Our Nuclear Future - Financial Risk and Externalities II

Hanford Facility, Washington

In my last article on the nuclear issue, "Our Nuclear Future, Financial Risk and Externalities",

I discussed Rating Agency Capital Models in the context of nuclear risks such as those posed at Fukushima, Chernobyl and Three Mile Island.

The issue of managing the risks associated with both military and commercial nuclear applications is a vital one, that should interest all of us and speaks to the very concept of externalities and how to manage them in a global world.  In this article I focus on commercial applications.

The Fukushima disaster was impacted by inadequate safeguards.  The tsunami risk was not adequately taken into account in planning where to place the back up generators which could restore power in the event of an interruption of power.  The back up generators were placed at point too near the sea wall protection that left them exposed to the tidal wave action of the large tsunami that hit off Fukushima on March 11, 2011, when an 8.9 magnitude earthquake was experienced.

How do we deal with the risk management issues concerning the financing, construction and operation of nuclear plants, and with the issue of managing nuclear waste from both military and civilian applications?  These issues concern low probability, high risk events, issues that fall outside of the scope of normal everyday events.

The federal government offers nuclear power plants some degree of protection from liability.  These limits on liability, which exist in order to encourage the construction and operation of nuclear plants for power generation purposes, do not do as thorough a job of mitigating risk as they should.  This is because an external party, the federal government, is responsible for the oversight.  In the case of Fukushima, where plants are constructed and operated across national boundaries, the issues become more complex.

The Fukushima Daiichi nuclear power plant was constructed and operated in Japan, by Fukushima General Electric (GE), Boise, and Tokyo Electric Power Company (TEPCO).  The components of the nuclear plant were provided by contractors such as GE,which provided six GE nuclear reactors. Other contractors were also involved. Multi-national resources were employed.  Liability issues are very difficult to ascertain.  It is very probable that the loss of the ability of the generators to provide power after interruption in service due to the tsunami materially impacted the fate of the nuclear material in those reactors and magnified the effect of the event.

Management of these issues across national boundaries presents a serious issue.  How do you price for risk when governments put caps on liabilities?  It is easier for companies to price for risk when the risk is limited!  The incentive for commercial entities to manage risk is reduced when they do not have to absorb the risk of extreme events in either pricing of their products, mitigation of that risk, or the application of design elements to manage that risk. The risk is shifted to the governments.

When all else fails, due to the failure to put in place elements that will mitigate extreme risk, governments have to step in.  At this point, governments must ascertain their own issues of financial accountability and debate among themselves.  This issue is currently unfolding as nuclear radiation emerges from the Fukushima disaster and manifests itself in the ocean, carried by currents, and in the air, as was the case with the Chernobyl event.

Clearly, there must be a better match between potential liabilities and mitigation of risk.  The problem occurs when it becomes financially unfeasible for companies to price for the risk of very low probability, high risk externalities.  The government(s) must retain the capability to regulate.  History has shown that government regulation is difficult in the face of corporate profits.  This was shown in the history of seeking to regulate the ASARCO smelter.

Nuclear power plants do not arise ex nihilo. They must be financed, built, insured.  How do you finance nuclear power plants?  They can be built with government financing and the government can assume all the risk.  In a commercial enterprise, across national boundaries, private parties can finance nuclear power plants if they have sufficient funds and can insure the risk of loss, either by commercial carriers, government support or by self insuring.

There are many financial instruments that may be available to finance nuclear power plants.  In addition, nuclear power plants require real estate.   A component of a nuclear power plant can conceivably be moved from one site to another, yet the ground below stays, and is subject to the risk of contamination.

It is instructive to look back at the history of Nuclear Power Plant generation in the Northwest.  The situation with Washington Public Power Supply System Bonds is instructive (WPPSS).  An article from HistoryLink.org discusses this history of one of the largest bond defaults in history.  Five WPPSS power plants were envisioned, and WPPSS power plant 2, the Columbia Generating Station, survives.  The facility is now called Energy Northwest, and produces 12% of the power generated by the Bonneville Power Administration.

A great portion of the Northwest's power supply is generated by hydroelectric sources such as those operating along the Columbia River.

The discussion of financing nuclear power plants rests with a projection of bond default experience over time (default matrices), and how bond ratings emerge through Rating Agency models such as Standard and Poor's, Moody's and A.M. Best.

Clearly, the issue of using bonds to finance nuclear power plants is a critical one, in more than one way.  WPPSS financing has provided an example of the risk of building nuclear plants, financing them, and having companies such as insurers and banks assume the risk of financing them.

