Rebuttable

-- In the context of greenhouse gas emission and climate change

     It is well known that air is a type of "public goods", which normally cost little to use. A public good generally carries the characteristic that everyone can use it without significantly affecting the use by others, and therefore free of costs. (For example, see here.) Water is another "public good" natural resource. In some occasions, lands and soils can be another type of "public good".

     The "public good" nature of air is the fundamental root behind the climate change issues supposedly caused by human activities. Because it costs little to emit greenhouse gases into the air, there is little financial incentive to stop. Unless, that is, people voluntarily choose to stop, or are involuntarily required to stop by government regulations.

     Government regulations, therefore, play an important role in managing the air quality, because they create financial incentives, and thus markets, for people to change behaviors. Availability of financial incentives and markets, on the other hand, is critical in stimulating capital investments and innovations. (Many people have studied this area. See, eg, here.)

     This causal relationship between regulations, markets, and innovations is clearly illustrated by a paper I recently read. The paper was written in 2001 by Taylor, Rubin, & Hounshell of Carnegie Mellon U, and titled "The effect of government actions on technological innovation for SO2 control". The authors analyzed the correlations between the Clean Air Act and innovative activities in the reduction of SO₂ emissions among power utilities. One of the approaches they used was to collect the numbers of patents issued each year in technologies related to the reduction of SO₂ emissions from 1887 to 1997. They discovered that US patents related to SO₂ control technology surged during a 5 year period encompassing the enactment of the 1970 Clean Air Act, rising from under 5 patents issued each year before 1967 to more than 75 patents issued in 1971. And the level of issued patents remained above the 1971 level for the rest of the study period that ended in 1997. (See Fig 4 of the paper here.)

     The authors noted that prior to the Clean Air Act f 1970, when EPA was established, the patenting activities in SO₂ control technologies were nearly non-existent, even though the federal governments had generously granted research funds in the areas. Today, the federal government has been debating whether to directly regulate greenhouse gas emissions (by taxes or caps) or to avoid direct regulations by providing research funding. At lease in terms of patenting activity, the Taylor paper should shed some light on the debate.

-- According to United Nations estimates

     In my previous posting (see here), I estimated that the potential size of the greenhouse gas (GHG) markets could reach the level of US$500 billion to US$8 trillion by year 2030. That estimate was based on the amount of GHG emission reductions needed to stabilize the GHG concentration in the atmosphere (100 billion tons by 2030) and the potential market price of GHG (US$5 - US$80 per ton).

     I just found out, however, that before my posting, the United Nation itself had came up with a direct estimate of the potential amount of investments necessary to avoid the undesirable consequences related to GHG emissions. (Report of the Secretary-General, "Overview of United Nations activities in relation to climate change", 10 January 2008. See here.) Its estimate was: US$15 trillion to US$20 trillion by 2030. Below is the relevant quote from the UN report.

"Global investments in the magnitude of from 15 trillion to 20 trillion United States dollars may be required over the next 20-25 years to place the world on a markedly different and sustainable energy trajectory."

     The UN numbers are far greater than my estimates, although the UN report did not explain how it made the calculations. Assuming my approach is generally correct, on the other hand, the UN number would imply that the market price of GHG could reach US$200 each ton. ($20 trillion / 100 billion ton = $200 per ton) That is ~560% return in ~25 years from the current price of ~$30 per ton, or ~7.8% annually, absent leverage.

[Note: The abbreviation "GHG" represents "Greenhouse Gas".]

     A couple of months ago, I went to a speech on environmental law. One of the speakers commented half-jokingly that just a few years ago environmental lawyers had pretty low popularity ratings. The presence of environmental lawyers in a transaction normally was considered a sign that troubles were brewing ahead. No more, the speaker said with a grin. These days, environmental lawyers are like rock stars, attracting admiring attentions.

