Climate change and the corporate arsenal

UN Secretary General, Ban Ki-moon, “The danger posed by war to all of humanity – and to our planet – is at least matched by that of climate crisis and global warming.” Prince Charles, addressing the European Parliament, “Fighting climate change is comparable to war, and a “courageous and revolutionary” approach is needed to avoid catastrophe. The private sector has a crucial role to play.”

Statements such as these, combined with the overwhelming scientific evidence on climate change, have led to a concerted shift in consumer, business and government opinion and action. Yet, investment in climate change initiatives and the environment pale in comparison to the numbers invested around the world in the military. Could such a simple change as calling it the “War on Climate Change” affect the decisions of government, corporations and individuals?

This article looks at the individual weapons in the corporate ‘arsenal’ in the war on climate change and how they can support and ensure corporations manage and reduce the risk associated with climate change. Further, it looks at the benefits, both financially and to the health and welfare of your brand, of a comprehensive carbon management strategy.

The first and most crucial step for corporations to make is commitment. The ethics and vision of a company should be the guiding light that helps determine how crucial the climate change issue is to the brand, both now and in the future. In addition to asking, “can we enhance our stock market value through climate change initiatives?” brands need to answer the question, “does our climate change policy and actions fit with our values and mission?” They need to make a public statement of their intentions, including setting out measurable steps to calculate, manage and reduce their carbon footprint, which is backed up by senior management, as a group, ‘walking the talk.’

‘Walking the talk’ includes clear leadership. Experience has shown when major corporations make a stand on key issues, the world listens.  Brands who are prepared to take on this initial fight can guarantee long-term brand image benefits, positioning themselves as an industry leader. Sector leaders who have embraced climate change early and consistently are seen by the public as the leaders and the ‘greenest.’ In a world where scepticism of business’ intentions and claims is rampant, leadership has to about actions and consistency, not press releases and tag lines. Leadership is the weapon in the corporate arsenal setting “direction”.

‘Direction’ may be influenced by stakeholders. Stakeholders, including consumers, government, employees and others are crucial to a brand’s reputation. A company needs to be able to answer the following questions: Is the brand listening to and acting on stakeholder concerns? Are the climate change issues that keep them awake at night the ones that companies are addressing? What role do employees see for themselves in the war against climate change?

Effective communication channels are critical in any military campaign and this war is no different.  Without companies engaging with their stakeholders, how will the knowledge and resources be deployed and used to best effect?

Dedicated resources   
A clear sign that business is serious about climate change is the level of internal resources dedicated to environmental issues. Lady Young, the Head of the UK Environmental Agency, recently stated, “This is World War Three. We need the sorts of concerted, fast, integrated and above all huge efforts that went into many actions in times of war.”

Again, there are several questions that a company needs to answer to ensure that they are addressing the issue. Is business factoring in climate change into each and every major decision? Is the most senior climate change person at the board level? Where is climate change on the risk register and in product design? This is not about this year’s budget, but rather how much is being invested over the next 10 to 20 years. Dedicated resources are about translating the commitment and leadership into sustainable planning and actions.

Setting clear, visible targets that relate directly to the brand’s ethics and vision are the key to transparency. Being transparent and consistent on internal processes, including the ones that generate the most emissions, as well as publicly setting improvement goals helps stakeholders better understand the issues. It also enables them to make more informed judgments about a brand, turning commitment and leadership into a tangible benefit for the brand. Transparency is also the most effective way of internally ensuring implementation of a brand’s vision, applying the business model of “what gets measured gets managed.”

In independent research, 70 percent of consumers want independent, third-party verification of corporate “green claims.”¹ The most difficult tools to put into use for corporations are commitment and engagement. Those two require the most change within an organisation and are, therefore, the most likely to be met with resistance. Verification, on the other hand, is the part of the process that validates all of the hard work and struggles. Verification is the final step that provides business with the platform to go out and shout about their accomplishments. With nothing less than a brand’s credibility on the line, who can afford not to have climate change data and claims verified?

Trust is the reason that corporations start this long journey. Trust from employees, customers as well as trust in what a brand stands for. It seemed ever so elusive in the early stages. Now, with all of the early struggles a distant memory and the confidence that independent verification brings, the full competitive advantages and benefits of the initial commitment are clear. Trust is the output of all of the other weapons in the corporate arsenal. Take all of them into account and trust is a natural result. Leave or discount any of the tools and trust can be lost forever.

What is victory in the war on climate change?
Let’s go back to our original comparison of climate change to war. If we put our entire arsenal to use, what would victory look like? Transparent efforts will lead to increased brand awareness and profits. From there, concerted stakeholder engagement leads to trust, which can enhance a company’s reputation as an innovative industry leader. One needs look no further than Toyota and their image as the greenest car maker. How much money will their rivals have to spend on research and marketing to level the playing field in the eyes of consumers?

How bad can defeat really be?
Turn the question around and the issue becomes more urgent. Companies failing to address climate change could face a public backlash from stakeholders, who see the brand as not doing their part, even worse, as proactively contributing to the destruction of our planet. Back in 2001, Dr. Andrew Dlugolecki, director of general insurance development at CGNU, the United Kingdom’s largest insurance group, stated “the rate of damage caused by changing weather will exceed the world’s wealth. Damage to property due to global warming could bankrupt the world by 2065.” Need further proof of that damage? CNN reporter, Dr Sanjay Gupta, reported on July 31, 2007 that the Carteret islanders in the South Pacific will be the first island community in the world to undergo an organized relocation, in response to their island sinking. The people of the Carteret are being called the world’s first environmental refugees.

Words and actions
Changing the words we use to describe the current climate change danger is not going to solve the problem. Business leading the way and applying all of the tools described here in a dedicated and transparent manner could just set the example that individuals and governments need to help them make the hard choices that will inevitably be necessary to sustain our planet. Could the stakes possibly be any higher?

When the juice runs out

It’s indisputable that we are running short of traditional sources of energy. And it’s our seemingly insatiable use of these sources that could prove calamitous for the global economy unless we make a serious attempt to redress the balance.

Some facts. We depend on oil for 90 percent of our transport, and for food, pharmaceuticals, chemicals and just about every aspect of modern day life. But some oil industry experts calculate that current reserves will last for just 40 years. So if we continue down this route we’ll need to find new reserves. But where? Although developments in technology have made oil extraction more efficient, the struggle to find alternative oil sources means that we’re now using less productive methods like deep sea drilling, often in environmentally sensitive regions like the Arctic.

Supplies of gas are finite too. And, although there’s still plenty of coal in the world, its use is difficult without causing even worse pollution to our already over-polluted planet.

Energy alone won’t determine the global economic landscape of the future – but it’s a major factor, and is already influencing the shift in political power, demographics, population movement and the dominance of what are now the burgeoning economies. Put simply, the rising economies of India, Indonesia, China, Brazil and Russia, and probably a few others still waiting in the wings, as either major users or producers of energy – or both – will shift the global economic centre of gravity. And, like everyone else, they’ll have to battle with the problems of energy shortage.

Who’s to blame?
Although the new economic powerhouses like China and India are major energy consumers, it would be unfair to point to these new kids on the economic block as the sole villains of the piece. While China’s consumption of oil is rising as a consequence of its rapidly expanding manufacturing base and the demands of its growing affluence, it doesn’t come close to the appetite for oil of the United States, whose population is a mere 300 million compared to China’s 1.3 billion. Currently, the US uses 2.7 million barrels of oil a day – more than India and Pakistan together.

But let’s not put all the blame on the US either. They’re just such a big target it’s difficult to miss. The UK government’s experts have estimated that 56% of energy used in UK homes could be cut using currently available technologies. We can install solar tiles, or miniature wind turbines the size of a satellite dishes. But how many of us can be bothered?

The penny is however beginning to drop with most of the world’s politicians. As energy sources decrease a whole new set of issues will surface – the main one being, of course, ‘Where will we get our energy from, and what will it cost?’

Already, the energy for our fuel, heat and light travels vast distances to reach us, and as recent events have shown, that means it crossing not just continents but political hotspots. An uncomfortable reminder of what the future could hold happened when Russia cut its supply of oil to Europe because of a row with Belarus. Russia accused Belarus of siphoning off oil from the pipeline en route, while Belarus countered that Russia hadn’t paid the tax for moving oil through Belarus – itself a ‘tit for tat’ move following Russia’s doubling of the price it charges Belarus for gas. It was when Belarus began legal action to recover the tax that Russia halted its export of oil.

While the disruption to supply was short lived, it brought home just how reliant Europe is on Russia for its energy supply. And of course, events like this only serve to trigger price rises too. EU Trade Commissioner Peter Mandelson succinctly summed up the situation – and the possible solution – in a speech at the EU-Russia Centre in Brussels last October.

He said that the key to improving the strained relations between the EU and Russia would be for Russia to join the World Trade Organisation, as this would create an obligation to more equitable trading conditions, and for Russia to commit to providing a secure and steady supply of energy to Europe. And when you think about it, both parties would benefit from that. But even if that did happen, it’s still a relatively short term answer – the problem is still that the world’s traditional oil resources are drying up.

What then is the answer?
New, sustainable sources of energy are being developed, and when they get here no doubt they’ll help us – or rather our grandchildren – live longer, healthier lives.

But till then our world will change to reflect the geographical and ethical shift in power, wealth and poverty created by dwindling supplies of energy. Pretty soon, we’ll be living in a world whose make-up is far removed from the one that we know today. International borders will still exist, but they’ll be different borders and they’ll have a different meaning.

We’ve seen already how the flow of people, ideas and information across borders bring into question ingrained assumptions about the nature of sovereignty and politics. How many of us can truly say that our beliefs of right and wrong, good and bad, progressive and reactionary, are neatly aligned to ‘party’ politics anymore? In the future, as this extension of cosmopolitanism continues, and power shifts from governments to individuals, markets and private enterprises, so new kinds of community will grow up, built around common values based on the way we live now, not how our forefathers lived. What we describe as ‘Western’ values will be challenged as economic and political power is redistributed. And growing migration for economic, political and, increasingly, environmental reasons will mean we can no longer define ourselves by where we were born.