Financial institutions take risks when they purchase company bonds.  The construction and operational risks (there are separate bonds for construction and operation) are borne by those that purchase the bonds.  Riskier enterprises are assigned a risk premium that is reflected in the interest rate offered on the bond.  The riskier the enterprise, the higher the interest rate, and the longer it takes the enterprise to retire the bond.  This is basic economics.

Given the history of WPPSS, it is difficult to construct a model for financing nuclear power plant construction.  History has shown that even rating bonds for more ordinary applications, is fraught with risk.  The financial events of 2008 have demonstrated to us how the domino effects of  certain companies being taken down can bring a financial system to the brink.  It is clear that certain financial institutions were allowed fail, while others were bailed out by the government.  Insurer AIG, for example, was bailed out, while Washington Mutual was allowed to fail.  This is a very interesting aspect to investigate, since Chase was left purchasing and holding the assets that Washington Mutual had accumulated over time.

The 2008 financial collapse is another blog article, however it is instructional in how bond defaults can bring down a financial system. Suffice it to say that mortgage backed securities, collateralized mortgage obligations, credit default swaps (CDS's) and collateralized debt obligations (CDO's) played a large role in this collapse. These issues reflected the financial arbitrage reflected in Rating Agency and regulatory agency capital analysis of financial institutions.  The actions that the government took, in deciding which institutions to rescue and which institutions to allow to fail, helped determine the path that would be taken.

Rating Agencies played a large role in the events that unfolded.  I have discussed Rating Agencies in previous articles.

Clearly, nuclear financing issues present complexities beyond those presented by other issues financed by our market system.  There are limits to liability that impact the nuclear arena.  We are left, then, with a cooperative issue impacting the ways in which governmental regulatory agencies can interject themselves into the system and regulate in a manner to mitigate low probability high impact risk.

This takes us again back to the past, and the issues attendant in regulating ASARCO Smelter Emissions and the problems that this issue presented.

These are the issues we face in these times of global warming and climate change, as we consider the risks and benefits of financing nuclear power plants.  Alternative energy sources are discussed in my article "Global Warming and Climate Change - Polar Pioneer" .

We must consider the issues of regulatory government as it is juxtaposed with issues concerning market operations, in dealing with situations that involve low probability, high risk events.  It is clear that unfettered market operations may bring about market collapse through the interrelationships that exist within the structure of markets. It is also clear that government regulation that is not strong enough may not be able to counter the impact of market forces that overrun it, especially considering the profits that can be developed in certain markets.  Furthermore, it is clear that government forces may act in a manner contradictory to public interest by choosing winners and loser, perhaps steered by an array of  predefined values of certain groups.

Can we trust government?  We must have checks and balances.  Do we want government to only have one option, or to offer choices?  I'm in favor of choices, as choices facilitate change, which is needed. Market research has shown that people can tolerate only so many choices; this has been in areas such as bottled peaches, cereal, etc.  Would we ever want our choices in cereals and bottled peaches to govern our choices in power generation and other key areas?  No, however the analogy is instructive.

We need a government strong enough to regulate; the problem in regulation, however, has shown that it is difficult for regulatory agencies to keep up with the profits that can be made from activities under investigation.  This is certainly true in the financial arena where new instruments, especially those employing financial arbitrage, arise in order to present profit opportunities that defy regulation.

Constitutional issues such as due process and informed consent are bell weather issues in our financial and social system.  The Justice Department has a long storied history in regulating monopoly.  These are all important issues as we consider regulation of markets, intrusion of regulators/law enforcement into markets, and imposition of systems which defy Constitutional rights.

These issues all reflect ongoing issues of climate change and global warming and the effect of the environment on certain populations.

Our Constitutional rights are now under attack and must be defended, especially as regards issues of due process and informed consent.  I have made a thorough examination of the social processes existing in our society today and find material flaws in social systems.

Social systems and the justice system as they currently exist need serious reforms to enforce the Constitutional rights that we hold so dear to us, as do imposed belief systems.

marilyndunstan.blogspot.com

Our Nuclear Future - Financial Risk and Externalities
Our Nuclear Future - Hanford and Spent Nuclear Fuel
Global Warming and Climate Change - "Polar Pioneer" and Arctic Drilling

Externalities

Chernobyl 25th anniversary 
Energy Choices and Risk
Global Warming and Climate Change-Polar Pioneer
Processing Risk and Uncertainty
Log in the Surf - 8.9 Japan Earthquake (9.0 updated)

History Link.org
Washington Public Power Supply System

Financial Rating Agencies and Risk - Liquidity

Iceberg, Weddell Sea, Antarctica

Updated 9/5/2015:
 

I took this photograph from the Icebreaker Kapitan Khlebnikov, as we transited the Weddell Sea from the Ice Shelf of Halley Bay to the Antarctic Peninsula.  Antarctica (map) is a land of beautiful desolation, and I was able to capture nature photographs depicting its stunning landscapes and the wildlife that inhabits it.  Many countries have stations in Antarctica and I was honored to be able to visit two of them, Neumeyer (German) and Halley Bay (United Kingdom).  