     Because of the rising public awareness of the risks associated with the alarming trends in global climate changes, investments in the GHG markets have surged recently, in tandem with the rising popularity of environmental lawyers. It was not too long ago, however, when "green investment" (which includes "GHG investment") was often met with skeptical eyes. The markets then were simply too small and the returns too low. Of course, concerns over global warming and the market-based framework set forth under Kyoto Treaty have changed the calculus. But the question remains whether this segment of the green markets can grow large enough to sustain sufficiently high returns. Other related questions also linger around for investors: Is this market already too crowded? Is it too late to enter? How long can investments continue to generate sufficient returns?

     Answers to these questions likely depend on two key factors: The amount of GHG emissions we will have to (or want to, or be able to) reduce, and the market price of GHG. For example, if we manage to cut 100 billion tons of GHG emissions within the next 50 years, and if the price of a ton of GHG is worth $1 throughout the period (an arbitrary assumption), then we have a potential demand of $100 billion. Our economy would have to invest that much capital within the period to invent new technologies, systems, or policies, or to implement existing technologies, systems, or policies.

     To get a more realistic estimate of the necessary amount of GHG emission cuts, I turned to the report published by the Intergovernmental Panel on Climate Change (IPCC). Recently, the panel published its "Climate Change 2007" final report. The report included estimates of the amount of GHG emissions that we would need to cut within the next century in order to stabilize the amount of atmospheric GHG at a sufficiently low level. According to the report, we need to cut in the order of ~100 billion tons of GHG between 2000 and 2030, and over 2 trillion tons of GHG between 2000 and 2100. (See table below.) Moreover, the panel estimated that the price of GHG could fall within the range of $5-$80 per ton. (Currently, carbon prices in Europe is ~$32. See here.) So, these numbers project the size of the GHG market in the order of ~$500 billion to ~ $8 trillion by 2030, and to grow 10- to 20-fold by the end of the century.

     To put these numbers in perspective, the IPCC report also estimated that energy infrastructure investments could total over $20 trillion by 2030. That means, the GHG market can account for ~3%-40% of total energy infrastructure investments before 2030, and the percentage will likely increase many fold by 2100.

     $500 billion to $8 trillion of demand during the next 30 years is sizable. And the demands will likely surge rapidly before the end of the century, if we manage to pull our acts together and the computer models are correct. These numbers actually already need to be increased today, because the IPCC projections assumed that the growth rate of GHG emission would begin to abate beginning year 2000. Numbers in the IPCC report, however, also indicated that between 2000 and 2004, the annual GHG emission growth rate did not decline at all. The growth rate actually nearly doubled that in the previous decade. As a result, the GHG emission reductions will have to accelerate relative to the IPCC projections in order to reach stabilization as scheduled. That will increase the size of the GHG market.

     Of course, these estimated ranges of GHG market size depend on the accuracy of the extremely complicated computer models. They also assumed that we human beings could achieve the scale of GHG emission reductions projected by these models. At this point, however, the observed climate changes seem to have outpaced most previous computer models. Whether or not we human beings can manage to achieve the projected GHG emission reduction goals, on the other hand, is a big question mark.

     Human efforts or hypes alone will not be enough to achieve the GHG emission reduction goals. We will need to figure out ways to effectively reduce the net GHG emissions, counting emissions through every node along the chain of interactions. That's a monstrously difficult undertaking. We have made significant efforts since Kyoto. For example, last year alone we saw member nations of the Kyoto Treaty reached an agreement to begin negotiating a new protocol to succeed Kyoto; Australia ratified the Kyoto Treaty; and, even US managed to enact a new energy bill. Despite these efforts, global GHG emissions have continued to accelerate in recent years. Whether we human beings can manage to stabilize climate changes remains the greatest uncertainty in estimating the potential size of the GHG markets.

     On a final note, investment funds controlled by governments have grown rapidly in size recently. It has been projected that these funds (called "sovereign wealth funds") can exceed $10 trillion by 2015. (See here.) That's more than the money needed to reach the GHG emission reduction target for year 2030 set by IPCC. Hopefully, managers of these sovereign wealth funds will increase their investments in this sector. That will be a win-win situation for the Earth and humanity!