Utopia or dystopia?
Predicting the future is always a dangerous exercise. Our predictions can always come back to bite us when they turn out to be wide of the mark. Science pundits in the ‘60’s often painted a picture of 21st century citizens being transported on hover-shoes to their pristine paperless office modules for their eight hours a week jobs: the rest of their time taken up with hi-tech pastimes from three dimensional chess to virtual golf. But occasionally they were right. A BBC programme from that time – ‘Tomorrow’s World’ – previewed hole in the wall cash machines in 1969, the digital watch in 1971 and the compact disc in 1981.

Now we are beginning to see the early signs of a world economy changed by the scarcity of energy, and we can predict with some accuracy that it can go one of two ways, depending on the action that our governments – and we as individuals – take.

Left to their own devices, the countries that own the sources of energy could theoretically hold the rest of the world to ransom. The price they charge countries which have no energy resources of their own will determine the economic competitiveness of those other countries. But in the end that would be self defeating. No country – even one self sufficient in energy – can exist wholly on its own. That’s like the selfish school kid who won’t let anyone else play with his football. Eventually, if he’s got any sense at all, he’ll see that cooperation has far more benefits. Similarly, it would be far better for nations, however they are defined in the future, to find ways of reaching agreement on a consistent and controlled supply for everyone.

And to control their own use of scarce fuels until sustainable alternatives are readily available. Yes, that would mean legislation and additional tax, but it’s a price well worth paying.

There’s also of course a genuine need for individuals to take responsibility for the sake of the planet. We can all take steps to conserve existing sources of energy. The vehicles we drive – if we drive at all – the way we heat our homes, our choice of holiday destination and how we get there. Maybe it will take some harsh law making to steer us in the right direction – many of us would far rather that it was a matter of conscience and intelligence. Perhaps that’s a little idealistic – but I’d like to think it isn’t.

Defining sustainability value

Are companies leading in their sustainability performance being undervalued by the market? Are companies with poor sustainability performance over-valued by current valuation models? There would be no bigger coup for the shareholders of sustainable businesses, (not to mention the health of the planet), if companies leading in their sustainability performance were to get their day at the bank in the form of premiums in market capitalisation. Global companies are taking brave decisions and have been investing significant capital to ensure that their business models are robust enough to withstand the long term risks of a carbon, water and ecosystem constrained world. Some companies are creating models of business that directly address global challenges and focus on value to society.

Yet to-date there has been little evidence that sustainability performance is being considered a significant contribution in the valuation of these companies. Perhaps until now. The world’s largest metals transaction, the $38bn acquisition in July 2007, priced Alcan’s stock at $101.03 representing a premium of 65.5 percent. According to Richard Evans’ statement above, is the Rio Tinto Alcan acquisition a sign of things to come in terms of sustainability performance increasingly being considered in business valuations? And if so, what does it mean? This paper argues three points:

New definitions of business value are starting to emerge – from the CEO
Climate change and other global challenges (i.e. sustainable development more broadly) are important issues for society, and are becoming increasingly important for business.

In 2005 CEOs of global businesses, and members of the World Business Council for Sustainable Development (WBCSD) conducted a study that concluded, “Leading global companies of the future will be those that provide goods and services and reach new customers in ways that address the world’s major challenges.”[1] Therefore, a company’s value will need to reach far beyond economic value to sustainability value. In reference to the Rio Tinto Alcan case, it seems that enlightened company executives are starting to communicate a new definition of value, sustainability value, to the investment community.

The brand valuation journey, which began with recognition in mergers & acquisitions, could provide a model for sustainability valuation
Intangibles such as brand, reputation and patents (once thought inconceivable to be assigned value) have transformed how modern business is valued in recent years. An Interbrand study of acquisitions shows that intangible assets represented less than 20 percent (on average) of the amount bid for companies in 1981, and has escalated up to about 80 percent (in some cases) today.  

It was the series of brand acquisitions in the late 1980’s that exposed the hidden value in highly branded companies and brought brand valuation into the spotlight. If the Rio Tinto Alcan example represents evidence of sustainability value being included in acquired valuation, could we be at the start of the sustainability valuation journey? Will companies start to be acquired for their track record on sustainability?

Sustainability value must be differentiated from brand value in business valuations for optimal benefit
Sustainability value must be differentiated from brand value because it is different, and because business valuation could play a very important role in promoting a sustainable future. For global companies of the future to be those that provide solutions to global challenges, these business models must be rewarded by the capital markets. In turn, for the capital markets to reward a company’s value to society, this sustainability value must be weighted highly in business valuations. If sustainability value were to be simply integrated into brand value, a unique opportunity to institutionalise sustainability value and sustainability valuation could be missed.

Why is this important? – A summary
Progress towards sustainable development, addressing the world’s most urgent challenges, must involve the capital markets. Business valuations need to link environmental and social performance with business value. The Rio Tinto Alcan case could signal that company executives and market actors are ready to act regarding the inclusion of sustainability performance in business valuations. The lessons learned from the brand valuation journey could provide a step by step guide for market actors and companies to accelerate this process. To fully optimise the opportunities that lie ahead in defining sustainability value, careful attention should be paid to differentiating sustainability from brand value – this will be good for business and good for sustainable development.

 “There is no doubt that the premium received by Alcan shareholders in the Rio Tinto combination was largely a reflection of financial performance. But, Alcan’s track record on sustainability, environmental stewardship and stakeholder relationships was also a very significant contribution.”[2]

Richard B. Evans, chief executive, Rio Tinto Alcan



The new era of responsible investment

Until recently, the role of capital and investment markets in sustainable development was little understood and widely discounted. While it has been clear for many years that financial liberalisation and cross-border investment grease the wheels of globalisation and help to fuel growth in mature and developing economies, the ways in which investment – particularly private investment – relate to the triple-bottom-line agenda have remained largely unexplored.

Two specific projects have helped to break the ice – the UN Global Compact’s Who Cares Wins initiative and the UN Environment Programme’s Finance Initiative (UNEP FI), both unique public-private partnerships within the UN system. Working in close collaboration, these efforts brought together a range of financial-market actors – principally fund managers and analysts – to explore the materiality of environmental, social and governance (ESG) issues to investment returns. Their work led to what we consider to be a breakthrough in understanding how various ESG issues – through transmission factors such as operational risks, reputation risks, innovation, and access to resources – relate to the value drivers of the underlying investment asset.

In many ways, these projects complement other initiatives in the financial world – such as the International Finance Corporation’s Equator Principles, the Carbon Disclosure Project, the Global Reporting Initiative, and the Enhanced Analytics Initiative, the last of which focuses on stimulating more mainstream research on ESG issues.

Corporate agenda
Most importantly, all these efforts helped investment markets “catch up” to the rapidly growing corporate sustainability agenda, reflected in initiatives such as the UN Global Compact, which today includes more than 3,900 corporate participants and hundreds of other stakeholders in more than 120 countries. Indeed, a major source of frustration for corporate sustainability leaders has been the apparent lack of interest by investment markets in corporate efforts to manage the risks and opportunities of ESG issues – be they related to climate change, human rights, or anti-corruption, to name just a few areas.

However, it has become clear that targeting the financial intermediaries would not be enough to truly move the agenda forward – asset owners would need to be mobilised on a much larger scale. This belief led the Global Compact and UNEP FI to form a special partnership with a small group of institutional investors. The aim was to develop an international understanding and associated framework related to a new concept of responsible investment – one that placed the materiality of ESG issues at the centre, while recognising the broader societal benefits of such an approach.

Launched in April 2006, the Principles for Responsible Investment (PRI) are in essence a set of global best practices for responsible investment. Rising numbers of institutional investors – from all regions of the world, and today representing more than $10trn – have embraced the PRI, marking a major advance in mainstream financial markets. The growth of this initiative has been extraordinary, and the principles – endorsed by both asset owners and asset managers – have quickly become the global benchmark for responsible investing.

Improving performance
By incorporating environmental, social and governance criteria into their investment decision-making and ownership practices, the signatories to the PRI can directly influence companies to improve performance in these areas. This, in turn, can contribute to our efforts to promote good corporate citizenship and to build a more stable, sustainable and inclusive global economy.

Two examples point to the potential of this approach: Recently, a group of PRI signatories – through the initiative’s Engagement Clearinghouse – began to engage with 33 automobile and steel companies that face supply chain risks related to slave labour in Brazil. And in January 2008, another group, representing approximately $2.13trn in assets, wrote to the chief executive officers of 103 companies in more than 30 countries to recognise frontrunners in the integration of ESG issues, while pressing laggards to improve their performance.

It is clear that we are essentially witnessing an evolution beyond the ethical for SRI movements – one based on the notion that ESG issues are material to long-term value creation and must thus be considered. And, by definition, this has special appeal to long-term investors – many of whom have long wished to break out of what’s been called the “tyranny of short-termism” – a situation that, in its most extreme form, sees asset owners – pension trustees, for example – pressuring fund managers to outperform quarterly indices rather than taking the long-term view for the benefit of their fiduciaries.

To be sure, these short-term pressures can also lead companies to behave irresponsibly. Indeed, the entire philosophy of the Global Companies is based on the long-term benefits of corporate citizenship and sustainability, which can also be recognised if companies diffuse universal values and principles deeply throughout their organisations and value chains – within boards, subsidiaries, and business partners.

The good news is that new dialogues are starting. More and more companies in the Global Compact are actively communicating their sustainability strategies and performance to the mainstream investment community.

In the meantime, it is clear that companies need to do a better job of disclosing information on potentially material issues. Many of the glossy CSR and sustainability reports we have seen in recent years still fall short of presenting meaningful data on performance and impact. The Global Reporting Initiative’s G3 guidelines are a significant advancement. And we are continuously refining the Global Compact’s Communication on Progress policy so that it is more relevant for the investment community. What is also clearly needed is more research on emerging and frontier market companies, particularly given the rising prominence of Southern transnationals. Here, the PRI initiative has once again taken the lead by launching a special push into emerging markets.

