Lloyds Rights Issue: Timetable and TERP

This is my third post on the topic of Lloyds upcoming rights issue. My aim is to provide a little clarification for those affected. Why am I doing this? Despite everything, I still believe in a “share-owning democracy”.

The Guardian’s Patrick Collinson wrote this recently:

“An equitable figurehead

In recruiting Honor Blackman as a Joanna Lumley-esque figurehead, the Equitable Members Action Group has chosen well. With-profits annuitants such as Blackman, who had no choice but to stay with Equitable, have suffered more than any other category of policyholder. The others were given a choice in 2000 to get out with a 10% cut in policy values. Those that didn’t take it want compensation galore instead. Are they really that deserving of taxpayer money?” [my stress]

Maybe I’m a bear of little brain, but the Equitable Life non-GAR with-profits policy-holders have had a large chunk of their assets arbitrarily confiscated – a court put the rights of GAR holders above theirs. If this doesn’t deserve compensation, I don’t know what does. More another time.

The lesson I take from this is that you’d better look after your own finances because you can’t trust the media to look out for you when the pros screw up.

When Lloyds announced their upcoming rights issue my initial reaction was to whinge about the complexity of “deferred shares”, which I concluded are worthless, just a device to get round some stupid rule.

I also noted on that first post and subsequently that you can determine how much cash you’ll need to take up your rights. You’re going to need ~50p per share you hold going into the rights issue.

I have no idea why Lloyds didn’t spell out in the various documents they’ve issued about the rights issue that you’ll need to find ~50p per existing share to take up your entitlement to new shares. If I may be permitted to give them some feedback as a shareholder, my opinion is that it would have been a good idea to specifically include the amount of money shareholders would need to find. Perhaps those involved and the officers of any other company doing something similar in future could bear this point in mind.

In my second post on the subject I also presented the argument that a rights issue can temporarily depress a company’s share price so might be a good time to buy shares either by subscribing to the issue or otherwise. [Nothing I write on this blog should be taken as financial advice].

From the search terms that are being used to reach this blog, there are two other significant areas of confusion: the timetable and the use of the term “theoretical ex-rights price” (TERP) to determine the issue price of the new shares.

Timetable

As I understand it, for the retail investor there are only 3 key dates and the first of these appears to be another anachronism (this whole process could do with a bit of simplification):

- 20th November (Friday): the “Record Date” for entitlement to receive rights. If you’re planning to buy shares near or after this date, then, if I were you, I’d check with a financial adviser or stockbroker as to whether the deal will be in time to qualify and whether there’ll be any extra bureaucratic hassle. The Prospectus says this:

“7 If I buy Ordinary Shares after the Record Date will I be eligible to participate in the Rights Issue?
If you bought [sic] Ordinary Shares after the Record Date but prior to 8.00 a.m. on 27 November 2009 (the time when the Existing Ordinary Shares are expected to start trading ex-rights on the London Stock Exchange), you may be eligible to participate in the Rights Issue.
If you are in any doubt, please consult your stockbroker, bank or other appropriate financial adviser, or whoever arranged your share purchase, to ensure you claim your entitlement.
If you buy Ordinary Shares at or after 8.00 a.m. on 27 November 2009, you will not be eligible to participate in the Rights Issue in respect of those Ordinary Shares.”

So what’s the point of the Record Date if it’s not a real deadline?

- 27th November (Friday), 8am: rights created and can be traded or exercised. This is when I’d expect them to appear in (online) nominee accounts.

- 11th December (Friday), 11am: rights must be exercised by this time, though if you have a nominee account they’ll probably advise you of a deadline earlier than this. The new shares can be traded from start of business on the Monday (14th December).

TERP

The Lloyds Prospectus (p.6) implies that the:

“…Issue Price [will] be set at a 38 per cent. to 42 per cent. discount to TERP…”

They also define the TERP as:

“the theoretical ex-rights price of an Existing Ordinary Share calculated by reference to the volume weighted average price on the London Stock Exchange’s main market for listed securities of an Existing Ordinary Share on 23 November 2009″.

Got that?

I thought I understood how to work out the TERP, but tried to check anyway. Wikipedia’s entry is little help. It doesn’t seem to me to contain any falsehood, but then it doesn’t provide a lot of information either.

Unfortunately, Wikipedia references something called Investopedia which has this to say:

“Although the stock price is not likely to change immediately following the new rights issue, it will change as the rights expiration date approaches.”

Rubbish. No wonder we’re all confused!

The whole point is that as soon as the existing shares are split into ex-rights shares and (nil-paid) rights (at 8am on 27th November in the case of Lloyds), the (ex-rights) share price adjusts – to the TERP – to reflect the split. The rights should theoretically trade at approximately the TERP minus the subscription price for each right (i.e. how much you have to pay to exercise the right). Once all the rights are exercised, which they will be, since rights issues are underwritten, the new shares will be identical to the existing shares and should trade at the TERP, plus or minus the effect of any changes in sentiment due to events after the start of the rights issue or just because sentiment changes.  I say “should” trade at the TERP, because there’s also the effect of the additional supply of shares, which may depress the share price below the TERP, as I discussed last time.

So what would we expect the TERP to be for Lloyds?

TERP Calculation

This is how I think the TERP should be calculated.

At present the shares are trading, handily, at exactly 90p. If we round down to 27 billion in circulation, Lloyds is currently worth £24.3bn.

The rights issue involves putting in more money (£13.5bn less £500m expenses) and creating more shares – we don’t know how many yet.

After the rights issue Lloyds should theoretically be worth £(24.3+13)bn = £37.3bn.

The TERP depends on how many new shares are created. For example, if the new shares are priced at 50p, there will be another 27bn. There will therefore be 54bn in circulation after the rights issue and each share would be worth £37.3/54 = ~69.1p.

In this case the rights would be expected to trade at around 19.1p.

If, in this example, the rights were trading at less than 19.1p or the shares at less than 69.1p after the start of the rights issue, then the implication is either Lloyds’ prospects have changed, or the rights issue has reduced the share price.

Lloyds say they want the rights price to be at a ~40% discount to the TERP. 50p is therefore too much (it’s more than 0.6*69.1p). You could iterate to an appropriate price but I expect they did some algebra:

No. of shares after issue = 27bn + 13.5bn/P (where P is the price of the rights issue)

TERP = (Share price before issue (known, let’s take this to be 90p, as now) * 27bn + £13bn) / no. shares after issue

P = 0.6 * TERP

Therefore, P/0.6 = £(24.3+13)/(27 + 13.5/P)

P (27 + £13.5/P) = £37.3*0.6

27P + £13.5 = £22.4

P = £(22.4 – 13.5)/27 = £8.9/27,  i.e. 33p.

and TERP = 33p/0.6 = 55p

Check: No. shares after issue = (27 + 13.5/0.33)bn = 67.9bn

TERP = £(37.3/67.9) = 55p

Easy, peasy!

