(John Kemp is a Reuters columnist. The views expressed are his own)

Warren Buffett’s acquisition of the remaining 77.4 percent of Burlington Northern Santa Fe (BNSF) railroad his Berkshire Hathaway does not already own looks like a strategic bet that America’s future energy needs will be met, in large part, through a massive expansion in coal-fired power generation coupled with carbon capture and storage (CCS).

Coal is the most important item moved on BNSF’s railroads. It accounted for almost half the tonnage moved by BNSF in the first nine months of the 2009 (214 billion revenue ton miles out of a total of 444 billion) and a quarter of the company’s revenues ($2.7 billion out of a total of $10.4 billion).

BNSF’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with CCS technology to curb the carbon-dioxide emissions.

BNSF controls the crucial rails linking the massive domestic reserves of the Powder River Basin, the Northern Great Plains, the Western Interior Basin and the Illinois Basin east to the main industrial centres of the Midwest and west to the major electricity demand centres in southern California.

* http://pubs.usgs.gov/of/1996/of96-092/Comp/main.gif
* http://www.eia.doe.gov/cneaf/coal/reserves/chapter1.html#fig1
* http://www.bnsf.com/tools/reference/division_maps/?menu=5&submenu=0
* http://graphics.thomsonreuters.com/109/US_ENRGY1009.gif

– John Kemp is a Reuters columnist. The opinions expressed are his own —

Perhaps the most frustrating aspect of much western comment on the unfolding crisis in Iran has been its over-simplification and lack of historical awareness. Perspectives are shaped by a single issue (western concerns about whether Iran is pursuing a nuclear weapons program) and the desire to draw a simple Manichean distinction between good guys (liberal-democrats) and bad ones (clerical-authoritarians).

The reality is far more complicated.

Part of the problem is a truncated sense of history. For most western commentators, the history of Iran’s troubled relations with the west starts in 1979 with the triumphant return of the glowering Ayatollah Ruhollah Khomeini at the head of the revolution which swept away Shah Reza Pahlavi’s western-backed regime and replaced it with a new Islamic Republic.

Western anxiety was compounded by the 444-day American hostage crisis that helped destroy the presidency of Jimmy Carter, and humiliated a United States still reeling from defeat in Vietnam and the Watergate crisis. Iran and the United States soon became embroiled in a series of proxy conflicts fought in Iraq, Lebanon, and via terrorist attacks on U.S. targets.

But for many Iranians the country’s troubled relations with the west can be dated further back — to at least the CIA-backed coup against Prime Minister Mohammed Mossadegh in 1953.

It marked a crucial turning point in Iranian history, something a bit like the Prague Spring, in which a popular, reforming and democratizing but also nationalist prime minister, who believed Iran should control the exploitation of its own petroleum resources, was removed by western intelligence agencies anxious to protect their countries’ interest in the oilfields.

The Pahlavist regime which replaced Mossadegh may have been modernizing and reforming, but it was also absolutist, dissolute and corrupt, and the Shah’s secret police, the SAVAK, ruthlessly hunted down and murdered opponents at home and abroad. While Pahlavist exiles abroad promote the memory of a modernizing golden age, there is no enthusiasm for monarchist restoration at home, and the Shah went into exile largely unmourned.

Criticism of the Shah’s regime was never confined just to religious conservatives. Even liberals were critical of the excesses of the Peacock Throne.

Iran therefore has no reason to love the western powers.

Subsequent events have deepened the mutual suspicion. When Iraqi President Saddam Hussein launched an unprovoked aerial attack on Tehran in 1980 and sent the Iraqi army across the Shatt al-Arab in a brutal war of aggression designed to exploit the turmoil and internal weakness of the fledgling Islamic Republic, the western powers stood aside.

Iraqi forces occupied the oil-rich and strategically vital province of Khuzestan, Iran’s cultural cradle, and captured the half-million strong city of Khorramshahr — and the west did nothing.

When Iran’s regular army and the volunteer forces of the Revolutionary Guard and the basij (the same groups now being used to suppress the protests) drove Iraqi forces back across the border and then moved into the al-Faw peninsula and began to threaten Iraq’s second city of Basra, Iraq resorted to chemical weapons — first the nerve gas sarin and then, when Iranian soldiers were given atropine-filled syringes as an antidote, switching to mustard gas.

Still the west did nothing. In fact, western companies were busy supplying the precursors Iraq needed to make its chemical arsenal and breach the Geneva Protocol. Meanwhile, western intelligence agencies were supplying Iraq with satellite reconnaissance photographs to aid the war effort.  Funding was catalyzed from friendly regional regimes to support Iraq’s faltering war effort and avert the risk of an outright Iranian victory.

To counter Iran’s successes on the ground, Iraq’s air force began strategic bombing of Iran’s cities, then switched to missile attacks on Tehran using Scuds, as Iran suffered its own version of the blitz.

None of this is to suggest Iran did not commit atrocities of its own, or to take Iran’s side over Iraq.

But when western leaders condemn Iran’s alleged quest for “weapons of mass destruction” and fulminate against Iran’s missile program, they betray a startling lack of perspective.

Some estimates put the number of Iranian soldiers who fell victim to chemical weapons as high as 100,000. Total casualties (killed or wounded) are put as high as 1 million. When Iran accepted a UN-mediated ceasefire proposal in 1988, Khomeini not unreasonably likened it to drinking a cup of poison.

