, data protection and privacy, diversity and equal opportunities, employee attraction and retention, government and community relations, human capital management (including training and education), human rights, indigenous rights, labor standards (including freedom of association and collective bargaining, child labor, forced labor, occupational health and safety, living wage), product misspelling, product safety and liability, supply chain management.

Source: PRI, Principles for Responsible Investment (in partnership with UN Environment Programme Finance Initiative and UN Global Compact),”Responsible Investment in Private Equity: A Guide for Limited Partners,” 2nd ed. (June 2011): 25.

Governance Issues: Separation of CEO and Chairman roles, appointment of independent lead director, independent compensation and nomination committees, audit committee independence, ration of non-audit to audit fees paid to the assigned auditor, CEO compensation as a % of cash flow, fair value of share-based compensation expense as a % of cash flow, ownership blocks greater than 5%, staggered board, poison pill, unequal voting rights.

Source: Goldman Sachs Global Investment Research, “GS SUSTAIN: Challenges in ESG Disclosure and Consistency” (October 2009):6.

Why do ESG issues matter?

Bruno Bertocci, Managing Director and Global Equity Portfolio Manager, at UBS Global Asset Management (Americas) Inc.really put it all into perspective when he described ESG issues as “material non-financial factors.” In other words, ESG issues are rarely quantified in the cold, hard financial data of the annual 10-K or quarterly 10-Q. Yet, they can be material and significantly impact future cash flows and firm valuations. They are hard to quantify but can be incredibly important to the investment decision-making process. As one famous physicist once said:

“Not everything that counts can be counted and not everything that can be counted counts.” Albert Einstein

You might recognize Mr. Bertocci’s approach as solid fundamental analysis. It’s the part of investment analysis that’s more art than science. Bertocci explains, “I’ve really always thought about it this way.” He explains that he went to work for T. Rowe Price when he got out of business school. But Bertocci notes, “I didn’t know how to pick a stock with my chemistry background.” Then, he reviewed T. Rowe Price’s notebooks on DuPont in the company library on their new product—nylon. Price had gone to the dime-store and observed that, “The ladies loved nylon. It was cheaper and lasted longer.”

Mr. Price’s observation was not a financial factor but Bertocci reminds us that it must be material and it must impact the business product—otherwise you are just wasting your time.

Bertocci also explains that material non-financial factors are data that can confirm or deny your expectations in the tails of the distribution. In other words, the stock might appear cheap on a discounted cash flow basis but ESG factors may reveal it’s a deteriorating business model. He believes ESG factors are an extension of mosaic theory and should be ranked in conjunction with the financial data. By doing so, you improve your information coefficient.

Again, I’m reminded of Howard Marks who says,

“Second-level thinkers know that, to achieve superior results, they have to have an edge in either information or analysis, or both” (78).

Today, Bertocci expects his day-to-day analysts to gain access to ESG information because he believes it’s predictive of future returns. He wants a technology analyst to compare Intel to Taiwan Semiconductor and then to have a conversation about the energy efficiency of one versus the other. Bertocci goes on to explain, “In my experience, the really big money is made with a long-term perspective that the market does not recognize.”

Creating Shared Value

Time for a short commercial break. By now, you probably agree that evaluating material non-financial ESG factors can add value to the investment process. But which firms are good at creating value in a “sustainable” fashion? And what does that really mean anyway?

In this regard, Bertocci recommends reading “Creating Shared Value” by Michael E. Porter and Mark R. Kramer, Harvard Business Review, January 2011 issue. In short, Porter and Kramer argue that creating societal value is a powerful way to create economic value for a business. In fact, there are vast unmet needs in the world and businesses that meet societal needs will significantly differentiate themselves and enhance their competitive position.

Creating value for the business and the community does not have to be a zero sum game. It doesn’t have to be an either or dilemma of profit that comes at the expense of the community. Think about expanding the pie rather than slicing it up and you have a positive sum game. It’s about doing good and doing well at the same time.

Principles for Responsible Investment (PRI)

Sustainable investing is moving much faster on the other side of the pond. Vicki Bakshi, Head of Governance and Sustainable Investment, F&C Investments explained that the United Nations-supported Principals for Responsible Investment (PRI) initiative is ubiquitous! She reports that there has been more forward thinking on ESG issues in Europe than in the US for a long time. Bertocci agrees and says, “you can’t win a public fund mandate in Europe if you don’t know the ESG issues.”

