Rebuttable

Bondholder activism in affecting corporate climate policies

nospam@example.com (Chia-Yu Chang) — Thu, 16 Feb 2012 01:10:14 -0700

- Augmenting shareholder activism

In recent years, institutional investors concerned with climate risks, particularly public pension funds, have sought to leverage their financial prowess to effect changes in climate-related regulations and corporate governance. For example, they petitioned SEC to require expanded disclosures of public corporations’ exposures to climate risks and their contingency plans, resulting in the promulgation by SEC in 2010 of a set of guidelines regarding such disclosure requirements. (See here.) Furthermore, investors have undertaken shareholder activism via resolutions and proxy votes to influence corporate policies regarding climate risks, for example to demand greater disclosure. (See here.)

These efforts have placed in the public domain more and more information related to the climate risk exposures and policies of publicly traded companies, which can spawn further public scrutiny and analyses, increase public awareness, encourage broader participation, and induce further disclosures in a benign cycle. There are, however, limitations to both approaches. On the one hand, regulators are reluctant to impose stringent regulations on the private sectors due to the weak economy. On the other hand, unlike public pension funds, shareholder activism is generally not viable for mutual funds, because of regulatory requirements on diversification, costs, and conflicts of interests; or for hedge funds, because of their short-term time horizons. (See here.)

Therefore, it may be useful to augment shareholder activism with bondholder activism to effect changes in corporate climate risk practices. US corporate bond market is sizeable, exceeding $7 trillion as of Q2 2011 according to Wikipedia, dominated primarily by institutional investors. Corporate bondholders as a whole, consequently, can exert significant influences on bond-issuing corporations.

As I mentioned previously, equity shareholders affect corporate governance primarily through shareholder resolutions, proxy votes, or even derivative actions. This means the influences of shareholders arise primarily after the purchase of the shares. Bondholders, on the other hand, affect corporate governance primarily through the terms of the bond indentures and therefore can assert influences both before and after the purchase of the bonds. For example, if prospective buyers are concerned with potential negative impacts from climate-related events (hurricane, flood, coastal line erosion, drought, etc) on the payment capability of an issuer corporation, the prospective buyers may negotiate to modify the interest rate, maturity, call/put features, or other numerical terms of the bonds. Or, they can negotiate to add a climate risk covenant to the bond indenture that is linked to certain climate risk factors such as enactment of climate legislation, inclusion of US in an international climate treaty, or the occurrence of some physical events. The threat of the inclusion of such climate-related provisions in the bond offering may impose significant influence on the borrower corporation’s climate policies.

Since such pre-purchase negotiations improve the performance of the bonds, mutual fund managers should be more willing to participate in the negotiations, without being overly concerned with the possibility of upsetting the corporate managers and thus losing future businesses from the corporation. Hedge funds may also find it easier to agree to terms that comport with their short-term profit strategies, as well as other long-term climate concerns. As a result, the aggregate influence of all potential bondholders can be much greater than that of shareholders. Finally, post-purchase/issuance, monitoring & enforcement of the terms and covenants of the bond indentures may be performed by hedge funds, which have gained tremendous experience in enforcing bondholder rights in recent years. (See here.)

As far as I know, this idea of augmenting shareholder activism with bondholder activism in affecting corporate climate policies has not been practiced before. Will it work? I am hoping to find out soon.

Climate change adaptation & market-based regulation

nospam@example.com (Chia-Yu Chang) — Thu, 26 Jan 2012 18:22:44 -0700

- Making the case for the formation of national climate-change insurance markets

In mitigating the impacts of climate change, market-based regulations (aka, cap-&-trade) have been championed as the preferred policy tool. (See my previous post on regulations, markets, & innovations.) EU has adopted cap-&-trade regulations for carbon emissions and established carbon credit markets, under the Kyoto Protocol, since 2005. And the northeastern states in US have been auctioning off carbon emission allowances to the power generators under the RGGI (Regional Greenhouse Gas Initiative) platform since 2008. California is set to begin emission trading soon.

The prices of the carbon credits traded in EU and under RGGI, however, have plunged precipitously. (See here & here.) Moreover, the Chicago Climate Exchange ceased trading carbon credit products in 2010. Recently, Canada withdrew from the Kyoto Protocol, and New Jersey broke away from RGGI. These developments raised serious doubts whether markets can be an effective policy tool with respect to climate change.

If not viewed as a policy tool, nonetheless, the carbon markets have done exactly what they are supposed to do. – Efficiently reflecting the aggregate balance of supply and demand. The decline in carbon prices reflects (among others) the over supply of credits issued by the EU governments, and the under demand in US & China for lack of policy supports (and also in EU for the weak economy). Therefore, as much as policy-makers and businesses engage in the wishful thinking that the markets would do the works on their behalf, the markets know better to call their bluff.

The lessons: Markets cannot function as an effective regulatory tool without adequate policy supports or implementation. On their own, however, markets can function as an efficient signal as to the aggregate impacts of supply and demand factors, including policy supports and economical conditions.

These lessons learned from the market-based efforts in climate change mitigation may have some important bearings on climate change adaptation. Adaptation has taken a back seat to mitigation in the climate change debates. This is understandable. After all, it makes sense to target directly the root of the problems (free emission of carbon). Moreover, reducing carbon emissions is associated with one clear objective, finite risk parameters (atmospheric CO2 concentration, mean temperature, & mean sea level), acceptable predictive models with large data sets, quantifiable risk levels and reduction targets, tangible commercial products, well-articulated technological solutions, and a definable timeframe.

Adapting to climate change, on the other hand, has none of these characteristics. There is not one central theme, but rather a murky set of sundry tasks that must be performed locally in response to unpredictable local conditions (eg, hurricane, flood, drought, extreme precipitation, sea level rise, heat wave, biodiversity changes, vegetation shifts, disease spread, healthcare, allocation of water & food, etc). And, other than water, there is no easily identifiable tangible commercial products associated with climate change adaptation. Adaptation, in short, is simply a tough sale!

The falling carbon prices, however, attests to the difficulties in achieving the mitigation goals considered necessary to maintain the atmospheric CO2 concentration at comfortable levels. Adaptation, therefore, is increasingly becoming an inevitable reality in the 21^st century. And yet, even though the public sectors have taken initiatives to address adaptation needs (see eg here), for the private sectors, adaptation remains a murky set of ill-defined speculative sundry tasks, and very little concrete actions have been taken to address the issues. (Eg, see here.) Without the extensive participation of the private sectors, public sector efforts in adaptation will not likely to be effective.