Given this history, western leaders are in no position to deliver credible moral lectures, and it is hardly surprising that Iran’s leaders and media mutter darkly about western interference. Nor is it surprising that the Obama administration, seeking to improve relations, has been anxious to avoid the impression of meddling.

– John Kemp is a Reuters columnist. The views expressed are his own –

Economic history is the only field of human endeavor where the past changes as much if not more than the present and the future. Policymakers and practitioners struggle to define and write a “narrative” of the past as a means to control how policy responds to current and future problems.

The debate now over financial reform is a case in point. Even though the banking system has only just emerged from the most severe shock since the 1930s, the battle over how to define the events of the last 18 months, and what they should mean for investors and regulators in future, is already well underway.

Contrasting speeches last week by Federal Reserve Governor Kevin Warsh and Bank of England Governor Mervyn King illustrate the two extremes around which the debate is polarizing:

* Warsh speech

* King speech PDF

The financial sector will exploit these differences to derail any fundamental overhaul of regulation.

Warsh’s speech characterized the crisis as the “panic of 2008″ and set it in the context of the previous two decades of rapid non-inflationary growth, implying the crisis was an irrational aberration in an otherwise well-functioning economic and financial system.

In effect, Warsh reprised a philosophy associated with former Fed Chairman Alan Greenspan: occasional, wrenching crises are a price worth paying for an innovative, dynamic and wealth-generating form of capitalism. Policy should focus on ameliorating the after-effects rather than risk stifling growth by aiming to prevent crises altogether.

In contrast, King made the case for fundamental reform. He highlighted the real costs which a crisis that originated in the financial system is imposing on the real economy, as well as the more intangible but no less profound impact on attitudes towards wealth-creation, reward and regulation.

While noting there was no support for “excessively bureaucratic regulation”, King made clear “change to the structure, regulation and indeed culture of the banking system is necessary. Blaming individuals is no substitute for acknowledging the failure of a system, of a certain type of banking.”

STABILITY VERSUS GROWTH

King’s speech echoes the famous analysis set out in Hyman Minsky’s “Stabilising the Unstable Economy”. Minsky made a compelling case that periodic crises were an essential part of a financial-capitalist system in which massive long-term investment projects were financed by issuing large volumes of debt. By breeding over-confidence and increasingly risky capital structures, periods of stability laid the seeds of their own destruction.

But unlike Greenspan, Minsky argued such crises were not a “price worth paying”. Appropriate regulation was both necessary and desirable to constrain risk-taking to an acceptable level, and could be achieved without sacrificing growth. King’s speech appears to be advocating something similar.

Warsh is re-fighting an old debate between “stability-first” and “growth-first”. It is a false choice, as a closer look at the historical record suggests.

The problem with his speech is its truncated view of history. He notes U.S. output (measured by real GDP) grew at an average rate of more than 3 percent a year between the mid-1980s and 2007, and was significantly less volatile than in earlier periods. Unemployment averaged less than 5.75 percent, a full percentage point lower than in the previous 15 years.

But this is a tendentious use of dates. Warsh has picked the start and ends points to support a pre-determined conclusion. It specifically excludes the last two years of underperformance (2008 and 2009) from the period of the Great Moderation (as if the current problems had nothing to do with the policies pursued in the preceding years).

And by choosing the start point as the mid-1980s, then going back 15 years, it lumps both the Volcker recession of 1980-1982 and the oil shock of 1973 into the same base period for adverse comparison. With a selective use of statistics like this, it is possible to prove anything.

It is worth looking further back, in a more neutral manner. The attached PDF chart shows annual GDP growth since 1930 and the average rates for 20-year periods (1930-1949, 1950-1969, 1970-89 and 1990-2009).

While annual GDP growth was certainly less volatile during the most recent period, the average growth rate (2.5 percent) was not especially high compared with the previous 20 years (3.2 percent) or the two decades of the 1950s and 1960s (4.3 percent).

Warsh focuses on the undoubted benefits that openness to trade and rapid financial innovation delivered during the 1990s and the first part of the current decade, describing them as the principal achievement of the Great Moderation. Minsky’s own golden era was the 1950s and 1960s, when relatively conservative bank balance sheets and strict regulation appeared to tame the violent boom-bust cycle of the pre-war years while still enabling brisk growth and unprecedented prosperity.

But it is not obvious from the historical record whether macroeconomic management has been superior over the last 20 years to the 1950s and 1960s. Nor is it obvious policymakers have to choose between financial stability and economic growth. It is possible to have respectable growth and stronger financial supervision.

KEEPING OPTIONS OPEN

Minsky attributed the stability of the 1950s and 1960s to the impact of wartime finance, which had swapped a large part of the private securities on bank balance sheets for government debt, increasingly their liquidity, coupled with the development of a more extensive system of lender-of-last-resort, deposit protection and bank regulation.

Much of that framework of prudential oversight and conservative balance-sheet management has been swept away in the last 20 years as policymakers have relied more heavily on “market discipline”. The debate is how far to go in trying to recreate it.

Bank of England Deputy Governor Paul Tucker has already suggested banks should be forced to hold a greater cushion of highly liquid assets (for which read government debt) to reduce liquidity risks. In his speech, King reiterated the point.

