Meltdown! Charting the effects of the financial crisis

Adam Stein | September 23, 2008

It takes more than wind to make turbines spin.

In the wake of the financial meltdown, some have wondered about about the broader implications of the disappearance of Lehman Brothers’ carbon trading desk. And the answer to that question, at least, is easy: there are no broader implications to the disappearance of Lehman Brothers’ carbon trading desk.

This is true for a variety of reasons, not least among them that Lehman Brothers was a small player in the carbon markets. The center of gravity in the carbon-trading world is in Europe. Beyond that, the carbon market itself is just one corner of the energy finance universe. So Lehman is a corner of a corner, and anyway the disappearance of a single trading desk is nothing really to fret over.

A trickier question is what affect the broader issues in the financial markets have for the development of clean energy. And, well, it’s hard to say, as all sorts of countervailing forces are at work.

It helps to step back briefly and consider what is actually going on in the economy. The Freakonomics blog recently offered up one of the most lucid discussions of the ongoing financial crisis. I recommend the whole thing, but in a nutshell:

Financial institutions borrow money all the time to fund their investments. When the real estate bubble burst, a lot of those investments lost value rapidly, leaving banks such as Bear Stearns and Lehman Brothers unable to borrow new money and unable to repay their existing debt. This situation can lead to a domino effect — “contagious failures” — in which borrowers are unable to repay lenders, who are then themselves sucked into the financial crisis.

The issue isn’t that all these financial institutions are suddenly worthless. By all accounts, most of AIG’s business is quite healthy, and the government will turn a healthy profit on the bailout. Rather, the institutions fail because they don’t have enough cash to cover their near-term debts, in much the same way that you can starve to death in your $3 million house if you don’t have money to buy bread. So the federal government steps in, effectively guaranteeing that these companies will be able to repay their loans. But even if the intervention works to stave off the contagion, very few institutions want to loan out more money in this environment.

This is a big problem for anyone who needs a loan to finance an investment or business activity. Guess who needs loans? Clean energy developers. Windmills ain’t cheap.

Looking broadly, I see at least five broad economic trends affecting the clean energy market over the next few years.

The credit crunch. Banks are having a hard time of it right now. This is an unequivocally bad thing for the clean energy sector. Clean energy projects typically entail massive up-front capital outlays, followed by relatively low ongoing costs. Banks provide the money for those up-front expenditures in the form of loans.

Except that right now, banks have retreated into their pillow forts. One analyst projects that, by 2020, the clean energy sector in Europe will require about 85 billion euros per year in financing to meet EU goals. Given the current pace of lending, debt finance will fall about 21 billion euros short. I’d put very low confidence in these specific numbers, but they are illustrative of the problem faced by energy developers who need cash to turn blueprints into megawatts. A secondary likely effect of the credit crunch is consolidation in the clean energy industry, as financially healthy energy developers (especially in Europe) snap up sound-but-cash-strapped counterparts.
Fossil fuel prices. To simplify: dirty energy competes with clean energy. High fossil fuel prices make clean energy projects look more attractive.

There are people paid much more money than to me predict the direction of fossil fuel prices, and I won’t pretend to have any special insight here. Based on my own analysis, which involves drawing a supply and demand curve on piece of graph paper with a crayon, I predict that fossil fuel prices will continue to gradually rise for years to come, while also exhibiting high volatility. The underlying upward trend in fossil fuel prices will be positive for clean energy development, but the volatility will blunt some of the benefit by injecting a high degree of uncertainty into the market.
Supply chain constraints. Whatever the state of the present economy, clean energy has been booming for several years now. One inevitable consequence of the growth is that manufacturers are having a hard time keeping up with demand for basic infrastructure, such as wind turbines. This situation should eventually right itself, but it will remain a brake on growth in the near term.
Global carbon policy. In fits and starts, governments worldwide are putting a price on carbon. And though the shortcomings of these early attempts have been well noted, in aggregate policymakers are stumbling in the right direction. These efforts are helpful, even if they aren’t anywhere near enough.
The economy. Although it is very difficult to make predictions about the direction of the economy, it appears likely the current downturn will continue for some time. Which is bad for the climate, mainly because of the way that a weak economy interacts with the other items on the list.

For example, slow growth saps the political will for dramatic action on climate change. Some legislative efforts, such as California’s AB32, are probably too far along to be at major risk for derailment. RGGI in the northeast is also pretty far along, but not so far along that New York Governor David Paterson wouldn’t consider bolting from the agreement. And, of course, federal legislation continues to lurch zombie-like around the halls of congress. The next president will have to expend a lot of political capital to pass a national carbon cap even under the best of circumstances. These are not the best of circumstances.

