After economic storm, Asia faces 2010 political risks

Investors who kept faith in Asia as the world teetered on the brink of financial meltdown a year ago have been richly rewarded – the region’s markets rode out the storm in spectacular style and posted stunning gains.

The economic outlook for 2010 appears far sunnier. But with frothy markets betting on a smooth return to business as usual, the danger of a sudden correction hangs over Asia, unless the region can steer its way past some treacherous political risks.

The two most important issues for the world economy in the coming year are political — the pivotal relationship between the United States and China, and the timing and coordination of exit strategies from the stimulus measures that kept disaster at bay.

Investors in Asia also need to be wary of political shocks that could suddenly overturn the region’s risk profile.

Upheaval in North Korea, where there are persistent doubts about the health of leader Kim Jong-il and where the economy is going from bad to worse, could cause profound regional instability. And the risk of a confrontation between nuclear-armed India and Pakistan, perhaps sparked by another militant atrocity in India, is ticking upwards again.

“A multitude of political, security and operational risks converge in Asia,” said Michael Denison, research director at London-based Control Risks consultancy. “The causes of the global recession are now well understood. The contours of the recovery, by contrast, are far from clear.”

Relationship problems

The United States and China are already by far the two most important countries in terms of political clout. And in 2010 China is set to overtake Japan as the second-largest economy. The “G2” relationship is key to shaping our destiny not just in the coming year or coming decade, but through the 21st century.

Like most relationships, it is not easy.

Pressure on China to allow the yuan to appreciate will become ever more intense in 2010 as economic storm clouds evaporate, and one-year non-deliverable forwards suggest modest gains by the currency by the end of 2010.

But Beijing will not want to jeopardise economic growth by letting the currency rise too quickly, and does not appreciate being told what to do by Washington or anyone else. In the United States, meanwhile, yuan weakness is regarded as a protectionist policy that threatens the U.S. recovery.

Into this volatile mix add the ever-present threat of import restrictions, like the U.S. imposition of tariffs on Chinese tyres in September, sparking a tit-for-tat trade war.

Plus the danger that Beijing’s backing of regimes that Washington finds unpalatable, from Pyongyang to Yangon to Tehran and Khartoum, explodes into a political confrontation.

Most analysts say Washington and Beijing are painfully aware of the risks and would step back from the brink before any dispute threatened the global economy. But the two countries have yet to find a way to communicate comfortably as partners. The risk of a misunderstanding or sudden chill in relations is real.

The second key political risk for Asia – and indeed the world – is dealing with the hangover from the stimulus measures that helped keep the global economy afloat over the past two years.

If governments withdraw the stimulus too soon, they jeopardise growth. But keep policy too loose for too long and they risk not just inflation but also catastrophic asset price bubbles. Given China’s importance to the global recovery, signs of property and equity bubbles there are a particular concern.

Another risk for investors is if countries trying to prevent bubbles and curb inflows of “hot money” tighten capital controls. Analysts say this could be a key issue for India and Indonesia in 2010.

Disagreements could also erupt within countries, between governments focused on safeguarding growth and central banks fearful of inflation and bubbles. That could lead to bad decisions, and make policy hard to forecast. Policy friction is already an issue in Japan. India and South Korea could be next.

Known unknowns

As in any year, the best-laid plans in 2010 could be derailed by unexpected shocks. We have no idea about some of the lightning bolts that will hit Asia in 2010 — the surprises that author and fund manager Nassim Nicholas Taleb calls “black swans” and former U.S. Defense Secretary Donald Rumsfeld called “unknown unknowns”.

But there are plenty of known unknowns to worry about.

Mass social unrest due to economic hardship was the dog that failed to bark in 2009. That could change in 2010.

“A structural rise in unemployment will represent a key macro, political and security risk in 2010, even in states like China where growth has remained relatively solid,” Denison said.

The decisive victory of the Congress party in India’s 2009 elections was another good-news story for markets that could be threatened if militants based in Pakistan provoke a confrontation again. Investors are already rattled that reforms in India are going slower than expected. The last thing they want is war risk.

“Another major attack would all but force India’s government to take a much more hostile approach to Pakistan … allowing Pakistan’s military leadership to set aside attacks on local militants and turn their attention to an enemy they feel less reluctant to antagonise,” said Ian Bremmer, president of the U.S.-based Eurasia Group political risk consultancy.

And finally, two key Asian heads of state are ailing, with the question of who and what will come after them far from settled. Thailand’s 82-year-old King Bhumibol Adulyadej has been in hospital since September, another complication in the long-running political crisis that has riven the country.

Many analysts expect instability to get even worse after his reign ends — giving Thai markets another rough ride. But most say there is little risk of contagion in other markets.

By contrast, when North Korean leader Kim Jong-il dies, the tremors will be felt in South Korea, Japan and beyond.

Many analysts say Kim’s death would herald the collapse of the regime in Pyongyang, leading possibly to prolonged civil war in North Korea, aggressive moves against the South, or the sudden reunification of the Korean peninsula. In all of these cases, the likely market reaction would be the same – panic.

Bankers of the Year 2009

Banker of the Year, by Country:

Mr Abdulkarim Ahmed Bucheery, BBK

Abdulla Al Hamli, Dubai Islamic Bank

Hassan Abdalla, Arab African International Bank

O.P. Bhatt, State Bank of India

Mr Musa Shihadeh, Jordan Islamic Bank

Mohammed Abdul Rahman Al Bahar, NBK

Mr Salim Sfeir, Bank of Beirut s.a.l

Omar Hussain Al Fardan, National Bank of Oman

Saudi Arabia
Abdulkareem Abu Alnasr, NCB

Mr Ergun Özen, Garanti Bank

Learning from the Cold War

The Cold War, the third major conflict of the twentieth century, is no exception to this rule. All three phases can be identified, and all three triggered intense debate.

There were, for example, those who questioned whether the Cold War was in fact necessary and whether the Soviet Union and Communism constituted a threat. Such “revisionists” were a distinct minority, which is a good thing, as there is no reason to believe that the Soviets and Communism were a benign force. As a result, the Cold War, a four-decade-long global struggle, became a reality.

There was also an ongoing debate about how best to wage the Cold War throughout its history. The two principal schools of thought were “roll back” and “containment.”  The former argued that nothing less than overthrowing communism – “regime-change” in today’s parlance – would do.

The latter approach held that efforts to roll back Communism in the short run were too risky, given the Soviet nuclear arsenal, and that the United States and the West should content themselves with limiting the spread of Soviet power and influence.

Containment prevailed, but this hardly settled the debate, as there were intense arguments both over where it should be applied (Vietnam, Central America, and the Middle East all come to mind) and how it should be carried out, i.e., the right mix of military force, covert action, diplomacy and arms control, and economic sanctions and assistance.

And now, exactly 20 years after the Berlin Wall came down, we are well into the third phase – the debate over why the Cold War ended when it did and how it did.

One school of thought maintains that the Cold War was won as a result of decades of sustained US and Western pressure on the Soviet Union and its allies. This pressure at various times took the form of US, British, and French nuclear programs; NATO’s willingness to counter Warsaw Pact deployments of both conventional military and tactical nuclear forces; the decision to defend South Korea against the North’s aggression; the arming of the mujahedeen in Afghanistan to bleed Soviet occupation forces; and the decision to build a costly missile-defense system aimed both at negating the Soviet Union’s principal military investment and bankrupting its government.