This is where I think markets may play a useful policy role in stimulating private sector adaptation efforts, not as a regulatory tool but by providing a signal as to the aggregate balance of the supply & demand factors, including climate science developments, policy supports, or economic conditions. Specifically, the market I have in mind is the catastrophe insurance market.

Currently, climate sciences are still unable to reliably forecast local climate variations (city or town) for more than a few days into the future. (Even if some high-resolution modeling tools may exist, my guess is they are likely to be extremely pricy and not widely available.) As a result, the most common way for businesses or individuals to manage their climate change risks is to purchase catastrophe insurances. These insurance markets thus provide a signal as to the aggregate supply & demand for climate change risk shifting, which in turn point to the aggregate supply & demand for adaptation.

If these insurance market prices are widely accessible to the general public, like the prices of Treasury and other debt securities widely available to the public through the media or internet, they may serve to better inform the public of the state of climate change risks, and thus stimulate more concrete actions. In most markets in US, both private insurance carriers and public governments (states & federal) offer climate-related insurance coverage, such as flood or hurricane insurance policies. (Eg, see here.) In fact, in some markets, the federal government plays a significant role. For example, by 2007, the federal National Flood Insurance Program (NFIP), established in 1968, has become the primary flood insurer in US. (See here.)

Therefore, the federal government should establish an agency to oversee and underwrite all federal climate-related insurances, and also ensure the establishments of sound and secure secondary markets in these insurance products and extensive distribution of the pricing information to the general public. Just like the Treasury securities markets, such national climate-related insurance markets may serve as a benchmark for the creation and pricing of other related markets, and as the basis for the creation of other analysis and decision-making tools. These national markets, pricing information, and additional tools should hopefully raise the public awareness of the risks of climate change, and thus the needs for adaptation, and facilitate informed and educated concrete actions in adaptation.

Of course, this is a very primitive idea. Many further considerations need yet to be worked out. For example, many insurance policies are not standardized, unlike Treasury securities. The premiums may not properly reflect the market supply & demand because of government subsidies. The markets may lack liquidity if the risks rise above a certain threshold. But, hopefully this will be a start!!!

11/14/2011 Presentation on Climate Change

nospam@example.com (Chia-Yu Chang) — Fri, 09 Dec 2011 13:11:13 -0700

- At the Climate Change & Green Energy seminar

Here is the ppt slides of my presentation at the 11/14/2011 Climate Change & Green Energy seminar, co-sponsored by TECO & ACUNS. The program can be found here. The title of my presentation is "Global Warming Mitigation -- Challenges, Taiwan, & Geoengeering".

Software patents and venture capital

nospam@example.com (Chia-Yu Chang) — Mon, 05 Sep 2011 19:40:40 -0700

- Patents used primarily to attract VCs by software startups

UC Berkeley Law School conducted a comprehensive patent survey in 2008, asking young start-up technology companies to respond to several patent-related questions. (See here and here.) More specifically, the survey included the following questions (not exhaustive):

Frequency of patenting;
Reasons for seeking or not seeking patents;
Comparisons of patents and other strategies in attaining competitive advantages;
Reasoning for acquiring licenses from other companies;
Perceptions of patents as incentives for engaging in innovation;
Perceptions of importance of patents in securing outside investments.

The ~1300 companies that responded to the survey encompassed the software, computer hardware, biotechnology, and medical device industries. More than 700 of them, however, were software companies. One of the co-authors, Pamela Pamuelson, wrote an interesting article in 2010 summarizing the survey results particularly of software companies. Below is a quick recap of her summaries:

Competitive advantage: The companies rated the strategies in gaining competitive advantages in the following order: (a) first-mover advantage; (b) complementary assets; (c) copyright, (d) secrecy (e) trademark (f) reverse engineering, & (g) patent.
Why patents: (a) to prevent competitors from using the technology; (b) to enhance reputation; & (c) to secure investments (including IPO).
Why not patents: (a) costs; (b) unpatentability of invention; (c) ease in designing around; (d) satisfaction in trade secrecy.

Therefore, the first finding of the survey is that software startups generally do not consider patents important in gaining competitive advantages. Unlike biotech or medical device companies, software companies prefer using first-mover advantage, complementary assets, copyright, trade secret, trademark, or reverse engineering to compete in the marketplace. (Click on thumbnail above to view original chart.)

The survey also revealed, however, that those companies backed by VC were much more likely to apply for patents than non-VC-backed companies. -- The software startups that participated in the survey were originally selected from 2 databases: ~500 from Dunn & Breadstreet (DB) and ~200 from VentureXpert (VX). About 10-15% of the DB companies and all of the VX companies were backed by VCs. In responding to the question whether they currently held or were seeking patents, only ~1/4 of the DB companies (with 85-90% not backed by VC) answered positively. On the other hand, ~2/3 of the VX companies answered positively.

Percentage of companies holding or seeking patents
DB companies (~500, 10-15% backed by VC)	~25%
VX companies (~200, all backed by VC)	~67%
All companies (DB + VX, ~700 companies)	~37%

From the survey results, it appears software startups use patents primarily to attract or retain VC investments, rather than as a competitive advantage in the marketplace. It is not clear, however, whether the change in strategy toward patents (with or without VC investments) was caused by the perception of the software entrepreneurs regarding VCs, or by the actual requirements of the VCs.

But, perceived or not, the fact that VCs and software entrepreneurs may hold such different views toward the values of patents is significant. It points to the need of a flexible patent system.

Software & patents

nospam@example.com (Chia-Yu Chang) — Tue, 30 Aug 2011 17:49:00 -0700

- Fair use for small companies

Recently, Marc Andreesen, the co-founder of Netscape, wrote an interesting article titled “Why software is eating the world”. (See here.) Basically, the article is a recap of the Web movements during the past 10 years since the internet bubble burst in the early part of the last decade. Indeed, Andreesen cited numerous software-focused companies that are biting into the market shares of many old-timer hardware-based companies. These software companies are mostly household names such as Amazon, Netflix, Pixar, Google, Groupon, etc.

Given the controversies that have been associated with software patents, I was curious how these “new” software companies approach patents. So, I looked up the US patents and patent applications held by the companies mentioned in Andreesen’s article. See table below.

