Peter Neilson, CEO, NZBCSD

1
Out of the recession into the clean economy
Peter Neilson, CEO, NZBCSD Waikato Lecture Series
2009 - University of Waikato 30 September 2009
2
The Global Financial Crisis (GFC)
Having survived the Global Financial Crisis, I
consider it important that we all learn from the
lessons of what happened so we might avoid it
happening again. Twenty years ago, I was
Associate Minister of Finance and had the honour
to supervise the preparatory work for the Reserve
Bank of New Zealand Act introducing inflation
targeting and a more independent central bank,
first for Roger Douglas and later, for David
Caygill when he also became the Minister of
Finance. As I also had day to day responsibility
for monetary policy, I had a ringside seat when
the then DFC and BNZ faced difficulties back in
the late 1980s and 1990. As events unfolded last
year, I had some sympathy for those facing the
recent crisis. It seems that although, as
humans, we have the capacity to learn, each
generation seems to need to be reminded that
3
The Global Financial Crisis (GFC) (cont)

• Extended periods of loose money and cheap credit
  eventually create higher inflation and asset
  price bubbles
• If you allow financial institutions to come to
  believe they are too big to fail, the cost to the
  taxpayer of averting systemic collapse will be
  massive and
• If businesses can privatise their profits and
  socialise their losses by passing them on to the
  taxpayer and thereby avoid bankruptcy, then there
  will be no shortage of people prepared to take
  one-sided bets and make very risky investments.

4
Soft Monetary Policy
What happened during the 1990s was that a number
of major economies adopted inflation targeting,
variations on the New Zealand innovation, and
inflation eased down steadily during that decade
of continuous growth, the longest period without
recession in US history, the so-called Great
Moderation. Confidence grew that if monetary
policy could effectively be used to lower
inflation, it probably could also help avert or
reverse a recession. When the tech stock
recession occurred in 2001, the US Federal
Reserve, their equivalent of our Reserve Bank,
cut interest rates from 6.5 down to 1, and they
were then held low until 2004 and did not return
to more normal levels until midway through 2006.
5
This was despite inflation expectations having
risen to more normal levels following the end of
the recession from the beginning of 2003. The
build up of liquidity and excessively low
interest rates helped fund a boom in the US
housing market which has now seen a dramatic
collapse of house prices and an increase in
foreclosures as households struggle with negative
equity (their mortgage being greater than the
market value of their home) after, in some cases,
having lost their jobs to pay for the interest
bills and repayments. The problem was bigger
because of the increased take up of the originate
and distribute business model for banks. Banks
and other institutions sold mortgages to home
buyers, and then bundled them into Structured
Investment Vehicles, which were on-sold to other
institutions as tradeable securities.
Unfortunately rubbish in a fancy new box is still
trash. The people selling the mortgages were on
a mainly commission-based earnings package, based
on the value of mortgages they sold, not the
quality of the risk. The interest rate on the
loans did not realistically cover the risk of
default. This was combined with poor risk
monitoring and Government encouragement to
finance people who had little prospect of making
repayments.
6
Milton Friedman once famously said that
Inflation is always and everywhere a monetary
phenomena. Once the dust has settled, central
bankers dont feel a need to defend their recent
performance, and a sober analysis has been
undertaken, and. I suspect the new version will
be asset bubbles are always and everywhere a
monetary phenomena.
7
Too big to fail
After the bail out of the hedge fund Long Term
Capital Management in 1998, and Beer Stearns in
March 2008, it was often assumed that you could
be too big to fail. This helps explain the
surprise of some when Lehmans was allowed to
collapse in 2008. After the Lehman collapse, the
US sharemarket dropped by 500 points in one day,
and soon afterwards the American International
Group (AIG) had to be bailed out with an USD85
billion loan. Suddenly everyone in the financial
markets was asking who would be next, and stopped
extending credit to each other or even offering
to complete some transactions. AIG was a major
player in the credit-default swaps market.
Suddenly any holder of credit default swap
insurance was worried whether its guarantor was
sound. As financial businesses stopped lending
and began hoarding cash, Central banks, backed by
the Government balance sheet, were forced to
fulfil their traditional role of lender of last
resort. In the US this involved the Secretary of
the Treasury purchasing preferred shares from
major financial institutions and injecting up to
USD25 billion into individual banks that, until
the Lehman collapse, considered themselves sound
and profitable.
8
Heads I win, Tails I win The one sided bet and
under-priced risk
Imagine you had a very rich uncle who said here
is 20,000. If you use it at the casino, you can
keep your winnings, but if you lose I will keep
topping you up for the 20,000 you would not be
surprised if you both bet more money and took
bigger risks. By the 2000s there were many new
bets available in more places