Wealth funds
What should also be noted is the importance of asset classes beyond the listed ones – including fixed-income, real-estate, and private equity. How sovereign wealth funds may or may not pick up on the responsible investment agenda will be a fascinating area of discussion and study moving forward.

Another powerful development is the convergence of corporate sustainability and corporate governance. Indeed, more and more companies in the Global Compact see sustainability as an essential component of good corporate governance, from the vantage point of risk management, transparency and sustainable long-term value creation. This is an expanded notion of corporate governance and one that goes much farther than many compliance-orientated schemes currently in use.

There are, of course, many challenges ahead. The majority of corporations in the world have yet to make a serious commitment to sustainability. Scaling up good practices thus remains both a challenge and an opportunity. And there is a danger that the ESG islands of activity within investment houses get pigeon-holed. Mainstreaming must be a priority.

Stock exchanges, too, have a role to play, through awareness-raising, the development of special indices, and even through listing criteria – an area that should be more actively explored. Unfortunately, the exchange industry generally seems reluctant at this point to take up the challenge and opportunity.

Overall, the leadership of those institutions that have committed themselves to this agenda deserves our recognition. Other investors around the world should join this historic effort to make investment markets truly responsible.

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Private equity takes stock for 2008

Last month’s 2008 Super-Return conference in Munich was a chance for the industry to take stock of the impact of the credit turmoil, and to predict how things might look in the future. With more than 1,000 delegates sharing news, gossip and their hopes and fears, there were few areas of agreement, but several topics were at the front of people’s minds.

Will fundraising hold up?
The delegates were relatively optimistic. Those agreeing it would hold up pointed to Vitruvian, which announced at the Super-Return conference it had closed Europe’s largest debut fund at €925m. Investors were also impressed by mid-market buyout firm Advent International raising its upper limit by 10 percent to €6.6bn.

And new investors, particularly sovereign wealth funds, were seen as important sources of money.

The more pessimistic delegates included David Bonderman, co-founder of TPG Capital, who said fundraising “will be tight this year”. Delegates also warned that the large, often public, pension funds that allocate a proportion of their assets to private equity could see this absolute sum of money shrink if other asset classes and their overall wealth falls with the equity and debt markets.

However, Joseph Dear, executive director at the Washington State Investment Board, said many, including his retirement scheme, would maintain their long-term, patient approach through any turbulence.

What is going to happen to buyout debt held by syndicating banks, and when will liquidity return?
The liquidity crunch has lasted longer than many delegates had expected, with part of the concern surrounding the lack of transparency over problems in the broader debt capital markets spilling over to leveraged finance, and bank liquidity stretched by the need to support hung loans from previous buyouts.

Euan Hamilton, global head of leveraged finance at Royal Bank of Scotland, said “greed across the market” had contributed to the difficulties. Carlyle Group said there was about $200bn of leveraged finance held by syndicating banks, which was down by $75bn from last July.

Of the leading US investment banks, David Rubenstein, co-founder of Carlyle, quoted Wall Street Journal and Morgan Stanley figures which showed Citigroup with $43bn of hung loans, JP Morgan with $26.4bn, Goldman Sachs with $26bn, Lehman Brothers with $23.8bn and Morgan Stanley with $20bn. Delegates said the crunch was likely to last the rest of the year, at least.

Are there going to be major defaults from Golden Age-vintage deals?
A feared recession was a talking point with Jonathan Nelson, chief executive of Providence Equity Partners, who said the US was already in one and the number of blow-ups was likely to increase from a current default rate of less than 1 percent.

However, defaults were seen as the last stage for companies in trouble as earnings fell and debt costs increased. Joerg Alting, head of leveraged finance in parts of continental Europe for Mizuho Corporate Bank, said a larger number of companies it tracked were behind their earnings plans, although still growing.

Jon Moulton, founder of Alchemy Partners, said that in the UK the most prominent exit route for private equity deals was bankruptcy, with 106 last year compared with 70 in 2006. Moulton said other signs of distress, such as equity changes by buyout firms to cover interest costs or financial restructurings, were also increasing.

This followed average leverage levels hitting 6.2 times a portfolio company’s earnings before interest tax depreciation and amortisation last year, up from 4.1 times in 2001. Ebitda minus capex divided by cash interest charges fell to 1.7 times from 2.5 times in this period.

Has the industry hit its high water mark?
Rubenstein said it was always darkest just before dawn. He added: “Deal volume will rebound and yesterday’s records will be left far behind.” However, this was for the longer term, delegates said, with the Golden Age of positive record-breaking finished in the current economic cycle.

Where will firms get their returns? And will they converge into alternatives/merchant banks?
TPG’s Bonderman said the preponderance of US deals compared to the value in the rest of the world seen in the past few years would reverse, with European and Asian deals taking precedence. Rubenstein agreed emerging markets would drive industry dealmaking and said eastern Europe had the lowest proportion of private equity dollars per GDP of almost anywhere in the world.

According to the Emerging Markets Private Equity Association, eastern Europe and Russian fundraising hit $14.6bn last year compared to $3.3bn in 2006 while deal volumes were $5.3bn and $4bn respectively. The other areas of high interest were minority investments, such as into telecoms company Sprint Nextel, Dutch cable operator Numericable, bond reinsurer MBIA, Chinese hotel chain Galaxy and foreign exchange service provider Moneygram International.

In the first half of last year there were 252 deals worth $25bn compared with 84 worth $5.8bn in the first two months, according to data provider Dealogic. Distressed debt fundraising in the first half of last year hit $25bn versus a 2008 leveraged loan maturity schedule of $175bn this year and $200bn next year.

Will returns fall?
Data provider Thomson Venture Economics found the top quartile US buyout funds returned 32.1 percent in the past year and an average of 21.8 percent over each of the past 10 years, while in Europe the figures were even higher at 78.6 percent and 37 percent respectively.
Almost all delegates expected returns to fall from these highs.

Can the industry improve its image?
The industry was too sanguine about the pressures facing it from politicians, trade unions and the media, panellist said in a discussion led by Carol Kennedy, senior partner at Pantheon Ventures. Rubenstein said the perception of the industry within the industry was better than the views held by those outside of private equity.

He said the solution was to continue to produce hard data; engage industry critics in debate; consider factors other than just returns when assessing or overseeing investments; involve portfolio companies directly in the effort; enhance transparency and their public focus; and recognise that some changes could and should occur.

Otherwise delegates feared the markets that already limited investment activity, such as in China, or had more onerous tax and regulatory rules would be joined by others which were considering changes.

Is the time right to strike deals?
Rubenstein was optimistic the deals being struck now would generate strong returns. He said in previous slowdowns, such as 1981, 1991 and 2001, US deals returned 14.8 percent, 19.5 percent and 15.3 percent respectively, while European returns were more modest at 9.2 percent, 18.8 percent and 3.4 percent.

What is the competitive threat from sovereign wealth funds?
Four of the top 10 SWFs have an active investment strategy, according to Citigroup, including Abu Dhabi Investment Authority, Singapore’s Government Investment Corporation and Temasek, the China Investment Corp and Qatar Investment Authority. But these active investors did not so far include wealth funds run for Norway, Saudi Arabia and Kuwait. Last year, SWFs bought 250 companies, up from 200 in 2001, but the deal values climbed to $69.8bn from $13bn respectively.

However, there was hope of a fruitful partnership between the two classes of investors. Rubenstein said: “In the future, sovereign wealth funds and private equity firms are likely to pursue large investment opportunities through joint ventures. Sovereign wealth funds will benefit from private equity firms’ deep pools of investment talent and deal expertise.”

Will US firms dominate the global industry in the future?
US private equity firms dominate the top 10 by assets, according to Rubenstein, but he predicted firms from other countries would break into the list over time.

The large US limited partners investing in private equity firms would also struggle, according to delegates discussing the list of most influential European investors, published for the conference by Private Equity news, the sister publication of Financial News.

Sharing and networking

The ACG is a grouping of corporations, private equity, finance and professional service firms that share ideas in order to boost corporate growth. With over 11,000 members, encompassing Fortune 500, Fortune 1000, FTSE 100 and mid market companies, across 53 chapters in North America and Europe the ACG has earned the right to call itself the “premier global association for professionals involved in corporate growth.”

The main focus of the ACG is the sharing and networking of individuals or groups who wish to build the value of their organisation. The ACG is focused on strategic activities designed to increase revenues, profits and stakeholder value. They aim to fulfil this goal by carrying out a range of activities that encourage the sharing of ideas, best practices and the building of relationships in order to give members exposure to opportunities for growth.

Achieving goals
Publications and literature, both physical and electronic are a key method that the ACG uses in order to carry out its goals. Its official publication ‘Mergers and Acquisitions, the Dealmaker’s Journal'(MAJ) is an eighty page publication that replaced the Association’s monthly newsletter, ‘ACG Network.’ Through the publication the ACG is able to offer coverage and analysis of key deals and influential developments in mergers and acquisitions. Distributed to over 10,000 subscribers it includes headline local, regional and international news that is related to all of the ACG’s members and chapters.  

The ACG also offers a monthly electronic newsletter to a database of current members, it utilises the interactive elements offered by the internet by allowing article submissions by members. Submissions for Achieving Corporate Growth are allowed to be 750-1000 words in length and they should be centred on topics regarding mergers and acquisitions (M+A) that are timely and instructive.

However a lot of the ACG’s work is done through networking and the sharing of ideals face to face between its members in order to maximise any M+A opportunities that arise in the market. Membership and involvement in the ACG can benefit executives, intermediaries and private equity firms.

Forging relationships
The biggest advantage the ACG offers to its members is the ability to forge relationships that will allow the sharing best practices and to be exposed to potential opportunities that could arise for corporate growth. For intermediaries the ACG offers an opportunity for long lasting relationships to be forged with Private Equity firms. For the Private Equity firms membership of the ACG allows them the exposure to take advantage of investment opportunities as they arise due to the sharing of ideas and strategies. Nearly 75 percent of members of the ACG advise that they have carried out deals as a result of membership.  