Company	# of US Patents & Applications	Age of company
Pixar	261	32
Amazon	479	17
Netflix	11	14
Shutterfly	39	12
Snapfish	0	12
PayPal	24	11
LinkedIn	1	9
Rovio	0	8
Skype	57	8
Facebook	33	7
Flicker	0	7
Twitter	0	5
Zynga	1	4
LivingSocial	0	4
Spotify	1	3
Groupon	1	3
Foursquare	0	2
Square	0	2

It’s pretty clear and not surprising from the table that older companies tend to build up larger patent portfolios than younger ones. This can happen due to the natural growth of a company’s products and technologies with time, and the consequential growth of its patent portfolio. However, the severe backlogs and delays in USPTO can also significantly impede patent protections for younger companies. (Eg, see here, where the inventor of a cloud-based video game technology waited for 8 years to receive a patent.)

Therefore, younger (and smaller*) technology companies do not really benefit much from the existing patent system, particularly for software companies. Even if they have the funding to submit patent applications, they will not receive the protections for the first 3-8 years of their operations. Admittedly, it is also less likely that they will be burdened with patent infringement lawsuits (until later, when and if they survive and grow bigger), but neither will smaller companies be able to effectively protect their inventions from being siphoned off by others, or to protect their investments.

Our patent systems have increasingly become the battlefield for large corporations. (Witness the fierce billion-dollar battle over the Nortel patent portfolios between Google, Apple, RIM, Microsoft, etc.) In that case, why not simply exempt smaller companies from patent infringements, expanding the fair use of patents? That seems to be only fair!

* P.S. Younger companies may not necessarily be smaller. Among the companies in the table above, Groupon, Zynga, or Twitter probably can no longer be considered "small". However, generally being young and being small do tend to go hand-in-hand.

SEC and the revolving door

nospam@example.com (Chia-Yu Chang) — Tue, 30 Aug 2011 01:24:52 -0700

- Public interests v private interests

Just read a scathing opinion piece on Bloomberg.com advocating the shuttering of SEC. (See here.) Why? The fast spinning revolving door between the regulator and the industry it regulates, and the resulting festering conflicts of interest. The author, William Cohan, cited another article published in the recent Rolling Stone issue by Matt Taibbi, detailing a whistleblower’s allegations that the agency had been destroying internal investigation records at least for the past 17 years. (See here.)

On the spinning revolving door, the Rolling Stone article listed the names of the 5 past directors of the Enforcement Division at SEC from 1985-2009, and their employers directly after their SEC tenures. I have copied the list below.

Directors of the Enforcement Division at SEC and Their Subsequent Employers
Year	Name	Subsequent Employer
1985 - 1989	Gary Flynch	Davis Polk*
1989 - 1998	William McLucas	WilmerHale**
1998 - 2001	Richard Walker	Deutsche Bank
2001 - 2005	Stephen Cutler	WilmerHale** / JP Morgan
2005 - 2009	Linda Chatman Thomsen	Davis Polk*
* According to the Rolling Stone article, Davis Polk "boasts many top Wall Street clients." ** According to the Rolling Stone article, WilmerHale is a "Wall Street defense firm so notorious for snatching up top agency veterans that it is sometimes referred to as 'SEC West'."

Everyone knows that revolving doors create severe conflicts of interest issues, and should be properly regulated. Regulators at SEC should particularly know that best. But when it comes to regulating one’s own private interests, public interests unfortunately still have to take a back seat, even for regulators.

Soros and hedge fund disclosure

nospam@example.com (Chia-Yu Chang) — Thu, 28 Jul 2011 14:08:27 -0700

It was reported recently that the hedge funds founded by George Soros, the fabled money manager, had decided to close themselves to outside investors and return about $1b of outsider money. (See, eg, here.) According to the news reports, the Soros fund managers stated in a letter to investors that they made the decision to avoid registering with the SEC. The letter indicated that the funds previously were able to avoid registration through some exemptions, but those exemptions are no longer available subsequent to the Dodd-Frank Act.

Prior to Dodd-Frank, the Investment Adviser Act required investment advisers ("IA") to register with the SEC, but provided several exemptions[1], including the “private fund” exemption, which exempted IAs having less than 15 clients during the past 12 months and not holding themselves out generally to the public as IAs. (See footnote 1.c.) Since Dodd-Frank eliminated only the private fund exemption, leaving the other exemptions intact, it is fair to conclude that the Soros funds avoided registration through the private fund exemption. In place of the “private fund” exemption, however, Dodd-Frank introduces a “family office” exemption (§409), allowing IAs that are “family offices” to be exempted from registration[2]. Thus, by returning the outsider money, the Soros fund will supposedly qualify as a “family office” and continue to be exempted from registration.

It is not possible to know for sure why the Soros fund manager would rather turn away money than register with the SEC. But I would guess it’s because they want to avoid the disclosure & record keeping requirements. In terms of disclosure, an IA registers with the SEC by submitting Form ADV, which includes 2 parts, Part I and Part II. (See here.) Part I is primarily form-based, whereas Part II is narrative-based. Without going into the details, I have listed in the table below the main disclosure items in each part.

Main Disclosure Items in From ADV
#	Part I	Part II
1	Identifying Information	Cover Page
2	SEC Registration	Material Changes
3	Form of Organization	Table of Contents
4	Successions	Advisory Business
5	Information About Your Advisory Business	Fees and Compensation
6	Other Business Activities	Performance-Based Fees and Side-By-Side Management
7	Financial Industry Affiliations Types of Clients	Types of Clients
8	Participation or Interest in Client Transactions	Methods of Analysis, Investment Strategies and Risk of Loss
9	Custody	Disciplinary Information
10	Control Persons	Other Financial Industry Activities and Affiliations
11	Disclosure Information	Code of Ethics, Participation or Interest in Client Transactions and Personal Trading
12	Small Businesses	Brokerage Practices
13		Review of Accounts
14		Client Referrals and Other Compensation
15		Custody
16		Investment Discretion
17		Voting Client Securities
18		Financial Information
19		Requirements for State-Registered Advisers

Of these items, Item #8 of Part II is probably of the greatest concern to the Soros fund managers, because it involves the fund’s proprietary trading strategies. The instruction for the item requests the IA to disclose: (1) the methods of analysis and investment strategies you use in formulating investment advice or managing assets.; (2) the material risks involved for each significant investment strategy or method of analysis; & (3) the material risks involved in a particular type of recommended security.

Furthermore, the Investment Adviser Act requires IAs to maintain records, which are subject to examination by the SEC[3]. The Dodd-Frank Act imposes additional record-keeping requirements, requiring IAs to maintain records needed to assess systemic risks. (§404(2)) The required information include:

(A) the amount of assets under management and use of leverage, including off-balance-sheet leverage;

(B) counterparty credit risk exposure;

(D) valuation policies and practices of the fund;

(E) types of assets held;

(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;

(G) trading practices; and

(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.

