credit subsidies

Hillary Clinton's use of her personal email account for official government business has been all over the news lately.  The concern is that the approach escapes the normal channels of accountability regarding official government business, and makes it much more difficult to protect government records for historical purposes.  

If an email is sent from a private address, does it make a noise?

Clinton is not alone.  Jonathan Silver, the former head of DOE's Loan Programs Office, did too.  He was clearly not as high up in the Obama administration as Secretary Clinton; and unlike Clinton, he seems also to have used his DOE email address.  Nonetheless, Silver did oversee the granting of some of the largest non-bailout loans to individual private corporations in US history.  And, like Secretary Clinton, he had a penchant for using his private email a lot. 

Great investigative work by Carol Leonnig and Joe Stephens in the Washington Post back in 2012 highlighted the issue.  They wrote that Silver frequently reminded staff not to include personal emails in DOE correspondance for fear of making the account subpoenable.  But it seems that if one just used private email, without having it appear alongside DOE addresses, that would be fine.  Indeed, he often relied on this less visible method for his own key correspondence.  Leonnig and Stephens: 

Silver repeatedly communicated about internal and sensitive loan decisions via his personal e-mail, the newly released records show, and more than a dozen other Energy Department staff members used their personal e-mail to discuss decisions involving taxpayer-funded loans as well. The Washington Post received the e-mails from Republican investigators on the committee.

"The frequent use of non-government e-mail accounts and the contents of e-mails leaves little doubt that DOE officials participated in an intentional effort to shield their communications from legal scrutiny and the public," committee Chairman Darrell Issa (R-Calif.) and subcommittee Chairmen Jim Jordan (R-Ohio) and Trey Gowdy (R-S.C.) wrote to Chu.

You can review examples of Silver's emails here.

And although the impetus for this Congressional review was concerns over loan guarantees to solar projects, most notably to ill-fated Solyndra, the problem is hardly isolated.  In terms of program risk to taxpayers, the  massive loan to the Vogtle nuclear plant in Georgia is the Mother of All Solyndra's.  With taxpayer exposure topping $8 billion, it is clearly a critical deal to review. 

And review it, I have.  As part of a project with the Southern Alliance for Clean Energy, I went through thousands of pages of documents and emails related to the Vogtle loan guarantee submission and evaluation.  These documents saw the light of day only due to roughly ten separate rounds of FOIA requests over multiple years -- submitted by SACE and the Emory University School of Law’s Turner Environmental Law Clinic . 

Yet the released information had very little linked to Silver's private email.  One can only speculate on why that correspondence was left out, and what important information related to the Vogtle deal we may be missing.  

Taxpayer exposure on Vogtle - some troubling trends

So how's the program doing?  Will taxpayers or others ultimately bear a heavy financial burden because of poor accountability on the review and pricing of massive federal credit support to Vogtle reactors 3 and 4?

If you ask DOE, their loan program overall is going swimmingly well.  In their November 2014 progress report, the Office of Loan Programs' current director Peter Davidson noted that loss ratios are low, and interest and principal payments are running above losses.  Many of the principal payments are back-loaded, so we shall see.  And interest, even if repaid, is still provided at a significantly subsidized rate for many of the borrowers. 

What about the Vogtle loan itself?  The trends don't look very good, actually.

• DOE determined the credit risk on $6.5 billion in government loans to Southern Company, the largest investor in the new Vogtle reactors (through its Georgia Power subsidary), was zero.  It is hard to imagine Peter Davidson's former employer, Morgan Stanley, reaching a similar decision.  The advance credit subsidy fee was one of the key risk management tools available to the Department to reduce losses.  By setting the credit subsidy figure to zero, DOE greatly increased the likely magnitude of taxpayer loss on this deal and established a bad precedent for future solicitations.  The irony here is that they didn't need to give the loan at all and the plant would still have been built:  Southern had said multiple times that they could proceed without the federal credit support. 
  