A second and very different school of thought emphasizes less what the West did and more what the Soviet Union was. In this narrative, the Cold War was not so much won by the US and the West as lost by the Soviets, the inevitable result of Soviet economic weakness and political decay.

Yet another perspective stresses that Western willingness to engage the Soviet Union as much as confront it played a major role in how history turned out. Détente helped to keep the competition from spilling over into conflict as it exposed the Communist world to Western ideas of freedom and capitalism along with their benefits. The Soviet and other top-heavy regimes increasingly found themselves losing the battle of ideas and, as a result, the support of their own citizens.

All of these factors played a part. Western willingness to deny the Soviets success was an essential component of strategy. But this alone would not have been enough; indeed, the Cold War could well have turned hot if Western strategy had consisted only of military competition and confrontation. It was important to moderate the competition in order to allow pressure for change to build up from within the Soviet bloc. And it was important to expose the societies under Soviet control to their shortcomings and to the advantages of outside ideas.

All of the above has implications for today’s challenges. To be sure, there is no global threat on the scale of the former Soviet Union, but there are dangerous challenges emanating from such countries as Iran and North Korea. What is required is a policy on the part of the global community that mixes military strength with a willingness to negotiate and interact, a policy of collective strength and collective flexibility.

It is important here to keep in mind that containment, the dominant doctrine of the Cold War era, sought to push back against Soviet and Communist expansion – not just to limit the reach of Soviet power, but to frustrate it – in order to create a context in which the inherent flaws of communism and authoritarian rule would come to the fore. Mikhail Gorbachev could only have done what he did amidst a crisis of confidence.

Today, the world needs to create similar crises of confidence in the minds of those ruling Iran and North Korea. The goal should be to limit what they can accomplish in the short term; to get them to change their policies in the medium term; and to set in motion forces that will bring about new and fundamentally different governments and societies in the long term. Such an approach served the world well during the Cold War; it could do the same now.

Richard N. Haass is President of the Council on Foreign Relations and author of War of Necessity, War of Choice: A Memoir of Two Iraq Wars.
© Project Syndicate 1995–2009

Leaving the Euro zone

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).

A single currency also means a common exchange rate relative to other currencies, which, for any country within the euro zone, precludes a natural market response to a chronic trade deficit. If that country had its own currency, the exchange rate would decline, benefiting exports and impeding imports. Without its own currency, the only cure for a chronic trade deficit is real wage reductions or relative productivity increases.

The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

The contrast between conditions in Germany and Spain illustrates the problem. The unemployment rate is now about 8 percent in Germany, but more than twice that – around 19 percent – in Spain. And Germany recorded a trade surplus of $175 billion in the 12 months through August, whereas Spain has run a trade deficit of $84 billion in the past 12 months.

If Spain and Germany still had the peseta and the D-mark as their respective currencies, the differences in trade balances would cause the mark to appreciate and the peseta to decline. The weaker peseta would stimulate demand for Spanish exports and reduce Spain’s imports, which would boost domestic demand and reduce unemployment.

Since the interest rate set by the ECB is now less than 1 percent, there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment. Spain and other high-unemployment euro-zone countries might oppose this policy but face monetary tightening nonetheless, because the ECB deems the overall state of the euro zone to warrant higher interest rates.

Spain is not the only country that would have an incentive to leave the EMU. Greece, Ireland, Portugal, and even Italy are often cited as countries that might benefit from being able to pursue an independent monetary policy and allow their currencies to adjust to more competitive levels.

The widening spreads between the interest rate on German eurobonds and some of the other countries’ euro bonds show that global bond markets take this risk seriously. For example, while the current yield on 10-year German government eurobonds is 3.33 percent, the corresponding yield on Greek eurobonds is 4.7 percent and 4.77 percent for Ireland’s eurobonds. These divergent yields reflect the market’s perception of the risk of default or of effective devaluation associated with leaving the euro.

Leaving the EMU would, of course, involve both technical and political issues. A government that wants to replace the euro with, say, the “new franc” (which is not to suggest that France or Belgium would be likely to abandon the euro) would have to reverse the process by which its currency was originally swapped for euros. But, having learned to do that once would make it easier to do it again in the opposite direction.

How would the exchange rate be set for the new currency? The obvious choice would be to start by exchanging one “new franc” for one euro and then leave it to the global currency markets to re-price the new currency. A country with a large initial trade deficit would expect to see its currency decline relative to the euro, say, to 1.2 “new francs” per euro, which would make its products 20 percent cheaper than products in other euro countries and would make imports more expensive. If that causes a rise in the departing country’s price level, the nominal exchange rate would have to decline further to achieve the same real adjustment.

Because individuals from the departing country could continue to hold euros, leaving the EMU would not cause a loss of existing wealth. But such a country would have to worry about more substantial economic consequences.

Global capital markets would recognize that a country with high unemployment might choose to pursue an inflationary policy or a policy or exchange-rate depreciation. That could lead international investors to withhold funds from a departing country and raise substantially the interest rate on its national debt.

There would also be political problems. Would a country that leaves the EMU be given a diminished role in EcoFin, the European Economic and Financial Affairs Council? Would its voice be diminished in European discussions about foreign and defense policy? In the extreme, would it be forced out of the European Union altogether, thereby losing its trade advantages?

These economic and political risks may be enough to deter current EMU members from deciding to leave. But remaining in the euro zone could impose significant costs on some of them. At some point, the inability to deal with domestic economic problems within the EMU framework may lead one or more countries to conclude that those costs are simply too high to bear.

Martin Feldstein, a professor of economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisors and President of the National Bureau for Economic Research.

© Project Syndicate 1995–2009

On the right side of the energy cycle

When Bahrain-based First Energy Bank “FEB” was conceived in early 2008, it wasn’t exactly the most auspicious time to be launching the world’s first energy-dedicated Islamic investor. As chief executive Vahan Zanoyan, long an authority on the sector, admits, the debut happened at the wrong end of the cycle. “We were establishing the bank at the peak of the energy market, probably the worst time to enter because of the downside risk,” he recalls.

So make that four months an eternity. The price of assets collapsed, although not right across the board as we shall see, and the newborn institution’s medium-term prospects immediately looked much brighter. “Suddenly, First Energy Bank made a lot more sense for counter-cyclical reasons,” Zanoyan says. “Now we’re very much on the right side of the curve.”

Having said that, he was never worried about the big picture: “The bank always made sense for conceptual reasons and that’s never changed.” That concept was based on highly targeted equity in a region bursting with potential, both in conventional energy and in renewables, as becomes more receptive for private equity.

Unique solar resources

The region’s potential for absorbing disciplined energy investment has never been in doubt. As a World Bank report noted in September: “The Middle East and North Africa (MENA) region has about 57 percent of the world’s proven oil reserves and 41 percent of proven natural gas resources. MENA is also endowed with unique solar resources. ”

The World Bank’s timely survey also identifies a pent-up need for the implementation of industry-wide efficiencies through judicious doses of private-sector equity. “In many MENA countries, petroleum product prices are distorted, cost recovery in electricity is low, efficiency of supply leaves a lot to be desired and energy intensity is relatively high. Carbon intensity is, on average, higher than in industrialised countries, and the potential for renewable energy is under-explored,” the report summarises. “The region is lagging behind in implementing reforms in the electricity sector and lacks private sector investment.”

Which is where the world’s first Islamic energy bank comes in, First Energy Bank’s latest deal – and its biggest to date – provides a fair illustration of how the picture is changing. In November, FEB announced a partnership with Saudi’s Project Management and Development (PMD) to build a USD 1bn polysilicon plant that is slated to meet fast-rising demand for solar power, not just in the region but globally. (Polysilicon is a vital component in the production of solar panels.)