• bets that the sharemarket would go up or down and
  for sharemarkets across the globe
• bets on commodities, currencies, or the default
  rate on a bundle of securitised mortgages.

Frequently the issuers had better information
than the lenders which helped the mispricing of
securities.
9
Securitisation was conceived as a useful way to
help diversify risk. Most of us cant afford to
lose 1 million, but many of us can afford to
lose 1,000 cutting up a big risk into small
parcels can help make us all richer provided that
risk is widely spread. But often, the

• risks were not understood by holders and were
  under-priced by issuers and
• credit agencies systematically underestimated the
  actual risks, particularly for housing backed
  securities in the US (credit ratings are paid for
  by the issuers, not the lenders, so credit
  agencies that are seen as too tough on the issuer
  may not be used next time). Credit ratings were
  prepared using spreadsheets of data provided by
  issuers not by examining the loans or mortgages,
  or a sample of them.

10
The efficient markets hypothesis was used to
build valuation models based on relative value
but which failed to provide useful information on
whether the absolute values were valid. The
models were helpful in telling you to buy shares
or bonds on a relative value basis, but gave
little useful information when shares and bonds,
and property were all over-valued because of the
sustained soft monetary conditions. Most economic
modelling assumed financial markets were the most
efficient of all markets, and were likely to be
self-correcting. Imagine the panic when the tool
you have used for 20 years appears disconnected
with market reality. If everyones model is
telling them to sell and they do, prices drop
even faster. During the 1990s and 2000s, major
financial institutions increasingly became
proprietary traders in other words, they
invested on their own behalf rather than acting
as intermediaries between investors and
borrowers, and therefore had much greater
exposure from making one bad call.
11
The incentive to do this was expanded when
traders were given bonuses for their profitable
decisions, but the risk of the bad calls was
effectively owned by their shareholders and the
taxpayer. If the organisation was a bank, in most
countries the retail depositors were protected by
Government-backed insurance, so they did not have
to worry about a run on the bank as worried
investors might withdraw their savings. Some of
these institutions also thought they were too big
or important to be allowed to fail. Many
homeowners and investors felt they could have
such a one sided bet by investing in real estate
through buying a second or third home to rent
out. The costs of investing in a second home
were deductible and the expected capital gain was
tax free.
12
Why did New Zealand initially not suffer as much
from the GFC as some other countries?

• The financial sector in New Zealand is a much
  smaller part of the overall economy than it is in
  the US or UK
• We started our recession slightly earlier and
  well before the GFC began
• A number of finance companies did get into
  trouble after borrowing short and lending long,
  but our banks were much better placed to survive
• Our major banks did not embrace the originate
  and distribute business model they look as
  though they

• were more careful about checking what they lent
  on
• had kept the mortgages on their own balance
  sheet
• were not covered by deposit insurance, so did
  have to worry about a possible run on their
  retail deposits if they were considered too risky
  so probably managed their overall risks better.

13

• Initially the currency dropped back when the OCR
  was cut rapidly, giving hope of a quick export
  lead recovery from the recession.
• Allan Bollard, as Governor of the Reserve Bank,
  had put more resources into prudential
  supervision and had tried to lean against the
  house price bubble by increasing the OCR ahead of
  most other central banks.
• Unfortunately this was effectively undermined by
  banks being able to borrow internationally at
  lower interest rates and with exchange rate
  insurance through hedging.