Icebergs have powerful symbolism, expressing concept in many different venues.  In the maritime sense, they represent hidden risk, as ten percent of the iceberg may be visible, the remaining ninety percent of the iceberg underwater.  The Titanic collided with an iceberg in the mid-Atlantic in 1912 and is an example of risk associated with transiting areas with icebergs.  These powerful metaphors or concepts can also be expressed in other venues, including the financial arena, where risk exists and may be hidden, subject to the impact of financial bifurcation points.  

Chaos theory discusses how financial risk, and bifurcation points can reflect hidden factors which sudden express what we term "Black Swan" risk events as typified by Mohamed A. El-Erian's work.

In the financial arena, these risks reside in financial rating models.  My June, 2015 article, Financial Rating Agencies and Risk, discusses Rating Agency models in the context of jet engines, which operate under a wide range of atmospheric conditions. Similarly, financial vehicles are tested under a wide range of scenarios, by various entities such as Rating Agencies and regulators in a wide variety of fields, including banking and insurance, under different legal constructs and governmental agencies.

As discussed in my article, Financial Rating Agencies and Risk, different Rating Agencies, such as Standard and Poor's and Moody's may reflect their analysis of risk in different ways.  General Electric (GE) is used as an example in my blog article. which discussed Standard and Poor's maintenance of GE's rating in the light of its decision to divest itself of real estate assets and exit its GE Capital Finance arm.  Moody's, however, downgraded GE on its decision, indicating GE was favoring equity investors over creditors.  These rating decisions reflect different decision processes by Rating Agencies, not explicit government agencies.  However these Rating Agencies have considerable impact over the manner in which financial decisions are reflected in the marketplace.

Clearly, there is hidden information which Rating Agencies, and governmental entities, are aware of.  When there is a relationship between Rating Agencies and financial entities, as in the payment of a fee in exchange for a rating service, there is an incentive for the Rating Agency to monitor the actions of the company, as money has changed hands, and participate in the decisions of the company involved.. At some point, however, the economic prospects of the company do not warrant the degree of risk assigned to it, and the Rating Agency may choose to exercise a number of financial tools in order to maintain its credibility in the financial marketplace as a reliable partner in assessing risk.

You see, the Rating Agency has two major clients; one, those purchasing its evaluations of companies, and another, two who pay for its services in order to exchange information, maintain a rating as to its financial soundness, and exchange information in order to do so.  Government agencies are a different entity involved, and they sit and cast a watchful eye over the ability of Rating Agencies to remain impartial; they are also concerned as to the ability that Rating Agencies have to move the markets, and, especially, their ability to impact major market moves that could mask efforts at financial or other types of terrorism.

This is where the increased complexity of emerging financial instruments presents a risk for regulators as they seek to keep up with new financial structures and derivatives such as special purpose vehicles, credit default swaps (CDS) and collateralized debt obligations (CDO's).  The Treasury, certainly, is interested in attack on the financial system.

A company does not exist in a vacuum; it exists within a financial structure of ever increasing complexity, reflecting not only national considerations, but a world economic milieu of globalization that impacts its decisions, as nations develop and industries expand, contract and relocate or adopt new methodologies such as outsourcing.  Externalities are always a consideration, and this this issue is discussed in my blog article of the same name.

This brings us back to the iceberg and the hidden factors. GE presents an interesting case study as we look to parse the actions of Standard and Poor's and Moody's in their rating of GE.  My blog article, Our Nuclear Future - Financial Risk and Externalities briefly discusses the issue of the six nuclear plants designed by GE, which were part of the Fukushima Daiichi Nuclear Site's design.  The interesting question is the use of ratings in conjunction with the use of chaos theory and bifurcation points to bring down the economy and financial system.

There are specific provisions (options) in financial agreements that allow a company to take action in the case of certain events such as ratings downgrades.  This puts a particular onus on Rating Agencies who have access to company information; it also presents a challenge to companies being rated as they seek to understand the processes which rating agencies use to rate their companies.

The interesting question in analyzing GE in the light of its departure from GE Capital, which finances GE engines, and from real estate, is its liquidity position and its exposure to risk from liquidity events in the light of the various risks that its operations faces.