On a start-up schedule of 2013, the partners have already signed with US-based Vinmar International to buy most of the plant’s annual production of 7,500 tonnes of high-quality polysilicon. Down the track, the venture plans to invest more deeply in solar power by manufacturing solar wafers and modules which many see as the sector’s version of killer apps.

At roughly 40 percent equity, 60 percent debt, the project looks conservatively financed. This reflects First Energy Bank’s, well, first principles. The general parameters, explains Zanoyan, is a judicious split of the bank’s resources along the lines of 40 percent equity investments, 40 percent Islamic debt finance and 20 percent Treasury investments. (As of September 30, 2009, the bank had total assets of USD 1.3bn and liabilities of USD 240m).

More than an investor

Also reflecting the way the bank intends to operate in future, its role in the project is more than that of investor. A subsidiary of First Energy Bank, Cosmos Industrial Investment, will manage and develop the plant, working alongside PMD, as it takes shape at Al Jubail industrial city, one of the most important manufacturing hubs in the Gulf.

With the cycle now working very much in First Energy Bank’s favour, it’s hunting for similarly promising deals and not just on its own patch. “Our mandate is global. The Board has put no limits on where we can invest,” Zanoyan explains. “Right now we’re looking at projects beyond the MENA region.” Nor, for that matter, is First Energy Bank confining itself to its sector of choice when it comes to other operations of the Bank. “Treasury is not limited to taking stakes in the energy sector,” he adds.

The institution’s prime mandate however is clearly the sector where the chief executive has spent more than a quarter century. From the outset First Energy Bank was set up to invest in profitable niches of the hydrocarbons industry – development, production, transportation, storage, refining and distribution – as well as in oilfield services and exciting technologies in power generation and renewables.

The choice of chief executive was clearly critical to that mission and Vahan Zanoyan seems to have arrived ready-made for the job. A pioneer in applied analysis of the political economies of oil-producing nations, a frequent speaker at energy conferences and a member of the Council on Foreign Relations, he joined the bank after ten years as president and CEO of global energy advisor PFC Energy.

With that mandate and its chief executive in place, First Energy Bank had little trouble attracting shareholders. Starting out with central bank approval for USD 750m in capital, it had to go back and request a higher ceiling of USD 1bn because of the pressure of investor demand. As Zanoyan recalls, “the extra USD 250m was filled almost overnight and we had complaints when we had to close it off.”

With authorised capital of USD 2bn, First Energy Bank started slowly largely because of the inflated state of the market but still found attractive projects. “We invested USD 250m – USD 300m in the first year, more than I thought we would because market conditions were not very favourable.”

Hard-headed analysis

Not that First Energy Bank is a soft touch. The projects that land on its doorstep are subjected to some of the hardest-headed analysis in the Gulf. One of the chief executive’s top initial priorities was to create a team of not just bankers but bankers who are very much at home in the complexities of the energy sector. That is, people who could drill down, if you like, into the fine detail of proposals.

“There’s a lot of banking expertise in the Middle East but not much energy-sector expertise,” says Zanoyan. “First EnergyBank’s ability to combine pure banking skills with sector-analysis skills is worth a lot more to us than the USD 1bn.”

His immediate executives appear to be similarly steeped in the industry. Before joining First Energy Bank, joint deputy chief executive Mohamed Shurki Ghanem who has overall responsibility for investment, originated advisory assignments for Arab Banking Corporation right across the energy market and worked in a senior research role for Opec in Vienna. His fellow deputy CEO Mohammed H. Al-Nusuf combines the roles of marketing private equity to institutional investors with unsentimental analysis. Ramzi Al Sewaidi, Head of Investment Banking, has experience with multi-billion dollar energy projects in the region. Between them, they run opportunities through a fine tooth comb.

They’re so hard-headed, in fact, that Zanoyan told the magazine that only five of the projects presented to his team of analysts have been put before the board. That’s five out of 70 proposals they have evaluated to date.

Typically, the polysilicon project got the full treatment before a proposal went upstairs. Already in the planning before it was presented to Zanoyan’s analysts, the project had already cleared most of the hurdles but that wasn’t good enough for the investigative team and the recommendation did not go before the directors until all the boxes were well and truly ticked.

In practical terms, this meant that the essential power supply agreement was signed with Saudi Electricity Company. Tenure on the industrial land was wrapped up. The all-important off-take agreement with Vinmar International was settled. And all this was preceded by a full range of market and technical studies that ended up by establishing the project’s viability.

Needless to say, if any part of the world is ripe for the mass-production of solar power, it’s got to be the Middle East and North Africa (MENA) region with its consistently high temperatures. No wonder many commentators on MENA energy are bullish on renewables, including the polysilicon industry.

Meantime the plant certainly seems to meet the competitive criteria. Not only will it be the biggest of its kind in the region, its technology is leading-edge and, reflecting recent progress in solar-powered research, will produce much more affordable energy than would have been the case even three years ago before a massive influx of R&D capital, especially in the US where much of the technology has been developed.

“It will be one of the lowest cost polysilicon producers in the world, “ summarises partner PMD. Indeed costs have collapsed in the last few years in the solar energy industry, which is now on the brink of competing in price with conventional forms of power.

Late last year, as investment conditions improved with the decline in inflated asset prices, Zanoyan promised “a rich pipeline of projects”. The polysilicon plant fulfilled that promise, but a few earlier projects also survived his team’s rigorous process and First Energy Bank, dipping its toes in the water, has made other relatively modest investments.

Last September it bought a nine per cent stake, costing USD 50m, in a USD 2.2bn water and power project run by Al Dur, the largest of its kind in Bahrain. First Energy Bank also has a positive outlook toward the oilfield services industry, especially drilling.  Although most industry segments face a downturn at the moment, crude oil prices have not remained depressed which bodes well for the drilling industry. So First Energy Bank recently finalised the purchase of 40 percent of Arab Drilling and Workover Company (ADWOC) from Transocean, in addition to its investment in Menadrill, an offshore drilling venture.

Still hungry for hydrocarbons

Although the trend toward renewables is here to stay, hydrocarbons will continue to attract a lot of investment and provide a major part of the world’s energy needs.  “There are no rapid and consequential substitutes to hydrocarbons,” says Zanoyan.  “Renewables will certainly be a priority for many governments, but it will take a long time for them to occupy a material share in the global energy slate.”

Although First Energy Bank’s capital is modest by the standards of the giants of the sector, appearances in this case deceive. The register counts a number of deep-pocketed, blue-chip regional shareholders who have the desire, capacity and know-how to invest in those projects that make it through the eagle-eyed analysts and appear before the board. They include North African sovereign wealth funds such as the Libyan Investment Authority, government and quasi-government organizations like the Abu Dhabi water and Electricity Authority, financial institutions and wealthy individuals from across the Gulf.

The advantages of this depth of capital are clear. “They give us a very diverse regional group of potential co-investors and much deeper pockets than we otherwise would have,” explains Zanoyan.

And although he doesn’t say so, shareholders’ deep pockets and Gulf-wide stature also lend credibility to First Energy Bank. If the institution, with its rigorous processes, has identified a project as a suitable location for its capital, then it implies a certain seal of approval.