So, if Lloyds shares are trading at 90p on 23rd November (the date Lloyds is using for their calculation), I’d expect the the rights to be priced at around 33p (I’ve indulged in a little rounding, so let’s not try to be too accurate now) and the TERP will be around 55p.

It’s quite possible I’ve made a horrendous error (or even more than one).  If so, I’ll be happy to post a correction if someone points it out. [22:00 12/11: I've already corrected a small error I spotted myself!]

 

Is Lord Turner Pissing in the Wind?

I went to the Campaign against Climate Change (CCC) conference on Saturday. My impression is that everything is turning a bit red-green – there was a heavy presence of the alphabet soup of revolutionary socialist groups. Perhaps the CCC event is typical of what’s happening to the climate change movement.

The headline on the front page of the Guardian today was: “£15,000 the cost of a green home – watchdog“.

The watchdog in question is the Climate Change Committee (henceforth this, not the Campaign against Climate Change will be known as the CCC!), headed by Lord Turner. It seems to me that the Committee’s brief should be to advise the best things to do, not everything that comes into their heads. And I should imagine most people would understand cost-effective to be one of the main criteria determining what is “best”.

Have they run the numbers?

Maybe we should before we spend £300bn (20 million houses at £15,000 each).

David MacKay reports that he was able to reduce his gas consumption by 27kWh/d, a staggering 67%. David was lucky in that he had cavity walls that are more cheaply insulated than the solid variety. I expect he was also highly motivated to maximise savings (and his savings include some thermostat manipulation), and not everyone would achieve such a good result. Let’s assume, though, that David’s 27kWh/d is the sort of energy saving we get for spending £15,000 on the average house.

There are about 20 million houses in the UK and 60 million people. The cost to save 27kWh/d/p is therefore around £5,000 per person by home improvements, or £5,000/27 = £185 per kWh/d/p.

How does this compare with other options?

MacKay lists costs of energy generation options in his Table 28.3. He doesn’t give the cost per kWh/d/p, but we can easily work it out:
- onshore wind provides 4.2kWh/d/p for £450/p, so £450/4.2 = ~£107 per kWh/d/p.
- offshore wind provides 3.5kWh/d/p for £650/p, so £650/3.5 = ~£188 per kWh/d/p.
I mention wind in particular because there will be a good correlation between wind availability and the need for domestic heating, since the wind cools the houses down. (Many homes have gas central-heating, of course. Electricity will displace gas burned in power-stations if it is not used to heat homes directly).

It’s clearly significantly better to build onshore wind than insulate homes at £15,000 a pop. It’s a toss-up between offshore wind and insulation.

Installing heat-pumps would, according to MacKay, cost £1000/person (implying £3,000/house) but save 12kWh/d/p, at ~£83 per kWh/d/p. People should definitely buy these. But Lord Turner doesn’t mention heat-pumps at all:

“Britain was running out of ‘easy things’ to do in the home[, Turner explained]. ‘After home insulation and more efficient boilers, we now need more intrusive things – double glazing, cavity wall insulation, solid wall insulation.’ ”

And I hate to say it, but according to David MacKay, nuclear power is cheaper still at £1000/person for 16kWh/d/p, i.e. £62.50 per kWh/d/p.

But. There’s always a but. This one is that I simply don’t believe you get as much saving for every £ of that £15,000. By the 80:20 rule, most of the energy will be saved by the first 20%. Here’s what I reckon: it’s a better deal to spend considerably less than £15,000 on each home – let’s say £3,000 – and instead invest in as much wind energy as we can possibly produce.

But. There’s always another but. The cost should be paid by home-owners. I think what I object to most is the statist approach. Apparently:

“The CCC believes that the cost of the scheme would be paid for by a combination of government subsidy and higher electricity bills.”

It’s not clear who pays through their electricity bills. Maybe the idea is you take out what is in effect a loan. But home-owners are generally fairly credit-worthy, so should take out a bank loan (or remortgage), if necessary, to make cost-effective home improvements. What’s proposed, though, is that at least some of the cost of the home improvements is to be spread amongst around – in particular, some, it appears, is to be borne by the taxpayer. This is just wrong. Why should those who don’t qualify for the subsidy pay to increase the value of other peoples’ homes? In ways that might not even be cost-effective.

In fact, if home-owners don’t take financial responsibility for the exercise it will certainly not be cost-effective. Consumption needs to be monitored to ensure the expected savings are made. And what’s more, home-owners need to manage their houses to ensure that energy consumption doesn’t bounce back up, that is, not simply turn the heating up or keep a few more windows open.

Simply handing out money is a good way of wasting most of it.

Instead, we should let the cost of energy be what it’s going to be, using the most cost-effective forms of low-carbon energy.

And then, sure, we should provide advice to home-owners – public information ads detailing how they might save money, and all that.

But people should then make their own informed decisions as to whether to save money or not. If necessary, the price of carbon should be allowed to rise until enough people do save energy or switch to renewable forms.

Lloyds Rights Issue: A Reason to Buy?

I’m rather surprised by the number of hits I’m still getting on a previous post, which noted the unnecessary complexity of the upcoming Lloyds rights issue and the way it’s been presented. I rather thought the weekend papers would clear the matter up, so was unsurprised to read the Guardian Money front page headline “Buddy, can you spare me £13.5bn?”. I immediately followed the injunction “>>Pages 4-5″ and fast-forwarded to read Jill Treanor’s examination of the “implications for small shareholders” and Patrick Collinson’s suggested “plan of action”.

I have to say I was rather disappointed.

Collinson suggests that:

“You got some Halifax shares when it floated. Now we at Lloyds want you to cough up a couple of hundred quid (we won’t tell you the exact sum till later)…”

[my stress]

Treanor also sheds considerable darkness on the point.

Now it simply isn’t true that Lloyds haven’t advised the exact sum investors will have to “cough up” (though they could have been clearer). As I pointed out last time, it’s quite simple: Lloyds wants £13.5bn, which will be divided equally amongst the ~27bn shares in circulation. That’s ~50p a share. If you own 1000 shares you’re going to be asked to put in £500. How many new shares you’ll get and at what price each is yet to be determined.

This is actually a step forward in the organisation of rights issues. The problem is that when a company announces it is going to sell a lot of shares, the price tends to fall – supply and demand – since not every share owner will be able to and want to put more cash into Lloyds equity. By delaying the announcement of the price of the new shares until the last minute, Lloyds has somewhat reduced the risk of the share price falling below the rights issue price, which would be a disaster, since, if you could just buy shares in the market for a lower price, there would be no point taking up the rights issue. The under-writers would end up with all the new shares.

What worries me most about Collinson’s comment piece and Treanor’s Q&A is that they omit part of the case for participating in the rights issue. What I’m about to say should not be construed as financial advice, but there are obvious reasons why a company’s share price might be depressed ahead of a rights issue and that in general a rights issue may be a good opportunity to invest.

