Trade my gasoline spill for your 'red mud' dump: A '(Vi)Pareto' Opportunity in Environmental Finance

Ganga Prasad Rao

http://myprofile.cos.com/gangar

Disclaimer: As with other columns and blogs in this series, the author makes no claims to factuality, or the outcomes therefrom. The author also explicitly rejects culpability for any financial, environmental, legal or other undefined impacts that might follow from adopting this proposal.

For decades, even the US, the nerve center of capitalism, evaded economics in its environmental policy-making despite evidence inefficient regulations were costly to the environment and the economy. Instead, it chose to persevere with medical risk benchmarks and technological innovation to guide its environmental programs and standards. Then came the pollution trading schemes in which firms and industries could trade their current and future emissions with each other and re-allocate production resources to jointly achieve economic and environmental goals. It was theoretically sound, practically feasible, and demonstrably a success. But, there has been little by way of a third means of achieving pollution control and remediation - the financial market itself.

Consider the case of Maritime Oil Spills versus Solid Waste Dumps (Maritime piracy, albeit an entirely genre of risk, could be clubbed with Oil spills for its unpredictability. Such aggregation favors a larger treatment of maritime risks and facilitates a flexible, if not an early resolution due access to multiple resource pots and the global reach of the financial markets). Superficially, the former is a multi-lateral 'Commons' problem that extends in to international maritime waters, and the latter a matter for the national, even regional/local administration. Whereas oil spills are an ongoing risk from a perennial activity that merely requires subscription either to a fixed annual group insurance fee (preferred by shippers with a long-term crude contract) or a 'pay as you ship' insurance (typically merchant tankers filling in incremental demand for crude and products), private solid waste dumps must be constructed in anticipation of the demand for garbage disposal, necessitating huge upfront investment toward land re-zoning, financial guarantees to obtain environmental clearances, as well as a financial cover until the dump achieves optimum operational scale years/decades down the road. Further, oil spills from maritime vessels occur in either the open seas, or in the importing/exporting nations. The rules that pin 'guilt' and financial accountability for spills are often confusing due vessel ownership/chartering issues, cargo ownership, route determination, insurance exclusions, and a host of other factors. On the other hand, solid waste, albeit generated within the consuming jurisdiction, may be traced back to imports from foreign, exporting nations. In fact, many in the US claim their backyard SW dumps were filled with hazardous substances found in cheap Chinese imported 'use and throw' stuff (and hence the 'NIMBY syndrome'. India too may worry about similar environmental impacts from its 'FDI in Retail' policy). The question of who ultimately bears financial responsibility for, on one hand, compensating oil spill damages in foreign/international waters, and on the other, for obtaining clearances, constructing, maintaining and closing solid waste dumps, as well as paying for environmental remediation and restoration has bedeviled policy makers. In fact, the lack of policy and legal consensus is evident in the prolonged nature of oil spill litigation and in the proliferation of solid waste that has literally spilled beyond  government-owned or -leased dump sites. Both issues have festered across decades and are ripe for a new approach.

In this context, it'd be opportune to consider a new paradigm for financing environmental remediation and control. In these days of globalization and free capital flows, trade in raw material, fuel, intermediates, and products brings about many unforeseen, even perverse environmental results. These negative environmental outcomes that often occur beyond the confines of the producing or consuming jurisdiction, are not resolved within the domain of conventional environmental theory limited to intra-jurisdictional optimization. Instead, one must look beyond for instruments that are valid globally and robust to different political and economic systems. When environmental policy-makers find themselves up the wall against extreme risk, uncertainty, extra-jurisdictional impacts, incompatible legal systems, and even unfriendly political regimes, financial markets offer instruments that may be strategically structured to serve as appropriate incentives or dis-incentives, or, in the case of uncertain/risky outcomes, provide effective hedges that pre-empt polar environmental outcomes. The globally integrated financial markets potentially offer an attractive 'via media' to resolve environmental issues that extend across, or, are common to multiple jurisdictions.