     Please click the link below for the Chinese version. 請按以下連結鍵閱讀中文版.

     Last weekend at the UN Climate Change Conference in Bali, UN member countries agreed on a road map to hammer out the post-2012 replacement for the Kyoto treaty, after a dramatic last-minute reversal of position of the US delegation. Today, the House passed an energy bill that will increase the fuel efficiency standard for all vehicles by 40% to 35 miles per gallon by 2020. The bill also requires that ethanol use increase 6-fold by 2022. The bill was sent to the White House. (See here & here.)

     During the coming century, our nation's climate policy and energy policy will become more and more entangled and intertwined, simply because fossil fuels, the principal sources of greenhouse gases, happen to be also our principal energy sources. Let's not forget, however, that they are not equivalent to each other.

     As shown in the table, an energy policy must address various issues other than global warming. Meanwhile, a climate policy needs to address factors not associated with fossil energy use. For example, livestock feeding and agricultural activities have been known to account for around 15% of greenhouse gas emissions. Also, the global nature of climate change requires much greater international interactions than energy.

     At this point, almost all factors influencing our energy policy are moving it closer and closer to our climate policy. Energy independence urges development of non-fossil energy sources (although coals, which are abundant domestically, satisfy this requirement). Declining worldwide oil reserves require development of new energy sources (although abundant coals can satisfy this end too). Even China is gradually waking to the reality that it cannot sustain strong economic growth if sea level rises dramatically and flooding or droughts become more severe.

     These factors, nevertheless, may someday move away from their current direction, pulling our energy policy from our climate policy. (For example, if Mid-East stabilizes, or enormous new fossil energy reserves are discovered.) If that happens, oil & other fossil energy prices may remain low, disrupting markets for clean technologies and carbon credits. In that case, climate policies may encounter greater conflicts with energy policies.

     We'll need to be aware of this possibility. And, at the same time, should work to find ways  to reduce the amount of green house gases our farms' manures send to the sky!

     Please click the link below for the Chinese version.

     A trademark (or service mark) is not just the name of a product. It is the nickname of the source company when used with that particular product. A trademark tells customers the quality of the product (from the quality of the source company) they can expect by simply seeing (or hearing, smelling) the mark. it is a powerful 24/7 salesperson.

     Therefore, most companies don't want to use the marks already used by their competitors, and don't want their competitors to use the same (or similar) marks for competing products. (For example, earlier this year Cisco sued Apple to stop it from using its iPhone trademark. See here.) Registering a trademark is becoming a popular way to achieve these goals. The number of federal trademark applications has indeed steadily increased in the past several years. (See chart by clicking on thumbnail.)

     The best way to protect a trademark, however, is not trademark registration, but to choose a good/distinctive mark to begin with. A good mark stands out from the crowd. It reduces the chances that the mark will be confused with other existing marks. It also reduces the chances that other companies in the future might innocently use similar marks for their own competing products.

     A good mark can also allow a company to begin marketing a new product even before its trademark is registered. It takes on average more than one year to register a federal trademark. (See table.) Very often, companies cannot afford to wait that long to market a new product, if only to make sure that the product's trademark can be protected. Choosing a good trademark from the get-go will allow the company to market the product timely, without taking big risks.

     Trademarks are generally categorized into 5 classes, with descending quality: Fanciful, Arbitrary, Suggestive, Descriptive, & Generic. (See here for more info.) Choose a fanciful or arbitrary mark to avoid stepping on other existing trademarks and to prevent others from innocently stepping on yours. Then, get register the trademark to officially announce your mark and to fend off others intentionally attempting to palm off your good name. That would be my best strategy.

     The influential private equity firm, Blackstone Group, disclosed in its recent IPO prospectus that it planned to establish a charitable foundation after it goes public and would contribute up to $150m in the foundation. (See here.) This got me thinking about the combination of for-profit and not-for-profit corporations.