The key point is supply and demand for the shares, that is, precisely what Lloyds is worrying about and the reason for the confusion about the offer price for the new shares. Many investors – funds or individuals – may simply be unable to put more money into Lloyds shares. They may just not have the cash. Or, especially if they’re a fund, they may not want Lloyds shares to rise as a proportion of their portfolio. This could even be against the rules of the fund.

Of course, some investors, such as index tracker funds, may be compelled to increase their holding in Lloyds in line with the increase in volume of its equity. But it’s difficult to think of a fund that would be compelled to take up more than its share of rights.

Therefore, it’s often argued, a rights issue is a good time to buy, because there is a surplus of sellers of the stock.

As Jill Treanor points out, you can sell some or all of your rights in the market, for example, to raise enough cash to take up the rest of your rights, a practice known as “tail-swallowing”. Such selling activity will tend to make the rights cheaper. But it’s important to understand that if the price of the rights falls, then so does the price of the existing shares. The reason is the (arbitrage) opportunity to simply sell shares and buy the rights.

Example: To simplify a little, say Lloyds shares fall to 60p when rights have been given to all the shareholders. The rights might entitle you to buy new Lloyds shares for 40p each (so you’d get 5 for every 4 shares you held at the qualifying date for the rights issue) so should sell for about 20p each (since once you’d put in the 40p you’d receive a new share exactly equivalent to the existing shares). If so many people sell their rights that the price is not 20p but drops to (say) 18p, then someone could sell shares for 60p, buy rights for 18p, subscribe to the issue for 40p and make (60 – 18 – 40)p = 2p a share. Do this for a few million shares and you’re building up a tasty bonus pot! What happens when people sell the shares to buy the rights, of course, is that the share price tends to fall until the price of the shares and the price of the rights are aligned again.

So, according to this argument, it may be a good time to buy Lloyds shares, e.g. by subscribing to the rights issue.

It might also be worth noting that Lloyds stated that it will not pay a dividend for 2 years. This may be another reason why some investors (income funds) will not want to hold the shares, though they may already have sold their holdings in the stock.

Of course, there are many reasons why it could turn out to be a bad time to buy Lloyds. They might screw up. Or we might experience the dreaded double-dip recession. And if so many people decide it’s a good time to buy Lloyds, this will push up the price and make it a bad time to buy! Though it is the largest rights issue in the UK to date…

At the end of the day, investors must make up their own minds, and, as I say, I’m not providing financial advice. Patrick Collinson (or his editors) are bold enough to allow themselves a headline “Lloyds looking unattractive” (or “Lloyds rights issue looks distinctly unattractive” in the online version). I just feel investors might also want to take into account the argument that rights issues can be a good time to invest.

Disclaimer: I worked for Lloyds in the early 1990s and own some Lloyds shares.

Why US & China, and not Europe, will Enjoy the Green Technology Bonanza

I’m still reading “Carbonomics” and, whilst mulling over some of Stoft’s (plot spoiler alert) somewhat unconvincing arguments for a carbon “untax” (actually it’s just a regular tax, the un- is an attempt to circumvent the public perception problem), I’ve had a rather nasty thought.

The question is, do aggressive policies of high fossil fuel prices and/or high green energy subsidies or passive policies of low fossil fuel prices and/or low green energy subsidies most favour the development of renewable energy technologies? My argument assumes that in Europe, fossil fuels will be kept expensive due to taxes, carbon trading and so on and renewable energy will be heavily subsidised, whereas in US (& China etc) fossil fuels will remain cheap and there will be limited subsidies.

Obviously my assumption is an over-simplification. In particular, there are sectoral differences, with transport fuels particularly expensive in Europe. But I’m trying to develop a general argument here, so bear with me.

Now, high fuel prices (and renewable subsidies) will encourage the early development of alternatives. So we see, for example, early leaders in solar appearing in Germany and wind in Denmark. Risk-free profits are a wonderful incentive!

But what market conditions will encourage the large-scale roll-out of renewable energy technologies? Well, it’s competition that eliminates the least efficient and forces the survivors to up their game. And, I suggest, competition is going to be most intense where energy prices are lowest and subsidies the most difficult to obtain.

Consider. If, say, two wind power technology players start out and are successful in selling in their home markets, the US and Germany, which will most easily penetrate the other’s market?

The US company will definitely be able to sell in the tough conditions for renewable technology in the US. The German company, on the other hand, has demonstrated only that it can sell in the easier German market with a higher cost of carbon and feed-in tariffs.

Obviously each case is different, and lots of other factors come into play (I’ve assumed that subsidies and fuel prices are higher in Germany than in US, which may not be the case for every renewable technology), but the company accustomed to easy sales is, in general, going to find it much more difficult to compete than the company that has had to fight harder.

The argument is related to the first-mover problem. It may not always be the case that the first company in a market ends up dominating it.

This is all rather awkward, don’t you think?

What it suggests to me is that the best policy at a national level must be not to tax fossil-fuels, nor to subsidise renewable technologies, but to limit fossil-fuel consumption and encourage renewable energy generation other than by price.

The best policy globally is to progressively reduce total use of fossil-fuels, thereby ensuring a level playing-field.

At the moment, no global policy is in place. It’s every country for itself, though there are rewards for reducing fossil-fuel dependency:
- greater energy security;
- a stronger position when a global deal is finally done, as it must eventually be if we’re not all to fry;
- the long-term economic advantage of lower cost – maximised if energy is produced most cost-effectively;
- the potential to export technology (and even energy, e.g. in the form of electricity), similarly maximised when the technology developed is most efficient.

For a country that wants to switch to home-grown renewable energy, policies that make sense therefore include:
- a progressively tighter limit on carbon emissions, implying internal emission trading;
- mandating the use of increasing proportions of renewable energy;
- removing obstacles (e.g. dysfunctional planning processes) to the production of renewable energy;
- a level playing-field for the various renewable energy technologies.

Policies that don’t make sense are those that support over-priced renewable energy:
- carbon taxes (where these price fossil-fuels more highly than necessary to achieve the desired rate of renewable energy uptake);
- feed-in tariffs, that provide guaranteed profit for renewable energy production, regardless of whether or not it is more expensive than other available technologies. Paying ~35p/kWh for electricity generated by solar PV on UK roofs, which I understand may well happen, must be one of the worst renewable energy policies that could possibly be devised.

Of course, whether you use taxes or emission limits supported by carbon-trading, there’s still the risk that if you try to go too fast you’ll spend a lot of money on renewable energy technologies that later turn out to have been very poor value for money. Another reason for insisting on global policies.

In my simplified world, renewable technologies that can survive without subsidies or inflated fossil-fuel prices are the ones that are ultimately going to dominate. Maybe this favours US and Chinese companies, even though Europe is adopting the most aggressive emission-reduction policies. Isn’t economics unfair?

Some Contrarian Climate Change Ideas

I had a day (well afternoon and evening) out of the home-office yesterday. I took the train to Cambridge and caught the first hour or so of a Cambridge Energy Forum on UK buildings before heading to the Guildhall for a well-attended public meeting on “what Copenhagen means for you”.