14
Some Tentative Personal Conclusions Regarding
Inflation Targeting

• Just as it was not feasible for a small open
  economy like New Zealand to run a fiscal policy
  in opposition to what was happening in the rest
  of the world, inflation targeting probably is not
  a feasible policy in New Zealand, or any other
  small open economy, as it cant be run in
  isolation from what is happening elsewhere
  without excessive volatility in its currency.
  Inflation targeting can work, but only in concert
  with what other major economies are doing.
• When New Zealand tightened monetary policy in
  advance of other countries (and pushing up our
  currency) visitors from the IMF and the OECD
  asked us why our real interest rates were too
  high when what they should have been asking is
  why most countries had theirs were so low because
  risk was being under-priced and monetary policy
  was too soft.
• We are only tentatively leaving the recession,
  but already house prices are accelerating when
  clearly house prices are still well above what
  long term trends in incomes and nominal GDP would
  suggest are sustainable.

15

• The September Monetary Policy Statement on p.3
  states what is more, consumers are already very
  indebted, with household credit at almost 160 of
  disposable income. Given this, we continue to
  believe that house prices will prove
  short-lived. I hope they are right.
• We have kept our cash rate above the level for
  many other countries also concerned about
  financial stability and as a consequence, the New
  Zealand currency may remain so high it will abort
  any export lead recovery.
• As the economy gathers strength, we will need to
  increase interest rates just as fast as we
  dropped them last year, or we will begin building
  pressure for a surge in inflation down the track.
  The need to do this in the run up to the next
  election reminds us of the benefits of having a
  system where, while the Government of the day
  sets the inflation target, the Governor can act
  independently to raise or lower interest rates as
  necessary to stay within the contracted inflation
  band.

16
What now?

• Cause Generally, risk was under-priced.
  Relative value models break down when risk is
  under-priced and all financial assets are
  over-priced risks are no longer offsetting but
  are correlated. This is compounded when assets
  are sold because they have lost value. When
  large numbers of investors unload the same
  assets, the prices drop further and more
  investors unload. In these circumstances, it may
  take a huge price drop before the floor is found.
• Weve averted the freefall through using major
  economic stimulus packages, by increasing
  liquidity, cutting interest rates to very low
  levels, and increasing Government spending and
  cutting taxes, both here and abroad.
• A question remains in New Zealand, will we have
  an anaemic recovery, like the Japanese, one which
  took 10 years because asset prices were kept too
  high, propped up by soft monetary policy and were
  slow to adjust?
• In New Zealand, there are issues with exchange
  rates, Government borrowing, over-leveraged
  housing, in some cases high farm debt levels, and
  still rising unemployment.

17
Recovery time fundamental changes

• If this were a normal New Zealand recession and
  only one or two of the US, EU or China were in
  recession our downturn would be mild and wed
  be looking to a strong export pick up within the
  next 6 to 12 months
• Unfortunately our currency may now be too high to
  sustain an export-led recovery.

18
Out of the recession into a clean economy
The economic recovery is running parallel with
emerging environmental issues

• Climate change
• Energy, water and other resource issues
• Just as the financial markets were not
  self-correcting and risk under-priced, in the
  environmental sphere we have not been charging or
  managing the risks (and opportunities), and do
  not fully understand our capacity to reach the
  natural limits of our planet.

19
Out of the recession into the clean economy

• Because people dont pay for many environmental
  services, we are encouraged to push up against
  its limits.
• We need to make sure the recovery is based on
  real green shoots.

20
Out of the recession into the clean economy
In the 1980s we were subsidising so many of
things we were exporting it was hard to tell the
difference between growth than was positive and
growth that was making us poorer. Dairy output
has quintupled since the end of subsidies,
positioning New Zealand to take advantage of a
global boom in demand for dairy products, driven
from China and India. There were costs of
adjustment 1 of farms went bust, but not the 10
that was predicted.
21
Out of the recession into the clean economy
We now need to take care we are not left behind
because of our reluctance to embrace user-pays
for the environment