The biggest event in their calendar is the annual Intergrowth conference which is now in its 35th year and will be held in Orlando in April with a record attendance of over 2,000 attendees expected. At the conference members of the ACG are able to network and to meet and develop relationships and this year’s conference has a number of added features to help facilitate dealings. Central to the Intergrowth conference in 2008 will be Deal Source, a social networking resource that will allow direct interaction between the attendees. Those who sign up early will also receive access to a full attendee list prior to the conference.

Additionally, those who attend Intergrowth will also have access to the Capital Connections online database of Private Equity firms and their portfolios of companies. There will also be educational sessions that will cover focused topics and inform attendees of the latest trends that need to be followed and adapted to. There will also be the usual golf outings, tennis sessions and the first ever Intergrowth 5k run.

Leading the VDR revolution

Conducting due diligence no longer means bidders must travel to a physical room and work around the clock, taking turns reviewing piles of complex paper documents. The concept of the VDR – first developed in 2001 – is simple. Parties involved in a transaction are invited to the VDR website by the host, who grants them personalised access rights. These participants are free to peruse their list of documents, conduct searches, print and save permitted documents, all based on their levels of access. All parties can work simultaneously, at their own pace, and at any time of the day or night, from anywhere in the world. Everyone benefits. Sellers are able to attract a broader range of buyers, and receive valuable insight into buyers’ interest in their deal. VDR streamlines the entire due diligence process, creating a much quicker path to liquidity.

Although the worldwide VDR market is relatively embryonic, the demand is increasing at an impressive rate. It is estimated that virtual data room technology was in use for almost 70 percent of all North America-based M&A deals in 2007, and the trend is spreading internationally, with the use of a VDR becoming more popular throughout Europe and Asia.

This growth can be attributed to five key factors:
1) Globalisation of M&A: Sellers naturally want to cast a wider net. A virtual data room enables them to reach more potential buyers than ever before, extending the invitation to buy across borders and language barriers.

2) Drive to efficiency: Companies (and shareholders) want their advisers to work efficiently and complete the process quickly. Virtual data rooms often reduce deal duration by 50 percent or more, saving considerable time and money. Bidders also enjoy cost efficiencies, with immediate access to business-critical information and reduced travel costs.

3) Compliance demands: With the current atmosphere in corporate governance driving buyers to ever deeper due diligence, the virtual data room provides opportunities to capture and report the details of due diligence review at unprecedented levels, providing peace of mind to buyer and seller alike.

4) Pressure to put capital in play: A virtual data room opens doors to a wider range of bidders and accelerates transaction speed. The end result is that bidder traffic is increased, more deals can be done in a shorter time frame and valuable capital is engaged quickly.

5) Expanding range of uses: Demand for other uses of virtual data room technology is increasing as companies and their intermediaries deploy a VDR for more types of transactions. Such uses include, but are not limited to, the facilitation of post-merger integration, pre-IPO collaborative workspace, portfolio company information management at private equity firms, hedge fund management and corporate data repository.

How do you determine which company is the best virtual data room partner?
A first step is to identify best practices and then use them as performance yardsticks. Here are nine important considerations for making a VDR purchasing decision:

1) Ensure the solution provider has an established track record of delivering quality service. It is critically important that buyers of virtual data room service do their own due diligence to ensure that a provider is customer-focused, has a proven technology and a track record that is strong and easily referenced.

2) The solution should integrate leading technology, support industry standards and work with globally accepted data formats. Technology should alleviate headaches – not add to them. The ideal solution will embrace ease of use and open standards while supporting legacy applications and databases. The deal owner and user experience should be easily customised rather than a one-size-fits-all process or off-the-shelf software. The technology should work with all globally accepted data formats for document sharing.

3) Choose a solution provider with deep domain and project management expertise. Confidentiality is paramount. Choose a company with a strong track record of success with the management and distribution of confidential information. It is important that a VDR provider understands the transactional business environment. Insist that a project management and service team has the specific expertise needed to communicate with any party to the deal professionally and competently. Top-tier solution providers offer comprehensive and ongoing support with consistent points of contact to maintain continuity.

4) Production facilities should be available around the globe for accelerated document capture. When time is of the essence, immediate document collection and delivery to the virtual data room may be a requirement. The best solution providers have document scanning facilities located in cities around the globe. Their teams specialise in making sure that a client’s unique document needs are met quickly and efficiently.

5) Ensure that changes can be made and questions can be addressed immediately, even in multiple languages. In the midst of a deal, flexibility is key. Sometimes requirements and needs can change in an instant. The ideal virtual data room should be designed to facilitate instant updates by any empowered user. Best-in-class solution providers employ client-facing resources with the skills and experience to counsel clients in effective ways to manage the mountain of data that a transaction requires.

6) The solution must engage the highest security. In a virtual data room environment, security is of the utmost importance. A potential partner’s technical capabilities – as well as their experience with sensitive corporate information – should be important considerations.

The following capabilities should be in place:

• Uncompromising and reliable security measures covering the application, staff and infrastructure;

• SAS 70 Type II certified hosting environments

• Global, multi-location data hosting with zero-downtime network guarantee;

• High-performance data back-up carried out many times a day;

• Database replication stored at dispersed geographic locations;

• A core competency in handling sensitive financial and business information.

7) Look for rapid data room deployment. Among virtual data room solution providers, speed is a key differentiator. Top-tier virtual data room solutions provide the tools to create indexes in minutes, not days, and enable document review in real-time as documents are captured, processed and posted.

8) Inquire about audit trail and archive capabilities. Audit capabilities are among the most important elements of any virtual data room, and should be examined carefully. The site host should be able to readily monitor user activity to gather intelligence related to buyer interest. At the close of the deal, comprehensive auditing capabilities can provide important proof of disclosure. User activity reports should be captured and delivered at the end of the project on storage media, providing an archived audit trail.

9) Remember: The solution is a rich service, not a software application. No two M&A transactions are the same. Sellers need a flexible system that can be easily customised, in conjunction with an expert project management team. It is important that the solution is robust and clients can choose to manage their own documents or rely on a professional project management team.

At the forefront of global VDR expansion, and readily meeting all these criteria, is Bowne & Co., the undisputed world market leader in shareholder communications, and provider of top-level marketing and business communications services.

Dealmakers rely on Bowne to handle critical transactional communications with speed and accuracy, and compliance professionals turn to Bowne to prepare and file regulatory and shareholder communications online and in print.

Marketers look to Bowne to create and distribute customised, one-to-one communications on-demand. With 3,200 employees in 60 offices around the globe, Bowne has met the ever-changing demands of its clients for more than 230 years.

So it is perhaps fitting that Bowne Virtual Dataroom is the choice of dealmakers around the world to facilitate due diligence review for financial transactions.

Major companies which have already experienced the benefits of the Bowne Virtual Dataroom during the buyout boom of the past couple of years include BCE, Inc. (Bell Canada Enterprises) and IPC Systems, Inc. (for details, see case study panels).

Building on its history of delivering results through outstanding service, Bowne engages BMC Group Inc. as the exclusive provider of its virtual data room technology and services.

For further information:

Fully implemented

What problems do commercial banks in the CEE region face in the field of sales and customer service?
CEE’s commercial banks – similarly to their European peers – find it increasingly difficult to differentiate from each other. Although there is still some reserve in sales, since the retail account, product, channel coverage is not complete but the difference between the profit rate of regional and European banks is continuously decreasing. Customers are less loyal to their banks even in this region compared to three to five years ago. It is hard to maintain product-based differentiation. Furthermore, technological drivers also force change: the internet generates transparency and it is revealed and spreads a lot faster if a service is not of appropriate quality. Banks operating in CEE shall also realise soon that real actions should be taken in the field of customer service and sales, and in the future the customer’s experience will determine the success of the bank.

As a consequence of the above, efficient and quality sales and service processes that bridge over bank channels shall be implemented in CEE countries with more developed bank systems as well. Thus Western European and CEE banks have to fight very similar problems in this field, since customers’ opinion about European banks is often that they are “impersonal”, there is no sufficient and appropriate information available to banks during communication with the customer, marketing campaigns do not target personal interests of clients etc.

What is the situation with branch networks in the region in comparison with other countries of the EU?
In Western Europe there is an apparent movement from the branch network towards electronic channels, although they still play a dominant role in both sales and transaction services. There are high expectations towards mobile solutions, which will predictably fulfill a serious role in communication between the bank and its customers.

On the contrary, a really significant lag must be made up in CEE countries, particularly regarding the density of branch networks. While there are 1,500 – 2,000 citizens for each bank branch in Western Europe (Spain is outstanding in this regard, there are approximately one thousand citizens for one bank branch), in CEE countries this is currently 4000-6000 persons/branch, indeed there are states where branch network coverage is even lower. It is also true that the branch network extensions currently being in process in CEE do not mean the same as earlier. Today commercial banks open diversified, more efficient branches that focus on certain products, services or customers, while a few years ago the opening of universal “large” branches was typical.

Opening branches along certain concepts is already spreading in our region as well: banks open branches that are similar to ‘shopping centres,’ ‘malls’ or ‘boutique networks’ and branch openings are preceded by serious conceptual planning and business case.

Can the alternative electronic banking sales and service channels used in CEE be compared to the solutions applied in the EU?
There is no significant lag between CEE countries and those in Western Europe in the field of alternative electronic channels, at least not regarding available banking services and solutions. Web2, mobile banking solutions and even mobile payment are gradually gaining ground. But unfortunately Internet penetration is not nearly as high in the countries of the region, as further to the West from us, but there is no measurable difference in the penetration of mobile phones, since coverage is practically 100 percent. The strengthening of sales activities is perceivable in case of all electronic channels.

What is the largest deficiency, the problem requiring a solution the most in the field of customer service and sales?
Primarily the lack of information about and to the customer hinders banks in being able to communicate with their clients in a targeted way. There are no banking front-end systems independent of channels, fully integrating processes, which could ensure that data and information characterising the customer and essential for the clerk/referee or the most attractive, customised bank offers are available at all times. There are no flexibly implemented, fully automated work processes that would increase work efficiency and could divert clerks from transaction and service activities to consulting services.