Maybe I’m an unreconstructed contrarian, but I find myself disagreeing with much of what I’m being told on the topic of global warming. Here are my latest musings.

What’s the target?

The Guildhall meeting started with a very competent whirlwind summary of the science of climate change by Emily Schuckburgh of the British Antarctic Survey. In particular she showed a rather longer graph than I’d seen before of historic temperatures and CO2 concentrations derived from ice-core analysis: around 800,000 years worth. During all this time the level of atmospheric CO2 had varied only between 180 and 280ppm, in close correlation with the temperature.

Furthermore, when temperatures have briefly spiked up during inter-glacials they have reached levels somewhat higher than at present (or in the entirety of recorded human history for that matter). Schuckburgh suggested temperatures may have been 4C higher than her baseline (presumably the pre-industrial average temperature, 0.8C lower than at present) for brief periods (and -8C lower during ice ages). Scary stuff.

Why then, do we think we’ll manage to keep temperatures within 2C of pre-industrial levels – and they’ve already risen 0.8C – at the sort of CO2 concentrations implied by the discussions at Copenhagen? We’re at around 390ppm right now and it doesn’t look like the proposed policies have much chance of keeping us below, at best, 450ppm.

And on top of that, CO2 isn’t the only greenhouse gas. Some have only just been invented! If we can’t get all the methane (CH4) and nitrous oxide (N2O) down to natural levels and the anthropogenic alphabet soup of CFCs, HFCs and so on down to negligible levels, then we’ll be even warmer.

Here’s my contrarian position (1): we need to get CO2 levels back down to the natural range of 180-280ppm. Presumably we’d aim for 280ppm, since 180 implies an ice age!

At present the strongest mainstream position – supported by reputable scientists and prompted by James Hansen’s landmark paper – is that we should aim for 350ppm.

The theory – perhaps I should say hope – is that we can “stabilise” levels at 350ppm and a 2C temperature rise. This is wishful thinking poppycock. In fact, the climate system is not a stable one. In particular, it will not be stable at 350ppm and a 2C temperature increase. It will have a tendency to warm further, for example, as ice melts, darkening the planet’s surface; as CO2 levels rise further as forests burn in the occasional much hotter summers we’d experience; as wetlands dry out and release their carbon too; and as the ocean circulation gradually slows due to the reduced temperature differential between the poles and the equator, removing less and less carbon from the atmosphere as time goes on.

We’ve opened Pandora’s box – we have to put all the demons back in, not just some of them.

Will the Gulf Stream slow and keep Britain cool?

This was meant to be a post about policy, but I’ll get the other science point out of the way, since this old chestnut came up in the Q&A at the Guildhall.

The point is that the Gulf Stream (as the North Atlantic branch of the ocean’s circulation is popularly known) can be disrupted by lots of fresh water flowing into the North Atlantic. Such water floats (because it’s fresh which makes it lighter, even though it’s cold which tends to make it heavier) and would prevent the circulation whereby (salty) cold water sinks as it approaches the pole, drawing more warm surface water up from equatorial regions, keeping Northern Europe, including the UK, a lot warmer than other regions at such a high latitude.

As the world emerged from the last ice age (and previous ones), it seems vast quantities of meltwater from the North American ice-sheet poured into the North Atlantic as ice-dams gave way. This disrupted the oceanic circulation and caused warming to reverse for a while, at least in the North Atlantic region.

It’s possible that meltwater from Greenland could have a similar effect to that from Canada, but unless someone’s asleep on the job, this isn’t imminent, since we’d see the water pooling in Greenland.

So, what will happen to the Gulf Stream in the absence of disruption from a sudden flood of meltwaters?

Here’s my contrarian position (2): the ocean circulation will strengthen in the short-term (which, depending largely on future greenhouse gas emissions, is likely to be a century or two), then gradually weaken as the ice-caps disappear. There’s no get out of jail free card for the UK, certainly not in our life-times.

The point is that the circulation is ultimately driven by the temperature difference between polar and equatorial regions.

More heat is captured by the atmosphere in the tropics than at the poles, that’s why you have a circulation in the first place. With the presence of greenhouse gases, even more heat is captured in equatorial regions and tends to be transported poleward either in the oceans or the atmosphere. More warm water stays near the surface until it cools as it approaches the poles. The result is a stronger circulation.

The presence of ice (Antarctica, Greenland, permafrost) keeps the polar regions from warming. Until this ice melts, more heat will be transported poleward. Indeed, the heat uptake by ice melt that drives the circulation.

Of course, the heat transport itself progressively melts the ice. When it’s eventually all gone, temperatures will tend to equalise between the poles and the equator, weakening the circulation. We’re not there yet, though.

I should remind readers that the ocean circulation is one of the major ways in which carbon dioxide is removed from the atmosphere.
[5/11/09 Afterthought: Oops, this throwaway comment could be a bit misleading. In fact, the ocean circulation returns CO2 to the atmosphere, so, if the circulation increases in strength, as I'm suggesting it will over the next century or two, the net effect will be for the ocean to take up less CO2 (net, the oceans are currently absorbing CO2 because the ocean and atmosphere are out of equilibrium because of the "extra" anthropogenic CO2 in the atmosphere). This mechanism represents a positive feedback during deglaciation warming phases, and, if my hypothesis is correct, during the current phase of global warming. When the ocean circulation is interrupted, then there is a positive cooling feedback as the ocean releases less CO2 due to the reduced circulation, taking up more net. This could explain the persistence of cooling phases during deglaciations (warming periods after ice ages), such as the 1000 year long Younger Dryas event.].

Therefore, as I said in my first heresy, we’d better get temperatures and CO2 levels back down before the ocean circulation strengthens too much. [5/11/09: Amended this sentence, see previous note in square brackets].

Burning wood is not a good idea

Everyone loves Julian Alwood! (He taught on my MBA programme). He told an amusing anecdote yesterday about how some well-meaning foreigners had tried to introduce a more efficient stove in Malawi. The problem was Malawians bash the meat while its cooking, apparently, and the new stoves didn’t last very long.

But the main point is that the big problem in Africa is burning wood. It releases carbon (and, almost as important, retains moisture). “Reducing deforestation” (George Orwell would have loved the double negative!) was mentioned by Chris Hope, among others, yesterday as the cheapest way to avoid deforestation. What’s really needed in Africa is a robust solar stove design, but more about that another time.

So why then was a picture shown at the Cambridge Energy Forum of a supposedly virtuous Briton carrying some logs to put on his fire?

I’ve harped on about the biofuel topic on this blog previously and will no doubt do so again (see the Biofuel category in the box on the right), but here’s my contrarian position (3): Everyone should avoid the use of all forms of biomass as fuel.

Here’s something you may have missed. A radio programme a day or two ago was discussing a satellite that has just been launched to detect moisture levels from space. The point was made that if forecasters had realised that European soil moisture levels were so low in 2003 they would have been able to forecast that year’s heatwave much more accurately.