Also, shareholders of this caliber have the capacity to stay in for the long haul. While as a bank, First Energy Bank is careful to plot an exit strategy if needs be, it’s also in a position to exercise what’s known as investment longevity and stay in for many years if the returns justify it. Explains Zanoyan: “Most of our investments have very different exit strategies within a two or three-year period, but if we choose we can stay in for the long-term. Some projects we have no intention of exiting because they are important for our portfolio. We are investors, not financiers.”
With that attitude, First Energy Bank could end up giving private equity a good name.
Local knowledge

After so many years of experience in consulting across the globe, First Energy Bank’s chief executive is by no means Pollyannaish about the sector, especially in his home base. He understands its idiosyncrasies, tensions and pitfalls.

Some countries are, for instance, effectively closed to outside equity investors in certain kinds of activities, notably Kuwait and Saudi Arabia, while some of those that are open may be overcrowded and highly competitive.

“But opportunities are available elsewhere in the region,” he points out. “And there’s no reason why we should be tied down just to the MENA region just because we know it better.”

Having said that, First Energy Bank is dedicated to a diversified portfolio of projects but remains cautious of investing in upstream projects such as exploration, which is a notoriously heavy consumer of revenue and capital with dismayingly long lead times. “No financial institution should take exploration risk,” he says flatly.

Meantime according to a groundswell of independent commentators, all the indications are that First Energy Bank and its partners have ended up with their timing right, even if a little fortuitously. At a November energy summit in Riyadh, economist Dr John Sfakianakis of Banque Saud Fransi, citing the recovery in oil prices over the last few months and the “cautious global recovery”, was unapologetically up-beat. “Even as the MENA region gradually recovers, investment opportunities abound [as they do] after any crisis,” he said.

Recent reports highlight the vacuum of private equity for MENA projects, which are typically large, complex and capital-hungry. Similarly, there’s said to be an even greater dearth of Islamic financing whose time-frames neatly match the long-term requirements of the sector. Although the underlying value of many Islamic-financed projects has reportedly declined in the last year, so have many conventionally-financed energy assets. Nothing has happened, say economists, that might shed doubt on the importance of Islamic finance, which in principle pursues investments in project development, joint ventures, M&A, and the purchase of assets.

In short, guided by Sharia’a scholars, First Energy Bank is seeking various forms of partnership rather than a narrow role as a mere financier.

The current hunger for capital can only intensify, according to the World Bank. Citing rapid population growth, urbanisation and economic development that, combined,  are putting pressure on existing infrastructure, its latest report predicts that the region will need energy investment alone of around USD 30bn a year for the next 30 years, or nearly USD 1trn altogether. This is equivalent to about three percent of the region’s total projected GDP and is about three times higher than the world’s average.

As the bank points out, the main problem is that the usual sources of capital simply won’t be able to keep up the required rate of investment: “The continued high and volatile prices of fuels are straining the finances of many net importing countries, both at the government and the utility level, and increasing costs of subsidised energy at home for the oil exporters.”

All up, it looks like a good case for “highly targeted private equity” if the region is serious about providing affordable, clean and reliable energy for its people.

Diamonds: now an investor’s best friend?

They are rare, beautiful, valuable and a girl’s best friend but traditionally diamonds have not been considered an asset class in their own right. They do not share the “haven” status of gold and their prices are more volatile than those of the precious metal. While the value of spot gold has gained about 25 percent this year, diamond prices have fallen by at least 10 percent, in line with the poor performance of the luxury industry, according to US-based IDEX Online Diamond Prices, which tracks global asking prices for the polished gems.

Some jewellery specialists are doubtful about the merits of diamond investing. David Bennett, the Geneva-based chairman of jewellery for Europe and the Middle East at London auction house Sotheby’s, said: “Like art, we would not advise someone to buy diamonds for investment purposes, although people do. We feel diamonds should be bought for the joy of wearing them.”

Diamond investment has had a controversial history, as for most of the last century, the market was dominated by a cartel led by mining group De Beers. In recent years, however, the market has broadened, with De Beers controlling 45 percent of it and Russia and Canada becoming the leading external suppliers.

But the growing demand for tangible assets and portfolio diversification has led to the launch of a number of diamond investment funds this year, which believe they can achieve double-digit returns for investors.

In March 2009, alternative investment manager KPR Capital launched a Cayman Islands-domiciled, investment diamond fund with a minimum investment of USD 250,000 (EUR 168,168).

This month, investment boutique Emotional Assets Management & Research launched a fund which invests in collectables ranging from fine art and rare stamps to diamonds and diamond jewellery. The fund is targeting a growth rate of 15 percent per annum with a minimum investment of GBP 100,000 (EUR 111,967).

Dazzling Capital, a London-based company investing directly in period jewellery, also opened its doors this month. The company is co-founded by former Christie’s auctioneer Humphrey Butler, former jockey and chartered accountant William Sporborg, and Christopher Holdsworth Hunt, co-founder of City brokerage KBC Peel Hunt.

The company, which requires a minimum investment of GBP 10,000 with an estimated 11 percent return, counts Lady Madeleine Lloyd Webber, wife of the British composer Sir Andrew Lloyd Webber, as one of its investors. Investors can also rent Dazzling Capital jewellery for a nominal fee of GBP 50.

Other investors said diamonds were too niche to gain a significant following. Scilla Huang Sun, the head of equities at Swiss & Global Asset Management, said it did not have a diamond fund because the class was too narrow to merit a fund of its own.

Diamond trading is growing in sophistication. Until recently, gems had been considered an illiquid asset. Auctions are rare and gem valuation was considered more of an art than a science. But in January, the Dealers Organisation for Diamond Automated Quotes, an online diamond exchange managed by Dutch bank ABN Amro, was launched.
The Belgium-based exchange attempts to overcome other traditional barriers to investment in the diamond market, such as high sales fees and low liquidity, and offers two-way auctions for polished diamonds, the first cash market for diamonds.

Diamond funds provide diversification benefits by investing in a range of pieces but many investors may want to buy their own diamonds, not least because they get to wear the jewellery when they want.

Some gems hold their value better than others. Holly Midwinter-Porter, a gemmologist at UK jeweller Boodles, said: “If you want to buy diamonds for investment purposes, they should be big and fancy. Red and green are the rarest and, unlike white man-made diamonds, are finite as they are only found in one or two areas in the world.”

She added that rare diamonds were a long-term investment and their portability made them more appealing than gold or art to some investors.

Another option for investors is the vintage diamond jewellery market, which is considered capable of offering better returns. Auctioneer Butler brokered a USD 4.5m deal with The Louvre museum in Paris in 2004, for an antique emerald and diamond necklace and earrings by Nitot, given by Napoleon Bonaparte to his second wife, Marie Louise of Austria. The owners had bought it for a fraction of the sale price a number of years before.

Private buyers are taking advantage of a rebound in diamond prices, although buying at auction can mean paying an eye-watering buyers’ premium of up to 25 percent plus VAT at houses like Sotheby’s and Christie’s. The seller is also charged a commission of between 10 percent and 15 percent up to GBP 150,000, so the auction house can take as much as 40 percent out of each transaction.

Last December, a record amount was paid for a diamond at auction. The 36-carat blue Wittelsbach diamond sold for USD 24.3m at Christie’s London auction. This May, a record was set for a vivid-blue diamond, with the seven-carat Josephine diamond changing hands for USD 9.4m at Sotheby’s in Geneva.

At another Sotheby’s Geneva sale this month, the star lot is a rare vivid-green diamond, expected to sell for up to USD 5m. It is barely the size of a small coin but its rare colour, a result of radiation in the rock, could make it a record-breaker.