A lot of banking front-end or operative CRM-type projects have started in the region with more or less success in the past few years. Unfortunately, currently there is no application that meets all criteria: supports all bank channels in an integrated way, from traditional branches, through Internet solutions to third-party agents, and in addition, covers both traditional services (e.g. fund functions) and modern sales functions, furthermore, operates real time, in an integrated way with account management systems, background systems supporting analytical CRM functions, marketing and campaign support systems etc.

No wonder, that large application producers do not have total banking front-end applications either. I think the complexity of this problem reaches, if not exceeds, that of integrated account management systems. In addition, such systems shall have outstanding flexibility: it is currently apparent and expected in an even larger degree in the future that there is strong movement between channels, which must be generated very quickly (movements, such as the bank’s internal branch network vs. strategic cooperation with third-party partners; traditional channels vs.

electronic channels). Present SW suppliers only cover certain fields, channels or process parts with their systems, the integration of which is unfortunately not a simple task. It must be underlined that we are not only talking about IT integration here, but at least process level, or rather business level integration, also including organisational issues and motivation tools.

How can FMC-Ness Hungary assist banks in solving the above-listed challenges?
FMC is an independent technological consulting firm that may and does assist its bank clients in solving tasks in several fields. On one hand, we have a detailed picture of the multi-channel solutions currently possessed by each bank in the region and we are aware of the business/technological drivers, along which future changes are expected. We have also prepared an FMC CRM barometer, in which we evaluated the maturity of Hungary’s largest commercial banks in the field of sales and customer service based on a complex criteria system we established.

Thus we can assist our clients on a business strategic and conceptual level. The special strength of FMC-Ness Hungary (differing from specifically strategic advisors) is that we possess serious project implementation and information technology experience; therefore we always suggest practically feasible solutions to our clients. In most cases customers assign our firm with implementation, from functional and technical specification to go-live of the realised, implemented systems, also including organisational and regulative works performed in the project.

For further information:

Economic growth puts global resources under pressure

Until recently, strategists agreed that rapid economic growth in the emerging economies was good news for everyone. Their stock markets boomed and cheap exports tamed inflation in the west.

The US Federal Reserve was able to reduce interest rates to unusually low levels, to reboot economies after the 2000 to 2003 equity bear market. The resulting supply of credit fuelled a consumer boom which helped every asset price to boom.

But every action has an equal and opposite reaction. As a result of economic growth in the past few years, companies and their customers are consuming commodities at a rate that puts the Earth’s resources under strain.

According to a survey produced for Robeco by research group Iris, we have entered an era where there will be an “abundance of scarcity” which could lead to a revolution in investment thinking. High commodity prices have started to fuel costs. The latest data from China suggests that its inflation rate has hit an 11-year high of seven percent.

Inflationary concerns have persuaded the Bank of England and European Central Bank to keep interest rates as high as they dare. Rising prices, illustrated by a rise in the cost of beer to £4 a pint, will lead to higher wage demands in due course.

The Federal Reserve has only cut US rates aggressively, due to the parlous state of the local housing market. Fear of rising inflation has been the result. Increased market volatility is set to become permanent as central banks struggle to contain inflation and prevent recession. The Vix index, which expresses the volatility of the S&P 500, has risen from nearly 10 to 25 over the last 12 months, and touched much higher levels.

Pension schemes with longer-term liabilities will need to consider switching out of bonds.

Seasoned hedge funds, stocks and commodity futures look increasingly attractive. Sector specialist Dawnay Day Quantum has estimated that 10 percent commodity allocations could be justified.
The market jury on the outlook for natural resources is still split.

Some back strategist Jim Rogers in his conviction that commodities prices will move higher. Others back sceptics led by US equity manager Bill Miller of Legg Mason, who reckons commodity booms go as often as they come.

But the argument that the world needs to face up to a sustained rise in commodity prices is starting to gain the upper hand with investors. Data supplied by RCM, the fund management arm of Allianz, shows over-the-counter commodity contracts boasted a sixfold rise in value in the three years to 2007. Investors are net long and commercial producers are net short.

In the latest Barclays Capital Equity Gilt survey, Tim Bond and Nicholas Snowdon take their cue from Thomas Robert Malthus, who argued in the 18th century that physical constraints would put a limit on economic growth.

The theories of Malthus became discredited because he failed to anticipate the volume of the Earth’s resources, and mankind’s use of technology to harvest them effectively.

But Bond and Snowdon argue that Malthusian limits to growth are now within sight. The global population, for example, has risen from 2.5 billion in 1950 to 6.7 billion. It could hit 9.2 billion in 30 years. The Optimum Population Trust, a think-tank, argues that the Earth cannot safely sustain more than 5.1 billion.

Its calculation takes account of the rapid rate at which increasingly prosperous individuals are using up resources. According to the World Bank, individuals in the middle and upper classes increased consumption by more than 200 percent between 1960 and 2004, against 60 percent for those on lower incomes.

Barclays Capital points to the escalating demand for meat, which uses up far more agricultural resources than grain. In 1990, Asia consumed 16.7 kilos of meat per person. By 2002 the total had risen to 27.8 kilos. People in high income economies increased their consumption by eight kilos to 93.5 kilos.

Consumption of every conceivable resource is particularly noteworthy in China. In the decade to 2004, there was a 50 percent increase in its energy demand per capita, which has gone on to escalate further.

African economies are being boosted by the desperate search for resources. Demand for aluminum, corn and soybeans has multiplied several times over. Chinese consumption helps to explain why the lifespan of copper resources has fallen by a third in the 10 years to 2006.

Supply and demand
The International Energy Agency, not renowned for scare-mongering, has suggested that demand for oil could lead to a supply-demand crunch in 10 years if there is a delay to drilling projects.

Barclays Capital says the crunch could happen as early as next year if regions outside the Organisation for Petroleum Exporting Countries fail to meet targets that look increasingly ambitious. Small wonder the price of crude is back up to $100 a barrel.

Investec Asset Management has warned that commodity prices will rise further in the longer term, citing under-investment as well as demand.

Elsewhere, the rapid production of carbon dioxide by fast-growing economies is putting a strain on the climate, with an eventual rise in temperatures of a damaging four to five degrees not impossible. If left unchecked, economic dislocation will result. Bad harvests, such as those which just caused a 25 percent jump in the price of wheat, will become more frequent.

There is even a link between the rising demand for commodities and the credit crunch. When the going was good, consumers benefited from cheap finance supplied by the Federal Reserve to dig the business community out of a hole. Since 2000, the ratio of US household debt to GDP has risen by 67 percent to 98 percent.

Generous terms were offered through operators in the capital markets who overlooked the poor quality of loans in their pursuit of a decent spread. Expansion financed by cheap debt went on to fuel the consumption of commodities across the world.

According to Barclays Capital: “The bubble in credit expansion ended because central banks needed to raise rates to deal with high inflation pressures, most of which had originated in the natural resource market.”

Higher interest rates eroded confidence that asset values, particularly housing, would keep going up and a credit crisis fuelled by mortgage sub-prime lending resulted.

Local demand
But the momentum behind the consumption of commodities is still in place as Asian economies seek to generate local demand to make good any loss of business caused by recession in the west.
These events represent bad news for bonds and a mixed future for equities, although the latter can perform well in a period of moderate inflation, particularly where dividend yields provide support.

Robeco argues that long-term value is on offer from equities exposed to natural resources, food, water, environmental and health care, where expenditure is not discretionary. Hedge funds capable of profiting from up and down markets are also worth a look.

Commodity futures are likely to gain much greater institutional attention, although consultants tend to be wary of their volatility. Putting money behind an experienced futures trader might be a better bet, although investors who yearn for a quieter life might prefer to opt for agricultural land. 

Petroleum company of the year: Manas Petroleum

Manas Petroleum’s focus since the company began just four years ago has been the exploration and development of giant hydrocarbon assets in Eastern Europe and Central Asia with the aim of building the next great global oil company. This has principally involved operations in countries which were formerly part of the Soviet Union or its satellites, which are now growing more moderate under the influence of Western Europe and China.

During this process, two critical elements remain for what the Manas management views as an historic opportunity to discover and develop major oil assets. The first is that although Russian exploration and development concepts and technologies were previously decades behind that of the West, Soviet record-keeping of geological results was excellent. An overview of Soviet Kyrgyz production and drilling records, for example, reveals an obvious trend towards larger fields as depth increased.

It also indicates that more large discoveries should occur as deep tests continue. Reinforcing this conclusion is the recent re-interpretation of other meticulously-kept Russian records relating to Soviet 1980s-vintage Kyrgyz seismic operations. The results that Manas and its partner have obtained indicate the existence of numerous, large, deep under-thrust, potentially oil-containing, undrilled structures.

Manas has consistently built a team of geologists and executives who are experts in this area and have demonstrated they have access to much of this information. This enables them to examine archived data using state-of-the-art Western concepts and technologies in their search for evidence of colossal oil deposits.

The second element is that many former Soviet Union (FSU) and Eastern European nations’ business environments are beginning to show dramatic improvements, which makes operating within their borders extremely attractive.

A key to the Manas success story is the fact that its executives are extremely well-acquainted with all the nuances of FSU and Eastern European political realities. They have a proven record of being able to operate and acquire world-class assets there and they know which countries are evolving in a pro-oil business fashion. They also possess crucial geological expertise which enables them to act immediately when opportunities arise.

Since Manas was founded as a private company, with headquarters  at Baar, in central Switzerland, it has assembled a well-diversified portfolio of high impact exploration plays spanning two continents and five countries. It includes agreements on and varying interests in more than five million acres of land in Central Asia and Eastern Europe. In a new departure, the company was recently  awarded an exploration license for the Magellan basin in southern Chile, an area fast becoming one of South America’s oil and gas exploration hotspots.

The company’s first project was its Kyrgyz Republic Fergana basin oil exploration play. It was a logical opening move because Manas’ ex-CEO Dr Alexander Becker received his PhD in structural geology at Kyrgyz Republic’s Frunze Academy of Science (Bishkek) before going on to discover two significant oil fields and being named the area’s top mapping geologist by the Soviet authorities.