Interesting factoid. I don’t know about you, but it suggests to me that one way we could adapt to global warming here in Europe is to increase soil moisture levels. How do we do that? More trees (including decaying ones), less arable farming, that’s how. And how do we achieve that change? We ban agrofuels (the right-on term for biofuels) and discourage biomass burning. Simple isn’t it, when you think things through?

Trying to reduce UK (or other comparable country’s) energy consumption is a waste of time, effort and money

I have to say I was stunned by the facts and figures thrown at me by the Cambridge Energy Forum (and in Michael Kelly’s talk on a similar topic in the Guildhall). I think they’ll put up a report of the meeting and slides on their site, in due course, so I won’t try to cover everything that was said.

Let it suffice for me to report that improving the energy efficiency of the UK’s housing stock turns out to be a Sisyphean task. (And even if we succeeded, energy consumption would tend to rebound as we spent the money saved! I won’t go into all this again – my most recent post on the topic is here). After you’ve insulated the loft and put in the low-energy lightbulbs – and anyone who doesn’t take the simple steps is an idiot – it starts to get really expensive.

And you can’t wait for new low-energy houses to be built to replace the existing housing stock because that would take 20,000 years. Or something.

The UK will not reduce its energy consumption by 50%. It won’t happen. The effort is futile. It’s a dead parrot of a policy.

The reason is economics. Importing solar-generated electricity can be achieved at a fraction of the cost per kWh. Promoting that sort of scheme is what everyone should be putting their effort into. And the Desertec plan was only mentioned once, en passant, in the Guildhall.

And then there are the economic reasons. People want to be richer, not poorer. They don’t want to be turning their thermostats down. And what’s more, people are tending to get richer over time – despite a raft of policies promoted by governments round the world designed by a secret global committee with the objective of halting this process – ultimately because technological (and learning) advances mean productivity tends to steadily increase (especially when regular economic recessions purge the least efficient).

The fact that more people are getting richer all the time suggests that policies based on changing people’s behaviour through taxation have had their day. We need to think again about behavioural taxes on everything from alcohol to carbon.

The main advantage (probably the only one, at least in this contrarian’s view) of a carbon tax (championed by the even more lovable Chris Hope last night), or any other way of pricing carbon, is that it makes dirty energy more expensive than clean energy, encouraging companies to invest in renewable energy production. This presupposes, though, that the main reason companies aren’t investing in renewable energy projects is price. And when I read in New Scientist magazine on the train home that “over 5 gigawatts of [UK] wind power are currently stalled by aviators’ objections” to possible radar interference alone, I really wonder whether price rather than the planning system really is the problem.

Nevertheless, internalising the carbon cost must be part of the solution. The problem with introducing a UK tax on carbon is that it will use up an enormous amount of political capital. To be effective there would have to be a huge shift to carbon taxes. And I can see the headlines already. “Driving is just for the rich in Cameron’s Britain”! Not going to happen, is it?

People certainly don’t like being morally preached at (as Chris Hope pointed out), but they like being taxed, and changes to how they’re taxed, even less.

The problem with a tax on carbon in general is that it sets no limit on emissions – so, since a tax simply redistributes spending power, could turn out to be ineffective.

A lot of intellectual effort seems to be going into working out what is the “right” price for carbon. The Kyoto idea of carbon trading may have had a lot of problems, but the principle of letting the market determine the carbon price (by squeezing supply) was the right one.

So what’s my contrarian position? OK (4): Right now energy policy should focus entirely on removing all obstacles to the development and roll-out of renewable forms of energy. Let’s see how far that gets us.

Guilt is not an appropriate emotion for dealing with this problem

Chris Hope was the only one last night who explicitly mentioned that the West caused the problem and should pay to fix it.

Well, I’m sure that “from each according to their abilities”, despite its connotations, might be a principle that could reasonably be applied in the context of international climate change negotiations. But what appears to be happening in the Copenhagen negotiations (I was hoping to find out more last night) is that the aid agenda has taken over the global warming agenda.

For starters, I don’t see a lot of evidence of binding emission targets being linked to these large transfers of money. But for the main course, we’ve brought some more presuppositions with us. There are serious doubts that aid is what’s needed to promote development. Yeap, for decades we’ve been following a seriously flawed policy. For example, Paul Kagame, President of Rwanda, wrote in yesterday’s Guardian, that “Africa must attract broad investment, not rely on handouts, if we are to sustain development”.

What’s needed is trade, not just aid.

Aah, you say, the Copenhagen largesse is investment. Well, maybe some of it will be spent wisely. But there is plenty of money in the world – too much in fact (that’s what caused the credit crisis) – looking for investment opportunities. Why do we need billions more?

A cynic, and I am one, so I’ll carry on, might even conclude that the $100bn or whatever comes out of the wash in Copenhagen, is in fact a further Keynesian stimulus for sluggish western economies. Think about it. Many of those pounds, dollars and euros are going to be spent on – to hazard a guess, as the details are not very clear – engineering projects that will be carried out by western companies. And I would have thought Gordon Brown (who’s driving this handout) is savvy enough to know this. Watch shares in Aggreko and Balfour Beatty when this deal is done!

And what happens when the money runs out? When we eventually decide we don’t need to pay developing countries for a climate deal, or decide that they’re not keeping their side of the bargain (whatever that is)? The money will be like aid, creating dependency.

On the other hand, and let’s call this my final contrarian position (5): paying for ecosystem services – and here’s some good news that could come out of Copenhagen – and/or energy, such as desert solar, will (if executed properly) provide countries with sustainable income streams which will support their further development.

Lloyds Rights Issue complexity: Um, why don’t we just change the rules?

The upcoming Lloyds rights issue is in fact quite simple. They are giving shareholders the right to buy ~50p worth of new shares for each of the currently existing shares they hold. The new shares will be offered at a discount, but their price has not yet been set, so, obviously, you cannot yet determine how many new shares you can buy. But you’ve been told, albeit somewhat cryptically, what you need to know right now: if you want to take up your rights, you’re going to need to find 50p for each share you own when the rights issue process starts on 20th November. [Summary paragraph added 8:45am 4/11/09].

But is it just me or is the organisation and presentation of this rights issue more complicated than it needs to be? [Reworded 8:45am 4/11/09].

I quote in full section 10 of Lloyds’ announcement of its rights issue:

“10 Share Subdivision

Under the Companies Act, it is not permissible for a company to issue shares at a discount to their nominal value, which, in respect of the Existing Ordinary Shares is currently 25 pence per share. It is proposed that the Company carries out the Share Subdivision which will reduce the nominal value to 10 pence per share. This provides the Company and the Joint Bookrunners with greater certainty that the Issue Price will be able to be set at a 38 per cent. to 42 per cent. discount to TERP [the Theoretical Ex-rights Price, which itself depends on the number of new shares being issued, so a bit of algebra is needed to determine the issue price for 38-40% discount based on the current trading price of the existing shares] irrespective of market conditions. The Board believes that the Share Subdivision also provides the Company access to the best available underwriting structure and terms. Although no decision has currently been made as to the Issue Price, in no circumstances will the Issue Price be below 15 pence. As noted in paragraph 8 of this letter, the Issue Price is expected to be announced on 24 November 2009, two days before the General Meeting. The Proposals are conditional on, amongst other things, the completion of the Share Subdivision.

