Sustainability in the Time of Austerity (by Jason Mitchell)

Austerity commands an increasingly prominent role among governments struggling to abide by the terms of rescue packages, as well as those under pressure to arrest spiralling deficits and debt-to-GDP ratios. And while earlier, near-punitive bail-out conditionality terms applied to cases like Ireland are now less severe, the political reverberations are visible across Europe, from French labour demonstrations to Greek and Spanish riots. Even the IMF, in its recent World Economic Outlook, acknowledged its own overestimation of fiscal multiplier effects and the broader constraints of austerity in current economic conditions.

In the economic boom leading up to 2008, investment in sustainable areas, such as renewable energy, is commonly viewed as a logical eventuality. Many of these areas, however, are proving vulnerable to economic shocks. In August, for instance, the UN called on the US to suspend its US corn-based ethanol mandate that has amplified grain price inflation through this year’s drought. Europe, in contrast, has reinforced ambitious policy goals at the national and EU levels through environmental norms.

These policies have laid out a low-carbon economy by 2020 through the establishment of carbon markets, emissions reductions targets, energy efficiency objectives and greater renewable power generation. However, these sustainable plans now bear some responsibility for producing their own economic rigidities that compromise national efforts to restore fiscal balance and competitiveness.

Labour, healthcare and pension costs have traditionally represented economic rigidities, and the counterweights of an unfortunate trade-off in the calculus of austerity. Europe bears widespread evidence of this, most recently in the protest refrain by the Spanish Worker’s Syndicate of Andalusia: “No! No! We do not want to pay off debt with healthcare and education.” The face-off between austerity’s sober pragmatism and sustainability’s Panglossian outlook has produced an ironic reversal. Choices in some ‘sustainable’ investments are producing unintended consequences now proving unsustainable in the context of weaker economic growth.

By itself, austerity represents a superficially straightforward exercise where costs – typified by IMF adjustment prescriptions like privatisation, liberalisation, tax reform and a recalibration of entitlements – fall back in line with prices. Yet, its political economy implications pose far greater complexities in sustainable investment areas like renewable energy.

The policy regimes that support renewable energy are largely premised on artificial pricing incentives. Build out generation capacity too aggressively as Spain did, and the government subsidies underpinning guaranteed rates of return produce asymmetric costs which have to be borne elsewhere in the economy. So while rebalancing efforts have already achieved shallow reversals in current account deficits for some EU countries, the issues of where and how to apportion these economic asymmetries is far from over.

Power to the People? 

In Europe, the conflation of political agendas and environmental ambitions has provoked heavy promotion in renewable energy installation over the last ten years. But many of these ambitions on a country level have not withstood the effects of recession. In solar, for example, we estimate nearly 16 unplanned negative revisions to solar subsidies since 2011 across Europe. In light of weaker economic conditions, the constraints under austerity, or poorly regulated renewable energy growth, governments are understandably more sensitive to rigidities and imbalances.

Not surprisingly, energy reform in Southern Europe represents one of the front lines where austerity measures and sustainable investment compete for primacy. Spain, Portugal and Italy are all dealing not just with the costs of a renewable hangover but how to integrate these new costs into structural adjustment programs that have already sparked political backlash.

For Spain, the nearly year-long energy reform process inherited by Mariano Rajoy, the Spanish Prime Minister, has cut through two administrations in order to reconcile industrial and political interests. At the root of the dispute is more than a EUR 5bn annual tariff deficit totalling roughly EUR 24bn. The tariff deficit represents two conflicting sides of Spanish policy: the economic demands of austerity at present, and its earlier ambitions to emerge as a leading alternative energy producer.

With one of the highest amounts of peak sunlight in Europe, Spain aggressively developed renewable energy from 2004, introducing an incentive-heavy feed-in tariff scheme to encourage initial capacity building. While Spain has eliminated incentives beginning in 2013, the issue of protecting guarantees to private investors and a powerful coalition of utilities interests remains. In addition, attempts at a comprehensive energy reform now resemble a tax reform with maldistributive repercussions.

Under the current proposed energy reform, Spanish consumers could still be hit by another 8% price increase, following a 7% electricity rate increase earlier this year. The government has offered to assume roughly half of the annual deficit, but this gesture simply internalises the tariff problem. It also compounds the government’s indebtedness rather than solving it more sustainably. As clearly illustrated in the following charts, Spain’s sustainable energy regime has already pushed energy inflation for both domestic consumers and industrial users above the level of other continental European countries even before this year’s increase.