• NZ plans to excuse agriculture from full
  emissions pricing until 2015
• The USA plans, in the Waxman-Markey Bill passed
  by the House of Representatives and now before
  the Senate, to offer farmers free tradable
  credits for emissions reductions from when it
  passes
• NZ plans to offer Australasian industry average
  intensity production no emissions price (or
  emissions cap or cut) on each extra unit of
  production provided its carbon use is at or below
  the Australasian industry average. We know the
  New Zealand dairy industry already has the
  worlds lowest emission intensity for its
  delivered product. Pasture fed cows are much
  more emission efficient than cows fed from grain
• The EU plans to make all non-ETS sectors,
  including agriculture, reduce emissions by 10
  combined by 2020. An EU country like Ireland
  with 25 of its emissions from agriculture has
  looked at a tax on cows to help meet that 10
  reduction target

22
Out of the recession into the clean economy

• We now need to take care we are not left behind
• NZ plans to take 90 years to phase out emissions
  subsidies to large emitters, including
  agriculture
• NZ plans to have effectively a 12.50 per tonne
  carbon tax for the first 3 years up until 2013
  when the market price of carbon is above 25 a
  tonne
• By 2015, we will have an all sectors, all gases
  ETS, but with almost no impact on heavy emitting
  industries who may face competition from
  producers that are yet face a price on carbon
• The several billion which could be raised from
  the sale of emission credits to large emitters
  making emissions in excess of their subsidised
  levels will not now be available to reinvest in
  clean economic development
• There is a large opportunity cost to not quickly
  advancing a range of measures to complement the
  ETS to lower emissions and drive long-term
  export competitiveness.

23
Out of the recession into the clean economy
We now need to take care we are not left behind
Lower targets could be more costly higher
targets beneficial. There is new research
(Climate Group/ Cambridge University) suggesting
that a global collaborative commitment to
reducing emissions by 30 could actually

• Increase GDP by 0.8 by 2020
• Create 10 million more jobs worldwide by 2020
  and
• Reduce the carbon price to from a USD65 per
  tonne to 4 per tonne.
• All this while lowering emissions 30 below 1990
  levels

- Climate Group, 22 Sept 09
24
Recovering rightnot wasting a crisis

• HSBC report on more than 20 economic recovery
  plans
• US430 billion allocated to key climate change
  investment schemes
• Key beneficiaries include
• rail
• transportation
• water infrastructure
• grid expansion and
• improved building efficiency

We believe that these commitments are but the
first installment of further efforts by
governments to use low-carbon growth as a key
lever for economic recovery, as part of both the
G-20 recovery talks and the Copenhagen climate
negotiations HSBC, February, 2009
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Pressures coming from all sides

• Carbon pricing
• Water footprint issues (for NZ a problem bigger
  than carbon content)
• US Dairy farmers plan to halve emissions over
  the next 25 years
• Next wave of protectionism based around
  relative environmental performance.

We havent much choice. Thats why proposed
weakening around the ETS is so disappointing.
26
Enlightened self interest
Time Magazine, in its September 21 cover story,
describes it as a trend to enlightened self
interest.

• 6 in 10 have bought organic products since
  January 2009
• 82 consciously supporting local or neighbourhood
  businesses
• Ethical investment funds up from 55 to 260 since
  1995 (US2.7 trillion, 11 of all financial
  market investments)
• 78 would pay US2000 more to get a car that goes
  35 mpg over a 25mpg car.

27
Where the public are Ask 100 New Zealanders

• 5 think its only about the economy
• 5 say its only about the environment
• 20 say that life is too hard for me to think
  about anything other than today
• 70 say I want a better standard of living and to
  maintain my quality of life we should make
  decisions on whats best long term.
• - UMR research for the Business Council

28
Values and market opportunities
Solution Seeker Market 24, 40 with
supporters (2008) Climate change the biggest
driver

• 83 of New Zealanders aware of the problems the
  world faces
• Want business and Government to take action, but
  loosing faith in their ability to respond
• Want authentic solutions they can buy.

29
September 2009 research where your clients and
customers stand
In principle, should businesses create long term
shareholder value by embracing opportunities -
and managing risks - resulting from economic,
environmental and social developments?
ShapeNZ/Fairfax Business Media survey completed
by 2,981 respondents 2 - 21 September
2009. Weighted to represent the national
population, the maximum margin of error on the
national sample is / - 1.8. 727 business
decision makers Maximum error /- 3.6.
Business decision makers
30

• Among senior decision makers
• 41 say their business reputation relies on
  sustainable business practice
• 61 say they balance making returns to investors
  with their role in the community
• 28 actively buying on whole-of-life cost basis,
  not just day-one price, while 39 practice
  something in-between
• 26 actively buying from suppliers who behave
  sustainably (22 dont care, provided at the best
  price)
• 64 regard supportive workplace as critical to
  organisations success
• 22 have or plan to measure their organisations
  carbon footprint.