Toward such a resolution, let us consider a Group Insurance Policy for oil spill damages (with optional piracy cover) subscribed to by shippers of crude and petroleum products. Refining being a volume-intensive, continuous process, the shipping of crudes to refineries too is a quasi-continuous activity that is insured for contents and spill damages in long, multi-decade insurance contracts. The insurance premiums are thus a pseudo-perpetual source of income to the issuer of the policy who covers for the damages in the event of an oil spill. These premiums could alternatively be considered analogous to a perpetuity payout to the issuer of the Insurance policy, if in return for a lumpsum obligation, the obligation being the expected Future Value of claims from a hypothetical future oil spill. The aggregate of premia collected in any period would be the sum of 'variable', tonnage-based premia paid in by crude suppliers for delivery of incremental supply, and fixed annual premia negotiated by crude producers with long-term supply contracts irrespective of actual volume. Elsewhere, and in the context of multi-lateral competition in global trade, a nation may seek to promote its exports - a high priority for its potential to stimulate employment and growth - over competing nations, by offering a 'sweetener' in the form of a large, initial lumpsum.While that lumpsum could take various forms and be justified on just as many grounds, it is appropriate, given international trade exploits the commons and the environment of the importing/consuming nation, to offer it as an Environmental P-Note that compensates them for any and all (environmental) externalities that might result directly, or indirectly, from the import, storage, consumption and disposal of its products (thus avoiding the transactions costs from decades long legal quagmire). The EPN represents an arms-length, limited liability, transferable financial instrument toward upfront, potential compensation for undefined and uncertain future environmental damages in the importing nation from consumption of goods originating in the exporting nation. The exporting nation offers a sovereign guarantee for the face value of the EPN during the period of its validity. It permits the leveraging of the EPN in national and global financial markets during the normal term of the trade agreement, and for the gains thus obtained to be available toward environmental and related causes in the importing nation. However, with a transparent incentive to nurture the trade relationship, the EPN does not 'vest' with the importing nation until the natural and normal conclusion of the trade agreement. Clearly, the face value of the EPN is 'politically negotiated' a priori as part of the bilateral (or, multilateral) trade agreement thus lending a decidedly strategic, multi-term, political angle to the matter. However, given competition among exporter-and importer nations, EPN face values will generally reflect potential inter-temporal profits, if not the 'gains from trade', bargaining position and the morality of the political leadership negotiating the agreement. Should the trade agreement be abrogated or annulled mid-course by the importing nation, the EPN would be returnable to the issuer-nation.

Both, the Oil Spill Group Insurance Policy portfolio, OSGIP, and the EPN are denominated in the same currency, and are instruments sought for their 'shadow financial value' - the OSGIP for the certainty of income stream from policy premium receivables, and the EPN for its present collateral value, for its potential in underwriting a Bond issue, its hedge value in currency exchange markets, and for its pareto discounting and buyback opportunities. Unlike the EPN, which cannot be separated from its financial value, the OSGIP may conceptually be bifurcated in to a 'good' and a 'bad'. The 'good' is not unlike a 'perpetuity coupon' that entitles the 'owner/creditor' to a highly certain stream of insurance premiums. The 'bad' is the uncertain insurance obligation that the 'insurer/debtor' inherits toward damages from the insured risk. Thus bifurcated, the OSGIP turns amenable, on one hand, to trading, discounting, and buybacks in the financial markets, and on the other, to cross-sectoral, cost-reducing risk-aggregation in the insurance markets. While the 'good' is sought at a lumpsum price for its positive shadow value, the 'bad' must be sweetened with a lumpsum - a lumpsum that approximates the discounted PV of the certainty equivalent of the uncertain future payout - before it becomes attractive to buy in to. Consider a fictitious example: A 10-year group insurance subscribed to by 100 shippers and that covers $1 billion of oil spill damages at $10,000 per month per shipper may be separated in to a 'perpetuity' coupon of $1,000,000 per month (that is further discounted to a lumpsum of $50 million in the discount market), and an insurance obligation of a billion dollars amalgamated with a Risk Aggregator for a sum of $200 million. Obviously, the Risk Aggregator reduces expected inter-temporal costs by exploiting scale and scope economies inherent in the insuring of incremental risks: scale measured in both insurance volume and the insuring of incrementally smaller risks, and scope being a synonym for the cost reductions due risk diversification across sectors and causes (natural, anthropogenic random, anthropogenic non-random, natural-anthropogenic interaction). Thus bifurcated, the spill risk is now 'insured' by a larger, financially more secure entity, while the perpetuity coupon trades between financial entities who hold different positions and expectations in the money market. As interest rates change with the stage of the macro-economic cycle, these entities find themselves potentially benefited by trading the perpetuity coupon, thus bringing about repeated pareto trades in the perpetuity instrument (This result extends to the case in which the ad valorem insurance for value of shipped crude or products is combined, or issued jointly with spill insurance, with the caveat that the trades are now further influenced by trends and expectations of variations in product prices). Thus, the legal green light to bifurcate the OSGIP and permit insurance risk aggregation sets in motion various interests that are individually and group pareto. Designed with appropriate institutions, financial instruments and regulatory fiats, they yield profits that may be channeled to obtain integrated and simultaneous control of multimedia pollution externalities.