Moreover, the risks of successive price increases in order to offset artificially pricing mechanisms are obvious: higher price-cost asymmetries disrupt the production function, detracting from external competitiveness through higher energy input costs. They amplify declines in domestic consumption, contributing to a paradox of thrift scenario. And, more broadly, they exacerbate an economic situation where unemployment runs at 25% (1), and consumer price inflation in October has accelerated to 3.5% (2), reflecting VAT increases, higher energy costs and volatile commodity prices. Spanish trade groups representing a 2.5 million labour base have been quick to protest against the implications on competitiveness (3). It’s likely the adjustment cost under any proposed energy reform will be simply passed through to end consumers, or translate into higher energy prices for industrial manufacturers. Alcoa, Arcelor Mittal and Asturiana de Zinc (4) have already warned that further hikes in energy prices undermine their competitiveness. Beyond discriminatory taxation, higher energy prices could ultimately lead to plant closures and a destabilisation of the Spanish electricity system.

In some cases, sustainable investment agendas are increasingly compromising EU legal framework. Both Spain and Italy have renegotiated retroactive energy incentives applied largely on an ad hoc basis. Changes in Spain under the Royal Decree have provoked lengthy lawsuits by private investors in solar energy, contesting that unilaterally renegotiated lower rates of return – even in times of austerity – contradict European Directives. Since 2011 the Italian regulatory regime has also had to re-architect its renewable energy mandate around a more pragmatic growth model, using reforms that have included a one-off Robin Hood tax to retrospectively moderate returns under the green certificate scheme in renewable energy.

Even Germany, unencumbered by an austerity program, now recognises the risk of a popular backlash to the compounded effect of its renewable energy surcharge. By Macquarie Securities’ estimates, Germany’s annual overall surcharge could grow to almost EUR 20 billion by 2011, inflating the average German household electricity bill by another EUR 58 in 2013 or 20% of the overall annual bill. 

Pragmatism Balanced by Opportunities 

The manner in which the pressures of austerity and the inherent rigidities in parts of ‘sustainable’ investment are reconciled in coming years will offer critical insight into shaping a more balanced approach to capacity building in areas like renewable energy. It may also provide clues for deficit-constrained countries on how to sustainably finance other infrastructure in public goods like waste, water and transportation using capital markets. Madrid, for example, is exploring options under a 50-year program to privatise its public water utility to cover network capital costs. In Germany, municipalities have privatised or partially privatised loss producing public hospitals to operators who, under a regulated returns regime, reinvest in a higher doctor count and new medical equipment.

From a financial markets perspective, greater emphasis on the sustainability of funding commitments as opposed to one narrowly set by environmental ambitions encourages more long-term private sector participation in helping to solve the public goods reinvestment problem. It may also help to redefine the relevance of sustainability across complete economic and business cycles, rather than just revisiting the concept in the good times.

Footnotes:
1. Unemployment rate (25.02%) as of Sept 30, 2012 as published by the National Statistics Institute (Spain), October 26, 2012.
2. Consumer price inflation of 3.5% for October as published by the National Statistics Institute (Spain), October 30, 2012.
3. Expansion, Oct. 4, 2012. “Rebellion of industrial electricity reform against government.” http://www.expansion.com/2012/10/04/empresas/energia/1349305410.htm
4. Stock names are mentioned for illustrative purposes only and this does not constitute advice to buy or sell any of the stocks referred to. 

Please note that opinions expressed are those of the authors and this material is for information purposes only.


THANKS

We thank Jason Mitchell and GLG Partners LP (a 
member of Man Group plc) for allowing us to publish this crucial article.

We look forward to the comments of our readers. 

BIOGRAPHY


Jason Mitchell is a fund manager at GLG Partners. He co-manages GLG’s Global Equity Fund, and also oversees the firm’s long-only and alternative sustainability investment strategies.

Jason has also acted as Advisor to the UK government’s Commonwealth Business Council and the African Development Corp., presenting energy and water financing structures across Sub-Saharan Africa to government ministries and multilateral agencies.

Jason has an MSc from the London School of Economics and a BA from the University of California, Berkeley. His articles and comments have most recently appeared in Aftenposten (Norway), Global Times (China), Institutional Investor, Responsible Investor, Wall Street Journal, Bloomberg, Hedge Fund Journal and CBNC’s Squawk Box.

He was selected as one of Institutional Investor’s 2011 Rising Stars and for a Fellowship for the British-American Project.