Stephen Lussier, executive director of the world’s biggest diamond miner De Beers Group, expects prices to grow strongly. He said that after a difficult year which had seen De Beers sales drop by over 10 percent net, a global scarcity of diamond mines and a surge in demand from China and India could turn diamonds into a sparkling investment.

© 1996-2009 eFinancialNews Ltd

LSE chief slams stamp duty and Tobin taxes

Xavier Rolet, the chief executive of the London Stock Exchange, has slammed stamp duty at a European hearing into “Tobin” taxes, warning it had a “significant dampening effect” on the UK economy and hurt savers and small companies.

Governments around the world have considered introducing new taxes on financial transactions in the wake of the financial crisis as a means of reducing their fiscal deficits and making the financial sector pay for its perceived profligacy.

But speaking at a European Parliament committee hearing, Rolet said the 0.5 percent tax levied by the UK Government on equity and bond trades was “a tax on the real economy that is paid by small and mid-size enterprises, savers and investors”.

He said: “We have our very own transaction tax in the UK. It is called stamp duty. Stamp duty is a tax on the real economy that is not paid by intermediaries such as banks but by corporations, savers and investors.”

Rolet cited research that found stamp duty reduced UK equity volumes by 20 percent and the average citizen’s life savings by up to 5 percent. The tax also increased the cost of capital for companies by up to 12 percent, with the greatest impact on high-tech companies, Rolet said.

Opponents of stamp duty argue that removing the tax would provide a much-needed boost to the economy, by stimulating investment and discouraging investors from trading in foreign, rather than UK, stocks. That view was supported by a 2007 report by UK consultancy Oxera, which claimed that abolition of the tax would result in a 7.2 percent increase in the value of UK listed shares, worth GBP 146bn (EUR 162bn).

The UK is one of only a handful of major countries to impose the tax. Trading is free in Germany and France, while US investors pay a negligible amount to cover the running costs of the SEC.

Rolet said that such “Tobin taxes” risk rendering Europe’s equity markets even less liquid and hurting small companies. He said: “Equities turnover in the EU is one tenth that in the US, and the weight bears predominantly on small companies that cannot raise capital elsewhere. It is a competitive and financial handicap for small companies.”

Rather than deterring investment in equities, governments should encourage it as a means of improving companies’ finances, according to Rolet. He said: “We are in the middle of a very profound financially-induced recession that is the result of a debt-fuelled binge. Banks cannot direct capital to SMEs because they need to repair their balance sheets. The solution is improved access to equities as an asset class.”

The idea of a “Tobin” tax was mooted in August by Lord Turner, the chairman of the UK Financial Services Authority, who said that they could help eliminate financial excess and profits. Last month, prime minister Gordon Brown appeared to carry out a U-turn when he suggested that such taxes could be considered.

A spokesman for the Treasury said stamp tax on shares raised nearly GBP 3.2bn in the 2008-09 fiscal year and was an important contributor to sound public finances and public services. He said: “Removal of the tax would result in significant reduction in public expenditure. There is no firm evidence that it significantly harms trade in UK equities, which has more than trebled since 1997.”

© 1996-2009 eFinancialNews Ltd

Banks launch FIG recruitment drive

Global players such as Barclays Capital and Lazard are competing to sign up senior financial institution group bankers with boutiques including Evercore and Moelis & Co as demand for financial services specialists outstrips supply.

FIG is the biggest fee earner for investment banks in Europe. According to Dealogic, fees from FIG in Europe stand at USD6.9bn for the year to date and represent 42 percent of the total fee pool. That is the highest proportion of total fees since the start of this decade. In the 12 months to the end of 2000 they were just 26 percent.

Financial institution work tends to be more specialised than many other areas of investment banking and so it is harder for banks to move staff from other businesses to plug gaps or grow a team organically.

Stéphane Rambosson, a partner at executive search firm Veni Partners and a former senior banker at Schroders and Citigroup, said: “There simply aren’t that many senior FIG bankers out there and this is likely to be a problem for anyone looking to build up in the market. Those that want to get into this business are going to have to look slightly off the beaten track to find the right people.”

Barclays Capital is looking to build a European financial institutions business and has hired Sheffield Haworth to line up potential candidates. Lazard has mandated headhunter Blackwood to help it find a replacement for FIG specialist John Hack, who left to become a partner at Clive Cowdery investment vehicle Resolution in June.

Speaking to Financial News earlier this year John Hack said: “There is a huge opportunity in FIG over the next two to five years and banks are keen to reshuffle their FIG teams in expectation of that. There is a lot of restructuring to do as global banking redefines itself. Winners will buy losers, some banks may break up and there will be large-scale restructuring, all of which has increased demand for FIG specialists.”

Jefferies, Fox-Pitt Kelton, Greenhill and Fenchurch Advisory Partners are also in the market for FIG bankers, according to bankers and recruiters.

As the dust settles after the financial crisis, bankers expect insurance companies, asset managers, banks and other financial companies to require advice on restructuring, raising cash and buying and selling businesses.

Mark Aedy, head of boutique Moelis & Co in European, hired former colleague Caroline Silver to build a FIG practice from scratch in July. Aedy said: “FIG represents a significant proportion of the total fee pool and there is every reason why it will continue to be a very active sector.”

Malik Karim, managing director and co-founder of London-based financial services advisory boutique Fenchurch Advisory Partners, believes boutiques have an edge at the moment.

Karim said: “While competition may appear tough for hiring, proven FIG bankers appreciate that clients are looking for real expertise, depth and recent track record. Joining an established boutique with momentum and critical mass is preferable to joining a start-up or dysfunctional unit in an integrated bank.”

Other banks may be looking to fill the gaps after their top FIG bankers left to join rivals. In September Stefano Marsaglia left Rothschild to join Barclays Capital as global chairman of FIG, while Citigroup lost former global co-head of FIG Chris Williams to Credit Suisse in May.

© 1996-2009 eFinancialNews Ltd

Clients keep faith

Writing about then Goldman Sachs banker Byron Trott in 2008, billionaire investor Warren Buffett said: “Byron is the rare investment banker who puts himself in his client’s shoes.”

The pair had worked together on Berkshire Hathaway’s USD4.5bn deal to take a majority stake in industrial conglomerate Marmon Holdings, while Trott also helped broker Buffett’s USD5bn investment in Goldman Sachs at the height of the financial crisis last year.

Considering their long-lasting relationship, it was perhaps not surprising that when Trott decided to strike out on his own this year, Buffett backed his enterprise, BDT Capital, and said he expected to call on Trott’s advice in the future.

Buffett’s decision speaks volumes about the power of relationships when it comes to appointing advisers for M&A deals. The past year has seen several examples of big-name bankers leaving bulge-bracket banks for pastures new – whether to an existing boutique or to set up their own firms – and taking their clients with them.

One of the most notable beneficiaries has been Evercore, which has landed several large mandates on the back of its team’s existing relationships. This month George Ackert, who joined Evercore in February to launch a transportation division, landed a role on Buffett’s USD36bn  deal to acquire the 77.4 percent of Burlington Northern Santa Fe railway it did not already own. Ackert had previously built up a 10-year relationship with Burlington at Bank of America Merrill Lynch, where he had been global head of transportation and infrastructure.

Star pharmaceuticals banker Francois Maisonrouge has helped the boutique land two prominent roles. This year, he advised French pharma group Sanofi-Aventis on its acquisition of the 50 percent of animal health company Merial it does not already own from Merck, and also landed a role advising Wyeth on its USD68bn merger with US rival Pfizer.

