Green Energy & Financial Reform

By Jefferson Goethals

What does financial reform have to do with the new energy industry? The success of financial reform will have a major impact on the clean energy industry. There are two critical issues.

1. New energy requires a great deal of capital, far more so than conventional energy.* The functioning of the markets that control the flow of capital is critical to our industry. When the financial markets fail, as they did in 2008, our industry takes a huge hit.

2. Many forms of clean energy function as a hedge against volatile fuel prices. The value of this function is related to the value assigned to other forms of hedging in the financial markets, such as futures and options.The more transparent these derivatives markets are, the easier it is to understand the value of energy sources like solar and wind.

It is worth understanding financial markets, how they function, and why they failed. Financial Markets—the stock markets, the bond markets and markets in commodities and derivatives—have three major functions:

· They distribute capital from investors to businesses and entrepreneurs

· They distribute risk from those who cannot bear it to those who can

· They distribute information in the form of prices and changes in prices

The financial markets failed badly at all three of their functions. Two of the failures caused the crisis, which was defined by the third failure. The markets badly mispriced the risk associated with sub-prime mortgages and they failed to effectively distribute this risk. When the mortgages failed, nearly every financial institution was affected, and the market could not reach consensus on the value of portfolios that included the toxic assets. Bad information led to badly mispriced and badly distributed risk.

Because there was no consensus on the value of toxic assets, there was no consensus on the value of the balance sheets that included them. This meant that nearly every financial institution in the world was potentially insolvent or in immediate danger of insolvency. As a defensive measure, financial institutions stopped lending, and businesses couldn’t get the capital they needed.

The financial markets functioned poorly, and for a short period of time they virtually ceased to function at all. The impact on our economy was dramatic, and we are still feeling the effects. The impact on industries that depend on cheap and easily available capital, like clean energy, was chilling.

The reform package that will soon become law is good, as far as it goes. It demands greater accountability from the private sector, it gives the government the right to intervene in financial institutions that threaten the economy, and it make derivatives trading more transparent. It will keep things more stable than they have been.

One of the critical issues has not been addressed at all, and that is the issue of compensation. The compensation of the people and institutions who run the financial markets is far too high, and it is tied to the wrong metrics. On balance, compensation for traders and investment bankers increases with increased volatility in the markets. Volatility increases risk for investors, however, which ultimately makes capital less available and more expensive.

Until this mismatch of interest between investors and financial institutions is solved, the financial markets will not function properly, and will remain in danger of another major collapse. Those who care about clean energy should celebrate the financial reform bill and immediately press for more.

*Clean energy is incredibly capital intensive. For example, a solar photovoltaic installation generates electricity for 30 years or more, just as a coal plant does. The solar installation is expensive to build, but has extremely low operations and maintenance costs. The coal plant is cheaper to build, but has ongoing operational costs, plus of course, the cost of the coal. As a result, the solar plant requires more initial capital per unit of energy produced over its lifetime than does the coal plant: in practice, nearly twice as much.

The solar industry needs the financial markets to consistently provide access to cheap capital. Without that, the industry literally cannot exist, and this accounts for the downturn in the solar industry during and immediately after the financial crisis.