It is advantageous, given there exists a positive shadow value for profiting from these 'attributes' in the financial market, and an opportunity to reduce insurer-insuree costs by aggregating/diversifying risks, to design a financial-cum-insurance strategy that exploits the OSGIP and the EPN to the advantage of the environment. The key to the design of this novel environmental strategy is legally permitting the re-assignment of ownership, and the privileges (separate from) obligations tied to these instruments, so they could be traded separately, and repeatedly, to exploit risk and financial arbitrage opportunities that arise at different stages of the macro-economic cycle across different market participants in different nations, and to channel the returns so obtained to fund preventive, remedial and compensating environmental programs, both nationally, and in the global commons. Toward the design of the financial system, let us first recognize a pair each of national and international bodies: the Solid Waste Authority, SWA, and the Export Credit Bureau representing the former, the Oil Spill Fund Authority, OSFA, and the Merchant Shipping Association, MSA, the latter.

The OSFA is an international organization that coordinates spill insurance and responses across friendly and competing nations (A Maritime Risks Resolution Authority would bring piracy risks too under its fold). It has the authority to offer, or sponsor, an Oil Spill Group Insurance to shippers of crude and petrochemical liquids. The MSA, too, is a trans-national association meant to espouse the cause of Merchant Shippers. Since the fleet of ocean-going vessels owned by merchant shippers is a fixed asset that must be maintained regardless of business, or the lack of it, one of the primary tasks of the MSA is to seek freight rates and vessel lease rates that support the industry across macro-economic downturns. When the state of the global economy and the industry does not permit such rates, the MSA adopts other financial and business strategies that assure the industry will have a source of income to cover its operating cost when freight volumes and vessel-leasing activity shrink.

The SWA, on the other hand, is strictly a national organization. There are as many SWAs as there are participating nations. Entrusted with the EPN by the foreign exporting nation, for undefined environmental excesses caused by the transport, consumption and disposal of its products, each SWA regulates the solid waste landfill industry in its nation by issuing licenses to operate dumps and ensures their environmental obligations are discharged. In the licensing auction rounds conducted by the SWA, those who bid the lowest for operating a landfill, environmental costs excluded, win the license for each auctioned site. Since the lowest, winning bid is likely to have underestimated the 'income elasticity of volume growth', the licensees, operating with a fixed annual revenue (the winning bid amount) and a high cost elasticity of output, will find the waste generated and the cost of operations rise non-linearly when the economy heats up (Conversely, the income elasticity of volume growth would be minimal for a closed cycle economy). It is to cover this 'unanticipated' rise in private and environmental costs that the SWA seeks to discount its EPN and/or buy in to the OSGIP stream of spill policy income.

On the final front, the Export Credit Bureau, ECB, of the importing nation facilitates trade, particularly exports by issuing export credit lines and guarantees. The ECB, dealing in large foreign currency transactions, happens to move the exchange rate with its operations. To carry out its operations while maintaining stability in exchange rates, the ECB must seek a 'foreign currency counterweight' - a financial instrument with a large face value, and denominated in the foreign nation currency that acts as an 'opposite hedge' to stabilize the exchange rate despite the lop-sided transactions that might occur during a currency depreciation-induced, export-led, economic revival. The EPN, guaranteed to its face value in the currency of the foreign nation, is a heaven-sent to the ECB ; it serves various purposes - collateral, exchange rate stabilization, and the facilitation of the export (credits), for which reason it is actively sought by the ECB.