     Most for-profit corporations, like Blackstone, do get involved in not-for-profit activities, directly or directly. However, most of these activities are normally initiated and controlled exclusively by the management, without much input from the shareholders. Such modus operandi simply adds to the public's cynicism toward corporate America's involvement in nonprofit -- particularly because there is a different way for corporations to contribute to the nonprofit causes. Let me explain.

     The principle difference between a for-profit and not-for-profit corporation is ownership. A for-profit corporation has ownership, but a not-for-profit does not. However, what if the ownership of a for-profit corporation includes an interest in contribution by the corporation to some non-profit organizations? If that is possible, it will permit the shareholders to exercise direct control over the company's contribution to nonprofits. And I think it is possible.

     For example, Blackstone in its IPO can set up multiple classes of shares, say Classes A, B, & C. When Blackstone initially issues the shares, a portion of the purchase price will go to the company (and invested for profit), but the remaining portion will go to some nonprofit groups. (See table below.) So, if I pay $100 for one Class B share, $90 goes to Blackstone, and $10 goes to some nonprofit groups. If I later sell the share in the secondary market, however, only the for-profit portion changes hands. Different classes will have different rates of dividends and/or different voting rights as incentives to purchase Classes C or B over Class A. Additionally, more complicated plans can offer different choices and combinations of nonprofit organizations for different classes.

     Will such kind of plans work? It seems so. Will it actually happen? Maybe, although probably not any time soon!

     In recent years, a secondary market for life insurance policies has grown rapidly, accompanied by similarly exponential growth in the securitization of life insurance policies. The market is supported by a group of organizers who purchase eligible policies from the original owners, re-package them, and then sell interests in these policies to investors. (See here or NY Times 12/17/2006 article "Late in Life, Finding a Bonanza in Life Insurance" for more details.)

     Based on the numbers I was able to gather, the size of the market has grown from ~$1B in 1999 to over $10B in 2005. (See chart below.) This rapid growth was fueled mostly by institutional investors, such as hedge funds and Wall Street firms. Even Warren Buffet's Berkshire Hathaway has invested in life settlements. It has been estimated that the market can exceed $150B in terms of the face value of insurance policies involved.

     There are occasions when a senior (or a company) might want to dispose of his/her life insurance policy. For example, emergency need for cash, changed goals in health care & estate planning, overly expensive premiums, dissolution of company requiring disposal of company-owned insurances, key employee leaving company, etc. In these occasions, the policy owner can sell the insurance back to the insurance company for the cash value. Or, he/she can sell the policy in the secondary market if it offers a better deal. Such competition between the primary and secondary markets should benefit consumers as a whole.

     To continue its current pace of growth, however, the market must address several legal concerns. First, most state regulations require that the beneficiary of a life insurance police possess an "insurable interest" in the life and health of the insured. If a stranger without an "insurable interest" becomes the beneficiary of a life insurance covering the life of another person, the stranger has the monetary incentive to accelerate the death of the insured person. That is not a desirable public policy! Many states (including New York), however, have allowed a stranger to become the beneficiary if the insured person voluntarily agrees to the arrangement. Even with this exception, the risk of abuse can be real. It is important for all transactions to incorporate some safe guards. (E.g., not permitting the investors to know the identity of the insured.)

     Second, the investment interests on the re-packaged insurances sold to investors may be "securities" under the federal Securities Act of 1933 and Securities Exchange Act of 1934, and thus may be subject to the registration, disclosure, anti-fraud, and other requirements under these federal laws. In 1996, the Appeals Court of the District of Columbia held in SEC v. Life Partners that such type of investment contracts are not "securities". The Appeals Court of the 11th Circuit, however, reached the opposite conclusion in 2006 in SEC v. Mutual Benefits. In these cases, the defendants, Life Partner Inc. and Mutual Benefits Corp., were organizers in the life settlement markets. Both of them employed hundreds of agents and brokers to purchase policies from seniors and sold fractional interests on these pools of policies to investors. Because of this split between the two courts, any issuance of life settlement interests under the jurisdiction of the 11th Circuit (Alabama, Georgia, Florida) will now be subject to the federal securities laws, but not those under the jurisdiction of D.C. Such discrepancy will have to be resolved by the Supreme Court.