  If DOE staff were confident in their decision, one would assume they would be proud to demonstrate its basis.  No such luck:  DOE has blocked repeated attempts to get detailed information on how they concluded that zero credit subsidy assessment was warranted. 
• Cost of the project has ballooned to as much as $18 billion and counting, and battles over who pays for the overruns are heating up.   The project's problems (likely in conjunction with a softening market for power) has led Southern Company to delay a second reactor project. 
• Southern Company CEO Tom Fanning sold the vast majority of his shares in the firm last fall, according to Barrons.  This was years prior to the expiration of the associated options.  He sold 275,600 shares in January 2014, and an additional 1,049,185 in September.  At that point, he had less than 40,000 left.  A spokesperson for InsiderInsights.com, a firm that tracks trading activity by corporate insiders, viewed the sales as "bearish" and suggested people avoid the stock.  The sales subsequent to DOE approval of a zero credit subsidy fee; in excess of historical sale patterns; and leaving only a tiny stake in the firm he is in charge of are all problematic.  Sometimes such a pattern precedes CEO replacement or retirement.  In this case, however, Fanning is still there. 
• While nukes were always sold as expensive to build but cheap to run, turns out they may not be very cheap to run either.  Exelon has taken the lead among current reactor owners in begging for alms in order to keep their plants on line.  And the alms, apparently, are quite substantial.  Tim Judson of NIRs has a good summary here.  Of course, these reactors have all been subsidized their entire lives, so perhaps begging for taxpayer handouts comes naturally.  They were subsidized when they were built; when they were deemed uncompetitive during power deregulation; for their accident risks, their waste management, and their accruals for plant decommissioning.  The list goes on.  But a key point is that if even the old reactors that have already paid off their capital can't operate competitively, what hope does a bloated Vogtle 3 & 4 have with cost recovery hurdles continuing to rise?

So how will this play out?  Southern Company rate payers are already feeling the pinch.  SACE notes that:

Georgia Power ratepayers are currently paying an additional over 9.4% on their bills for the Nuclear Construction Cost Recovery (“NCCR”) Rider due to anti-consumer state legislation passed in 2009 to incentivize building new reactors. Since 2011 customers have paid over $1 billion since the Company began collecting the NCCR tariff for financing costs and taxes that would normally be recovered over the normal life of the facility.

Oh, and if I were one of the town administrators in the Vogtle service area who had signed on to one of the take-or-pay, hell-or-highwater power purchase agreements for power from Vogtle 3 and 4, I would be starting to sweat.[fn]Here's some representative wording for MEAG: "The Conditional Commitment provides that the Project Entities will be the borrowers of the Guaranteed Loans. On or prior to entry into the Definitive Agreements, MEAG Power will enter into a take-or-pay, "hell or high water" power purchase agreement with each Project Entity for all of the power, energy and other services generated by such Project Entity's ownership interest in Vogtle Units 3&4. These power purchase agreements between MEAG Power and each Project Entity will be "back-to-back" arrangements requiring MEAG Power to make payments to the Project Entity to the extent that MEAG Power has received payment under its corresponding power purchase or sale arrangements." [/fn]

Politicians love government credit subsidy programs.  Direct loans, or loan guarantees (where the government will make good on a debt lent by others), provide a quick infusion of capital to favored constituent groups or industries with little or no immediate budget hit. 

Often, there is a nice story to accompany the subsidy:  a new industrial plant or a production line expansion.  Sometimes the sponsors pump up the volume with visions of this or that loan being the spark needed to bring entirely new industries into a state, jump-starting good jobs at good wages for decades to come.  There are ceremonies, of course, and press releases, dinners and TV interviews that boost the politician's stature and reelection prospects.  Many glowing words of public-private partnerships are usually spoken.

The beauty of the credit program approach is that if (or when, as defaults are fairly common) the loans go bust,  years have gone by.  The politician who made it all happen may be out of office.  Or if still active, he or she may be on to other subjects and not easily pinned to the problem.  Quick benefits, little immediate cost to the Treasury, and lots of time between funding and potential fall-out:  what's not to like?

Clarifying the fiscal cost of credit subsidies

The reality, of course, is not so sanguine.  The credit support often flows to activities with substantial risk.  Funding decisions too often rely on political criteria as much or more than economic ones.   And subsidy recipients may also have competitors, sometimes even in-state, that are disadvantaged by the programs.

The Federal Credit Reform Act of 1990 (FCRA) was an important step in bringing some fiscal reality to the political happy times, at least at the federal level.  The probability of losses associated with each lending program had to be assessed, and the estimated losses included in the budget of the funding agency.  Each year, this "credit subsidy" value would be updated based on new information, and in comparison to the Treasury's cost of borrowing.  This was a big improvement:  loan guarantees would no longer look "free" simply because no cash changed hands at the inception of a deal.  Borrower defaults from either the loans or the guarantees would be picked up and linked to the specific lending program.  The potential for transparency and accountability was created.