Today, there are 1,325 signatories to the PRI initiative representing asset owners, investment managers and service providers with $45 trillion (USD) in assets under management. These signatories voluntarily commit to recognizing the materiality of ESG issues by adhering to the following six principles:

  1. We will incorporate ESG issues into investment analysis and decision making.
  2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
  3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
  4. We will promote acceptance and implementation of the Principles within the investment industry.
  5. We will work together to enhance our effectiveness in implementing the Principles.
  6. We will each report on our activities and progress towards implementing the Principles.

Importantly, Bakshi describes F&C’s process of digging deeper in their requests for proposals (RFPs) to uncover the actual extent to which ESG factors are incorporated into asset manager’s investment decision-making process. Bakshi says, “we want to differentiate [ourselves] from tick boxes with six pages of questions on ESG factors. We ask (1) what is your process? and (2) give me examples of when your valuations changed as a result of ESG factors.” Today, Bakshi sees more engagement by institutional asset owners voluntarily reporting on stewardship in their mainstream reporting. In addition, she points out that the Dutch are the most advanced in this area today and it’s also spreading to even larger funds.

ESG Methodologies

Lucas Mansberger, CFA, CAIA, Consultant with Pavilion Advisory Group Inc., facilitated a panel discussion with asset owners to discuss how they incorporate ESG issues into their investment process. The audience agreed with Mansberger as he emphasized that ESG questions on RFP’s are becoming increasing more detailed and difficult to answer.

Given the incredible economic and social importance of ESG issues, not to mention the growing scale of ESG investing ($45 trillion), it’s critical for asset owners and managers to be proficient in applying practical methods to address ESG issues within their investment decision-making process. The most common “ESG methodologies” to accomplish this are:

  • Active Ownership
  • Best in Class Selection
  • ESG Integration
  • Exclusionary Screening
  • Impact Investing
  • Thematic Investing

For most people, exclusionary screening is the first thing that comes to mind. Simply put, it’s avoiding certain companies based on ethical concerns or norms. Kristy Jenkinson, Managing Director Sustainable Investment Strategies,Wespath Investment Management, explained that Wespath excludes firms that earn significant revenues from gambling, alcohol, tobacco, pornography, weapons and the operation of prison facilities as part of their ethical exclusions. Wespath is a division of the General Board of Pension and Health Benefits of the United Methodist Church with approximately $21 billion under management.

Likewise, William Atwood, Executive Director for the Illinois State Board of Investment (ISBI), indicated that the State of Illinois has a number of statutorily mandated investment exclusions. These include a Sudan Divestment Policy for human rights violations and exclusions of oil-related and mineral extraction sectors in Iran due to current US sanctions against Iran for seeking to acquire weapons of mass destruction and for supporting international terrorism. The ISBI is responsible for managing the over $ 15.1 billion in assets for Illinois’ General Assembly Retirement System, Judges’ Retirement System and the State Employees Retirement System.

Atwood also explained that ISBI’s investment managers proactively look for buildings that meet LEED green building standards because they add value to the portfolio of properties and have an impact on the bottom line. In addition, ISBI looks for minority and female-owned brokerage firms and investment managers as well. In this regard, Atwood notes that the inclusion of “non-Wall Street” managers provides ISBI with additional diversification of investment and operational risk.

In addition, both Jenkinson and Atwood are engaged in active ownership in which they aggressively vote on proxy issues and engage with management on key issues. Atwood’s been involved in “say on pay” issues to address executive compensation and Jenkinson mentioned engaging on climate change and human rights issues. Bertocci also pointed out that the very best analysts think about management quality, governance and how management incentives benefit shareholders and drive behavior.

ESG Integration refers to making explicit inclusion of ESG risks and opportunities alongside traditional financial analysis but does not necessarily require a peer group comparison like best in class selection. And best in class selection prefers companies with better ESG performance relative to their sector peers.

Wespath was a primary signatory to the United Nations Principles for Responsible Investment (PRI) and asks all of their money managers to adopt it—and about 80% of them have. Wespath then benchmarks its managers against their peers to assess their ESG integration. This assessment includes comprehensive questions on who reviews and approves the ESG policy, how often it’s updated and how it’s incorporated into compensation, training and performance.