Indeed, liquidity is an important consideration in analyzing a company's financial soundness.  An example where liquidity events have taken down companies is General American Insurance, where exposure to risk from institutional investors brought down the company.  General American had high exposure to funding agreements, which allowed policyholders to exercise a put option (withdraw funds without penalty) upon the adverse action of Rating Agencies. The construction of funding agreements involved mark to market issues and the use of put options in mutual funds (7 day put options).  Moody's downgraded General American's insurance financial strength rating from A3 to Ba1 on August 9, 1999.

The interesting question with the actions of Standard and Poor's and Moody's with regards to GE is the divestiture of the GE Capital financing arm and the Real Estate assets; both of these events seem to reflect a move to better match projected assets and liabilities by increasing liquidity, potentially in the light of anticipated liabilities.  These are the hidden, or unknown issues that confront regulators.

Why discuss GE?  With issues of climate change and global warming, jet engines, which operate under a wide range of atmospheric conditions utilize various fuels for combustion under a wide degree of parameters representing different aspects of aviation usages, including private, commercial and government use. My blog article on the Polar Pioneer discusses these issues in the light of exploration and drilling for petroleum products in the Arctic. The availability of fuel and the mode of combustion and types of engines employed will always be an important characteristic of any decision process as we analyze our future options.

Many people have contributed to the issues discussed in these blog articles and I express my appreciation to them and to their contributions.

Liquidity issues are important factors in assessing financial risk.  They represent one category of risk among others that can reflect bifurcation points which can impact the economy.  Organization structure is also important, as indicated by the Barings Bank issue where Nick Leeson was involved on both sides of the house, trading and operations.

Alamy.com - Risk Lightbox

marilyndunstan.blogspot.com:

Financial Rating Agencies and Risk 

Externalities

Polar Pioneer and Climate Change - "Polar Pioneer" and Arctic Drilling

Kapitan Khlebnikov (Icebreaker)

Wikipedia:

Titanic

Fukushima Daiichi Nuclear Site

Mohamed A. El-Erian

Maps:

Antarctica Map -One World - Nations Online

Rating Agencies:

Standard and Poor's

General American Insurance:

General American News - Mississippi Department of Insurance
Standard and Poor's- What May Cause Insurance Companies To Fail--And How ThisInfluences Our Criteria

GE:

GE - Fixed Income Investing

Externalities and Risk - The Seattle-Tacoma International Airport

Birds, Third Runway, Seattle-Tacoma International Airport

The City of SeaTac held a meeting on March 24, 2015 that included discussons on the Seattle-Tacoma International Airport Sustainable Master Plan by Port of Seattle representatives.   A news report of the meeting can be found on the SeaTac blog.

My comments at the meeting addressed the issue of externalities associated with airport operations and their impact on the surrounding community, especially in the area of health.  Externalties are an important topic in social and economic policy.  An externality is the consequence of an economic activity affecting a party that did not choose to participate in that activity.

There are a myriad of issues surrounding development in the area of the Seattle-Tacoma International Airport.  The airport is an engine of growth and development which brings business into the region, and as a hub, enables the flow of commerce to other areas of the country and the world.  The airport provides economic benefit through the multiplier effect.  The multiplier effect is an economic term to express the economic effect that the introduction of an engine of growth has on the community.

The airport provides jobs to support direct and ancillary airport operations.  As business cluster around the airport (e.g. Car Parks, shuttles), these activities provide an engine for the economy's growth.

However economic activities have costs, as well.  In addition to direct costs to service airport operations, costs may include building more roads to service traffic that serves the airport and other municipal items.

There are a number of externalities arising out of airport operations.  These issues involve air, water and noise pollution, impacts on the respiratory and other health systems, and even sense of smell.   There are psychological impacts, as well, including psychological impacts that express themselves over a wider social framework.

Airport externality issues are felt on a local basis, by those living at the edges of the airport, nearby, those under flight paths and on a city level as cities adapt to the challenges presented by the airport's growth. While these externalities are felt most acutely locally, they are also expressed over a wider distance throughout the region as the area struggles to deal with challenges presented by increased commercial and passenger activity.

I list blog articles regarding  externalities in a variety of areas (below) to establish a context within which the impact of the airport can be viewed as an individual example of an externality.


"Externalties"
 "World Air Pollution Organization Report on Air Pollution and Health"
 "Climate Change and Global Health"
 "Avian Flu"
"Mt Rainier Balance of Risks"
 "Nuclear Balance of Risks"
"President Ronald Reagan and Alzheimer's Disease"

Externalities

Externalities


Refinery Exhaust Stacks, Anacortes, Washington (image on Photoshelter)

Air pollution from a fixed stack is a good example that can be used to explain the concept of an externality. I discussed the externalities previously in a blog article (Risk and Externalities) in the context of the BP oil spill and its widespread impact in the Gulf of Mexico.