So the scorecard on macro trends in the clean energy sector reads: credit crunch, very bad; high fossil fuel prices, very good; supply chain constraints, bad but self-righting; global carbon policy, nascent but directionally correct; overall economic malaise, generally dampening.

Anything to add to this list?

< Previous: The financial sector and the “real economy” Next: More iron than carbon >

Comments

1. By Tom Harrison on September 20, 2008 12:32 PM

This is a good analysis, Adam.

I would have to say that the financial crisis is pretty much bad for pretty much everyone. In addition to the points you make, this issue distracts national attention from energy and climate issues -- it's a crisis that is certainly much more immediate, and most likely one that will affect us for a while.

Easing oil prices and concomitant easing of gasoline and heating oil have made an issue that was at the forefront of our minds just a few months ago a quickly fading memory. And this issue was driving the political debate. The financial crisis will deliver a coup-de-grace for the remains of that discussion. Sigh.

One question: does the financial meltdown affect the outcome of the Presidential election? It seems to me that our government policies are the most important single thing that can affect momentum now.

The candidates have certainly differentiated their positions on alternative energy. Whether this is just political pandering will be seen later, but based on what they say, "Drill, baby, drill" isn't getting my vote.

Tom

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2. By Adam Stein on September 20, 2008 2:31 PM

Yes, the crisis is bad news all around. It's difficult to comprehend the scope of either the problem or the proposed solution. In purely political terms, I have to imagine this hurts Republicans more than it does Democrats. This has little to do with the candidates' positions on the issues, and more to do with the fact that a) voters tend to trust Democrats more on pocketbook issues and b) the incumbent party is more likely to be punished during an economic crisis. (I understand that Democrats now have a narrow majority in Congress, but I don't think anyone blames the current problems on the 110th Congress. These issues have been years in the making.)

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3. By Remi on September 21, 2008 10:15 PM

Lehman owned a subprime lender called BNC Mortgage and closed it down in August 2007 following the infamous crisis. This led to about $25 million charge and $27 million reduction in goodwill. The crisis spilled over to 2008 and Lehman’s losses started to mount. Though it closed BNC Mortgage, it held on to large positions in lower rated mortgage tranches when securitizing the underlying mortgages. It probably did so hoping for a reversal in the market. It is also possible that it couldn’t sell the lower rated bonds.

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4. By Phoenix Woman on September 24, 2008 5:37 AM

Here's a slightly different take on the heist, erm, bailout. (By the way: Bush may be itching to further trash our dollar by loading even more debt onto it -- even the mere prospect of a $700 billion body-blow sent oil, and thus inflationary pressures, soaring -- but the rest of the world isn't exactly leaping to follow his example. Canada's Stephen Harper has already ruled it out.)

Do remember that Hank Paulson's an investment banker himself -- he takes care of his own first, last and always. Also, the crash could have been predicted by anyone who witnessed Phil "Americans are whiners" Gramm's successful efforts to kill Glass-Steagall in 1999. Gramm is the guy who McCain wants for either Paulson's or Bernanke's jobs. What was that again about Republicans being good with money?

Former Treasury Secretary Robert Reich has looked at the proposed heist of $700 billion -- which by the way is more money than what we've spent in Iraq in nearly six years of war and occupation -- and is but one of a growing number of experts crying foul on this deal.

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5. By Phoenix Woman on September 24, 2008 5:57 AM

David Cay Johnston, financial writer for the NYT, is telling his fellow reporters to start doing their jobs and to stop swallowing Paulson's tales uncritically:

http://poynter.org/forum/view_post.asp?id=13611

Ask this question -- are the credit markets really about to seize up?
If they are then lots of business owners should be eager to tell how their bank is calling their 90-day revolving loans, rejecting new loans and demanding more cash on deposit. I called businessmen I know yesterday and not one of them reported such problems. Indeed, Citibank offered yesterday to lend me tens of thousands of dollars on my signature at 2.99 percent, well below the nearly 5 percent inflation rate. That offer came after I said no last week to a 4.99 percent loan.

If the problem is toxic mortgages then how come they are still being offered all over the Internet? On the main page AOL generates for me there is an ad for a 1.9% loan (which means you pay that interest rate and the rest of the interest is added to your balance due.) Why oh why or why would taxpayers be bailing out banks that are continuing to sell these toxic loans?

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6. By Adam Stein on September 24, 2008 7:11 AM

I thought that David Cay Johnston article was interesting, but it was also fairly well demolished by Felix Salmon and Ryan Avent.

There's plenty of justified skepticism over whether the currently proposed bailout plan is the right one. There doesn't seem to be as much skepticism over the question of whether the goverment ought to do something to stanch the flow.