But by using the Treasury's cost of borrowing as a benchmark, and by ignoring the costs of loan administration, FCRA always understated the real subsidies associated with loans.  This is because pretty much every borrower had a higher financial risk than Treasury, and the higher risk was not being picked up in loan pricing.  With hundreds of billions of dollars in all sorts of lending programs, these measurement problems become quite important.  And, it is possible that they may, at last, be getting fixed.

Improving on FCRA rules with "Fair Value" estimates

On October 16th, the Financial Economists Roundtable (FER), a group of senior financial economists from many of the world's premier universities, released a statement on "Accounting for the Cost of Government Credit Assistance."  FER was founded in 1993, and Roundtable member Deborah Lucas notes that this was the first statement in the Roundtable's existence on which there were no dissenting votes.

FER concludes that the current government accounting rules used to calculated the budgetary costs of government credit programs "results in the systematic understatement of the cost of federal credit programs."  There is no mincing words here:

The apparent cost advantage of government credit assistance over private lenders is, in the opinion of the FER, primarily due to FCRA accounting rules, rather than to any inherent economic advantage of the government.

They continue:

Under FCRA rules the recorded budgetary costs of most federal credit programs are calculated by discounting to the present the projected expected cash flows over the life of the loan or guarantee using current, maturity-matched, Treasury interest rates as the discount factors.  Use of Treasury rates as discount factors, however, fails to account for the costs of the risks associated with government credit assistance -- namely, market risk, prepayment risk, and liquidity risk.  These costs must ultimately be borne by taxpayers, just as they must be borne by the equity holders (owners) of private lenders that make private loans..."

FER proposes using instead "discount rates that capture all risks borne by taxpayers, and in particular by the use of discount rates consistent with market-based or fair value estimates of cost."  The cost of Treasury debt isn't what matters:  "Although the government can borrow at low Treasury rates, its full cost of capital when it makes a risky loan is higher because it also includes a fair return to taxpayers and the public, who bear the associated risks."  Imagine that:  the idea that taxpayers, as providers of large quantities of capital to high risk enterprises, deserve a fair return on their investment.  That would be progress, indeed.

This shift in valuation is something I've favored for many years.  Back in 1993 when I did my first work on energy subsidies, I insisted on a definition of subsidies as "(1) government-provided goods and services, including risk-bearing [emphasis added], which otherwise would have to be purchased in the marketplace; and (2) reductions in tax burdens compared to standard treatment for a similar activity."  Risk-bearing is a central element in many of the subsidies that government provides, and often increases the degree to which subsidies distort marketplace choice.  Yet it was too often viewed as being not a "real" subsidy at the time because there were no immediate cash payments.

Practically, my study attempted to capture the fair value of loans, and to deal with the concerns that risk subsidies weren't "real" by establishing a subsidy range.  The low-end of the range compared credit pricing to the direct cost to the Treasury of borrowing capital of a similar duration -- basically the FCRA approach plus the administrative costs of the oversight agency.  The high-end estimate incorporated the "intermediation" value of having the low-risk Treasury borrowing on behalf of higher-risk enterprises on capital markets, obtaining rates and terms that would not have been possible for the borrower to get itself. This is quite similar to the Fair Value approach being proposed by FER.

My work drew a distinction between the cost of credit support (which drove fiscal impacts on government budgets) and the value of the credit support (which drove inter-fuel distortions in energy markets).  What is nice about the FER statement is that they are merging the two:  they are saying that the "cost" to the government really does need to pick up these other risk factors, and the value of this intermediation is actually a cost of the program to taxpayers. 

Better measurement can lead to better decisions: applying "Fair Value" approach to other intermediation subsidies

FER is careful to state that improved loan costing is a separate issue from whether any particular credit subsidy program is beneficial or not.  Nonetheless, much will change in terms of the incentives to use government as a bank if the full value of the subsidies is visible, and we will likely see tighter, better, lending programs as a result.  It is also important to note that the exact same logic FER has applied to loans and loan guarantees applies to other subsidy forms in which the government is intermediating in private markets to provide a good or service at a discount. 

There is a clear parallel with government-subsidized insurance programs, but the logic likely applies to mandated purchases as well (since the mandates set a demand floor that greatly reduces the risk of large capital investments in production capacity).   Government-owned enterprises, whether public power or more complex service organizations like the Nuclear Waste Repository or the Strategic Petroleum Reserve, are other likely candidates.  These initiatives usually have a mixture of risk-shifting instruments (grants, tax exemptions, subsidized credit and insurance) that understate the costs of operations and subsidize the product or service being delivered.  A fair value approach would be expected to illustrate the cost of these initiatives much more clearly, and in the process demonstrate that there are less expensive routes to achieve similar public policy goals.