Maisonrouge had previously been chairman of life sciences at Credit Suisse, where he was responsible for managing the firm’s relationships with large healthcare clients including Wyeth, GlaxoSmithKline and Roche.

Other smaller boutiques have also benefited from the trend. In foodmaker Kraft’s continuing bid for UK confectioner Cadbury, the US firm mandated boutique Centerview Partners alongside Lazard, Deutsche Bank and Citigroup.

James Kilts, partner and co-founder of Centerview, used to work for Kraft as chief of the worldwide food group at Philip Morris, which acquired the company in 1988. He had previously served as senior vice-president of strategy and development at Kraft.

Meanwhile, Foros Group landed a role as financial adviser to the transaction committee of the board of US healthcare data provider IMS Health, which in November agreed to be acquired by private equity firm TPG Capital and the CPP Investment Board, an arm of the Canada Pension Plan.

Its chief executive Jean Manas is a former head of M&A for the Americas at Deutsche Bank. Other senior members of the Foros team include Fehmi Zeko, formerly vice-chairman in global banking and chairman of global media and telecommunications for Deutsche.

The firm landed its first mandate in June, advising Virgin Mobile USA on its USD420m sale to telecoms firm Sprint Nextel, working in concert with Manas’s former employer Deutsche Bank.

© 1996-2009 eFinancialNews Ltd

Mom and pop

When the family shareholders in Australia’s Myer retail group suggested they might sell out completely in the forthcoming AUD2.5bn public listing, there was a volley of complaints from institutional and individual shareholders. If the family didn’t retain a significant investment, particularly in the middle of the financial crisis, what did that say about the 109 year-old group’s future?

While mum and dad investors felt betrayed, local fund managers argued that the Myers as well as the other major shareholders, Texas Pacific and Blum Capital, should stick around on the share register as a show of confidence.
The family bowed under the pressure. To restore faith in the chain – and boost the share price in the middle of an institutional book-build, it allayed investors’ fears by announcing it would retain around a fifth of the pre-float shareholding. In the current environment, that affirmation made the job of chief executive Bernie Brookes much easier as he toured the world’s financial capitals.

Eighteen months ago, it’s unlikely that institutional shareholders would have reacted in such a way. In the UK and US in particular, institutional analysts tended to regard family blockholdings as a millstone around a company that made for eccentric decisions, undue influence on chief executives (the Ford family were routinely accused of “meddling”), excessively long-dated strategies and an inexplicable aversion to debt.

But eighteen months is a long time in a crisis. Family shareholdings in some of the world’s biggest businesses including Ford are increasingly seen as an anchor in the financial storm, particularly so because of the problems and even collapse of once-preferred categories of shareholders such as private equity, hedge funds and even such typical institutional investors as insurance companies and wealth management funds.

Compared to some of the above, particularly private equity and hedge funds, the traditionally low or zero debt of family shareholders among other virtues has come to be viewed as a stabilising influence in companies where other shareholders may be awash with debt.

This recognition of the anchor value of family shareholdings, if not necessarily control, is well-founded. A recent landmark study of the top 1000 companies, both private and listed, in four countries – France, Germany, Italy and UK – notes: “In continental Europe family firms are more profitable than non-family firms.”

The April 2009 study – The Life Cycle of Family Ownership by researchers from the London Business and Said Business schools, University of Oxford and Milan’s Bocconi University – is the most comprehensive and thorough in many years of the relative influence, profitability and importance of family-owned firms. It goes on to point out there are a surprising number of them. According to the study, two thirds of the top 4000 companies in these four nations are family-owned.

The stabilising role of family control – or at least influence  – is not however news to long-term students of Europe’s family firms. While largely negative institutional research has tended to dominate the issue, a series of scholarly studies over the last few years contradicts many of its presumptions. For instance, far from “meddling” in a firm’s executive, in Germany families tend to “exert strong disciplining of poorly performing management” to the company’s long-term benefit, argued a 2003 study in the Journal of Small Business Management.

Europe’s faith in the family-owned business model is also reflected in ownership patterns. “We find that among the largest 1,000 firms in each country, family controlled blocks are the most important category of ownership in the three Continental countries, as high as 57 percent in Italy and 43 percent in Germany. In contrast, it is only 23 percent in the UK,” add the Life Cycle study. 

The family touch appears to be an important element of the firm’s continuity, for instance in their banking relationships. While most UK family-owned companies were swallowed up by outside investors because of their need for capital, many European families built up such good relationships with their lenders over the generations that they didn’t have to resort to IPOs to raise money.

And in a shock finding, most of the surviving family companies in Britain are owned not by UK families but by European or American ones. “[Over half] of UK family firms are controlled by foreign families,” notes the report.
German banks, governments and institutions are so enamoured of family ownership that, when a family sells out of its business, the new owner is another family. The classic recent case is the family-owned Schaeffler Group’s family’s EUR12bn bid for tyre-manufacturer Continental AG.

In Germany, things don’t change much even after IPOs. After the IPO, two thirds of companies remain under the absolute majority of the original, family shareholders. Even when non-voting shares are issued, most family blockholders will continue to exercise dominance. Like France, Spain, Italy, Switzerland and other European countries, Germany has an insider system as opposed to an outsider system such as in the UK and US with their highly regulated emphasis on independent directors, codes of compliance and other factors.

“Families may be more likely to dilute control in outsider systems, where the value of the private benefits of control are lower, new equity is less expensive and the market for corporate control is more efficient,” explains the Life Cycle study. “Conversely, families may be more likely to stay in control in insider systems, where the private benefits of control are greater, new equity is more expensive and the market for corporate control is less efficient.”

After following the fortunes of companies in both systems for ten years, the study concluded that goes a long way to explaining the overnight discovery by institutional shareholders of the long-held virtues of companies where families have a strong say. “Over the 1996 – 2006 decade, UK family firms have a lower chance of survival as family-controlled firms than French, German and Italian family firms,” it notes. “Only 44 percent of UK family firms survived over the decade as family-controlled firms, compared with 74 percent in Germany, 64 percent in France and 78 percent in Italy. “And right now, survival is clearly the name of the game. One company that has long earned top marks from analysts despite its family dominance is Spain’s Inditex, parent of the Europe-wide Zara fashion chain. Listed since 2001, it’s one of the most admired firms in the world and a regular subject of academic case studies despite the fact that founder, executive president and major shareholder Amancio Ortega rarely talks to the media or public, breaking all the transparency rules of “outsider” systems.

Another is France’s 50 year-old “street furniture” firm, JCDecaux, that illustrates the resilience of the family model. Publicly listed but controlled by the sons and daughters grouped around founder Jean-Claude Decaux, it was predictably hard-hit by the slump in the advertising-based, front-line spending on which it depends. Yet it stayed well in the black, with profits down by 40 percent, considerably better than the rest of the industry. A contributing factor to the mitigation of losses, analysts point out, is the firm’s conservative funding typical of family firms. Its ratio of net debt to ebitda is just 1.6 times, much lower than the media sector’s average ratio of four to five. Even in the US where strict, governance rules favour much more diluted shareholdings than in Europe, the family format is more dominant than assumed. “It might not be apparent to many consumers, but some of the biggest and best-known American companies still have deep family ties,” explains a consultant to family companies. “Wal-Mart (the Walton family), Motorola (the Galvin family), Comcast (the Roberts family), Tyson Foods (the Tyson family), Campbell Soup (the Dorrance family), The New York Times (the Sulzberger family), Coca-Cola (the Woodruff family), and Archer Daniels Midland (the Andreas family) are just a few.”