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7. By Ken Bagstad on September 24, 2008 10:51 AM

While the credit crunch obviously has tough implications for renewable energy financing, and may be causing real economic pain, let's not blindly back ourselves into a "grow baby grow" mentality regarding the economy. As Joseph Canadell recently pointed out (http://www.pnas.org/content/104/47/18866.abstract), faster than expected growth is among the factors putting us in worse shape than ever with respect to global carbon emissions. Growth is also certainly wiping out gains in carbon intensity being made in countries like the U.S. Until we get global CO2 emissions limits in place, even growth in renewables won't solve the problem, as we continue to see fossil fuel use expand. Climate change offers some of the best evidence yet that the size of the economy needs to respect environmental limits.

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8. By Tom Harrison on September 24, 2008 5:10 PM

Ken Bagstad --

I think you hit the nail on the head with your comment. As a student of economics in college, and having been in start-up businesses in the following almost 25 years, I have heard over and over the mantra that growth is the secret to success. If you're not growing, you're dead, the saying goes. Perhaps recent events suggest an alternative (or at least a rebuttal)?

As one of the founders of an "inappropriately successful" start-up during the Internet boom I can assure you that growth was everything -- profit, fundamental value, and anything that resembled what passed for management quality in the past was thrown out, and our company, which had been in business for 18 months was sold for an outlandish sum (hint: a little less than 1 billion dollars) to a buyer who had bought into the whole foolishness. Our gain -- their stockholders loss, as it turned out (sadly, we were bought in stock, not cash).

And in 2002 everything crashed. As it turned out, miracles don't happen.

Then time passes. Despite a war, which taps into our national resources, our President implores us to spend (not, for example, to plant Victory Gardens).

And spend we did, creating more, and more growth. And of course, that was all leveraged. The over-extended credit of mortgage borrowers and credit card borrowers seems to have been used to create more leveraged instruments used by our (trusted?) financial institutions to put themselves into precarious debt, too. Spend, spend, spend.

No Victory Gardens producing. Just spending for the sake of "grow, baby, grow". No unified plan for the country -- let the free market handle it. Oh, how I have fallen -- 20+ years ago I graduated as a disciple of trickle down, supply-side and Uncle Milty Friedman. Nowadays, my views are different.

(And, to be fair to Milton Friedman, his economic views respected external costs, such as pollution, or perhaps CO2 or other greenhouse gasses, that were not captured in the economic price models. But even Friedman, considered radical right to this day, has been ignored).

Perhaps we can use this latest crisis, years in the making (and ignored for as many, just as the previous one, terrorism, was) to wake up finally and take ownership of what is real, versus the fantasies our leaders (of both parties) have been spoon-feeding us for many, many years.

Learn, baby, learn!

Tom

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9. By Kent on September 24, 2008 8:06 PM

It's a very good article.

At the risk of dumbing things down. All the truths of the article not withstanding, we simply cannot fail in the mission.

As for the reference to Milton Friedman, for anyone who has even the slightest warm feelings about anything that he and The Chicago Boys have ever done Namoi Klein's "The Shock Doctrine" will cure you forever.

Kent

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10. By Jon on September 25, 2008 11:44 AM

Just glancing at the comments already made, and there are some good ones, I haven't seen mentioned the simple fact that a bad economy will drive down consumption in the short term, which is a good thing for the environment because it means we're spending less money producing trinkets that get thrown away. It's not the best way to cut greenhouse gas emissions, but if it could bring about a change in consumer habits towards conserve, reuse, and repair rather than gorge, throw away, and replace, that could be a good thing.

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11. By megacleve on September 25, 2008 11:50 AM

I want to commend on a very insightful article (for me), and I am frequently impressed that you are very well read, but my highest praise is for the quality of your writing: "And, of course, federal legislation continues to lurch zombie-like around the halls of congress." That image will definitely keep me laughing all day.

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12. By Adam Stein on September 25, 2008 11:59 AM

@10 -- Jon, I actually get into that topic a bit at the end of this post. Basically, a recession might reduce consumption a bit, but it doesn't really offer any lasting environmental benefits.

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13. By AD on September 26, 2008 11:39 PM

I would like to suggest that every dollar spent causes carbon burning and every dollar earned came from some carbon burning. A businessman who wants a bigger house needs to run after many more customers each day. Being modest & steady life with some little surplus is the best way to live. Growth could cool down just a bit but it would allow us to live better family life - corporates would generate less wasteful rat races and we could just be happy.

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Meltdown! Charting the effects of the financial crisis

It takes more than wind to make turbines spin.

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