Needless to say, these disclosure and record-keeping requirements raised genuine concerns within the hedge fund industry. As a consequence, Dodd-Frank also provides that “proprietary information[4]” received by the SEC or other government agencies will not be accessible to the public through the Freedom of Information Act. These safeguard measures, however, obviously were not enough for the Soros fund managers to submit to registration.

If the family office exemption were not available, I wonder whether they would have considered patenting their previously secret strategies! (See my previous post on patenting trade secrets here.)

[1] For example:

a. All clients of IA resides in same state as the IA (§203(b)(1), Investment Adviser Act);

b. All clients of IA are insurance companies (§203(b)(2));

c. IA has less than 15 clients in past 12 months, does not hold itself out as an IA to the public, & does not advise investment companies or business development companies (the private fund exemption, §203(b)(3));

d. IA is a charitable organization (§203(b)(4));

e. IA is a church plan under §414(e) of the Internal Revenue Code (§203(b)(5));

f. IA is registered with CFTC (§203(b)(6));

g. IA is subject to state regulations and manages less than $25m (§203A(a)(1)(A));

h. IA is subject to state regulations and does not advise an investment company (§203A(a)(1)(B)).

[2] The SEC has defined a “family office” as one that (a) has only family clients; (b) is wholly owned by family clients and exclusively controlled by family members/entities; and (c) does not hold itself out as an investment adviser. 17 CFR 275.202(a)(11)(G)-1 (adopted on 6/22/2011, effective 60 days after publication on Federal Register)

[3] The term “records” is defined as “accounts, correspondence, memorandums, tapes, discs, papers, books, and other documents or transcribed information of any type, whether expressed in ordinary or machine language.” §3(a)(37), Securities Exchange Act.

[4] “Proprietary information” includes “sensitive, non-public information regarding-- (i) the investment or trading strategies of the investment adviser; (ii) analytical or research methodologies; (iii) trading data; (iv) computer hardware or software containing intellectual property; and (v) any additional information that the Commission determines to be proprietary.” §404(2), the Dodd-Frank Act.

Transforming Regulators

nospam@example.com (Chia-Yu Chang) — Mon, 11 Jul 2011 19:44:00 -0700

- Mindful of the limits

The movie Transformer 3 was a huge box office hit this summer. I haven’t seen it yet, but have seen the previous two. Honestly, I didn’t really like them that much. The kid characters were way too serious and the visuals were way too crowded and unfocused. However, I must admit that that “transformation” theme common in most super-hero movies has its psychological allures. Watching those cars and trucks transform into giant robots (or batman don on the black tight outfit and mask, or superman unbutton his shirt to reveal the V letter, or the supermarion puppets in the Thunderbirds series slide through high-tech tunnels and gear up to operate the marvel rescue planes) is utterly satisfying to us mortal beings. Transformation is dreams-come-true, is hope.

And therefore in the Dodd-Frank Act (Wall Street Reform and Consumer Protection Act), we (or, rather, the Congress) transformed the federal regulatory schemes and rested our hope of safeguarding the integrity of the financial system on the newly-transformed regulators. That is, if the free markets championed by capitalism failed, regulations will come to the rescue.

I’ve always believed that markets without regulations will not work. However, to think that regulations will solve all our problems is also unrealistic. Attesting to this limit are two insightful studies on the performance of the Office of Currency Controller and the Federal Reserve at the task of separating banking and commerce during the decades leading to the financial crisis, conducted by Prof Omarova of U of N Carolina. In the first study published in 2009, Prof Omarova investigated how OCC broadly interpreted the “business of banking” restrictions on commercial banking activities to eventually allow commercial banks to enter into various types of derivative markets[1]. (See here.) In the second study, Prof Omarova turned to the Federal Reserve’s use of its exemptive authority to permit insured banks to engage in transactions with affiliates that exposed the banks to tremendous credit risks of the affiliates[2]. (See here.)

Separation of banking and commerce is one of the fundamental cornerstones of US banking and financial law. The National Bank Act of 1863 limited commercial banks to engage in activities “necessary to carry on the business of banking”, excluding dealing and underwriting securities as amended by the Glass-Steagall Act[3]. The Bank Holding Act of 1956 extended the restrictions to bank holding companies and affiliates.

OCC, as the regulators for federally chartered banks, is responsible for interpreting the “business of banking” clause. Prof Omarova’s study showed that since 1960’s, OCC had adopted a broad interpretation of the clause, which was given a nod by the Supreme Court in 1995[4].

With respect to derivatives, OCC first opened the doors to those referencing conventionally permissible assets (eg, interest rates, currencies, or gold) by relying on the “look through” doctrine. When this doctrine became too restrictive, however, OCC switched instead to the “functional equivalency” doctrine. Under the “functional equivalency” approach, an activity would be permissible as long as it performed similar functions as other permissible activities, regardless of the underlying assets. This approach opened the door for commercial banks to matched commodity swaps, commodity-linked deposits, unmatched commodity swaps, swap warehousing, and eventual equity swaps. Finally, by defining “business of banking” as virtually all forms of financial intermediations in an approach named “elastic definition” by Prof Omarova, OCC permitted banks to engage in physical hedging of commodity and equity derivatives, cash settled commodity derivatives (eg, electricity), physically settled commodity derivatives, and derivatives on various underlying indices (eg, inflation property, and catastrophe indices).

Therefore, by the time the financial crisis broke loose in 2007-2008, US commercial banks had gained the power to enter into virtually all kinds of derivative transactions. Post-crisis, however, the Dodd-Frank Act limits permissible derivative activities for commercial banks to those taken for hedging purposes and those referencing a permissible underlying asset. (That is, those permissible under the “look through” approach.)

Derivative activities authorized by OCC under different interpretations of “business of banking” clause
Interpretation Approach	Permitted Derivative Activities
Look-through	Derivatives referencing permissible underlying assets
Functional equivalent	- Matched commodity swaps - Commodity-lined deposits - Unmatched commodity swaps - Swap warehousing - Equity swaps
Elastic definition	- Physical hedging of commodity & equity derivatives - Cash settled commodity derivatives - Physically settled commodity derivatives - Derivatives referencing inflation, property and catastrophe indices

The wall separating commercial banking from investment banking was significantly narrowed / lowered / weakened after the repeal of Glass-Steagall in 1999, permitting bank holding companies to enter into virtually all types of financial service businesses under the holding company umbrella. What’s left of the wall is primarily Sections 23A and 23B of the Federal Reserve Act, which set forth restrictions on transactions between commercial banks and their affiliates[5].