It is proposed that, pursuant to the Share Subdivision, each existing Ordinary Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one ordinary share of 10 pence in the capital of the Company (a “10p Ordinary Share”) and one deferred share of 15 pence in the capital of the company (a “Deferred Share”). The purpose of the issue of Deferred Shares is to ensure that the reduction in the nominal value of the Ordinary Shares does not result in a reduction in the capital of the Company.

Each Ordinary Shareholder’s proportionate interest in the Company’s issued ordinary share capital will remain unchanged as a result of the Share Subdivision. Aside from the change in nominal value, the rights attaching to 10p Ordinary Shares (including voting and dividend rights and rights on a return of capital) will be identical in all respects to those of existing Ordinary Shares. No new share certificates will be issued in respect of the 10p Ordinary Shares as existing share certificates for existing Ordinary Shares will remain valid in respect of the same number of 10p Ordinary Shares arising from the Share Subdivision. The number of Ordinary Shares of the Company listed on the Official List and admitted to trading on the London Stock Exchange’s main market for listed securities shall not change as a result of the Share Subdivision. The Share Subdivision will not affect the Group’s or the Company’s net assets. Consequently, the market price of a 10p Ordinary Share immediately after completion of the Share Subdivision should, theoretically, be the same as the market price of an Ordinary Share immediately prior to the Share Subdivision.

In addition, it is proposed that, pursuant to the Share Subdivision and as required by Article 3.1.4(i) of the Articles of Association, each existing Limited Voting Share of 25 pence in issue at the close of business on the date of the General Meeting will be subdivided into one limited voting share of 10 pence (a “10p Limited Voting Share”) and one Deferred Share. Aside from the change in nominal value, the rights attaching to 10p Limited Voting Shares will be identical in all respects to those of existing Limited Voting Shares. No new share certificates will be issued in respect of the 10p Limited Voting Shares as existing share certificates for existing Limited Voting Shares will remain valid in respect of the same number of 10p Limited Voting Shares arising from the Share Subdivision.

The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.

No share certificates will be issued in respect of the Deferred Shares, nor will CREST accounts of shareholders be credited in respect of any entitlement to Deferred Shares, nor will they be admitted to the Official List or to trading on the London Stock Exchange or any other investment exchange. The Deferred Shares shall not be transferable at any time, other than with the prior written consent of the Directors. The rights attaching to, and restrictions upon, the Deferred Shares are set out in Resolution 6.

At the appropriate time, the Company may repurchase the Deferred Shares, make an application to the High Court for the Deferred Shares to be cancelled, or cancel, or seek the surrender of the Deferred Shares using such other lawful means as the Directors may determine.”

Got that? You’ll be tested on it later!

In fact, all section 10 says is that to get round some stupid rule, and in case Lloyds shares fall before the rights issue completes, we’re all going to be issued with “deferred shares”. These are totally worthless. I just hope they don’t actually show on my trading account, cluttering up the screen and statements.

Frankly, who cares about the nominal value of shares? And, if the rule that companies can’t issue new shares at below the nominal value of existing shares is so easily circumvented, does it really have any point? Maybe the law could simply be changed to add “unless approved at an AGM”.

I’d rather the army of accountants and company lawyers running large companies were employed making sure the business doesn’t screw up, not worrying about worthless deferred shares. Someone was obviously paid to write the paragraph that ensures the deferred shares are worthless. On the other hand, maybe it was worth it for the amusement value. I like it so much I’ll quote it again, this time with a bit of emphasis:

“The Deferred Shares created on the Share Subdivision becoming effective will have no voting or dividend rights and, on a return of capital on a winding up of the Company, will have the right to receive the amount paid up thereon only after Ordinary Shareholders have received, in aggregate, any amounts paid up thereon plus £10 million per Ordinary Share.”

Perhaps they should index that £10 million to RPI. We might experience hyperinflation.

Lloyds is also waiting till the last minute before telling us what the issue price of the new shares will be, in case the short-sellers get their teeth into the situation. Actually I don’t care very much. What I want to know is how much I’m going to have to put in for each share I own. Then I can calculate the total amount I need to find. Shareholders are being asked for about 50p per share they own at the record date for the issue (20th November), calculated by dividing the amount to be raised (£13.5bn) by the number of shares in circulation at the moment (just over 27bn, a number which won’t change materially over the next couple of weeks). Lloyds’ announcement could easily have included the exact amount as a headline (I haven’t read all 200,000 pages of the documents they’ve issued today).

Rights issues remain dysfunctional as I explored here, here and here around 18 months ago (when HBoS was passing a hat around, ironically enough). All that’s been done is to try to speed the rights issue process up, which introduces new problems: the regulators haven’t speeded up the process of moving money about, and the post, for obvious reasons, is even less reliable right now (let’s hope we can all exercise our rights online or by telephone, eh?). As I said in my previous posts on this topic, it must be possible to devise a way of raising funds from shareholders that isn’t vulnerable to attack by short-sellers. Such a scheme would surely save on underwriting fees, for starters. Lloyds will only raise £13bn net from its £13.5bn rights issue. I can live with putting money into basically sound companies that need it, but it sticks in the craw that so much disappears in transaction costs (and in this case, a windfall tax in all but name). Especially when I’m not going to get any dividends for another 2 years!

The Great Carry Trade III: Nouriel Roubini Frets about US and a bit on Japan

When I used to frequent the Internet Chess Club they’d often use a message something like: “A hush descends as Grandmaster So-and-so enters the room.” Well, I feel the same reaction should greet Professor Nouriel Roubini’s entry into the discussion of the Great Carry Trade. It’s worth hanging on the Professor’s every word…

Roubini notes that:

“…while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades…”

Roubini, characteristically, worries most about the unwinding of the dollar carry trade.

I don’t know, I think there is a wrinkle here, which is that the US dollar can’t actually depreciate, not fully, anyway, because of China’s dollar peg. Therefore it hasn’t got so far to snap back in a panic. Sure, there can be some unwinding if the market suddenly perceives emerging markets to have become overvalued, more risky or growth less certain. This damping of the dollar’s movement makes dollar-funded carry trades less risky than they would be otherwise. This is not good, because it will allow bubbles to inflate even more than would otherwise be the case.

Roubini writes as if carry trading investors are making a currency gain by borrowing dollars, over and above emerging currency and other market movements. That’s only true if your accounting currency is neither dollars, nor, say, sterling, which is hardly appreciating nor going to appreciate against the dollar (and also appears to meet the criteria for a carry-trade funding currency). In fact, it’s only really true if your investors want euros or possibly yen at the end of the day, though one wonders why they don’t just borrow in those currencies to reduce the risk, if they believe a flight to safety would favour the dollar.