Impact investing attempts to generate and measure social and environmental benefits along with a financial return. Finally, thematic investing is based on emerging trends such as social, demographic and industrial trends. But how can a money manager or an institutional investor effectively measure “sustainability?” The good news is that new standards for sustainability reporting are improving dramatically.

Sustainable Accounting Standard Board (SASB)

Jenkinson points out that many corporate sustainability reports are “murky at best and terrible at worst.” Often, corporate sustainability reports simply highlight only corporate charitable contributions and the annual volunteer day in the community. Fortunately, Bertocci and Jenkinson point out the value of SASB and its work to help organizations identify material, decision-useful information for investors.

The Sustainable Accounting Standards Board (SASB) is a 501(c)3 non-profit that helps corporations disclose sustainability information that’s useful to investors. Importantly, the SASB Materiality Map can help companies and investors identify issues that are most likely to be material on an industry-by-industry basis (e.g. health care, non-renewable resources, financials, technology and communications, transportation and services). Then, for example, within the non-renewable resources industry the map identifies the sector (e.g. oil and gas midstream) and then identifies certain environmental issues (GHG emissions, air quality, biodiversity impacts) and, in this case, governance issues (accident safety and management, competitive behavior) that are most likely to be material for more than 50% of the industries in the sector.

Ultimately, Bertocci would like to imagine a world where there is a willingness of the company to adhere to SASB standards and willingly move sustainability data into the body of mock 10Ks. Then, Bertocci says the information must be provided to the firm’s external auditors so that reasonable assurance can be provided on the materiality of the reporting.

Jenkinson expressed less interest in the form of the reporting (e.g. integrated as one report or as a separate ESG report) but emphasized that she wants to know if the firm is really integrating ESG issues in the actual strategy and risk management activities of the firm.

The Elephant in the Room – Alpha

Linda-Eling Lee, Ph.D., Global Head of Research for MSCI’s ESG Research Group, who moderated the asset manager panel discussion, addressed the elephant in the room by asking, “Does ESG hurt your returns? Yes or No?”

Let’s face it, professional investors and academics know its difficult to generate alpha and consistently outperform the market due to skill rather than luck. TheEfficient Market Hypothesis (EMH), in all of its forms, suggests that all available information is already incorporated into the price of a security and suggests that it’s essentially impossible to beat the market. Bertocci points out that even large asset managers still question active management. Even worse, there can be a general perception that ESG hinders returns.

Yet, Sir John Templeton, CFA, was an extremely successful investor who did not invest in businesses engaged in tobacco, alcohol, gambling and tobacco based on moral grounds (exclusionary screening). In addition, CalPERS (the California Public Employee Retirement System) has effectively engaged with underperforming companies and generated excess returns relative to their benchmark (CalPERS Towards Sustainable Investments & Operations – 2014 Report (15).

The short answer is that academic research studies on investments that take ESG factors into account show no consistent outperformance or underperformance (CFA Institute – ESG-100 Question #69). In other words, the studies have found no systematic bias either way. But clearly, the academic difficulty of attributing abnormal excess return (alpha) specifically to “E, S and G” factors alone won’t discourage successful investors from identifying incredibly valuable ESG issues (material non-financial factors) that can reduce investment risk, avoid losses and exploit opportunities for higher returns. Here are some examples:

Adam Strauss, CFA, Co-Chief Executive Officer of Pekin Singer Strauss Asset Management and Co-Portfolio Manager of theAppleseed Fund (APPLX, APPIX) says, “There are two important rules to remember about investing: Rule #1: Don’t lose money and Rule #2: Don’t forget rule #1.”

Strauss offers two examples of successful ESG investing. First, he explained that Pekin Singer Strauss looked at investing in BP in 2009; however, their analysis concluded that the company had a safety culture problem based on the March 23, 2005 BP Texas City Refinery explosion, the 200,000 gallon Prudhoe Bay oil field spill in March of 2006 and several other incidents. Therefore, Strauss avoided the 52% drop in BP’s stock price (from $60 to about $29) 50 days after the Deepwater Horizon accident on April 20, 2010. Strauss noted that the safety culture issue was not on the balance sheet but it was a material issue.

Secondly, Strass cited John B. Sanfilippo Inc. (JBSS) as having positive ESG factors prior to Pekin Singer Strauss’ investment five years ago. According to Strauss, JBSS has a responsible management team that’s well aligned with shareholders and stakeholders and an environmentally sustainable food product that’s good for human health that offers a high-quality source of vegetarian protein. Their nut products even take less water and land per pound of protein to produce than other sources of protein.