23A and 23B aim to achieve two goals: (1) protecting a bank from losses suffered in transactions with affiliates; and (2) restricting banks from transferring to affiliates the subsidies derived from the federal safety net[6]. To achieve these goals, 23A generally limits the transactions between a bank and its affiliates to 10% of the bank’s capital stocks and surplus for each affiliate, and to 20% of capital stocks and surplus for all affiliates. The section additionally prohibits the bank from purchasing low-quality assets from affiliates, requires transaction terms to be consistent with safe and sound practices, and sets collateral requirements. 23B, on other hand, requires affiliate transactions to be made according to prevailing market terms.

The Federal Reserve is responsible for enforcing 23A & 23B, and is authorized to exempt affiliate transactions from the statutory restrictions if such exemptions are “in the public interest” and “consistent with the purposes” of these sections[7]. According to Prof Omarova, however, it turned out the public interest in providing desperately needed liquidity to the non-banking sector during the crisis decisively outweighed the public interests in protecting the deposits of the public from speculative activities.

In his study, Prof Omarova examined the interpretive letters issued by the Federal Reserve between 1996 and 2010 in response to requests to exempt proposed affiliate transactions from 23A requirements. The table below summarizes those instances listed in Prof Omarova’s paper when the Federal Reserve granted exemptions to the 23A requirements. As shown in the table, Prof Omarova found that during the crisis, when protections of commercial banks afforded under 23A seemed most needed and justified, the decision-making processes at the Federal Reserve were actually dominated by the imminent need to provide emergency liquidity to the non-banking sector. At the time of market crises, the public interest in achieving the twin goals of 23A (protecting banks from losses from affiliates and preventing transfer of federal subsidies) proved to be illusive against the competing interest in providing funding to all.

Therefore, the logical construct of 23A was turned upside down by the empirical experiences gathered during this crisis. The exemptive authority under 23A proved to be too powerful for the whole design to work. Post-crisis, the Dodd-Frank Act amended 23A by, among others, giving FDIC the power to veto exemptions granted by the Federal Reserve.

Regulations, no matter how extensively and carefully constructed, will not likely prevent the occurrence of the next market crisis. Prof Omarova’s studies show that regulators are liable to mistakes, as are all mortal beings. After Glass-Steagall, however, for almost 75 years, the US financial system prospered without a major crisis. If we want to pull off another record, however, lots more than the Dodd-Frank Act will be necessary!

Instances when Federal Reserve granted 23A exemptions
Year	Bank*	Exempted Affiliate Transaction	Conditions**
Pre-crisis 1: Corporate reorganization
2001	C	Transfer of commercial finance, credit card, and consumer finance assets	1;
2003	C	Transfer of residential mortgage assets	1;
2004	C	Transfer of residential mortgage assets	- No transfer of low-quality assets; - Quarterly cash payments for 5 years following transfer;
2006	C	Transfer of subprime mortgage assets	- Quarterly cash payment to offset value of low-quality assets; - Continued cash payments under 2004 exemption;
Pre-crisis 2: Securities lending
2001	JPM, BNY, BOA WC	Securities lending by bank to broker-dealer	2; 3;
2005	BOA	Securities lending by broker-dealer to bank	4; 7; 8; - Only to securities with a “ready market”;
During crisis 1: Asset-backed securities
2007	C, BOA, JPM, B, RBS, DB	Reverse security repo with broker-dealers on asset-backed securities	4; 5; 6; 7; 8;
During crisis 2: Auction-rate securities
2008 - 2009	WC, NT, BBT, FTB	Purchases of auction-rate securities	- Commitment to repurchase assets turning low-quality; - Remaining well-capitalized after purchase; - Purchasing at fair market value; - All purchased securities be highly-rated; - Repo agreement allowing banks to sell securities to parent at full purchase price plus interests;
During crisis 3: Money market funds
2008	All member banks	Purchase of asset-backed commercial paper from money market funds	- Purchase made on or after 9/19/2008; - Purchased securities used as collateral securing emergency loans from FRB; - No specific objection from FRB
During crisis 4: Repo market
2008	All member banks	Short-term financing for assets ordinarily financed through repo market	4; 5; - As over-collateralized as affiliate’s repo clearing bank on 9/12/2008; - Aggregate risk profile of exempt transactions not exceeding that of affiliate’s repos on 9/12/2008; - Bank’s top holding company guaranteeing affiliate’s obligations; - FRB right to prohibit any bank from exemption;
During crisis 5: Emergent mergers
2008	JPMC, WF, BOA	Extension of credit and guarantee to merged affiliate (Bear Stern, Wachovia, Merrill Lynch)	4; 5; - Fully collateralized; - BHC guaranteeing affiliate’s obligation to bank;
During crisis 6: Conversion to BHC
2009	GS, MS, CIT	Conversion to Bank Holding Companies
During crisis 7: GMAC
2008	GMAC Bank	Extending credit to auto purchasers	- Exemption used only for customers of unaffiliated GM dealers, and not for high-risk loans; - Limit on aggregate amount of transactions; - GMAC commitment to reimburse bank for losses on loans; - Bank commitment to hold a dollar-for-dollar risk-based capital; - GMAC pledging collateral acceptable to FRB equal to 10% of aggregate transaction amount;
2009	Ally Bank (renamed from GMAC Bank)	Extending retail and wholesale credit for auto purchases	- Same conditions as 2008 exemption;
*Bank abbreviations: B: Barclays; BBT: BB&T Corp; BOA: Bank of America; BNY: Bank of New York; C: Citigroup; DB: Deutsche Bank; FTB: Fifth Thirteen Bank; GS: Goldman Sachs; JPMC: JP Morgan Chase; NT: Northern Trust; RBS: Royal Bank of Scotland; WF: Wells Fargo; WC: Wachovia
**Common conditions: 1. Cash capital contribution to offset value of low-quality assets; 2. Adequate daily mark-to-market and collateral procedures; 3. 23B compliance; 4. Daily mark-to-market; 5. Daily margin requirement; 6. Over-collateralized; 7. Documented as “securities contracts” for bankruptcy purposes; 8. Affiliated broker-dealer executed substantially same transaction from unaffiliated 3rd party at substantially same time;

[1] Omarova, Saule T., The Quiet Metamorphosis: How Derivatives Changed the “business of Banking”, 63 U. Miami L. Rev. 1041 (2009).