In 2006, British-based engineers Scott Pickford estimated that part of Manas Petroleum’s Kyrgyz Fergana holdings had a P50 an in place resource of 1.2 billion barrels of light oil – an estimate the company is confident will be significantly upgraded.

On the southeastern border of the Kyrgyz Republic is China’s Tarim basin, where the massive Xinjiang field is estimated to supply a fifth of China’s total crude demand. Kazakhstan, home of the super-giant Tengzig, one of the world’s ten largest oil fields, is directly north. The Manas concessions are in an area which shares the same oil saturated geology as China’s Tarim. Both the Tarim and Fergana basins are part of an oil-saturated belt which extends westward and ends at the massive Caspian oil basin. All three areas were first known for their shallow oil production.

Superbly defined
Elsewhere, Manas sees huge oil and gas potential in Albania. The company has production sharing contracts there which cover more than 3,000 square kilometres, and an independent study by American-based engineers Gustavson Associates describes Manas’s oil and gas prospects as “superbly defined virtually drill ready.”

The report adds: “A 2005 light oil discovery by Occcidental Petroleum approximately 50 kilometres south of the Manas blocks has established that the same thrust sheet as the Tirana sub-thrust anticline is Ionian and in fact does contain oil. This substantially reduces the A,B,D,E blocks’ exploration risk as it greatly increases the probability that the giant anticline outlined by Shell and Coparex is in fact the oil-saturated Ionian formation.”

No matter how promising the Albania project might be, Dr Becker is quick to point out that there is always the potential for disappointment with explorations. “We know the prospects’ reservoir capacity is very large and that there is oil in the system,” he says. “But we will never really know for sure if some unexpected geological event has intervened until the prospects are drilled.

“We are getting other companies to take on most of the risks and pay the bills. We may end up with less of a project but we also get to play safe and smart by spreading our risks among many great high potential projects. And that’s how we plan to build a large oil exploration company.”

For further information
Tel: +41 (0) 44 718 10 30

Connected in a web of mutual interdependence

A barrel of oil now costs twice what it did a year ago, and four times what it cost in 2002. Real prices are now higher than they were at their last peak – 1980 – and look like climbing further still. Plenty has been said about the global economic pain that trend is causing. But the price of oil is not just high, it is volatile, too, and that causes problems of its own.

“Volatility is worsening and the fluctuations are more pronounced than they were in the 1990s,” says Yan Wang, senior economist at the World Bank Institute. Wang says that unlike previous oil shocks, which were largely supply induced, recent price increases reflect growing energy demand in emerging markets, especially China and India. International capital flows seeking investment opportunities in the face of a declining dollar have also played an important role.    

Prices have gone up even though oil stocks around the world are not critically low.

Oil output by the Organisation of the Petroleum Exporting Countries (OPEC) has recently edged higher, and OPEC has “tremendous potential” to increase supply, says World Bank senior energy economist Shane Streifel.

Volatile prices make it harder for oil importers to budget for energy costs. Volatility also hurts economic growth, investment and trade, says the World Bank – several developing countries have lost ground in the fight against poverty as a result. The Philippines reckons 4 million people slid back into poverty in 2006 because of rising oil prices and a higher cost of living.

Oil exporters also face challenges managing revenues and planning development.

A booming oil sector and rising currency may mean other sectors in the economy fail to grow and develop. Volatile oil prices have put pressures on developing countries to look for ways to smooth out the bumps in the market.

The World Bank published a study in 2006 – “Coping with Higher Oil Prices” – that looked at the experience of 38 developing countries that tried various ways of managing volatility. Chile, Malaysia, Thailand, Indonesia and others used “price-smoothing,” in which a country sets a target oil price. The government subsidises oil if the international price goes above the target, and imposes taxes if it goes below.

But such a policy often ends up encouraging more fuel consumption and subsidising the rich. In Indonesia, the government reformed the fuel subsidies and compensated the poor by paying them conditional cash transfers.

Another technique identified in the report is hedging – using financial instruments such as futures and options and “collars” which could mitigate price risks at a cost. Countries can also build up oil security stocks that they can release to reduce the impact of a temporary shortage or a major price shock.

A longer term solution is switching to alternative fuels, including renewable or synthetic fuels, or reduce energy use through energy efficiency or by cutting the amount of energy used in production, which is becoming a priority. Energy switching is often from oil to much cheaper coal in developing countries in East Asia, worsening the environmental picture.

If the reasons for the changing supply and demand levels are well understood, the more interesting question is whether the forces shaping the demand and the supply curves will shift. World Bank managing director Graeme Wheeler addressed this point in a recent speech on oil price volatility. Some big variables are in play, he said.

On the demand side, the energy intensity of production in OECD economies has diminished markedly since the 1970s, argued Wheeler.

Greater efficiency and substitution into alternative energy sources will help to moderate oil demand, but Chinese demand for oil is currently increasing by 15 percent a year. The International Energy Agency (IEA) projects global energy demand to rise more than 50  percent between now and 2030 – with China and India accounting for almost half of this increase.

On the supply side, there’s limited excess capacity in oil producing countries and many potential new sources of supply carry considerable political risk, said Wheeler. “With the lack of net investment in oil refining capacity over the past two decades and the long gestation periods in installing new refining capacity, these supply constraints will be costly to rectify.” 

The IEA estimates that US$20 trillion needs to be invested in the energy sector over the next 25 years to secure sufficient supplies, he noted.

“There’s been considerable debate over the role that oil speculators and traders might have played in exacerbating volatility and inducing upward pressure on prices,” said Wheeler. “Some of this sentiment may date back to concern about the role that Enron’s energy traders played in manipulating the market for natural gas on the West Coast. My impression is that increased speculative activity in futures markets result from the high level of oil prices and uncertainty about forward prices, not the other way around.”

Whatever its sources, Wheeler said that high and volatile oil prices present challenges to governments in managing the terms of trade impact and its consequences for traditional macro-policy instruments, and regulatory and distribution policies. 

“Oil producers have often struggled with the effects of exchange rate appreciation on traditional export industries and the ensuing deterioration in governance – often characterised by growing corruption.  While GDP per capita in resource-rich countries increased by 50 percent in the four decades to 1998, per capita income growth for resource-poor countries was four times higher.”

Wheeler pointed to governance arrangements based on frameworks similar to those adopted by Norway and the State of Alaska that are beginning to emerge in several developing countries. 

The goal is to convert non-renewable resource endowments into permanent sources of investment income using diversified asset strategies and strict budgetary or stabilisation rules.

Sovereign wealth funds are relevant here. These funds currently manage assets of around US$2.5 trillion and some projections suggest that this could reach US$12 trillion by 2015.  The IMF, World Bank, and OECD are developing a code of conduct for these funds, including provisions on institutional structure, risk management, transparency, and accountability. That follows concerns that such funds will use their wealth to achieve political rather than investment goals.

“Some of the political rhetoric has become highly inflammatory, [but] there are some important issues here,” said Wheeler. “Given that these are state-owned investment vehicles, would it be appropriate for them to take an aggressive speculative position like George Soros’ hedge fund did in shorting sterling in 1992?”

Soros’ investment behaviour is widely credited with forcing the UK to leave the European Union’s Exchange Rate Mechanism.

“If used responsibly, commodity hedges and other risk management building blocks can help enormously in managing balance sheet risk.  Hence, it’s pleasing to see that financial market instruments and strategies are being examined,” said Wheeler. “Governments are keen to manage their balance sheet risks.  They do so through a range of mechanisms by, for example, being conscious of the currency exposure of their assets and liabilities, by building up foreign exchange reserves, privatising assets, and adopting sound principles of fiscal management – including managing contingent liabilities.”

In 2000, the World Bank introduced several hedging products to help developing countries manage their balance sheet risks.  With these products, countries have the opportunity to manage exchange rate, interest rate, and commodity price risk in the portfolio of loans that they receive from the International Bank for Reconstruction and Development (IBRD), part of the World Bank. “We can also use these instruments to transform their non-IBRD portfolios,” said Wheeler. However, he waned that governments using derivatives have to understand their pricing characteristics.  “We have recently seen how competitive pressures drove investors to take on greater risks in their search for high yield,” he said. “We saw dominant institutional investors investing in complex structured products with risk and return characteristic that they did not fully understand – even more so when market liquidity began to dry up with corresponding uncertainty on how to value underlying cash flows.”

Even with efficient financial markets, there remains a critical challenge for many developing countries.

“One of the cruel ironies today is the connection between rising energy and food prices,” said Wheeler. “This coupling can have devastating implications for global poverty and food security.  Higher energy prices have increased fertiliser and transport costs and stimulated bio-fuel production.”

In the US, for example, a quarter of the maize crop – representing over ten percent of global output – went into bio-fuel production last year.  Higher energy prices, drought, and rising demand have led to a 75 percent increase in the price of staples since 2005 – prices are at a 20-year high.

“Just as the poorest on this planet are the most exposed to the effects of climate change, they are also highly vulnerable to the effects of rising fuel and food prices,” said Wheeler. “Food and energy prices usually represent over 70 percent of the consumption basket of the poor. The long-term consequences are considerable.  Poor households will cut back on food consumption and education – and girls will invariably be the first withdrawn from schooling.  Reliance on traditional fuels will increase with obvious environmental consequences.”

“This leads to an important point.  The catalyst of globalisation will only be sustainable if it can create opportunities and benefits for all. Today, given  the recent revisions to purchasing power parities, well in excess of over a billion people live on less than $1 a day.”

That means “the benefits of globalisation are by-passing many of the poorest,” says Wheeler: they are in danger of becoming politically and socially disenfranchised and disconnected from global society.

“We have seen how their exposure to higher food prices recently led to riots in West Africa and South Asia. A world where a large proportion of the population remains trapped in extreme poverty and unable to share the benefits and opportunities of globalisation, carries unacceptable costs in terms of human suffering, economic losses and political tensions, and has important potential implications for security within countries and across borders.”

Wheeler said that concerns about the slowdown in industrial economies, should not cloud the benefits of globalisation and the ways in which trade had boosted investment, spread technology, and enabled labor mobility – all of which “are boosting productivity growth and delivering millions of people from poverty.”