And so, the various interests and incentives converge in financial markets. Both, the OSFA and the ECB bid for the EPN, while the MSA and the SWA bid for the OSGIP. In the normal course of events, the OSFA would deposit its insurance policy premiums in low-risk assets such as the bond market, and the SWA its EPN with Banks for Collateral fee, or with Bond Issuers for an Underwriter's fee. But if the economy were responding to an interest rate stimulus, the SWA, anticipating a period of higher interest rates in a future characterized by larger trade in crude and products, would offer its EPN in the discount market while concomitantly bidding for the OSGIP. In discounting ahead of a rise in interest/discount rates, the SWA hopes to pre-empt competing SWAs and obtain a larger discounted lumpsum for its EPN. Similarly, in seeking the OSGIP, the SWA intends to profit from the expectation of rising stream of income from the variable, 'pay as you ship' policy premiums. Simultaneously, the OSFA, fearing a loss of bond value resulting from an anticipated hike in interest rates, finds the EPN an attractive 'FV Lumpsum' to discount and buy in to both for capital protection (and for the additional cover it offers in the event of an oil spill when the tanker industry is stretched to its capacity; the EPN is also additional protection against an 'un-obliging' Risk Aggregator. For this reason, it'd be appropriate to require the Insurance Aggregators to participate in the issue of the EPN). Toward this objective, the OSFA scans the SWAs of different nations for EPN discounting opportunities. The OSFA is also open to pre-empt the rise in interest rates by trading its OSGIP for a higher lumpsum at an earlier date, and either leverage that lumpsum to palm off the insurance obligation to an Insurance Aggregator, exploit the impending rise in money market yields, or, diversify its risk-return by investing the proceeds to charter and re-lease general merchandise vessels just as charter rates turn north on the cue of an expanding global economy. (Perhaps the OSFA would rein in charter rates if global economic activity were 'oil-intensive'?). On the third front, Merchant shippers, burdened with the fixed cost of holding a ready fleet of freight vessels, walk the fine line between raising charter rates that carry with it the risk of putting the brakes on global economic expansion, and letting the OSFA charter its vessels for a lumpsum that reins in rates and insures (energy-intensive) economic growth. When the global economy approaches its zenith, the Merchant Shippers up their bid for the OSGIP for the steady source of income that it represents and the financial insurance it provides should their fleet remain idle in the contractionary phase of the global macro cycle. On the final frontier, the Export Credit Bureau (of the importing nation) too evinces interest in the EPNs in the hope it may, during a period of increasing trade, leverage the EPN toward underwriting export credit and loans in foreign currency to the face value of the EPN. When the macro-cycle turns around, the ECB is caught with too much foreign currency exposure (the local currency appreciates when the economy is reined in with higher interest rates). Fortuitously, the SWA, which discounted the EPN ahead of rising interest rates is now all too willing to buy it back and book its 'EPN profits' before rates fall to accommodate the next growth cycle, and just in time to fund remediation of environmental excesses of the growth phase.

The OSFA's bid reflects its view of the bond market, in particular how it'd react to expected firming of interest rates. The ECB's bid, on the other hand, would reflect its assessment of export credit demand (a demand sensitive to exchange rates). The question then arises whether the rise in economic activity is driven or accompanied by currency depreciation. If GDP growth and exports are driven by artificial currency depreciation, then the Bond market is likely to tank when, following a surge in GDP growth, a hike in interest rates causes the currency to appreciate. When this is the case, the OSFA is likely to bid over the ECB for the EPN as a safe haven for its bond market holdings (The EPN could also cover oil spills that might occur from the volume-driven rise in exports). Fearing an artificial currency-depreciation induced export bubble, the ECB too backs off from extending too much credit to exporters. If however, the GDP growth were driven by fundamentals, (or, the Fed/Central Bank was expected to stimulate the economy with a drop in interest rates inducing currency depreciation) then the ECB would have its hands full with demand for export credit. It'd bid higher for the EPN which provides it the foreign currency cover necessary to issue export credit without destabilizing the exchange rate. The OSFA then moves its bond holdings to charter and re-lease merchant ships and profit from the sustainable growth in exports. In either case, the SWA obtains a large, if discounted lumpsum for trading its EPN over which it parks in money markets to exploit the anticipated rise in interest rates.

Similarly, both, the SWA and the Merchant Shippers seek the OSGIP, endowed as it is with the certainty of income stream embodied in the insurance premium receivables. The SWA would be the more aggressive of the two bidders at the start of an economic expansion, especially if the Insurance portfolio were weighted heavily toward the 'variable pay as you ship' tonnage-based insurance subscribers, because that would enrich it consequent the rise in crude volumes shipped in times of rising economic activity. The  income stream would be a 'just-in-time' for SWA licensees who must contend with larger volumes of solid waste. In that event, the Merchant shippers raise their charter rates. Toward the end of the economic expansion however, the Merchant shippers, seeking a cover for their fleet in idle times, bid higher for the OSGIP. They vary their bid in the fraction of the OSGIP portfolio comprised of long-term contracts with volume-invariant, fixed insurance premiums. The larger that fraction, the lower the MSA pegs its freight and charter rates to tide over the downturn in economic activity. When the Merchant shippers outbid the SWA, the SWA takes its cue, and promptly buysback the EPN before discount rates drop with falling interest rates and force a higher lumpsum payout.