On the production side, externalities come into play when the full cost of production is not reflected in the cost of the good.

Air pollution emissions may contain various pollutants, gaseous and particulate matter. The area impacted and the degree of impact will be affected by the pollutants released and the meteorological conditions.

For example, a temperature inversion will keep cold air close to the surface under a layer of warm air so that the air does not mix well vertically. The pollutants will be kept closer to the surface and their impact will be greater.

Sulfur dioxide emissions may impact lakes and fish (as acid rain), and thus ecosystems. Sulfur dioxide is a harmful pollutant for humans as well as fish. Sulfur dioxide can adhere to airborne suspended particulate matter. If the particulate matter is small, this may ease entry into the lung where the sulfur dioxide can do greater harm.

Air pollution is a direct result of the manufacturing process that extends from the stack into the community and beyond. It’s impact results in costs to others. Thus there are costs associated with air pollution that are not included in the production costs. To the extent that this is true, the product produced is under priced, and the public, an external entity, is paying those additional costs.

Costs include medical costs, as well as reduced life expectancy due to the pollution. Air pollution, in addition to being unhealthy, reduces visibility, may add odor, and adds quality of life issues. Pollution impacts maintenance of buildings and other structures.

Determing costs attributable to air pollution is a complex problem. There have been studies done to ascertain such costs. For example, a RAND study looked at health costs in California attributable to air pollution above state standards. That study would reflect air pollution due to a variety of causes, not just the point sources discussed in this blog article. California has a great deal of automobile pollution which contributes to carbon monoxide and ozone pollution problems.

Monitoring and regulation of air pollutants requires resources as well. Air pollution regulation and monitoring exists at the federal, state and local levels.

To reiterate, the producer’s price does not reflect these costs. Thus the price of the good is under priced with respect to other options because it does not include the cost of these “external” costs which others must bear.

When full external costs are brought into the mix, the producer’s price must necessarily increase. As it increases, other competing options may become more attractive and the producer may lose business. Alternatively, the producer may choose to upgrade the method of production to reduce the pollution, a cost they may not be willing to take if full external costs were included.

Air pollution is one example of an externality.

The situation becomes more complicated where the risk matrix considers low probability, high risk events. Such events may be difficult to estimate and to price for. Even assuming these low probability, high risk events could be reasonably priced for, it may be impossible for the producer to compete with prices reflecting such a risk margin. Competitors in the same field may refuse to include such a risk margin, thus driving the producer out of business. Competitors in other fields without such a risk margin will be at an advantage.

Where the risk margin for the low probability, high impact event is not priced for and is not included in the pricing there is the potential for considerable externality impacts should the low probability high impact risk event materialize.

As previous nuclear disasters have shown, the low probability, high risk event presents considerable externality issues in the nuclear arena, considering the serious impacts of radiation. (See my blog articles, Chernobyl 25th Anniversary and Energy Choices and Risk).

Risk and Externalities

Western Sandpipers Flying (blurred motion), Ocean Shores, Washington

Events are unfolding as the President’s Commission continues its inquiries into the 2010 Gulf Oil Spill. A major focus is around the cement used to plug the Macondo well. As Halliburton was a contractor for BP, issues of responsibility swirl around the interpretation of contractual language as well as actions in determining responsibility. These issues then emerge into the financial marketplace in as part of stock decisions and rating agency actions.

The decisions made by Halliburton and BP regarding the cementing and associated issues will be exposed to heavy scrutiny. The degree of indemnification provided to Halliburton in the BP-Halliburton contract will be closely examined and interpreted. Time will tell where all the lawsuits will come down, how many civil and criminal penalties will be assessed, and to who.

It is likely the quantum of risk will reflect decision-making processes in key areas such as the cementing issue. Those decisions should reflect the impact of externalities on the risk-decision spectrum. The question will be how much weight was given to immediate issues of cost and time versus the long tail risk of a disaster, including the impact of a spill on the coastal areas, the ocean ecosystem and birds that don’t buy stocks, don’t pump gas and whose idea of take out is a worm coming out of the sand.

Societies like to look at redress, at making victims whole, bringing back ecosystems. The concern is where does the money come from to accomplish these goals and is it enough? Redress also includes assessing and enforcing responsibility. Societies also need to address solutions looking forward to help prevent and mitigate future disasters, including regulatory and other solutions.