Until 18 months ago, Ford was one firm that attracted criticism from analysts. With just 3.7 percent of the company’s total equity, the descendants of Henry Ford control 40 percent of the voting rights through their class B shares dating back to 1936.

And that control is rock-solid. Bill Ford is chairman and CEO, father William Clay Ford Sr is a director along with Edsel Ford II. Elena Ford, a grand-daughter of Henry Ford II, heads product and market planning for prestige brands while a brother-in-law of Bill acts as his chief of staff.

Suddenly, nobody seems worried about it. After the  government’s rescue of GM and Chrysler – and Ford’s refusal of a bailout, virtue is seen in the way the family pulled the firm through the crisis. While GM, a classic publicly-owned beast, has been delisted, Ford’s share price has been rising steadily and was heading towards USD10 by year end. The company even expects to break even by 2012. Its rivals aren’t evening nominating a date.

Meantime back in Europe, family-owned European automobile companies are riding the storm particularly well. Although the feuding family shareholders of Volkswagen and Porsche are in a battle over control of the latter, nobody’s complaining about their profits. And there’s no serious debate that the firms would be better off without the families.

G20 and bank bonuses

The resistance to mandatory bonus caps for bankers’ bonuses was as inevitable as the public clamour to strip these “fat cats” down to size. In the end – after much politicking worldwide – the bankers won the first round. Mandatory caps have been rejected in favour of a system whereby cash bonuses are limited and deferred, and rewards are paid in shares, though with the possibility of clawing them back if bank profits fall.

The key G20 policy is that 40-60 percent of variable pay should be deferred for at least three years. The changes are expected to be implemented in some countries, such as the UK, by the end of the year. France, Switzerland and the Netherlands are adopting pay standards that in some respects are stricter than the G20 recommendations.

Already, many banks have decided to re-examine and change their pay and reward structures in accordance with the G20’s principles. Barclays says that it is reviewing the amount it pays in basic salaries and that it is complying with G20 guidelines on guarantees, giving the impression that it is not paying guarantees lasting more than one year. US banks such as Morgan Stanley and JP Morgan, on the other hand, mindful of how entrenched massive executive pay is on that side of the Atlantic, appear to be still keeping pay high, but are favouring “clawback” clauses whereby pay rewards can be reclaimed – but only if managers and executives have acted “improperly”.

At the end of October Swiss bank UBS said that it plans to reform its pay structure by hiking fixed salaries and matching bonuses to sustainable performance, although it will not implement the changes until key units return to profit. The Swiss bank had already overhauled its compensation system at the end of 2008 after the Swiss government rescued it from the subprime crisis with a cash injection. But an internal memo released to UBS staff on October 5 showed the bank now plans to go further to meet regulatory demands in Switzerland and internationally.

“At UBS, the ratio of variable to fixed compensation was in some cases particularly high,” the memo said.” Fixed salaries at UBS should, in the future, be high enough that the variable portion can be adjusted from year to year, while still ensuring that the total compensation is in line with market standards.”

Swiss competitor Credit Suisse Group has also announced a review of its compensation structure. UBS said bonuses would in future be based on the profitability of each division after deducting capital costs. Other indicators, such as revenue quality and the market position of the division, will also be taken into account. “We can only fully implement this system, however, when our most important businesses return to profitability,” UBS said. “For compensation decisions for the transition year 2009, our general approach is to offer market-competitive compensation in all divisions.

The G20’s stance has prompted some governments to codify in law or through regulation that bankers’ bonus arrangements must be made more transparent and open to question. At the beginning of November, French Finance Minister Christine Lagarde announced new rules to introduce tougher regulation of bankers’ pay, with a view to pushing the issue to the centre of the G20 agenda in Scotland and stealing a march on their hosts. Lagarde said the rules for French banks, which include a rule stipulating that banks publish some details of employee bonuses annually, will apply both at home and abroad. Another set of wider principles, which establishes more general rules about transparency and the reinforcement of internal audits on pay, will apply to all banks operating in the country. “This will allow us to have a strong say in demanding other G20 members do the same thing,” Lagarde told a press conference. “We need a level playing field.”

Wide application

France has indicated that it is concerned that the implementation of rules aimed at limiting compensation in the financial sector is not happening fast enough, and that some countries may want to stick to general guidelines rather than enforce more precise rules – a situation that the US is in favour of. The French rules include two sets of regulations. A government decree will apply to all banks operating on French soil, and sets the wider guidelines. “We want the principles to be applied in the widest possible manner,” Lagarde said. The decree provides for more transparency in the yearly publication of banker remuneration, a split between the fixed and the variable part of remuneration, as well as a ban on guaranteed multiyear bonuses, and the principle that the total amount of compensation should not hamper the reinforcement of shareholder equity at banks.

Detailed dispositions, including the obligation to spread at least 50 percent of bonuses over four years (a percentage that is increased to 60 percent for the highest bonuses) and that at least half of the variable part of remuneration should be attributed in shares, are part of regulations set by the French Banking Federation. The rules are extra-territorial and will apply to French banks wherever they operate.

However, not everyone is convinced that the G20’s campaign will be effective. In fact, some believe that it will be counter-productive and will not succeed in either capping executive pay, or make the decisions on why such pay awards are devised any more transparent than they presently are. According to some analysts and accountants, bank profits will become distorted and far harder to scrutinise and compare as a result of the G20 changes to banker remuneration.

Analysts at Credit Suisse have published a note highlighting the “potential accounting confusion” arising from moves to defer about half of bankers’ bonuses following the September decision by the G20 countries to order a global shift in pay structures. They warn that the way the new bonus packages are structured could lead to disparities between banks and the way they account for staff compensation, under IFRS2, the international accounting standard governing the issue. Daniel Davies, the analyst who compiled the Credit Suisse report on the issue, said: “Several investors have commented to us that this is a confusing accounting policy that does not follow market practice.”

His analysis suggests that Deutsche Bank would show one of the most marked uplifts in profits – USD845m, or 14 percent – this year, while at BNP, there would be an USD811m, or nine percent, boost. The most extreme gain – of 29 percent, or nearly EUR1bn – would be evident at Crédit Agricole, Credit Suisse said, because the French bank is believed to defer none of its bonuses and would move to a 50 percent deferral ratio.

However, such findings have been dismissed by other institutions. For example, the International Accounting Standards Board said that there was little scope for confusion, arguing that only if there was doubt over whether an employee would get a bonus in future should the accounting treatment be deferred.

There are more immediate worries, however. As countries are hanging their rules on remuneration and reward schemes to reflect public anger at home, there is a danger that such approaches will conflict with those taken by other countries which means that the reforms will not be cohesive. For example, US financial groups with operations in London are increasingly concerned that UK regulators’ tough stance on pay could create a two-tier system in which UK bankers’ bonuses are smaller and spread over a longer period than those of US colleagues.

Wall Street executives say the line taken by the FSA contrasts with the more flexible approach of the Federal Reserve and could lead to uneven pay scales for bankers in similar jobs on opposite sides of the Atlantic. “We have legitimate concerns on how we can pay our people fairly,” said a senior banker at a big US bank. “The FSA appears to be more heavy-handed than the Fed so which guidelines should we be following?”