     Finally, as more and more organizers enter the market, competition to obtain eligible policies from seniors will increase. Potentials for fraud will rise. In fact, in October last year, the then attorney general of New York, Eliot Spitzer, brought suit against Coventry First, one of the large life settlement organizers, for allegedly rigging the bid process in buying the policies. Like many other states, New York currently does not have a law regulating the life settlement market. A model regulation, however, was released back in 2001 by the National Association of Insurance Commissioners. The model regulation was adopted by some states and contributed (at least partially) to the rapid growth of the industry. As this market grows, more and more states will eventually enact laws and regulations governing the industry. That should bring more clarity to the regulatory frameworks and sustain continued growth.

     COLI (Corporate-owned life insurance) has been around for a while. A company purchases life insurance policies (as owner and beneficiary) covering the lives of its employees for two main purposes: (1) to fund employee benefit plans; and (2) to compensate itself for the loss of covered key employees. In the former case, if the company sets up a retiree health care benefit plan for its employees, it can buy life insurances on its employees with face amounts equal to the estimated health care costs of the employees. The life insurance proceeds can subsequently be used to cover those health care costs. In the latter case, the insurance policy is called a "key-man" policy. A company buys key-man insurance policies sufficient to compensate for the losses and expenses to the company, or to buy back an employee-shareholder's shares, if a current key employee-shareholder passes away.

     The federal tax treatments of a key-man COLI can be complicated. However, some of the main tax characteristics of a key-man COLI are:

1. The premiums of the policy are NOT tax deductible for the company;
2. The proceeds of the policy are tax free for the company;
3. The proceeds of the policy MAY be subject to estate tax for the insured employee.

     Characteristic #1 spawned various tax shelters in the 80's and 90's, which led to a series of federal COLI legislations, the most recent one being the COLI Best Practice Act incorporated in the Pension Protection Act, enacted on 8/17/2006. (See here for more details.)

     Characteristic #3, on the other hand, may pose as a problem for a company where an employee-shareholder holds a controlling interest. Internal Revenue Code §2042(2) provides that proceeds of an insurance policy owned by and benefiting entities other than the insured person will be included in the insured's estate if the insured had any "incidents of ownership" on the policy. "Incidents of ownership" includes the power to change beneficiary, to surrender or cancel policy, to obtain a loan against the policy, etc. For a controlling employee-shareholder, this means that his estate MAY have to pay tax on the proceeds of the COLI covering his life, because he does have the above powers over the company. Fortunately, subsequent IRS regulations made it clear that as long as the COLI proceeds are paid only to the company or to a third party for a valid business purpose, the controlling employee-shareholder will not be considered to have "incidents of ownership" on the COLI. (26 C.F.R. §20.2042-1(c)(6))

     Part of the reasons behind this regulation is that the company's stock price should reflect the insurance proceeds to be received by the company. That means the insured person's estate is taxed once already on the higher value of the stocks. Paying estate tax on the insurance proceeds would have been double taxation.

     To be safe, however, a company having a controlling shareholder may want to prohibit (in its shareholder agreement) the company from changing the beneficiary of the COLI to any other entity without a valid business purpose. Or, to take it one step further, to limit the power of the controlling shareholder in managing the COLI.

     A consideration in drafting a shareholder agreement or a buy-sell agreement.

-- Chinatrust's botched attempt to take over Mega Financial

     One of the biggest headlines in the financial industry this year is the surging global merger & acquisition activity. Many of these M&A deals were huge (involving billions of dollars) and likely completed with complicated financial arrangements. The inner workings of most of these financial arrangements will probably not be known to the public for a long time. In one rare instance, however, we did get the chance to peek into the intricate structure of one of such M&A deals. -- The botched attempt by Taiwan's Chinatrust Financial Holding Company (CFHC) to take over Mega Financial Holding Company (MFHC). Particularly, it's interesting to learn how CFHC incorporated derivative instruments into the intricate web of M&A gamesmanship.

