Saturday, October 17, 2009

Hey, that's our money!

An article by Todd Wallack and Andrea Estes in today's Boston Globe demonstrates the risks inherent in direct governmental participation in private corporations.

Here, the Commonwealth of Massachusetts decided to put money into a solar energy company:

The incentive package from the state included nearly $21 million in direct grants to the company, $22.6 million in tax incentives, $13 million in grants to build roads, upgrade electrical transmission lines, and upgrade other infrastructure to support the 450,000-square-foot Devens plant, a $1-per-year lease for 23 acres at Devens worth $2.3 million, and $17.5 million in loans.

There are two types of risk associated with this kind of investment. The first is that the firm might fail, taking with it millions of dollars in state assets. That is particularly likely in the energy field, where changes in world oil prices and advances in technology or unexpected competition can quickly make mincemeat of a firm's business plan.

In this case: A big problem is the price of solar panels, which keeps dropping, in part because of sinking demand and competition from China. The U.S. Synthetic Fuels Corporation, staked with billions of dollars in federal support, was another casualty of these kinds of market forces.

The second risk is that political bodies have trouble with the concept of sunk costs. Private firms consider past investments as fiscally "gone" for purposes of evaluating future investments. But the government often behaves as if investments have a carry-forward risk of embarrassment, so it is more likely to throw good money after bad.

This part of the story demonstrates the latter point:

...After its efforts to borrow elsewhere failed, the company recently asked MassDevelopment for a new $5 million loan. ...MassDevelopment staff members warned last month that the company does not currently generate enough cash to pay it back, and gave it the highest score possible for risk, 6 out of 6. The $5 million request is also double the $2.5 million limit allowed under MassDevelopment’s own guidelines. Nevertheless, MassDevelopment’s board unanimously approved the loan at a board meeting Sept. 17.

Some Governors and Presidents like to believe that they are more able than the private markets to evaluate and support technologies and companies consistent with their policy agendas. The problem is that they use our money in support of their hunches, changing the private sector's risk-reward calculus that is essential for a proper evaluation of the investment's value.

4 comments:

Cleary Squared said...

Well said.

Alternative energies seem to be the "hot and trendy" alternative to traditional commodities, but they too have their drawbacks because the tests are either not thourough enough or are inconclusive.

I think the reason why governments chase these follies without thinking it through is that their voters want instant gratification against high energy prices, but it isn't going to happen until those tests and plans are rooted in reality. You have to know the unintended consequences, just as you described here.

Andrew Tarsy said...

Two points I take with your response to this unfortunate situation Paul. First, a factual point. In this case, the $5M loan is not government throwing good money after bad as a result of some uniquely governmental psychological tendency (thank goodness other sectors don't do that either!). As I understand it, the loan is part of the original deal, whether that provided a bypass of the MassDev guidelines or not.

Second and more important, I believe the government takes on risk to create long term changes that are beyond the appetite of the capitalists all the time across all functions. And private investors take a pass all the time on investments that create benefit that is too diffuse and widely shared, too risky, or too remote in time for their often narrowly defined metric. Of course you are not saying that the life sciences value chain should be sustained without government support. Would investors have tackled the D-Day Invasion? What about public school? Why can't private capitalists devise a tool to monetize the irrefutable economic value of higher graduation rates and devise some sort of investment vehicle to cause private money to flow there? It would be no less complicated than Credit Default Swaps.

The attempt by the State to accelerate the clean tech sector's development reflects vision and requires patience. Investment of public dollars and partnership in cleantech and life sciences was and is a great accomplishment of the past 3 years in spite of the setbacks that will surely occur. These unusual investments are about long term vision of lasting and shared prosperity that are socially and environmentally responsible. That vision would certainly be helped by caps on emissions that would raise energy prices and unleash market forces to create more demand for solar power, for example. But the conventional wisdom in the private sector is largely to lobby against such change, preferring the bird in the hand of dependence on foreign oil, in spite of all the reasons to give it up.

We will survive these terrible economic times. Our leaders need to retain a long view and not lose their vision just because we have a society that wants easy answers. And a government that is willing to both use market forces as a tool and simultaneously deploy resources to correct defects in the market is doing exactly what we want and need. I am grateful for our visionary venture capitalists but even more grateful for visionary public leadership even when circumstances require me to be more patient than I would like to be.

Paul Levy said...

Well, Andrew, it is all a matter of degree isn't it? No one can deny that the government should invest in the military and other such purposes; but here it is taking a flyer on a single company in a big sector (i.e., renewable energy resources) that is, in fact, getting a lot of private investment money.

Government investment in life sciences is not in the area of commercialization. It is mainly funding basic science research, leaving the private sector to take inventions through the next step to commercialization.

I'd like to suggest that if there are enough people like you who feel that the commercial sector is not doing the job, then create a nonprofit foundation and get private donations to fund these startups, rather than using tax revenues.

e-Patient Dave said...

Paul, thanks for the clear exposition of the issues. As someone with a business orientation and (I hope) social consciousness, I'm grateful for the way you describe how things play out.

We learned about future value and net present value in business courses; I don't recall anyone talking about "future embarrassment," but yeah, that's a real issue when political adversaries can club you over the head with how your plans played out, and voters can put you out of a job. Seems to be a good example of a perverse incentive.

And as someone involved in high tech, having watched industries grow and die, I know what you mean about the pressures that arise when a private firm fails to support itself. I might be off about this comparison, but I can think of no more horrid example than the taxpayers ("That's our money!!") bailing out incompetent finance executives, who then turn right around and in less than a year give themselves more huge bonuses.

We get lost in the "illions." My friend Thom Hartmann noted on the air this week that the $23B in Goldman Sachs bonuses, just announced, is enough for 115,000 four-year scholarships to Harvard at $50,000 a year. In a real sense, that's our money: those losers, those executives who drove their stockholders' company into the toilet with bad stewardship, would have driven themselves into the toilet too, but instead they get to dip into "our money."

---Andrew, re "Would investors have tackled the D-Day Invasion? What about public school?" - Paul's note is specifically about government participation in private corporations, which (as I understand it) are required by law to work to improve shareholder value. Whole different game from operating for the public benefit.

I also wonder what "investor" would simply give that kind of money to a company because they think it's a good idea, without taking a stake in the enterprise - at least to have a hand in how the money's spent? When George Soros (widely known for his philanthropy, like him or not) gave $250M to Indigo, a company where I worked ten years ago, you can bet he was on the board - that weren't no grant!

Interesting perspective, Paul.