In a perfect world, publication of what is at its core a listing of financial commitments to energy activities by public banking institutions should not be an item of particular note.  For the most part, the shareholders of these banks are Western nations with a tradition of accountable public institutions and democratically-elected governments.  It would seem only natural that the credit supports (including direct loans, loan guarantees, and various export insurance products) extended by these banks would be easily accessible; and that such information would include which firms got on the taxpayer's credit line, how much they got at what terms, and how diligently they've been keeping up on payments.  Given the scale of commitments (the face value of credit supports provided to the energy sector alone by the nine institutions covered in Oil Change's Shift the Subsidies database were nearly $103 billion between 2008 and 2011), the expectation of full transparency does indeed seem a reasonable one.

Alas, the world is far from perfect.  And against the imperfect backdrop of highly fragmented and not very precise information on credit supports, the work done by Steve Kretzmann and his team is a big step forward.  It's not a new issue for Kretzmann.  He and I have had discussions on this topic going back a good six or eight years; and even back then he'd been pondering the issue for awhile. 

What is great about his current presentation of the topic is the ease with which detailed listings of commitments can be accessed, and the very creative ways in which important distinctions are graphically displayed.  It is always tough to distill core messages from a large set of data, and I think they've done a nice job.  They use color, of course -- "green" projects are, well, green.  Relative magnitudes are enhanced using symbol tags and larger circles to show who gets the biggest pot of credit.  The sorting capabilities (by fuel, geography, time) and drill-downs to information on the specific project are extremely good.  I also appreciate their decision to include resources like biomass, incineration, and large scale hydro into an "other" energy category rather than pretending that these resources are inherently clean power sources.

Overall, this is a solid platform that I hope they will be able to expand and extend in the following ways:

• More lending institutions.  The multi-lateral banks are not the only big players in the world of subsidized credit.  In fact, export support agencies in major nations are often far less transparent, while also more likely to use sovereign credit to prop up their own national champions.  A combination of lower visibility and larger pressure from entrenched domestic interests also suggest that the national banks will do less to align lending with social or environmental goals.  For all of these reasons, it is extremely important to get the key export credit agencies added to the mix here -- with at least a core group of France, China, the US, Japan, and Russia to start.
• Cleaner definition of "subsidy".  The current database measures subsidies as gross credit supports.  Gross patterns of support are important, as they indicate the most likely winners and losers from the banks' activities, and highlight what I refer to as selection bias in the lending institutions with respect to what forms of energy do and don't get funded.  Over time, this selection bias can greatly alter the energy path of particular countries (particularly those where nearly all of the energy infrastructure has relied to some degree on the international credit support), and even on the direction of research and innovation. 
  
  That said, the actual subsidy associated with any specific loan is not its face value, but the difference between the terms offered by the credit agency and what that borrower could get on the open market.  I call this intermediation value, because the lending institution is using its own borrowing capacity and risk profile to intermediate in capital markets on behalf of a weaker borrower (in the unlikely scenario that a borrower had stronger credit than these institutions, it would self-select out of the program).  The financial benefits of intermediation come through two main venues:  lower costs of debt because the bank becomes a guarantor of the loan; and the ability of the borrower to fund a project with much more debt than would be permitted in a market transaction.   Using more debt cuts borrowing costs because equity financing is generally more expensive (sometimes very much so) than debt financing.  You can read additional background here.

The newer and higher risk the technology being financed, the poorer or more politically unstable the country a project is going into, and the larger the capital going into a specific deal, the higher the intermediation value of these credit programs are likely to be.  While getting the value exactly right can be hard, we can clearly do better than just reporting the face value of the commitment.  Quite helpful in taking that step would be a much higher degree of transparency by the banks in terms of credit terms and loan-specific performance. 

• More shades of green.  I'd like to see more precise judgments made on projects in the biomass or large scale hydro space, as some of them may deserve to be put in a "dirty" energy category if their environmental impacts are particularly large.  Unfortunately, this could also be the case for some of the centralized solar technologies (due to their use of water) if they are located in arid regions.  Particularly for projects that can results in large scale land conversion, the fuel source matters less than the ancillary impacts of the project on ecosystems.