Vicki Bakhsi added that F&C Investments excluded Brazilian oil giant Petrobras for investments in 2012 due to their poor protection of minority shareholder voting rights. And, as we all know, corporate governance issues have continued to plague Petrobras as they are currently involved in a corruption scandal. F&C actively engaged with Hon Hai (Foxxcon), the largest manufacture of Apple products, by visiting their factories and found that their labor polices were generally good but monitoring and implementation was weak. One year after F&C engaged Hon Hai management on these issues their processes improved. That’s effective engagement on an important governance issue.

Finally, Bertocci reminds us that the incremental benefits of the “E” and the “S” (in ESG) really depend on the business. For example, at Adobe energy costs are not material but at a steel company they obviously would be significant. He says, “we must not paint the analytical process as the same for everyone.”

Fiduciary Duty

In the investment world, institutions like universities, hospitals, foundations and public and private pension plans have a fiduciary duty to the beneficiaries of their plans.

“A fiduciary duty is a legal duty to act solely in another party’s interests. Parties owing this duty are called fiduciaries. The individuals to whom they owe a duty are called principals. Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent. They also have a duty to avoid any conflicts of interest between themselves and their principals and the fiduciaries’ other clients. A fiduciary duty is the strictest duty of care recognized by the US legal system.” Legal Information Institute, “Fiduciary Duty: Definition,” Cornell University Law School.

Atwood explained that ISBI has a fiduciary duty to maximize the risk-adjusted rate of return their pension plans. Ten years ago, Atwood noted that many asset managers felt it would be inappropriate to incorporate ESG issues into the investment-decision making process out of fear of violating fiduciary duty. Those who take this stand typically argue that it adversely affects financial performance. However, this view is changing today.

Notably, the international law firm Freshfields Brockhaus Derringer produced a report entitled “A Legal Framework for the Integration of Environmental Social and Governance Issues into Institutional Investment” in 2005 which covered nine jurisdictions (Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom, and the United States) and concluded that:

“…integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” (13)

Constituent Demands – Fossil Fuels

At the same time, institutions can face demands from their constituents (and organizations like to divest from areas like fossil fuels out of concerns for the environment and global warming. In this regard, Australian Natural University (ANU), Stanford, University of Dayton, University of Glasgow (U.K.), Pritzer College and San Francisco State have opted to sell either their coal or fossil fuel investments. (See “Fossil Fuels Stir Debate at Endowments” by Dan Fitzpatrick, The Wall Street Journal 9 Sept. 2014) Furthermore, at the U.N. Climate Summit in September of 2014, more than 800 institutions and individual investors, with more than $50 billion in assets, vowed to divest from fossil fuels. On the other hand, Harvard, Yale, Cornell and Brown have elected not to divest.

The arguments for divestment are often for either moral or financial reasons. From a financial standpoint, some wonder if we are creating a “carbon bubble” from excess fossil fuel reserves on balance sheets that may never be burned and later resulting in stranded assets.

On the other hand, as reported by the Associated Press, Harvard’s Robert Stavins argues that divestment is largely a symbolic act—without much direct impact on CO2 emissions—that can distract from more meaningful activities. (See “Should Endowments Divest Their Holdings in Fossil Fuels?The Wall Street Journal 23 Nov. 2014.)

Moving Forward

In my opinion, the significance and materiality of ESG issues cannot be ignored in the investment decision-making process. They must be integrated into the process. We may debate the risks of global warming but few would argue that the air quality in Beijing or Shanghai is any good—so one way or another things will have to change. (See Chai Jing’s Under the Dome – Investigating China’s Smog) As a result, failure to understand how sustainability issues impact your investment portfolio can lead to significant risks and missed opportunities.

As Howard Marks says,

“Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance. To distinguish yourself from the others, you need to be on the right side of those mistakes” (342).

Additional ESG Resources

ESG-100 – CFA Institute, CFA Institute – ESG Resources, Environmental Markets: A New Asset Class

Dow Jones Sustainability Indicies, FTSE4Good Index Series, MSCI ESG Indexes,MSCI ESG Research Products

UNEP Finance Initiative, Carbon Disclosure Project – Driving Sustainable Economies, ISO 14000 Environmental Management Certification, GRI – Global Reporting Initiative