He went on to suggest it was unsustainable that banks could take highly risky investment strategies while backed by an implicit (and free) state guarantee. Either regulation must be tightened, banks must pay for the guarantee, or it must be restricted to a range of “narrow banks” performing utility-like payments and basic lending services.

Rather than a set of detailed and perhaps politically unrealistic policy prescriptions, King’s speech should be seen as a plea to keep the debate and options open, not close them down prematurely and revert to business as usual.

King is right to try to encourage a deeper examination of the origins of the crisis. But radical reform seems unlikely. Wall Street and the City of London are already fielding an army of well-paid, silver-tongued lobbyists to deflect it. And as the divisions between King and Warsh reveal, regulators are too ham-strung by disagreements among themselves to force fundamental restructuring on a reluctant the industry.

– John Kemp is a Reuters columnist. The views expressed are his own –

Steady improvement in manufacturing surveys, payroll data and freight movements all indicate the U.S. economy is approaching the low point in the business cycle and should hit the bottom within the next one to four months. But that does not necessarily imply a strong and sustained expansion is about to get underway.

It is possible to be optimistic that the worst of the downturn is now over (or nearly so), while remaining cautious about prospects for strong and sustained recovery once the cyclical turning point is passed.

The slow and fitful recovery from the last recession is one reason to be careful. The National Bureau of Economic Research (NBER), the traditional arbiter of the U.S. business cycle, dates the last trough to November 2001 (eight months after the expansion peaked in March 2001 and just two months after the attack on the World Trade Centre). But signs of a strong and sustained recovery did not emerge for more than two years.

Fitful expansion in 2002 and 2003 is one reason the Fed kept interest rates so low for so long. While many commentators now see this is a significant error that contributed to subsequent bubbles in the bond and real estate markets, at the time the slow recovery caused officials, led by then-Governor Ben Bernanke, to worry more about the risk of deflation taking hold.

The Fed was still cutting interest rates to 1.00 percent as late as June 2003, an insurance policy against falling prices. It did not feel emboldened to begin raising them from this ultra-low level until June 2004.

Uncertainty caused by impending war between the United States and Iraq was certainly one factor overshadowing the recovery, but not the only one. Widespread pessimism and a cautious approach to new investment and hiring all helped ensure recovery was very slow. It failed to become clearly self-sustaining for almost three years.

The same could easily happen again.

RESTOCKING AND FINAL DEMAND

Headline increases in gross domestic product (GDP) can be separated into growth from final demand (consumption, business investment, government spending and exports); and increases in the level of inventories held by manufacturers, distributors and retailers along the supply chain (including raw materials, work in progress and stocks of finished but unsold items).

Sustainable increases come from final demand. Inventories are more volatile. Large changes in either direction tend to be quickly reversed within a quarter or two. A large build up in one quarter is usually followed by an equally large reduction in the following one.

The attached chartbook shows quarterly growth rates for GDP, final sales and inventories since 1948, and how the U.S. economy behaved in the first four quarters after each recession ended. Click here for PDF.

Headline GDP and final sales have proved much more stable than inventories. GDP and final sales have been negative in 37 and 35 quarters respectively out of a total of 245 since 1948. In contrast, inventory changes subtracted from GDP about half the time (119 quarters) and added to it roughly as often (126 quarters).

Recessions since 1948 can be divided into two very distinct groups:

(1) Severe recessions characterised by declines in final demand for at least two consecutive quarters. There have been four of these severe recessions (ending in 1954, 1974, 1982 and 1991).

(2) Other, inventory-driven recessions where final demand remained positive (most of the time) but the attempt to liquidate excess inventories by cutting production below final consumption pushed the economy into recession (defined as two quarters of negative overall GDP growth). There have been five of these “other recessions” or “inventory recessions” (ending in 1949, 1958, 1960, 1970 and 2001).

Past experience suggests the early stages of recovery are very different depending on whether the economy is emerging from a severe recession or an inventory-driven one.

In the case of deep recessions, recovery has been led by final demand. Inventory changes continued to subtract from GDP growth in the first quarter after recession ended and did not begin to make a substantial positive contribution until the third quarter (six to nine months later).

The pattern after inventory-driven recessions has been very different. Growth in final demand was much less important, with inventory rebuilding supplying most of the initial impetus for expansion.

In four of the five inventory recessions since 1948 inventories made a positive contribution to GDP from the first quarter after the downturn ended. The exception was the anaemic recovery after the 2001 recession. The lack of a stronger inventory response in this instance may have contributed to the failure to achieve a self-sustaining recovery in this case. But in every case, the inventory-driven recovery fell away somewhat in the second quarter after the recession ended before surging again in the fourth.

From the charts, it is clear that the current downturn looks much more like a severe recession than an inventory de-stocking one (with sharp falls in final demand in both Q4 2008 and Q1 2009).

If this is the correct characterisation, inventory rebuilding may play only a limited role in the early months of the recovery. Assuming the cyclical trough occurs during Q3 (between July and September) re-stocking might not make a significant positive contribution to growth until Q1 or even Q2 2010.

Analysts hoping for inventory rebuilding to provide much of the impetus for recovery in the second half of 2009 may be disappointed. Any expansion in the final months of 2009 is likely to be much slower and more uncertain.