Since the dollar’s decline is primarily taking place against the euro, it follows, incidentally, that as I argued last time, the next phase of the game will be characterised by a eurozone trade deficit as well as a US and (not that it’s very significant to the rest of the world) a UK one.

Martin Wolf worries – to a very deferential Tech Ticker audience – that eventual US rate rises will have a dramatic effect. Sure. But – since interest rates do most of their work in curbing inflation through their effect on the foreign exchange rate – that simply means they won’t have to rise very much, doesn’t it? Of course, this will help to fuel further borrowing in US…

It might be worth comparing the dollar carry trade to the yen carry trade. The crucial difference is that the yen carry trade was/is inherently risky, because the yen has, for decades, been undervalued, given Japan’s persistent trade surplus (increasing again in 2009).

But we are in a fairly unusual situation of a reserve currency doomed to eventual decline: we can borrow cheaply in dollars because of its reserve status, but, as its status as a reserve currency diminishes, it will be seen to be fundamentally overvalued because of its trade position and the vast overhang of dollars already in foreign hands. So borrowing in dollars is something of a one-way bet – you don’t have to worry that your fortune has the Ponzi quality of depending on everyone else continuing to want to borrow in dollars. The dollar isn’t going to snap back up – notwithstanding a temporary recovery during the next major crisis – because its value is already being held up by central banks wanting to buy them. Rather, the dollar’s value can be expected to decline over time as it is replaced (by a mix) as the world’s reserve currency. Compared to the yen carry trade the dollar carry trade is a bargain, risk-wise. No wonder emerging market equities are breaking records!

Ambrose Evans-Pritchard is always an entertaining read. He writes today that the next crisis could be a Japanese default. But Japan’s trade surplus must make this unlikely. All they’ve got to do is divert some of Japan’s private savings to the public purse. Maybe a little easier said than done, of course, but there’s still plenty of scope. Of course, if they let their national debt rise from 2 to say 3 times GDP, it could start to get tricky to service…

Meanwhile, Peter Tasker worries about an asset bubble bursting in China. This seems closer to the mark. He compares China to Japan and notes that:

“If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event [for the "final manic stage" of the bubble], setting off a Godzilla-sized credit binge.”

There also seem to me to be similarities with the Great Crash of 1929. We are in a fairly unusual situation of a reserve currency doomed to eventual decline, but it is not a unique situation. Didn’t the UK coming off the gold standard in 1925 convince investors that the dollar was the place to be? Blaming Churchill (who took the decision) is wrong-headed. The problem was that the peg existed in the first place, not that we came off it. It might be hitting the ground that does the damage, but the problem is trying to float in the air in the first place.

It seems to me the sooner China appreciates its currency the less painful it will be for everyone. Especially as, the longer Chinese economic growth exceeds that elsewhere, the bigger the relative size of its economy and the greater the imbalance caused by the undervaluation of its currency against the dollar. As I said when I started trying to get my head round all this, currency pegs are a very bad idea indeed. You may be able to market the buck, but you can’t buck the market.

“Carbonomics” Critique, Part 1

I began reading “Carbonomics” by Steven Stoft late yesterday. I’m only just starting Chapter 3 (of 31) but I can already reach a conclusion.

My very first impression was that “Carbonomics” brings some logical thinking to the debate. I see no reason to change my view: there is no doubt a lot of good material in the book.

But within minutes I could see that Stoft’s overall prescription, sadly, is in dreamland.

I’m posting my initial thoughts immediately whilst I am still in a state of shock.

The history of thought is littered with discarded, but complex and sophisticated, bodies of knowledge, from scientific theories – the Ptolemaic universe perhaps, to political programmes – communism, for example; indeed more than bodies of knowledge, entire institutions, even civilisations, all built on foundations that later proved to be constructed of no more than intellectual straw.

Some of the foundations of “Carbonomics” consist of no more than straw.

I am indeed stunned. I started reading and first came across some encouraging comments in the Preface (a chapter which should never be skipped). The author notes the inefficiency of current policies to improve energy security and global warming and promises to “fix energy policy”. He will be guided by the story of physics, and produce Mr Tompkins in Wonderland for economics. “The hardest part of learning new ideas is giving up misconceptions”, he writes.

I must admit that by this point I was already starting to feel a little uneasy. I don’t, for example, believe that “physicists have a tradition of explaining advanced ideas to the public just because they find the concepts fascinating.” No, they do it to try to prove how clever they are (except for a small number who simply have Asperger’s syndrome). And, given that their belief system doesn’t hang together (relativity and quantum physics are as yet unreconciled) they hope that the more positive feedback – or pats on the back – they can extract from their audience, the truer what they have told them will become. Stoft notes that Einstein “found the uncertainty of quantum mechanics… so disconcerting that he never accepted it”. Quite right. Einstein was a holistic thinker. That was his genius. All the facts had to be taken into account, however alien a theory eventually resulted. He understood that all may not be as it seems, but he could not accept contradictions into his world view, even if others could live with them. So in asserting that “God does not play dice”, Einstein was not being a stick in the mud, but demonstrating he was on the side of the good guys. Even if he didn’t have the whole answer, at least he knew there was a question.

I labour the point because it soon became apparent that Stoft’s thinking is not sufficiently rigorous. He is not prepared to accept inconvenient truths.

It’s a shame, because Stoft starts so well with an excellent account of the effects of the 1970s oil price spike. When the Great Depression is so often mentioned as the worst of economic times, I often feel that the discourse is US-centric – cultural domination perhaps. For the 1970s was as decisive for modern Britain as the 1930s was across the Pond. Inflation and unemployment, a pervasive sense of decline tinged with incipient anarchy. The Punk Era, swept away by the Thatcher Revolution.

Never mind, my point is that Stoft’s prescription will fail. Reading his first chapter I assumed Stoft would urge measures to keep the oil price high. But it suddenly dawned on me that his prescription is the precise opposite!

There’s a why Stoft is wrong, which owes something, I feel, to a US-centric world view.

And then there’s the how Stoft is wrong. I’m afraid to say he has not followed his own prescription in the last line of his Preface, to “pay close attention to the way governments and markets really work”.

Stoft, it seems, still bears grudges against OPEC. On page 4 he explains how he wants to avoid “paying OPEC another trillion dollars in tribute”. He writes of how, by 1986 “OPEC had been crippled”. On p.5 he notes how he will explain “how to crush OPEC again”. On page 6 he reminds us that “conservation… crushed OPEC in the early 1980s”. There’s a bit of a lull while he advocates a “consumers’ cartel” to counter OPEC and worries about how to deal with “free rides”…

Powerful stuff. Where have I heard this sort of thing before? Oh, yes, I remember now – it’s eerily reminiscent of Russia railing against NATO. Yes, that’s right, Russia’s demon is a mutual-defence pact. To many in Russia (unfortunately many of those in positions of power), the idea of Ukraine or Georgia joining NATO – to ensure, as sovereign nations, their own defence – is little short of an invasion of the Motherland itself. I wonder, I just wonder, if OPEC members feel the same way. Let’s just step into Wonderland for a moment. Maybe they feel they have a right to the riches under the desert (or wherever). I know, I know, I’m of the view that oil wealth is a fortunate (or often not so fortunate) windfall. But the actual state of affairs is what we have to deal with – and de facto those countries endowed with generous fossil-fuel reserves are determined to maximise the value of those reserves.