[2] Omarova, Saule T., From Gramm-Leach-Biliey to Dodd-Frank: The Unfulfilled Promise of Section 23A of the Federal Reserve Act, North Carolina Law Review, Vol. 89, 2011; UNC Legal Studies Research Paper No. 1828445.

[3] 12 USC §24(Seventh).

[4] Nations Bank of North Carolina v. Variable Annuity Life Insurance, 513 U.S. 251 (1995).

[5] 12 USC §§371c & 371c-1.

[6] Transactions Between Member Banks and Their Affiliates, 67 Fed. Reg. at 76,560.

[7] 12 USC 371c(f)(2).

Software Patents

nospam@example.com (Chia-Yu Chang) — Fri, 14 Jan 2011 08:25:00 -0700

- Tiptoeing for a balance, or taming of the shrew

Many people have discussed the case, Bilski v. Kappos, and so I will not repeat it. (See, e.g., here & here.) As a quick introduction, Bilski was an inventor who applied for a patent on a “method of hedging commodity transactions”; USPTO rejected it; it was appealed eventually to the US Supreme Court; and on 6/28/2010, the Supreme Court rejected the patent application as well.

Bilski did not involve software directly, but its sibling category, “business methods” (specifically, “method of hedging”). Software, however, invariably involves steps (ie, methods) of computation, and therefore the general holding in Bilski with respect to method-type inventions could be applied to software patents by analogy.

The big-picture issue in Bilski was the threshold question, “What type of ‘method’ inventions are not eligible for patents regardless of whether they are new, ingenious, or properly disclosed to the public?” The Supreme Court held that if these “method-type” inventions are simply “abstract ideas”, then they would not be eligible for patent protections, categorically. (Four of the justices would have held that all business methods were not patentable.) The Court, however, declined to give a clear guidance on how to define “abstract ideas”, and simply threw the ball back to the lower court (ie, Appellate Court of the Federal Circuit; no pun intended) to find the solution.

Most people agree with the principle that “abstract ideas” should not be eligible for patent monopolies. The principle has been a fundamental cornerstone of US patent laws since as early as the nineteen century. (E.g., Rubber-Tip Pencil Company v. Howard, 87 U. S. 498 (1874)) The devil, however, is in the details. And the real battlefield is in how USPTO and the courts decide which inventions are “abstract ideas”.

With respect to software inventions, BPAI (Board of Patent Appeals and Interferences of USPTO) in its recent decisions appears to have equated “abstract ideas” with the term “software per se”. Moreover, BPAI has shown increasing tendency to dispose of software patent applications based on the “software per se” ground since 2007. (See table below.)

**Number of Applications Disposed of By BPAI on “Software *per se*” Ground**
Year	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010
#^*	0	0	0	0	0	0	2	3	13	18	44
*: The numbers were obtained by searching for “’software per se’ AND 101” in the BPAI opinion database available on USPTO website.

I have listed below some of the software applications that have been rejected in 2010, post-Bilski, by BPAI on the “software per se” ground.

Case	Date	Claimed Invention^*
Ex Parte Proudler	07/08/2010	Method of controlling data security by associating sets of usage & security rules to individual data.
Ex Parte Birger et al	07/13/2010	Method of communicating between a network and an application by using a middle layer and a global address.
Ex Parte Fellenstein et al	07/27/2010	Method of finding best time to contact a user in a messaging system by compiling & using statistic usage data.
Ex Parte Choo et al	07/28/2010	System of controlling file access in an OS, by setting up rules for compartments in the OS.
Ex Parte Ramanujan	08/12/2010	Apparatus of converting a digital value in low bits to one in high bits.
Ex Parte Christian et al	08/23/2010	Method of determining and applying security screens to input received thru web pages.
Ex Parte Russo et al	08/30/2010	System of grouping social network subscribers.
Ex Parte Hong	09/21/2010	Method of filtering an image by determining filter strength and using contrasts with neighboring pixels.
Ex Parte Kropaczek et al	10/13/2010	Method of optimizing an objective function, where the objective function includes the sum of a credit term and a penalty term.
Ex Parte Sung et al	10/28/2010	Method of detecting malicious intrusions in a computer network by using detecting algorithms.
Ex Parte Martin	11/15/2010	Memory program monitoring data level of buffer memory receiving compressed data.
Ex Parte Asare et al	11/17/2010	Method of modeling the component hierarchy of an OS.
*: The descriptions are my own paraphrases.

In these cases, BPAI referred to MPEP 2106.01(I), which is titled “Functional Descriptive Material: ‘Data Structures’ Representing Descriptive Material Per Se Or Computer Programs Representing Computer Listings Per Se”. The term “software per se” under BPAI, therefore, seems to refer to “data structure per se” and “computer listing per se”. Furthermore, the texts of the MPEP section distinguish the “per se” category based on whether the software or data structure defines “structural and functional interrelationships” between the software or data structure and other claimed elements of the computer. The section, however, does not define any standard or test in determining whether such “structural and functional interrelationships” have been sufficiently defined to avoid the “software per se” rejection.

Note that not all applications that had been rejected by the examiner on the “software per se” ground were affirmed by BPAI. See, e.g., Ex Parte Thornton et al, 01/06/2011. ("A system that manages the updates of land parcel drawings.") Moreover, in its first opinion after Bilski, (Research Corp Tech v. Microsoft), the Appellate Court of Federal Circuit on 12/8/2010 held that a method of generating halftone images was patent eligible. This holding contradicted with BPAI’s earlier determination in Ex Parte Hong (see table above), which also involved methods of processing pixel images. It remains to be seen whether BPAI will modify its position toward all software patent applications following Research Copr Tech, or distinguish the opinion on its facts.

Even after the anxiously anticipated Bilski opinion, there is still no clear legal guidance in deciding whether or not a software invention is simply an “abstract idea” and thus barred categorically from patent protections. This void will certainly result in more confusions and inconsistencies at USPTO and the various courts, and thus impart greater uncertainties in the software patent application processes.

Goldman Sachs code leak

nospam@example.com (Chia-Yu Chang) — Tue, 14 Jul 2009 09:06:56 -0700

- Are trade secrets patentable?

The media reported early last week that an ex-employee of Goldman Sachs had been arrested by the federal authorities for allegedly stealing the codes of the company's proprietary trading system. (See here & here.) According to the reports, US prosecutors told the court that the revelation of the secret codes would cost the company "millions upon millions of dollars". What is more, the prosecutors said that the stolen codes could be used to "manipulate markets in unfair ways". It also appeared that the ex-employee left GS in June this year to work for another company also engaging in the business of proprietary trading.