– John Kemp is a Reuters columnist. The views expressed are his own –

The current contango structure in crude oil futures and most other commodity markets — with future prices significantly above the spot market — is providing a strong incentive to buy and store record quantities of raw materials, with most of the cost borne by retail investors in exchange-traded funds and institutional investors in long-only commodity indices.

This “cash-and-carry” strategy rewards market participants with access to storage or finance at the lowest cost. It is providing huge profits for physical commodity merchants, investment banks, and the owners and operators of warehouses and tank farms during the downturn, and helps explain the record profitability from commodity operations reported recently by some of the largest banking and trading groups.

In the current market, the cash-and-carry strategy rewards well-connected “insiders” such as investment and commercial banks able to secure almost unlimited financing at zero-cost as a result of quantitative easing programmes.

DOING THE CONTANGO

In a contango market, the Futures Price = Spot Price + Finance (interest rate on the money borrowed to own the physical commodity) + Storage (cost of hiring tanks, tankers or warehouses) + Insurance (premiums for insuring the commodity against loss, sinking, damage, theft etc). Click here for PDF. More generally, the equation can be re-written to cover any market (whether contango or backwardation, when the futures price is below spot) so the Futures Price = Spot + Finance + Storage + Insurance - Scarcity/Prompt/Convenience Premium. The prompt premium is the additional price a consumer is prepared to have spare material on hand “just in case” rather than risk having to go out into the market and buy it at an uncertain price or even find it is unavailable.

When commodity inventories are low, the convenience/scarcity/prompt premium can become very large and dominates all the other terms in the equation, ensuring the futures price is below the spot, and the market is in backwardation. But otherwise the term is small and the cost of finance and storage exceeds the convenience/prompt premium and the market is in contango.

In practice, we can ignore the insurance term because (a) it tends to be quite small and (b) does not change very much. For this analysis, we will also ignore the prompt/convenience premium since markets are well supplied at present and expected to remain so for the foreseeable future, with high stocks of crude oil, aluminium and other commodities.

In this simplified world, Futures Price = Spot + Finance + Storage. In some sense, the futures price is above spot because by buying forward the purchaser avoids the finance and storage cost. Conversely, the spot price is at a discount because buying now and holding into the future incurs finance and storage charges.

So far, we have assumed the finance and storage costs are the same for all market players. But in practice the cost of finance varies over time and among market participants. On the storage side, the cost depends on whether you own tanks/vessels/warehouses; whether you have leased them on a long-term deal; and whether a special discount is available.

In principle, the Future Price = Spot + Finance + Storage relationship should hold for the marginal market participant doing the storage and reflects the marginal players financing and storage charges.

But for everyone else with lower financing and storage costs the actual cost of storage should be below the cost reflected by the contango. For these players, it pays to buy physical commodities, put them in storage, and then hedge the long physical position with a short futures position, pay the smaller storage and finance charges on the physical and receive the larger yield from the contango.

REWARDS FOR INSIDERS

Market participants with access to cheap finance (banks) or cheap storage (tank farm and warehouse owners, or those with long term deals) can make money on the physical deals.

This is one reason many commodity firms run a physical trading house and a warehousing company in tandem together with a futures brokerage. The point is to exploit synergies and run a balanced business that is somewhat insulated from the cycle.

The physical trading business directs metal to the warehousing company and tries to ensure they are full (and therefore earning rental income from the metal). Whether the company takes the income as rent (accruing to the warehousing arm) or as a cheap rent deal (with extra contango income accruing to the physical trading desk) is a matter for the tax accountants.

But it creates an attractive synergy. When the economy is booming, warehouse stocks will be low, so earnings on the warehousing company are poor, but futures turnover is usually high in a bull market, so the futures brokerage and speculative book make money. When the economy is in recession, futures turnover drops and commission earnings fall, but the warehouses will be full earning plentiful rental income.

Only a small number of metals trading companies are fully integrated (comprising a customer-oriented broker, a physical trading business, and a warehouse). But most others will have special arrangements with one or more warehousing companies. There are similar systems in oil — with banks taking leases on tank farm space or floating vessels to play the same strategy.

BACKWARDATION RISK

So far we have assumed that the physical and financial parts of the store and hedge game mature at the same time (ie the lease on the storage space and the futures positions mature on the same date). In this trade, there are no risks.

But it may be possible to spice up the returns by accepting some risk by mismatching the two legs of the deal. A close look at the shape of the futures curve reveals that the steepest contango is usually for the first day or month, with progressively smaller contangos thereafter.

Instead of taking a 3-month lease on some storage space and putting on a short position 3 months forward to hedge it, some physical traders will take a 3-month lease and put on a short position 1 month forward (earning the biggest bit of the contango) with the assumption they can roll the short forward by another month and then another when the correct time comes.

The risk here is the market flips into backwardation at some point before the 3 months is up. In which case rolling short positions forward will incur a cost not generate revenue.

Either the backwardation has to be paid (reducing total returns on the strategy) or the metal/oil has to be delivered before the 3 months are fully up against the maturing short position, in which case the player is paying storage costs on empty tanks/warehouses.

Long-term storage plays popular with many banks and trading houses at the moment, where shorts are repeatedly rolled, are a bet that the market will not flip into backwardation, and no one will organise a squeeze, before the storage deal matures.