In solving the problem of global warming (and energy security) we have to deal with the world as it is, not how we would like it to be.

Maybe I can lay down something of a more specific principle here. Short of war, there will only be progress in international negotiations if win-win situations are created. Sorry about the cliche. Maybe I can get rid of it. Because, actually, we’re in a multilateral situation and we need win-win-win… in fact a win superscript n, win raised to the power of the number of interest groups.

Stoft is writing from the US. Let’s put to one side that he hasn’t even convinced his own country’s body politic to take the problem seriously yet, let alone of his particular approach. Let’s pretend he manages to do that. Even if that were to happen, I’ve got news for him. The world out there is not full of buddies who will be happy to participate in a “consumers’ cartel”. In fact, it may be unfair only to Canada & Australia to say that the US has only one reliable sidekick with any clout at all on the world stage. Yeap. Be nice to the UK. OK, I’m being facetious – there is some alignment of national interests, at least with the EU and Japan. But the problem is that several populous developing countries show no clear sign of wanting to play ball.

I feel I’ve written moreorless enough for a first reaction, so it’s fortunate that how Stoft is wrong has already been touched on in previous episodes of Uncharted Territory.

The general problem is the Displacement Fallacy, though I appreciate that Stoft intends to avoid this through international agreements, starting with China. Good luck, mate, but I don’t think you’ll manage it.

Reflections on Oil supplemented by Reflections on Reflections on Oil considers how the oil market will react to attempts to choke off demand. The important point is that the oil producers themselves will act as buyers of last resort.

Before I sign off I should mention that Stoft’s discussion of a tax on fossil-fuel and an “untax” (general distribution of the tax revenues) will not work as he seems to expect for imported products. Stoft is clearly unaware of the Man in the Wardrobe fallacy. Oil at $80 + $20 tax (Stoft’s example in ch.2, on p.21) will not have the same outcome as oil at $100. In the first case, the importing country still has $20 to spend, perhaps on more oil imports or perhaps on other goods, the sellers of which can themselves then afford to import more oil.

I haven’t read enough yet to determine whether Stoft is aware of the rebound effect or Jevons’ Paradox, whereby using a resource more efficiently can actually increase consumption in the long term. The signs aren’t good, though.

Although I’m disappointed with Stoft’s overall vision, I will read on, because large parts of Stoft’s analysis are sound. The first part of chapter 2 shows, for example, how cheap it would be to move away from reliance on fossil fuels.

Watch this space.

—–
As an unreferenced endnote, I admit hypersensitivity to inaccuracies or ambiguities and two have been particularly irritating:
- in Ch.2, footnote 1, p.19 Stoft writes of a policy “that would ‘cap the long-term concentration of greenhouse gases [GHGs]… at 450 [ppm]‘. We are now just over 380 ppm.” CO2 alone is at “just over 380 ppm”. I can only guess whether the policy proposal referred to is to keep all GHGs at a CO2 equivalent level of 450ppm or to keep CO2 below 450ppm – which, it’s now becoming clear, would be too high.
- at the start of Ch.3, on p.21 Stoft remarks that: “Back in the 1800s… Jevons predicted peak coal in England”. Maybe it’s a cultural thing, but to me “the 1800s” refers to the decade 1800-9, inclusive. Stoft means “the 19th century”, here. Jevons in fact wrote “The Coal Question” in 1865 (Wikipedia). And, btw, he was probably talking about Britain, not “England” (Wikipedia thinks so). No offence taken.

The Grandmother Of All Stealth Taxes

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

The Great Carry Trade II: more on the Problem of China

Yesterday I explained why I consider that we’re in the midst of an era that could be termed the Great Imbalance. I go along with the the view apparently held by Nouriel Roubini that the so-called “Great Moderation” – the period of low inflation – is/was a mirage.

The point is that there is more than one tectonic shift taking place: low inflation has been caused, not by monetary conditions alone, but primarily by a historic reduction in the power of labour to raise wages and hence prices. Inequality is rising, full employment in developed countries is a half-forgotten phenomenon, jobs move around the world as part of globalisation; whereas the disruption of this supposedly happy state of affairs is caused by, well, trade imbalances.

A year ago I reported how the FT’s Martin Wolf had put his finger on the button (in fact, he’s written an entire book on the topic). Today I open my FT and see the argument outlined again, this time by Martin Feldstein in a piece titled “Why the renminbi has to rise to address imbalances”.

Feldstein argues that the US must increase household savings and China must increase domestic demand and “exchange rates must also adjust”. But this logical relationship is wrong. Exchange rates are the driver here. If the renminbi is allowed to rise against the dollar, American household savings and Chinese demand will adjust automatically.

Feldstein correctly notes that in the next phase of the Great Imbalance the euro will be drawn into the fray. The renminbi has dragged the dollar down. We’re going to start to see imports from Germany substituted by domestic Chinese (and American) products. (Europe will likely blame protectionism, and if they retaliate that would be a self-fulfilling diagnosis). Of course it will all be explained as due to the development of China, things they’re doing right that we’re doing wrong. The low dollar will be easily explained as a shift away from the dollar as a reserve currency since China will naturally hold more euros – a counterpart of its trade surplus with the region. But in fact all this will be the result of misaligned currency exchange rates!

Perhaps we should ask ourselves why China follows this policy when India does not. One problem India may avoid but China must face in the future is the sustainability of their industry. It’s all very well making things cheaply in external money terms, but we also have to consider whether they are being made efficiently in terms of physical real-world resources: labour, energy, the cost to the environment and so on. If these are being systematically mispriced – and it’s difficult to see how they could not be – then there will eventually be a reckoning, a crisis in China and a Great Rebalancing.

At the risk of oversimplifying, the difference with Japan, perhaps, is that, through successful industrial policies, Japan achieved export-led growth more by greater efficiency (such as quality) compared to the competition. This was sustainable even in the era when Japan was popularly termed “the Land of the Rising Yen”.

Feldstein’s conclusion is that:

“Fortunately, the Chinese economy is expanding rapidly and its growth is becoming less dependent on exports. When it has the confidence to allow the renminbi to rise, we will be on the path to reduced global imbalances.”

I don’t know. I think they need to start now, or maybe not to be starting from here at all. It seems to me that, in the real world, economic shifts are marked by destructive crises. We’ve probably got a few years before the wheels come off again. Or, if governments use the time wisely, maybe the train can yet be switched to a level track. Interesting times.