That’s why the price of oil – and the ability to manage volatility in the price – is so important. Wheeler pointed to the “drami” or “the endless knot” – one of the eight lucky signs of Buddhist philosophy – as an illustration of the challenges of globalisation.  “It symbolises how citizens of the world – across countries and over time – are connected in a web of mutual interdependence,” he said.

Specialising in economic analysis

It isn’t just corporate bombast. It’s a reality many US businesses have already witnessed. For many corporates, transfer pricing is the most important issue any large global business has to face up to during the next five years. Tax authorities – including Her Majesty’s Revenue & Customers (HMRC) – are getting tough with any company which may have pushed the envelope when it comes to clearly explaining their transfer pricing regime. But it’s also an environment where tough, intellectual rigour is increasingly valued says Dr Ted Keen of Ballentine Barbera, the US-based transfer pricing boutique specialist. “A lot of countries have already adopted the OECD Guidelines and the arm’s length principle into law, but though that gives countries the same basic rules, each country interprets the rules slightly differently. And you’ve got to remember that the OECD guidelines are just that – guidelines: there is no one correct transfer price! Producing economic evidence and analysis in support of your transfer pricing policy is critically important.”

Know your way in a changing landscape
The issue has certainly been underscored by Sir David Varney, former executive chairman of HM Revenue & Customs (HMRC). HMRC has taken a much tougher line with business, especially large operations. Varney repeatedly underlined that more resources were being ploughed into transfer pricing enquiries and would follow a clear action plan when not enough information is offered. “We’re expecting to see a lot more recourse to litigation generally,” says Keen, “especially in the UK. We’ve already seen a lot of action in the US, Canada and Australia. Certain types of companies, such as the largest drug companies, are being targeted. So the government isn’t wasting time on small fry. There’s a huge amount of money at stake.”

Litigation of transfer pricing matters is also quite a change in culture too. Tax authorities traditionally have had a close relationship with accounting firms – many tax partners in UK accounting firms got their start as tax inspectors. “So when taxpayers and their accountants go into negotiation with HMRC, they’re dealing with people who already know each other.” But with increasing prospects of litigation, lawyers are now starting to challenge the accounting firms’ dominance in the transfer pricing arena says Keen. ‘Law firms traditionally have been much more involved in the transfer pricing area in the US than in the UK. We’re now seeing law firms in the UK and Continental Europe getting more involved in transfer pricing. That has to give multinationals an advantage when it comes to litigation. Lawyers know the litigation process better. So the landscape is definitely changing.”

A more positive message
However, Ballentine Barbera’s Gerben Weistra says the EU is gradually developing a more consensual view on transfer pricing issues to prevent double taxation via the EUTP forum. In addition, “the OECD recently issued a paper suggesting changes to the 1995 guidelines. What they’ve done is incorporate some of the practices in the guidelines. You could say that there will likely still be differences in interpretation of transfer pricing regulations between countries, of course, but it’s becoming more about being less dissimilar than different, I’d say. In terms of transfer pricing, the EU has focused on the free flow of capital growth, taking away practical barriers to growth. . So it’s really about overcoming the differences at the theoretical side now.”

He says it’s useful to remember that many European countries are still working out their own transfer pricing initiatives. “Still, even if the now suggested changes are implemented some countries, of course, will interpret it to the letter, while others will be trying to find their own way with it.”

Weistra also says he is surprised some companies are still – within varying degrees – not aware of the huge financial ramifications as they should be. “Some companies still say things like ‘oh, our transfer pricing is audited out’, or they ‘don’t consider it a material issue’. Frankly, that surprises me.” He says some operations remain preoccupied with the process of transfer pricing issues, rather than the technical side and implementation of their policy. “Since Sarbanes Oxley, we see more people again who are interested about pricing procedures, and who is involved therein. They’re less interested in the technical side and implementation of a policy. But the process, actually, is not that different to what it was 10 years ago, although there are obviously new reporting rules for audit purposes. The key question however is about whether you have in fact a proper and consistent transfer pricing policy, how it is applied and communicated and what deviations might lie inside it. That is where possible transfer pricing corrections would arise.”

It’s also about getting a sense of where the legal argument really lies. For example, Greg Ballentine, a founder of Ballentine Barbera, has been involved in many landmark transfer pricing court cases helping build Ballentine Barbera’s reputation and invigorating debate on all the issues. Plainly it’s not about following tried-and-tested formulas that may have worked a few years ago. Something more demanding is now needed.

Imagining the future
So how will the role of transfer pricing develop? Dr Ted Keen thinks that Europe, including the UK, will need to get used to a great deal more transfer pricing litigation. “In the past, HMRC, for example, would have been quite reluctant to penalise tax payers and they would often give them the benefit of the doubt. But we’re seeing a lot more pressure from a variety of special interest groups who are interested in governance and how companies make their money. Just read the front page of The Guardian newspaper. You’ll see frequent challenges to multinationals’ transfer pricing practices to avoid paying UK taxes.”

Is there any way to avoid the expensive and lengthy litigation process? Some companies will certainly want to explore the use of advance pricing agreements (APAs) in greater detail. The advantages of APAs are simply certainty and consistency, especially useful for companies with less predictable audit cycles. Keen says the French government, for example, are increasingly looking hard at such arrangements. “There’s a lot of APA activity in France right now and certainly the French government seem quite eager to enter into APAs. The bigger you are, the easier it is to bear the fixed cost in terms of money and time. But others still prefer to handle transfer pricing issues if and when they arise under audit.” The Germans, on the other hand says Keen, have changed their transfer pricing rules slightly but significantly. “Germany is a very high tax country for business so many companies have attempted to scale back their operations there. The Germans don’t like this, of courses, so have implemented new rules on how they will look at supply chain reorganisation and disposals of business.”

Of course, it’s always quite a judgement call when considering your taxable footprint in one country compared to another. And a change your transfer pricing policy will inevitably upset at least one tax authority. But a rigorous examination of the facts and a thorough knowledge of your industry and market will help to support your case.

No right way
What are the key issues for transfer pricing going forward? Much of the real debate says Keen remains focused on intangible property and just where and how those after-tax profits are declared. “Much of the issue arises from licences to use intangible property, like patents or brands, to develop, manufacture and/or distribute goods or services. Where you incurred the costs and risks of developing your valuable intangible property will dictate where profits arising from those intangibles should be recorded. Multinationals who have a clear and well-documented strategy and policy for funding the development of their intangibles will be in much better shape than those who don’t. There is no one right way to do this, and what’s right for one might be completely wrong for another. It’s up to each multi-national to work with their economic and legal advisors to figure out the best strategy for them within the bounds of the OECD Guidelines. This will help them avoid costly litigation down the road.”

In other words, each case is different, and the OECD guidelines are just that – guidelines. “That’s why you need very tight economic analysis of your own operation and circumstances – that’s our specialty.”

Custodians juggle challenges of risk and reward

Custodians have a love/hate relationship with risk. On the one hand, they are wary of using their balance sheets for client financing, a reluctance that has helped investment banks make headway in the administration business.

At the same time, custodians are interested in administering highly complex investment portfolios and products, many of which carry a significant operational risk. Custodians also want to play a part in risk measurement and analytics, although few have developed a compelling service proposition. Even the largest custodians are feeling their way when it comes to risk services.

According to Gunjan Kedia, global head of product management at Bank of New York Mellon, part of the problem is that each client has a unique perspective on risk. She said: “There is no hard and fast definition of risk services. Clients talk about risk in different ways, and we take a consultative approach to providing management and analytics products. Risk is a very broad spectrum and we need to ensure that we have sufficient intellectual capital to cover it.”

Some firms, such as JP Morgan, leverage their investment banking expertise to develop their risk capabilities, while others provide turnkey solutions to smaller clients. Jay Hooley, a vice-chairman of State Street, said the bank was concentrating its efforts on this sector. He said: “We are working on our risk analytics and modelling capabilities. We are focusing on those boutique managers that do not have the infrastructure to handle risk analytics in-house.”

While risk measurement and analytics represents a further expansion of value-added services, the real challenge for administrators lies in quantifying and managing the risks associated with processing complex structured products and dealing with a very different client base. Alternative investment managers do not behave in the same way as institutional pension plans and mutual fund managers, presenting administrators with client servicing, operational and technological issues.

Hans Hufschmid, chief executive of GlobeOp, one of largest independent administrators, said the “know your customer” principle has never been more important. He said: “You definitely have to be more careful about the firms with which you do business.” Hufschmid said despite the fact that the alternatives industry is relatively tight-knit, a lot of due diligence is still required.

“This is an industry in which everyone knows everyone. We get referrals from prime brokers, law firms and accountants, and then we work hard to get to know our prospective clients.”

Custodian banks are fully aware of the challenge. Tim Keaney, head of international asset servicing at Bank of New York Mellon, admitted that the industry has not yet got everything right. He said: “All of us could do a better job of understanding clients, but we are all starting to ask the right questions.”

Some of those questions will undoubtedly revolve around the risk/reward ratio. Custodians have long argued that they need to be better compensated for the work they do and the risks they assume, and they are quick to make the point that the price of staying in the race is increasing all the time.

Hooley said complexity has its costs. “To meet the demands of clients in servicing more complex instruments, we have to spend at higher levels, and others will have to as well.”

Specialist services
For some custodians, one way to deal with the pressures of complexity is to outsource specialist services. GlobeOp, for example, said “three or four” of the world’s largest custodians use it for over-the-counter derivatives processing, while SuperDerivatives, the asset pricing and revaluation specialist, claims the majority of global custodians use its revaluation services.

David Gershon, chief executive officer of SuperDerivatives, said custodians need the help of specialists in such a complex area. He said: “Custodians realise that they cannot afford to deliver a poor service. That’s why they use us.”

Gershon feels the widespread adoption of derivatives as an asset class is putting pressure on administrators and their systems. “Planning capacity for future volumes is not a trivial issue. The growth of the OTC derivatives market requires a serious review of the operational infrastructure needed to support client activity. There is also the significant challenge of managing multiple data sources,” he said.