This seems a fairly safe bet in the current environment of cheap money and plentiful inventories.

– John Kemp is a Reuters columnist. The views expressed are his own –

Power generation from renewable sources such as wind turbines, solar cells and biomass plays a small but important part in satisfying total electricity demand around the world, and is growing at an exponential rate thanks to generous public subsidies and government support.

Renewable sources have increased their share of worldwide generation from just 0.4 percent in 1980 and 1.1 percent to 2.3 percent in 2006. In its “World Energy Outlook 2008″, The International Energy Agency (IEA) projects their share will double to 4.9 percent by 2015, and then almost double again to 8.7 percent by 2030. Click here for PDF.

Policymakers are relying heavily on renewable generation to meet projected growth in the electricity demand over the next 20 years while limiting growth in the emission of greenhouse gases.

Unlike reserves of oil and gas, which may be exhausted within the next 70 years, renewables will remain a source of power indefinitely. Much the same could be said of coal, but renewables do not contribute to increased carbon dioxin concentrations in the atmosphere.

But with renewable sources still costing more per kilowatt hour than conventional power from nuclear or fossil fuel plants burning gas and coal, renewables have not yet reached “grid parity” with other power producers and are struggling to penetrate the power market.

Market penetration depends on subsidies, price support and quota schemes mandating power suppliers buy a minimum share of their electricity from renewable. But widespread variations between countries and even within them suggest uptake is sensitive to the form in which support is offered. In particular, guaranteed prices for renewable producers have been more effective than quota systems in encouraging widespread development of wind and solar power.

RENEWABLES PENETRATION

Since all OECD governments are committed to increasing the share of renewables in total output, it makes sense to rank policy effectiveness in terms of market share rather than absolute watt hours generated.

On this measure, penetration ranges from 25 percent in Iceland, 20 percent in Denmark and 9 percent in both Germany and Spain, to 1.6 percent in the United Kingdom, 1.3 percent in Sweden and 0.6 percent in Japan.

In absolute terms, the United States is the world’s largest producer of renewable energy with 72,000 gigwatt hours (GWh) last year. Only Germany (60,000 GWh) and Spain (27,000 GWh) are comparable. But it is also by far the world’s largest producer and consumer of non-renewable power (more than 3.7 million GWh). The share of renewable generation in the total was actually rather small (just 1.7 percent) and puts it in the middle of the international spectrum.

Some country-to-country variability can be explained as the result of past policy choices and natural resource endowments. Iceland’s high share is based on its abundant geothermal resources. France’s low one the fact nuclear plants provide three quarters of the country’s total power output, leaving little demand for renewables or power from any other source.

But historic policies and natural resources cannot explain why Denmark, Germany and Spain generate six times more renewable power (proportionately) than the United Kingdom, the United States and Sweden.

PRICE GUARANTEES OR QUOTAS

The main factor determining policy success is the structure of the program. Price-support systems (used in Denmark, Germany and Spain) have been more effective than quota-based systems (used in the United Kingdom, Sweden and parts of the United States):

(1) Price-based feed-in-tariffs (FITs) guarantee renewable power producers the right to sell electricity into the grid at a fixed rate set by law, or in some variants at a premium over the peak market price or some average of the prices in a previous period:

* FITs guarantee priority access to the network (grid managers must buy power offered by renewable producers first at the agreed price, even when competing conventional generators offer power more cheaply).

* The grid pays a premium for renewable power (allowing renewable generators to recover the higher costs associated with their generation).

* In the most successful schemes this price is reasonably predictable (it is either fixed in cents per kilowatt or linked to an annual average) to make it easier for renewable producers to obtain project financing.

(2) In contrast, renewable obligation certificates (ROCs) and renewable portfolio standards (RPS) are quota systems. They require power sellers to buy a minimum number of megawatt hours (MWh) or a minimum percentage of total sales from renewable sources. Power sellers receive credits for every MW of renewable power they buy and must acquire a set number of credits by the end of the compliance period, buy surplus credits from others, or pay a financial penalty.

Quotas have been adopted by the United Kingdom, Sweden and most state-level governments in the United States that have set renewable targets. Favored by economists as the most efficient way to produce a given volume of renewable energy, since they encourage lowest-cost options to be developed first, they are seen as “market friendly”, technology neutral, and more compatible with integrating renewable output into the wider power system. In theory, the target volume of renewable power is guaranteed because tradable creditable prices will rise until enough renewable generation is incentivised.

Because quota systems do not guarantee a price for the power being sold to the grid, prices remain highly variable, determined by supply and demand in the wider power market, which can make it hard to obtain project financing.

Uncertainty can prove fatal to projects involving with high upfront capital costs (such as solar and offshore wind farms), long payback times (7-10 years), or where developers are small technology-driven companies relying on bank-based lending rather than established power utilities which can finance projects on their balance sheets. Quota systems have not tended to encourage innovation.

In contrast, price-based FITs have proved extremely successful in encouraging widespread installation of wind turbines (Denmark and Germany) and solar cells (Germany and Spain). Because they guarantee prices and revenues for an extended period, up to 20 years in some cases, loan finance is readily available, even for projects on a fairly small scale. In Germany and Spain, banks will provide loans for solar cells at household level.