     CFHC is one of the large financial holding companies in Taiwan, with ~10,000 employees. In early 2005, Taiwan government announced plans to gradually reduce the number of financial holding companies in the country by half. CFHC consequently decided to increase its stakes in another large financial holding company, MFHC (which has ~8,000 employees). According to Taiwan law, a financial holding company must obtain government approval to invest in another financial holding company. The subsidiaries of a financial holding company, however, are not subject to such a requirement, except that commercial banks are not allowed to hold more than 5% of a single company's outstanding shares.

     Thus, CFHC instructed its banking, insurance, and other subsidiaries to purchase MFHC shares in open markets. By fall of 2005, CFHC had obtained control, through its subsidiaries, of ~6.1% of MFHC shares. That was, however, not enough. CFHC further instructed the Hong Kong branch of its banking subsidiary to purchase ~$390m of structured notes issued by Barclays Bank. The structured notes were linked to MFHC stock prices, and thus would have been equivalent to ~3.9% of MFHC outstanding shares. Thus, by this time, CFHC had effectively controlled ~10% of MFHC.

     In January 2006, CFHC submitted application to the regulator for approval to acquire 5-10% of MFHC in the open market throughout the following year. The plan was announced to the public after the Chinese New Year holiday. MFHC stock surged after the announcement. CFHC then cashed in the structured notes (through a 3rd party), with sizeable profits. Then, most interestingly, the issuer of the structured notes sold the MFHC shares that it used to hedge the structured notes, allowing CFHC to pocket a majority of these shares.

     So, by June of 2006, CFHC had acquired control of ~15.6% of MFHC, and was able to gain 4 seats in MFHC's 15-seat board. If it had gone as planned, CFHC would probably have continued on to control more shares of MFHC, and eventually the board. Things turned sour, however, when regulator questioned the sale of the structured notes through a 3rd party and indicted several top CFHC executives for breach of trust and unfair enrichment. It will now be difficult, if not impossible, for CFHC to takeover MFHC.

     In this botched attempt, CFHC used the structured notes to add 3.9% of MFHC "virtual" shares to what it was able to acquire through its subsidiaries. The additional exposure allowed CFHC greater profits (rightfully or not) when MFHC shares rose after the investment plan was publicly announced. These "virtual" shares, moreover, turned into real shares when the structured notes were redeemed and the hedging stocks sold in the open markets.

     The use of derivatives is probably widespread in M&A deals, limited only by imagination. Derivative instruments, such as credit derivatives, can be rather beneficial tools for risk management or reward enhancement. However, when they are abused, it is very difficult to catch because of their private nature. Tough job for financial regulators!

HAPPY NEW YEAR 2007!!!

     Google rolled out its brand new "Patent Search" tool yesterday. (See here.) I quickly tested the tool. Looks like it includes only issued US patents, not published patent applications. (I am guessing non-US patents and patent applications should be coming soon.)  At this point, the Google Patent Search tool does not offer much more than the search features provided in USPTO web site. (Here.) I did a quick search for the phrase "spinal cord injury" on both the USPTO web site and Google. USPTO returned 1875 results, but Google returned 672. Not sure why yet. Also, for each individual patent, Google Patent Search displays the "Abstract", "Claims", "Citations", and "Referenced By" sections as texts. The "Description" section, however, is only available as images. The USPTO database is all text-based, except older patents.

     I am sure Google will be improving this patent search tool. But what's next beyond patents? How about court records, or other public records? Will Google's free-use business model threaten Westlaw and Lexis? Will consumers like myself be the true beneficiaries of Google's ambition to catalogue whatever there is to be catalogued?

     Good time to be a writer!