This piece of news did not raise too many eyebrows in the markets. GS's stock prices were virtually unchanged through the week. It does raise a few interesting related questions, though. For example, if the codes can indeed be used to unfairly manipulate markets when fallen in the wrong hands, did GS take advantage of that malign capacity while it had the secret possession? Also, did the ex-employee sign any non-compete agreement that should have prohibited him from working in a similar field?

I am not going to talk about these questions in this posting. Rather, I would like to focus on another question related to the intertwined paths of trade secret and patent. -- Now that the cat is out of the bag, can GS seek to patent the previously secret strategies to prevent others from using them? Or, more generally, even if the secret codes had not been stolen, can GS patent the strategies after profiting (supposedly) from them secretly for some time?

On a first look, there seems to be little reason for GS to pursue patents for the stolen strategies. Proprietary trading firms normally prefer to keep their strategies confidential, because if too many people trade the same strategy at the same time, any profit opportunities will quickly disappear. Even though theoretically a patent may allow the owner to stop others from using the strategies when they are no longer proprietary, figuring out who is/are using the strategies and enforcing the patents can be challenging. Moreover, it may take years to obtain a patent, when the strategies will most surely have outlived their usefulness.

There is, however, no guarantee that others will not obtain patents and seek to prevent GS from using the strategies. Also, it is not entirely impossible to find out whether the major players (maybe not all the players) are using the same strategies. Patents therefore may be effective and useful in preventing these major players from using the same strategies. In addition, even if the strategies have lost their values in proprietary trading, they may still have significant values in hedging, corporate financing, preventing "unfair market manipulations", non-proprietary trading for clients, risk management, and other uses.

Whether the secret strategies are patentable will depend generally on the normal criteria, principally whether the strategies are new and non-obvious. A more specifically related issue here is whether the past secret use of the strategies by GS would preclude the strategies from the patent grant.

This issue arises because the main goal of the patent grant is to encourage public disclosure of inventions. It would contradict this goal, if an inventor is permitted to keep an invention secret and profit from it for a long period of time, and then continue to be eligible for the patent monopoly when trade secret is no longer a desirable or viable strategy.

The patent law does not explicitly address this issue. The Patent Act requires an inventor to submit a patent application within one year only if the invention is "in public use". (Patent Act §102(b)) The courts, however, have broadly construed the term "public use" in this context to include most commercial activities, excluding only strictly confidential uses. For example, the courts have held that giving corset steels to a close friend to wear intimately without restrictions was public use (Egbert v. Lippmann, US Supreme Court, 1881); selling to the public a product manufactured by a secret method was public use for the secret method (Metallizing Engineering v. Kenyon Bearing, Second Circuit Court, 1946); limited market testing of a product manufactured by a secret method was public use for the secret method (Dippin' Dots v. Mosey, Federal Circuit Court, 2007).

Giving these previous cases, does the "secret" use of the strategies by GS in the public markets to profit for itself (and perhaps for its clients) constitute "public use"? (Assume that GS invented the strategies and has used the strategies for more than one year since the invention.)

I have not found any case that directly addresses this fact pattern. And, it can be argued that because GS used the strategies strictly in confidence, not giving up the strategies to the public domain, the uses were not "public use", even though GS did profit from them. The previous lines of cases, however, were not concerned about whether the public had learned about the invention. Rather, the core of the holdings was that the inventor had given up the patent rights by keeping the invention secret for too long.

Therefore, it is most likely that GS will not be able to obtain a US patent on the secret strategies. Other countries, however, may still allow trade secrets to be patentable.

Protection of foreign trademarks

nospam@example.com (Chia-Yu Chang) — Tue, 05 May 2009 05:04:00 -0700

-- The value and vanity of fame

[Note: In this posting, the term "trademark" includes both trademark and service mark. Also, jurisdictionally I refer primarily to federal trademark protections, not state protections, except where explicitly stated otherwise.]

Trademark protections are generally limited by national boundaries. A trademark that is protected in, say, Germany does not automatically mean it will be protected in US. Particularly, trademark protections are conditioned on "use", but this "use" generally is limited geographically only to uses within US territories. Therefore, a trademark first used in a foreign country may not necessarily be protected in US, if it was not first used in US.

In an increasingly globalized economy, such territorial limit is bound to give rise to an increasing number of disputes. The recession and the consequential shift of focus to the domestic economy in many developing countries (particularly BRIC: Brazil, Russia, India, & China) will only accelerate the trend. -- Many small, strictly domestic businesses in these developing countries will benefit from the thriving domestic economy and grow quickly into national franchises. At that point, these businesses will seriously plan expansions into the US markets, but might find their trademarks already used by others in US. It's predictable that many of these foreign businesses will challenge the existing US trademarks, in an attempt to extend their foreign trademark protections to US.

In general, because of the territorial limit of trademark protections described above, these foreign businesses will not prevail. US courts, nonetheless, have recognized an exception to the territorial limit of trademark protections, and have granted protections to foreign trademarks (that were used in US later than other domestic trademarks) if they are "famous" or "well-known" in US. This "well-know mark" exception, however, is not derived from express US trademark laws, and as a consequence has created conflicts among different courts.

Consider first a case in California. A large supermarket chain in Mexico had used and registered the mark GIGANTE in Mexico (but not in US) since 1960s. A US company opened two food stores in California in 1990s and called them "Gigante Market". Then beginning in 1999, the Mexican supermarket chain entered the US market and opened several stores in Los Angeles and called them "Gigante". Lawsuits ensued to determine who, the US company or the Mexican supermarket, has right to the GIGANTE mark. The 9th Circuit Court recognized the "well-known mark" exception and held that the Mexican supermarket chain, which first used the GIGANTE mark in Mexico, could have rights to the mark in US, if the mark was determined to have been "well-known" in California, among other factors.

In 2007, however, the 2nd Circuit Court in NY reached an opposite conclusion from the 9th Circuit Court. In the NY case, the ITC Hotel established Bukhara Restaurant in 1977 in New Delhi, India. The restaurant was voted Best Asian restaurant and one of the top 50 in the world by Restaurant Magazine of UK in 2007. ITC did open a restaurant in Manhattan in 1987 but closed it in 1991. In 1999, several ex-employees of the original Bukhara Restaurant opened two restaurants in Manhattan. The new restaurants were named Bukhara Grill and had similar interior deco as the original ones. The New Delhi Bukhara sued the New York Bukhara, asserting the "well-known mark" protection. The 2nd Circuit Court, however, refused to recognize the "well-known mark" exception, citing absence of a clear intention of the Congress to enact such an exception into federal trademark laws.