TILTING THE PLAYING FIELD

The most common objection is that FITs may not be efficient because they do not promote the sequential uptake of lowest-cost options first. Most FITs are designed so higher-cost forms of renewable generation receive higher guaranteed prices to encourage the uptake of a diverse range of technologies. But there is a risk that power consumers can be forced to pay high prices for extended periods even if the generation cost eventually declines.

Most FITs have some flexibility built into them. While prices for existing producers of renewable energy are guaranteed for the lifetime of the FIT, the terms on which new FITs are offered to new projects can be adjusted periodically in response to changes in uptake rates and costs. In Germany, increases in uptake and cost reductions result in “degression” — a cut in the guaranteed price offered to new producers once certain target levels are met (previous guaranteed tariffs are not altered).

The objection remains that FITs involve the government picking winners rather than allowing technologies to emerge through market-based competition. But the need to recover high upfront capital costs over long timescales in volatile power markets means that large-scale renewable power generation may not be consistent with private financing unless some form of price support is forthcoming.

If policymakers want to encourage it, with all the associated costs, recent experience suggests feed in tariffs and price guarantees will prove far more effective than the quota systems favored so far in the United States and United Kingdom.

-- John Kemp is a Reuters columnist. The views expressed are his own --

LONDON, April 9 (Reuters) - The Bank of England's terse press statement announcing it will maintain overnight rates at 0.5 percent and continue the existing 75 billion pound quantitative easing (QE) programme gives no clue about whether the Bank intends to extend the programme when the first tranche of asset purchases are completed in June.
But officials will have to make a decision soon: unless they signal a commitment to extend QE, gilt yields will rise even further in anticipation that the major buyer in the market will withdraw.
The QE programme is dogged by ambiguity about its objectives (which a cynical observer might conclude is deliberate).
Officially, the aim is to prevent inflation falling below target by accelerating money supply growth, not manipulate the yield curve for government and corporate debt.
In this, the Bank's avowed strategy is more conventional than the Fed's ambitious efforts to determine the cost of credit for borrowers throughout the economy. It is a straightforward quantitative easing patterned on the Bank of Japan, rather than a credit easing patterned on the Fed.
If true, the measure of success is how much the money supply has been boosted at the end of the three month period; the Bank should be indifferent about whether ending QE causes yields and borrowing costs to rise.
So long as money supply has risen consistent with the inflation target, and the Bank can discern some green shoots of stabilisation if not recovery, officials can declare victory, end the programme, and keep the other 75 billion pounds of asset purchases authorised by the chancellor in reserve. Yields can be left to find their natural level.
But many suspect the Bank's real objective is yield control -- in which case it will have to announce another round of buy backs of gilts and corporate bonds in good time, well before the current programme is completed, to shape market expectations.
The results of the existing round have been unimpressive.
After falling initially, gilt yields are almost back up to the level they were at before the Bank's foray into unconventional monetary policy.
The snag is that if the Bank stops buying, other investors will struggle to absorb all the new government paper on offer without a major increase in yield -- pushing up borrowing costs for everyone, precisely what the Bank has sought to avoid.
The Bank's dilemma is whether to push on (heightening fears about inflation) or call a halt (risking a spike in yields all the same).
Either way, the Bank needs to give the market, as well as the Treasury and the Debt Management Office, plenty of warning about its intentions.
(Editing by Richard Hubbard)

Prominent senators have put Gary Gensler’s nomination to head the Commodity Futures Trading Commission (CFTC) on “hold” in a bid to force the administration to take a tougher line on commodity regulation.

Gensler’s nomination was approved by the Senate Agriculture Committee on March 16, but almost immediately put on ice before it could reach a vote on the Senate floor by Senator Bernie Sanders (Independent, Vermont) and one other unidentified senator.

Holding a nomination is a relatively common procedure allowing any senator to request a delay before it moves to a vote on the Senate floor, ostensibly to seek more information or testimony from the nominee.

However, the practice is controversial because it allows even a single senator to delay the confirmation process, in some cases indefinitely, and because holds can be placed anonymously. Senators simply notify their party’s floor leader, who will prevent the nomination from coming up on the Senate calendar for a vote.

ARCANE, BUT CRUCIAL
While the practice is arcane, it plays a crucial role in the nomination process. Holds can block nominees with whom the senator has a strong personal or political disagreement; punish past transgressions by the nominee; or create bargaining leverage with the administration on related issues, or even unrelated ones.

But in this case the hold appears to reflect substantive disagreement. Announcing it, Sanders criticized Gensler for backing financial deregulation when he was a senior official in the Clinton Treasury Department and said the CFTC needed “an independent leader”.

Gensler has already denied playing a significant role in drafting the Commodity Futures Modernisation Act 2000, including the now-controversial exemptions from CFTC oversight for over-the-counter (OTC) energy derivatives (the so-called “Enron loophole”), which led to the Commission having no visibility over large unregulated positions on OTC markets.

In a pre-confirmation letter to Senator Carl Levin, Gensler admitted “excessive speculation” could cause sudden price changes and this had actually happened in recent years owing to the massive influx of investment money into commodity indices.

He promised to review the myriad “hedging exemptions” the CFTC and commodity exchanges have granted allowing swap dealers and investment banks to exceed normal position and accountability limits.