September 2009 research
Has the organisation you work for or with
deselected suppliers in the past year because of
their environmental, social or ethical
behaviours? Business decision makers
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Whats driving the risk and opportunity?

• Climate change affecting trade USA, Japan,
  Europe, Australia will have ETS (The Chinese
  Central Bank is investigating an ETS for China)
• Customer expectations lifecycle carbon
  labelling (Tescos Wal-Mart, the EU, then other
  markets. The wise will lead now, not delay). 5
  billion in exports to EU. What of NZ-supplied
  ingredients in exports from third countries to
  the EU?
• Staff expectations
• A general belief it is the right thing to do.

32
Where is the pressure coming from?

• Government regulation Emissions Trading Bill,
  Waste Bill, Taupo and Rotorua Lakes clean up
• Government procurement Green star ratings for
  buildings, national standards, 6 billion pa 34
  core agencies (local government procurement to
  come as cities, like Wellington)
• Corporate procurement supply chain greening
  gaining ground.

33
NZ opportunities from pricing carbon

• Nitrogen inhibitors
• Methane reduction
• Commercial afforestation
• Permanent forest sinks
• Bioenergy (2nd generation biofuels)
• Geothermal
• Wind energy
• Ocean energy
• Electric vehicles
• Home and building insulation.

34
The New Zealand opportunity

• Pricing carbon Sending clear investment
  signals early, rather than later
• Major opportunities in the new green economic
  evolution
• - 12.3 billion in new investment.

35
Sustainability focus performs better

• Firms with "true commitment to sustainability"
  outperform industry peers in the financial
  markets.
• Most sustainability focused companies may well
  emerge from the current crisis stronger than ever.

A T Kearney, global management consulting firm
36
Sustainability focus performs better

• AT Kearney findings
• 99 firms on the Dow Jones Sustainability Index
  and the Goldman Sachs SUSTAIN focus list of green
  companies and tracked stock price performance for
  six months through November 2008.
• In 16 of 18 industries included in the review,
  businesses deemed "sustainability focused"
  outperformed industry peers over three- and
  six-month periods and were "well protected from
  value erosion.
• During the three-month period, September through
  November, the performance differential was 10
  percent over six months, 15.
• Performance differential average of 650
  million in market capitalisation per company.

Source http//atkearney.com/shared_res/pdf/Green_
Winners.pdf
37
Sustainability bottom line impacts

• The report cites a global consumer packaged goods
  company
• Began sustainability efforts more than 10 years
  ago
• Since changed its business model to incorporate
  sustainability practices in every link of the
  value chain.

Since 1988, increased production volume 76, cut
greenhouse gas emissions 16, water use 28,
energy use 3. In 2007, improvements in energy
efficiency led to a 30 million savings.
38
Sustainability bottom line impacts

• Many corporate drives to reduce waste and
  emissions, use renewable energy and produce goods
  that have less of an impact on the environment
  have seemingly become me too efforts in recent
  years. Yet companies with a history in green
  innovations have reaped the most benefits.
• "And those that continue to make meaningful
  investments will continue to prosper, both in
  terms of business results achieved and public
  perception."

A T Kearney, global management consulting firm
39
NZ the benefits of sustainability
4
3
1
2
Members were asked to list outcomes as a result
of their business sustainable development
practices or initiatives in the past 12 months

• Opportunity Identified new business
  opportunities (82)
• Brand Enhanced brand value (73)
• Staff Attracting and keeping staff (64)
• Savings Cutting costs (47)
• Business Council Member survey 2008

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Thank you

• Peter Neilson
• 64 9 525 9727
• E-mail peter.neilson_at_nzbcsd.org.nz
• Web www.nzbcsd.org.nz