As a result, currently foreign "well-known marks" can be protected by federal laws in the states within the 9th Circuit (AK, AZ, CA, HI, ID, MT, NV, OR, WA), but not in NY. The conflict will need to be resolved by the Supreme Court or by the Congress.

Finally, I note that the 2nd Circuit Court in the Bukhara case eventually asked the NY State's highest court to help answer whether a foreign "well know mark" may be protected under NY state laws. The NY's highest court answered, "Yes", although under the theory of misappropriation of commercial advantages in the unfair competition context, not as a "well-known mark" exception to the territorial limit on trademark protections.

The pursuit of fame

Turns out to be not in vain,

Insofar as a mark of trade

Is the center of the realm.

It's the federal or the state

That will be the game.

Climate change & economic stimulus

nospam@example.com (Chia-Yu Chang) — Wed, 11 Mar 2009 15:01:00 -0700

-- Risk & reward

[NOTE: This article was originally written in Chinese in January 2009, and published in the newspaper World Journal on 2/26/2009. I want to thank the World Journal for its generous permission for me to post this updated English version here.]

President Obama's $787 billion economic stimulus plan is now in full swing. The enormous government spending plan spans several key areas, including tax cuts, social welfare, education, healthcare, housing, scientific research, infrastructure, and energy. It was clear from the beginning, however, that climate change was one of the most important elements in his stimulus plan.

Aiming to turn the public's concerns over climate change (and the related issue of energy self-reliance) into the driving motor for economic growth, the president's plan will invest heavily in energy-related infrastructure construction, such as smart power grid and renewable energy. It will also invest in other venues capable of reducing greenhouse gas emission, including improving energy efficiency, electric vehicles, or green manufacturing facilities.

For those concerned with potential undesirable human impacts on the earth's climate, the stimulus package should be exciting news. Climate change, however, is still a controversial subject, entailing numerous uncertainties and risks. It will be necessary to understand these risks to properly understand the associated risks introduced into the stimulus plan, and the economy, by the inclusion of the "climate change" element.

Government bureaucracy: Greenhouse gases are invisible and odorless, and pose no direct harm to human health. Releasing the gases into the air incurs little, if any, direct costs. As a result, large-scale reduction in greenhouse gas emission is unlikely, unless the government intervenes to regulate the activities. Government bureaucracy, nonetheless, introduces a first layer of risks into the stimulus plan.

The gap from science to policy: A majority of scientists now agree that human activities and the greenhouse gases they generate were principally responsible for the drastic rise in the earth's surface temperature during the past century. Uncertainties, however, still exist due to several factors such as the natural fluctuations in the earth's climate, the uncertainties in our models of climate change, the uncertainties regarding the impact of human activities, and the errors in data collected. These uncertainties will result in a gap from science to policy, adding another layer of risks.

Broad scope of influence: Every corner of our modern industrial society, including power plants, industrial factories, transportation, agricultural activities, or buildings, directly or indirectly releases greenhouse gases. The impact of any government policy will be broad in scope and enduring in time, which increases the risk of heightened political confrontation.

Cost pressure: Businesses need to invest in research, equipments, or services to reduce greenhouse gas emission. With the weak economy, the cost pressure will transform into high political pressure, diminishing the efficacy of the stimulus plan.

Immature technology: Green tech has made significant progresses in the past decades, leading to successful products such as solar photovoltaic panels, wind turbines, hybrid engines, etc. There is still a long way to go, however, before green tech can upstage petro fuel as our main energy source, and otherwise reduce greenhouse gas emission in other areas. In the 70's, US implemented a cap-and-trade system to reduce the emission of sulfur dioxide that was the source of acid rain. The system successfully stimulated development in new technology, and achieved its goals in less than 50 years. It is unknown, however, whether the domestic experience can be transplanted to the global climate change issue.

Uncertain market demand: In the past several months, the oil price has fallen from ~$147 to less than $40 a barrel. [UPDATE: The oil has rebounded recently to ~$50 / barrel.] If global economy and oil prices remain depressed, so will the market for credits in greenhouse gas emission reduction (a/k/a carbon credits), delaying the development and implementation of new green tech.

Reluctance by developing nations to participate: Among the 4 BRIC nations, China has become the world leader in the aggregate amount of greenhouse gas emission, surpassing US recently. The emissions by Brazil, Russia, and India are not too far behind or are increasing rapidly. These 4 nations, however, have been reluctant to limit the greenhouse gas emission of their domestic businesses, for fear of slowing their own domestic economic growth. As a consequence, political pressures have been mounting within US against unilateral reduction in domestic greenhouse gas emission. This political pressure will not disappear in spite of the new government.

Unintended consequence: Several years ago, the US government encouraged the production of ethanol as a replacement of petro oil. Many farmers therefore sold the corns from their farms for the production of ethanol, which resulted in shortage of corns in the food markets and caused food prices to surge. All the other methods in reducing greenhouse gas emission may result in similar unintended consequences in the complex societal or biological chains.

In light of these risks, and the surging federal deficits, the rate of success of the stimulus package will depend on its ability to attract diverse private investments and international participation. To the private sectors, on the other hand, these risks may represent new demands and new markets. When viewed from the right angle, risk and rewards are often two sides of the same coin.

For a Chinese version published on the World Journal, please click the link at the end of this paragraph. 欲閱讀在世界日報上發表的中文版, 請按此連結鍵 here.

Government regulations, markets, and innovations

nospam@example.com (Chia-Yu Chang) — Fri, 07 Mar 2008 14:15:04 -0700

-- 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.

Potential size of greenhouse gas (GHG) markets

nospam@example.com (Chia-Yu Chang) — Tue, 04 Mar 2008 18:15:57 -0700

-- 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.

Potential size of the greenhouse gas markets

nospam@example.com (Chia-Yu Chang) — Fri, 22 Feb 2008 15:25:20 -0700

[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.

**Computer Model Estimates of GHG Emission Cuts Needed to Stabilize Atmospheric GHG Concentrations**
Model	CO2 stabilize at 650 ppm*		CO2 stabilize at 490-540 ppm*
	2000-2030	2000-2100	2000-2030	2000-2100
1	90	2700	220	4300
2	60	1800	200	3000
3	60	1900	230	3800
Note: All GHG emission numbers are in billion tons. The numbers are my own estimates based on a bar chart in the IPCC report. They do not represent the actual numbers used in the report. *ppm = parts per million

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.

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