Gensler’s statements have gone much further than the CFTC has been prepared to go in the past. The Commission continues to argue fundamentals rather than speculation were the main cause of recent price volatility. And his comments create a rationale for tighter regulation.

ANXIOUS FOR TOUGHER APPROACH
But they do not appear to have satisfied Sanders (who sits in the Senate as an independent but was a self-described “socialist” when he sat in the House of Representatives) or other senators anxious for the CFTC to take a tougher approach.

In reality, the dispute is about more than the nominee himself. Gensler is a lightning rod for broader concerns about the administration’s attitude to regulation in general and commodity regulation in particular.

Opposition centers not just on Gensler’s own past role, or commitments he has given as part of his confirmation hearings, but the suspicion he is a continuity candidate would support a continuation of the “light touch” approach to regulation pioneered by the Clinton administration and popular until recently.

Unable to exact a price from Treasury Secretary Timothy Geithner and National Economic Council chief Lawrence Summers for bailout packages and a regulatory approach many in Congress think is not tough enough on Wall Street, senators are flexing their muscles where they can by blocking Gensler.

It is hard to see how much further Gensler can go to assuage concerns which in essence center on his regulatory “instincts” and “philosophy” — unless he gives cast-iron commitments about future regulatory actions, which would curb his scope for later action.

President Obama’s nominee to head the Securities and Exchange Commission (SEC) has already been confirmed. In contrast, the continued failure to appoint a head for the CFTC leaves a policy vacuum at the top of the world’s most important commodity regulator at a time when both Congress and the administration have started to think about how to overhaul the entire financial regulatory framework.

By convention, holds are honoured by party leaders on the Senate floor. The administration could try to save the nomination by pressing Sanders and the anonymous senator to withdraw their objections and let the matter proceed to a vote. But it may be difficult to exert pressure on a senator popular in his home state, known for taking a non-conformist stand and sitting as an independent.

So the administration may have to offer some creative concessions or find a new nominee.

– John Kemp is a Reuters columnist. The views expressed are his own –

Intense criticism of the Fed’s role in the financial rescue program and the decision to triple its balance sheet, including monetizing a portion of the Treasury’s debt, has forced the central bank to issue an unusual defense of its actions (http://www.federalreserve.gov/newsevents/press/monetary/20090323b.htm).

It attempts to placate critics by acknowledging the real risk of inflation, and marks the Fed’s first attempt to set out an “exit strategy” for ending quantitative easing and other credit programs once the crisis is safely passed.

The joint statement issued with the U.S. Treasury reflects “the common views of the Treasury and the Federal Reserve on the appropriate roles of the Federal Reserve and the Treasury during the current financial crisis and in future.”

The last time the Fed and Treasury were forced to reach such an agreed statement defining their respective responsibilities was in 1951. Over the previous 15 years, monetary and fiscal policies had largely become fused as a result of the Great Depression (with interest rates kept artificially low to support recovery, then abandoned as a tool of monetary management in favor of reserve requirements) and World War Two (with rates repressed to help finance the government’s massive borrowing program).

Even after the war had finished, the Fed held short-term interest rates at just 1 percent. Rates did not begin to rise until the start of 1948, and they were still at just 2 percent by the end of 1952 (https://customers.reuters.com/d/graphics/WARTIMEFINANCE.pdf).

Crucially, the Fed also enforced a 2.5 percent ceiling on long-term Treasury yields through open market operations to hold rates down and support the federal government’s massive wartime borrowing program and the need to refinance the debt at low cost. Precisely what the Bernanke Fed is now doing through its Treasuries purchase program.

The distortions created in financial markets as a result of a long period of ultra-low rates and massive government borrowing made an “exit” from the program extremely difficult.

One result was the huge bout of post-war inflation in the late 1940s, when the massive amount of liquidity in the system intersected with the removal of price controls, industries geared to wartime rather than consumer production, and the outbreak of the Korean war.

Copper prices, for example, doubled between 1946 and 1948 and there were smaller but sharp increase in the price of most other raw materials (https://customers.reuters.com/d/graphics/METALSPRICES.pdf).

Not until 1951 were the Fed and Treasury able to reach an accord on their respective roles, and was the Fed able to start gradually normalizing interest rates. The Fed gradually loosened its control over long-term rates and allowed them to drift upwards.

The joint statement issued by the Federal Reserve and Treasury on Monday evening reiterates that “Actions that the Federal Reserve takes … such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy.”

It notes that the Treasury has a “special financing mechanism” which helps the Fed manage its balance sheet. The Treasury used this supplementary financing program to sterilize the Fed’s asset purchases during the early stages of the crisis in September and October 2008 by issuing extra cash management bills to soak up the additional liquidity the Fed was pumping into the system and prevent a build up of (potentially inflationary) bank reserves.

The supplementary financing program was subsequently abandoned in favor of a more expansionary policy of unsterilized asset purchases. But it could be reintroduced to issue new Treasury securities and drain excess bank reserves and liquidity from the system if necessary.

STERILISATION

But the most important part of the joint statement notes “the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.”

What this last point means, in plain English, is that the Fed recognizes that the massive increase in bank reserves caused by its purchases of financial assets for cash or easily marketable securities does pose an inflationary risk once the heightened demand for cash is saturated, or starts to fall back to more normal levels.