Even as custodians look to specialists such as GlobeOp and SuperDerivatives for support, they are discussing new outsourcing opportunities with clients. Most of the banks report a renewal of interest in investment operations outsourcing, largely driven by the buyside’s need to find processing solutions for alternative investments.

Many custody firms are also looking at increasing their business with hedge funds, having recognised that they need to get closer to execution and financing if they are to generate better returns.

BNY Mellon is evaluating the opportunities with hedge funds from a number of angles. Art Certosimo, head of broker-dealer and hedge fund services for the bank, said it is interested in collaboration, rather than straight competition, with the investment banks. He said: “We want to build partnerships with the top-tier prime brokers. We can help them to manage their administration more effectively. We are looking at establishing tripartite relationships with prime brokers and hedge funds.”

At JP Morgan, the focus is on better integration of what the firm does for hedge funds, according to Conrad Kozak, global head of investor services. He said: “We are improving the packaging of our services for hedge funds. The firm has a lot of different relationships with hedge funds, and we are working on a more integrated marketing approach.

Brokerage model
There is also an increasing amount of noise among trust banks about the need to change the securities financing and prime brokerage model. Although Citigroup has launched a comprehensive hedge fund servicing capability that combines execution, financing and administration, no other custodian has publicly indicated that it is ready to take on the prime brokers.

However, the mood is certainly moving in that direction. Trust banks believe they can offer a different type of service that would enable hedge funds to break their dependency on prime brokers.

Hufschmid is sceptical about their ability to compete. He said: “Trust banks do not have a Wall Street mentality. Prime brokerage is alien to their culture, and that will be a hurdle.” Yet the big interest in 130/30 funds, a market Merrill Lynch predicts could rise in value to $1trn within five years, may force custodians to take a more aggressive approach to protect their client base. They will not want to see their clients launching 130/30 funds, only to miss out as the valuable administration mandates go to independent administrators or investment banks.

As this year’s R&M Global Custody Survey results show, the big custodians are in no position to relax when it comes to client service, a lesson that JP Morgan has taken to heart. Kozak said: “We are focusing on the delivery of our services on an end-to-end basis, from implementation onwards. We need to ensure that the quality is consistently high across all areas. We have to do a better job of understanding what the client wants and how we deliver it. That’s the challenge facing the industry.”

Web retailing: more is more in e-commerce

Many business leaders, disappointed by online sales growth, see Web consumers as disloyal and unwilling to spend. But that’s because the managers are not exploiting what customers value most: engagement.

Online automobile shoppers want information about cars, yes, but they also want to learn about such other topics as travel, sports, apparel and finance, our research shows. Online shoppers for upscale clothing might typically want information on art or even business.

Most firms limit their sites to providing narrow information about the products or services that are for sale. Indeed, the majority of managers we spoke to in our global study told us they believe that a broad array of information diverts attention from the core offerings.

Loyalty points
But we found it helps customers search for solutions, invites them to think of all the ways the core products might add value to their lives, wins their loyalty and entices them to buy. In fact, we found that exploiting consumers’ desire for engagement is the single dominant driver of superior shareholder value for e-commerce companies.

Our research involved an analysis of more than 1,700 e-commerce sites, along with interviews of 238 consumers and 112 managers in the United States, Europe and Asia over four years. Some 57 percent of the managers were disappointed by their firms’ online sales growth, but only 17 percent had a plan to change their sites to improve sales – an indication that they didn’t even know how to start turning things around. Most believed that price was the only important way to attract online customers.

We scored the sites on the five practices that customers said they cared about most, and we found that a higher overall ranking on those practices is associated with greater company value as measured by Tobin’s Q, the ratio of market value to asset replacement value. In addition, the shares of the 25 companies with the highest-ranking sites outperformed the Standard and Poor’s 500 by two percentage points, on an annual basis, from 2003 through 2006.

Four of the practices are increasingly common and expected by consumers – without them, sites can’t hope to keep buyers around long. They are: personalized shopping, clear categorisation, order tracking and in-depth product- or service-related information.

It’s the fifth practice – customer engagement through the provision of information on related products and services – that represents the most significant opportunity. A high ranking on this practice is a stronger predictor of the company’s Tobin’s Q than the rankings of any of the other four. The top 25 companies for customer engagement outperformed the S&P 500 by more than 12 percentage points, on an annual basis, throughout the period. Only about 23 percent of the sites in our sample made use of customer engagement practices.

Brand attachments
Ralph Lauren’s e-commerce site is a good example of how to engage users. Through the online “luxury lifestyle” RL Magazine, consumers are invited to regularly revisit the site to learn about fashion, art, sports, healthy diets and business – facilitating brand attachments and associations that go beyond the core product. Corporate performance reflects the success of the e-commerce site: The firm’s Tobin’s Q increased from 1.6 in 2003 to 2.6 in 2006, and its stock price more than tripled from 2003 to 2007.

One very effective way for a company to start learning what its customers are interested in is to offer Web visitors a wide list of topics and ask them to vote on which they like. The firm can use those responses to help it decide which attributes – wealth, attractiveness, exclusivity, for instance – it wants customers to associate with its brand.

The next step is to provide supplementary information that will help customers make those associations. Porsche, for example, uses the Web to offer adventure tours and travel information, reinforcing the brand’s image of passion and high performance.

Bringing it to the next level

SEPA was officially launched on January 28 with the successful introduction of the SEPA credit transfer instrument. The regulatory authorities had a clear vision, set in the Lisbon agenda, to make the European financial market the most efficient in the world. This meant that the European financial market, which was very much fragmented along national borders, needed to be harmonised. Simply put, harmonisation brings more transparency to the market. This allows participants across the region to enjoy the same information on offerings to make educated choices on products and services.

Time and money
Harmonisation creates healthy competition between providers of financial products and services which, in turn, improves market efficiency, fosters innovation and dismantles unjustified lock-in situations. Regulators can declare SEPA a success when consumers and businesses have more efficient, openly accessible and easy-to-use payment instruments, in a more competitive and innovative market.

The biggest challenge for regulatory authorities is time. On the one hand, the momentum created by insisting the industry provides an ambitious implementation agenda cannot be sustained indefinitely, and risks disappearing in the soft consensus that past instruments were not so bad after all. A long cohabitation of legacy and SEPA payment products would be extremely costly to everyone. On the other hand, SEPA implementation needs massive and rapid investment, which in several instances clashed with investment cycles of stakeholders. Finally, it has become clear that SEPA roll-out is a succession of steps, starting with credit transfers, giving the impression of open-ended regulatory pressure.

Across Europe, payments represent about a quarter of a bank’s operating revenues and a third of operating costs: payments contribute to less than 12% of a bank’s overall profits. Yet for many banks payments are considered a core business if only because it involves client intimacy and because it provides a steady if unglamorous revenue stream. Although the definition of “core” varies geographically and over time, banks usually rate the quality of infrastructures and sustainability of business models as the two key conditions to making SEPA a success.

Banks expect SEPA will push market infrastructures to be more cost-efficient and agile. Market infrastructures will must be able not only to segment and diversify their offerings, but also to help customers better serve their clients and fight off competitors through faster time-to-market and proactive product innovation.

Last but not least, because payments will have to travel faster and more securely across Europe, banks will not be able to compromise the resilience and security of market infrastructures. In the newly competitive environment created by SEPA, reputation risk will be managed more closely than before.

SEPA is likely to force banks and other stakeholders to raise their game. Banks could look at other industries, such as the automotive, and organise their payment businesses like assembly lines. They could collect and assemble parts from various internal and external sources, force themselves to better identify the various components of the payments value chain, and build a sourcing strategy that supports a wider business strategy. Banks could combine growth and industrial strategies, use and develop white label products and utilise innovation and development resources more efficiently. A number of banks have already taken this entrepreneurial route.

Corporations at the centre
Since the Lisbon agenda agreement, consumers and corporations have been at the centre of the regulator’s attention. Authorities have based most of their SEPA cost-benefit cases on the benefits it will bring to society in general, and to the financial services’ end-user in particular. The main benefit EU authorities usually identify for end-users is a reduction in bank transaction charges for all payments.

Large corporations, with significant activities in different countries, will be satisfied as SEPA benefits go beyond the charge reductions on cross-border payments and the avoidance of new charges on intra-border ones. Many have expressed they are looking for the harmonisation of technology and the customisation of commercial products, for simplification of operating processes and for more differentiation in business relationships, demanding new services like individual electronic signatures, management of mandates or harmonised trade services.

Market infrastructure providers are probably the only SEPA stakeholders for whom 2010, and thereafter, is going to be a zero-sum game. Not only will their numbers reduce substantially, driven by the need for scale to meet the other SEPA stakeholders’ pressure for lower payment processing costs, many will see their own traditional clients compete with them, as large global transaction banks will offer sourcing alternatives to smaller institutions.

Additionally, the market experienced a major value shift, from an applications focus to a network focus. If payment instruments are standardised across SEPA, they can be processed in a fairly standardised way. Financial institutions, particularly the largest ones, want independence from proprietary standards and channels. They want to internalise as much value creation as possible, by focusing upon the major payment routes.

Winning edge
SEPA is an opportunity and it will be up to each participant to find their way through the change to end up on the winning edge. There is hardly ever a business case for each stakeholder to invest in infrastructure, unless it is done in cooperation and with clear leadership. The purely competitive approach as well as the soft and wide consensual method have both shown limitations when it comes to radically change an industry with strong legacy systems. Participants must be ready to engage in a new cooperation/competition model.

In conclusion, it has become clear that if the future of SEPA depends on known and unknown elements, four major ingredients are required for it success: harmonisation of standards and interface; a network with extended reach in terms of geography, stakeholders and business activities; a reliable provider of reference data; and a catalyst for win-win developments. SWIFT will continue to foster these ingredients in support of the SEPA community.

SEPA will succeed if financial institutions continue to provide leadership through an effective and neutral governance structure. They could build on the embryonic structure they set up around SEPA standards testing. They could bring it to the next level – a structure ‘beyond compliance.’