Unlike the SWA, the OSFA is an insurance agency that is not obligated beyond its payout upon a spill incident. It could, if it were so permitted, choose to bank its profits from OSGIP 'operations'. However, as a prudent insurance firm, the OSFA might sponsor or fund activities and services as diverse as OSHA training, Ocean Vessel Information Systems, Weather Information Systems, and even the subsidizing of loans meant for replacing aged ships. Such supplementary 'investments' enhance the reliability of ocean transport of liquids and reduce the risk of spills, thus protecting the environment, the shippers, and indeed, the crude producers and suppliers. The question arises how one may ensure SWA's gains from EPN operations are translated in to real, verifiable environmental gains, and not creamed off from the cake by politicians who negotiated its face value to start with. Toward resolving this crucial matter, it'd be appropriate to conceive of Efficiency Services Firms, EfSF, and Environmental Service Firms, EnvSFs. Efficiency Service Firms engage in the planning and implementation of economy-wide closed-cycle technologies that contribute to reductions in material intensity of processes and products that eventually obtain reductions in the generation of solid waste and energy consumption. The primary business of Environmental Service Firms is to provide environmental services toward the remediation and restoration of the environment despoiled by (production- and) consumption-externalities. These Environmental Service Firms seek the advice of Environmental Advisors who suggest appropriately-scoped remediation and restoration programs that reduce the multi-media externality from the transportation, disposal and landfilling of solid waste. Both types of firms are empowered by an enabling regulation to obtain loans from Banks participating in EPN operations. Cognizant, on one hand, of the interest rate volatility during a macro-cycle, and on the other, of the potential future gains to the SWA from its EPN operations (which they are in a position to discount prospectively), and taking in to account the potential for business growth, the banks issue loans to EfSFs and EnvSFs upon certification of expected efficiency and environmental gains by the Advisors. These loans, vide the regulation, turn in to the conditional obligation of the SWA.

Upon the conclusion of the program, the EfSFs and EnvSFs submit their report listing remediation costs and environmental benefits as verified/vouched for by the Environmental Auditors, to the SWA. The SWA, on being satisfied with the claims of environmental gains, pays the creditor-banks off in order of descending net benefits. If the Advisors were prescient, the EfSFs and EnvSFs diligent, the Auditors sincere, and the Banks perfectly foresighted, efficiency and environmental services would be provided exactly to the point where marginal benefits equaled marginal costs. The SWA would then have just enough profits to pay off all loans extended by the banks to the EfSFs and EnvSFs. In the general case however, under-provision of environmental services, implying closed cycle technology or restoration activity whose incremental benefits were larger than incremental costs were not undertaken, would let the SWA cream some profits away from its EPN operations which it might further divert to expanding landfills. Similarly, too early, or too much an adoption of new technology and excessive remediation beyond the 'MB=MC' point (or incorrect valuation of costs and benefits), could result in the SWA running out of profits to discharge its loan obligations. When this happens, the banks suffer a loan default, and take the Advisors and the Auditors to task.

Thus designed, this proposal exploits financial incentives and macro-cycle volatility, often the handiwork of politicians hand-in-glove with the industry, to foster efficiency gains and obtain multimedia environmental gains. Amalgamated with an Insurance Aggregator, the OSGIP is administered by a financially more secure entity; profits from OSGIP 'perpetuity operations' are channeled to spill risk-abating activities. On the other hand, the EPN serves many interests, in particular trade, while providing real environmental gains from its discount and buyback operations. Larger the interest rate 'hi-lo' spreads within a macro-cycle, the higher the potential gains for the SWA and OSFA from EPN and OSGIP discounting and buyback operations, and the larger the environmental remediation programs that they can support. The choice between EfSFs and EnvSFs increases competition for SWA funds, and balances efficiency against environmental equity. The fear of loan default ensures banks involved in EPN operations are diligent in issuing loans to only to worthy projects proposed by the EfSFs and EnvSFs. The proposal is an efficient means of balancing progress toward a closed-cycle economy while obtaining remediation of past environmental excesses.

Trade red mud for gasoline? How 'bout your garden for my lake ... Ooops! Your garden and your lake !