The Fed wants to head off this risk by being able to sterilize some of the excess bank reserves at the appropriate time in future. In particular, it wants the ability to replace the bank reserves (which are cash-like instruments that banks can tap on demand) with longer-term liabilities (which will tie up bank funds and cannot be accessed immediately).

One option is to have the U.S. Treasury issue debt to the market (draining excess funds from the banking system) and depositing the proceeds with the Fed (where they will be under the control of the government, rather than the banks, so pose less inflationary risk).

The total volume of Fed liabilities would still be the same, but ownership would switch from the private sector (where it might be inflationary) to the government (where it would simply represent an inter-governmental transfer that would allow the Treasury to fund some of its massive borrowing requirement). This is what the Fed means about the Treasury being able to help the Fed manage its balance sheet.

NEW FED DEBT

The other option is for the Fed itself to start issuing debt securities to the banks, which they would buy with cash and excess reserves. The Fed would essentially swap one form of liabilities (excess reserves) for another (Fed debt). If the debt was structured appropriately, it could be much less “money-like” and liquid, absorbing some of the excess liquidity in the system.

What the Fed is hinting at in this statement is that it will ask Congress for the (unprecedented) power to issue its own debt securities. The advantage of these Fed securities would be threefold:

(1) Because they would be issued by the Fed rather than the Treasury, they would not count toward the federal government’s debt ceiling. Since they will in fact be contingent liabilities of the United States government, Congress might choose to impose some restrictions on the amount of debt the Fed can issue, and other oversight requirements. Fed officials are likely to oppose this, however, arguing they must preserve maximum operational “flexibility” to respond to crises and changing conditions.

(2) By design, Fed securities will be less liquid than cash, bank reserves or U.S. Treasuries. Various restrictions could be placed on how they are traded. For example, the Fed might insist that they can only be held by member banks of the Federal Reserve System. This would make them less money-like and reduce the risk that banks would be able to use their holdings as quasi-reserves against which they can safely extend new loans. Or they could simply be made non-tradable like U.S. savings bonds. The key point here is that the Fed securities have to be less liquid and money like than the bank reserves they will be replacing. They will be a very special form of debt.

(3) Banks will probably be compelled to hold some of these new securities as part of regulatory reforms that will oblige them to hold more capital. That would give the Fed a guaranteed market into which it could sell these securities. It would help drain liquidity from the system by replacing excess reserves (which the banks are holding optionally) with special Fed securities (which they would have to hold as a matter of law).

– John Kemp is a Reuters columnist. The views expressed are his own –

Investors have started to balk at absorbing large quantities of U.S. government debt, taking on substantial inflation and devaluation risk in return for little reward. While the government has no trouble placing short-term debt with a maturity of up to 2 years, longer-dated securities are proving much harder to sell.

Increasing resistance from the market explains why the Federal Reserve felt it had no choice but to announce it would start buying back longer-term U.S. Treasury securities last week, in a $300 billion program of direct quantitative easing and monetization.

The attached chart (https://customers.reuters.com/d/graphics/TREASAUCTIONS.pdf) shows the amount of 10-year U.S. Treasury debt placed at each of the auctions since the beginning of 2008, the interest rate which the government offered (coupon yield), and the range of rates (high, low, median) the market actually accepted through the auction process.

The government has been steadily cutting the coupon rate on offer from 4 percent in September 2008 to 3.75 percent in January 2009 and 2.75 percent at the auctions held in both February and March. But the market’s appetite for longer-term debt at such low interest rates has been waning.

The median yield which the market has demanded in the auctions has risen steadily from 2.35 percent in January to 2.71 percent in February and 2.98 percent in March. The high yield is up from 2.42 percent in January to 3.04 percent in March.

The March auction results show the government’s borrowing program was in increasing trouble. The median yield the market accepted (2.98 percent) was 23 basis points above the coupon the government was offering (2.75 percent); the government was forced to place the issue at a substantial discount (the debt was sold for an unusually large discount of 2.49 percent to its face value, or just 97.50 cents on the dollar).

The ratio of bids placed to securities sold (the “bid-to-cover” ratio) was also very low in both February and March (2.2 bids to every 1 sold), confirming that investors were looking for more yield than the government was readily paying.

Moreover, the proportion of securities purchased by primary bond dealers for their own account (60 percent) was down sharply in these auctions compared with last year (when 70-80 percent was normal). Instead, large shares went to indirect bidders (35-37 percent) which include foreign central banks bidding through the Federal Reserve Bank of New York, which may not have strictly commercial motives. The residual went to direct bidders via the primary dealers.

In the absence of the Fed move, the government would almost certainly have needed to raise its coupon from 2.75 percent to 3 percent or even higher at the next auction. It would have reversed the downtrend in place since last autumn and sent a powerful signal to the market that lack of demand was driving long-term interest rates higher.

The buy-back program — targeting 2-10 year Treasury securities — looks like an attempt by the Fed to forestall a rise in coupon payments that would otherwise have been inevitable, triggering a sharp rise in long-term borrowing costs across the economy.

But the program’s likely effectiveness is open to question. Yields on 10-year Treasuries have already risen more than 20 basis points from last week’s lows, and are now just 30 points below the level prior to the Fed’s announcement. Given the size of the government’s borrowing needs — which dwarfs the $300 billion buy back program — the program is unlikely to hold back the rise in yields for long.