Dodging a car crash

The Fed and the FSA have issued compensation guidelines in an effort to clamp down on lucrative pay structures widely blamed as one of the causes of the financial crisis. While the Fed proposals steered clear of a benchmark – instead asking the top 28 banks in the US to show their pay schemes did not encourage excessive risk-taking – the FSA code requires banks to comply with specific principles by January, or face enforcement action.

The UK has also already forced the UK’s top five lenders – HSBC, Barclays, Standard Chartered, Lloyds Banking Group and Royal Bank of Scotland – and 11 foreign banks (Deutsche, JPMorgan Chase, Goldman, Citigroup, Bank of America, Morgan Stanley, Société Générale, BNP Paribas, Nomura, UBS and Credit Suisse) to sign up to pay reforms agreed at the G20 meeting in Pittsburgh in September. Key elements of those include deferring 40-60 percent of bonuses over three years, potentially reducing the total level of cash awards paid out for 2009, and outlawing so-called “multi-year” guaranteed bonuses.

“The FSA is trying to legislate through the back door,” said a senior London-based banker. “Unless they find common ground with the US, it will cause problems for most banks.” However, people close to the FSA say it will press on with compensation reform even in the absence of international consensus.

But there have also been very strong hints that not all banks are on board with the G20’s plans. At the same time as some banks announced publicly that they were overhauling their bonus and remuneration schemes in an effort to implement the G20’s code of best practice, Lord Griffiths, the vice-chairman of investment bank Goldman Sachs, put his head over the parapet by claiming the public should tolerate bumper City bonuses for the good of the UK economy. Griffiths, a former special adviser to Margaret Thatcher, said he was not “ashamed” of the generous reward policy at Goldman, which just days before his comments had inflamed the bonus debate by revealing it was on track to hand out a record USD22bn to staff at the end of the year.

Speaking at a debate on regulation and ethics in financial services in London in October, Griffiths said the public should “tolerate the inequality as a way to achieve greater prosperity for all”. “I believe that we should be thinking about the medium term common good, not the short term common good,” he added. “We should not be ashamed of offering compensation in an internationally competitive market which ensures that businesses stay here and employ British people.”

But there is already a tremendous amount of scepticism as to whether bankers will actually acquiesce and surrender to public expectations about executive pay any way. Bankers reckon there are a number of wheezes to get around the G20 bonus rules, which require pay to be deferred over three years with a greater proportion paid in shares than in the past.

One such method to disguise the true level of remuneration is to lift basic pay. For example, Bob Diamond, president of Barclays Capital, has a salary of GBP250,000 a year – small in the context of his bonuses that can reach GBP20m. Yet bolstering basic pay deals could help cushion bonus cuts – a route that has not been lost on UBS, for example.

Another method is to “lend” bankers their bonuses. Last year, RBS was forced to pay bonuses in subordinated debt. It granted loans, albeit at market rates, to bankers whose bonuses were no longer in cash and is expected to do so again next year. If that option does not appeal, banks can sell their shares – even the G20 bonus principles suggest paying in shares. RBS, now majority-owned by the UK government, is banned from paying cash bonuses to anyone earning more than GBP39,000 and is likely to pay bonuses in shares for the 2009 financial year, which bankers can then sell immediately. A more politically sensitive approach might be to just decline to sign up to the agreement. While the major UK-based banks have assured the government they will adhere to G20 principles.

The way forward?

Many of the world’s leading banks have already announced – or hinted at – changes to their remuneration and bonus policies. Here are just a few examples.

Barclays Capital
Barclays says that it is reviewing the amount it pays in basic salaries and that it is complying with G20 guidelines on guarantees, giving the impression that it is not paying guarantees lasting more than one year.

Most staff will receive 50 percent of their 2009 bonus payment in paper immediately convertible into cash in June 2010. A further 25 percent will be available in June 2011, with the remainder available in June 2012. Senior managers will receive 33 percent of their bonus each year, spread over three years. Executive directors will receive nothing until 2012. Clawback clauses are also in operation, but while salary has not increased, remuneration experts suggest that there has been a hike in the company’s flexible benefits package to compensate.

Morgan Stanley
Morgan Stanley has a clawback mechanism which is active for three years after compensation has been paid, and which is triggered by “conduct detrimental to the company or one of its businesses”. In May, the banking group reportedly increased base salaries for managing directors to USD400k, up from USD250k, and announced that 25-30 percent of total compnsation will come from base salary in future, up from 15-20 percent historically.

The bank has said that it is going to operate a bonus clawback policy, but one which will only become active in the event of dishonest and improper behaviour.

Credit Suisse
Bonuses below CHF125k will be paid entirely in unrestricted cash. Above this, a variable proportion (determined by a secret table) will be deferred. Of the deferred element, 50 percent will be paid in Scaled Incentive Share Units (SISU) linked to the bank’s share price and return on equity (RoE); the other 50 percent will be paid in Adjustable Performance Plan Awards (APPA), based on the bank’s RoE.  The bonus system also includes a “clawback” clause: for example, APPAs are adjusted downwards if an employee’s business area is loss making.

The Swiss bank has said that “the larger the bonus, the bigger the deferred equity compensation” and some of the bank’s managing directors and senior vice presidents are rumoured to have received 100 percent stock bonuses last year.

BNP Paribas and SocGen
Under new French bonus rules at least 50 percent of all bonuses must be deferred, though that figure will rise to 60 percent for higher amounts. In August, BNP agreed to halve its bonus pool to EUR500m for the first half, although this applies only to the cash component of its payouts. Bonus deferrals at BNP Paribas will occur on a sliding scale: below EUR150k, everything will be paid in cash; between EUR150-350k, 25 percent will be deferred; between EUR350-500k 35 percent will be deferred; and above EUR500k 50 percent will be deferred.

Cleaning up energy

The energy market of the future is unlikely to be dominated by traditional mining and crude oil technologies. Australia is rich in coal resources yet relies on imported oil products for most of its transportation energy needs.

Australian company Linc Energy has successfully combined two technologies, Underground Coal Gasification (UCG) and Gas to Liquids (GTL), to provide Australia and other coal-rich nations with an opportunity to provide energy solutions from their own resources. The company began its UCG trials on rural farmland in Queensland’s coal-rich Surat Basin. Linc has since developed its demonstration facility near Chinchilla to become the world’s only facility to demonstrate the conversion of coal in-situ for the production of liquid hydrocarbons.

The Chinchilla Demonstration Facility showcases the combination of UCG to GTL. About USD50m has been invested in the facility to establish operations. Linc Energy’s UCG to GTL technical development has attracted specialised employees from all over the world. It employs the largest expert workforce in the industry.

Coal gasification is not new. It has been used since the 1800s to supply gas to cities and towns, generate electricity from gas turbine power stations, and produce synthetic liquid fuels. UCG has been utilised in both commercial and trial scales since the early 1900s. One commercial UCG operation remains in the former Soviet Union. Known as Yerostigaz, this operation continues to supply UCG synthesis gas to a nearby power station to substitute their conventionally-mined coal supply. Linc Energy has a controlling interest in Yerostigaz and is working to improve production and capture intellectual property from its forty-plus years of operation.

UCG technology allows energy to be recovered from deep, lower rank coals that are otherwise worthless to conventional miners. UCG converts coal into a synthesis gas (syngas) of primarily carbon monoxide and hydrogen while it is still in the ground.

To achieve the conversion of coal into gas, an oxidant is injected into the coal seam. The coal seam is then ignited. The heat generated from combustion, in combination with the water in the coal seam, allows for the conversion of the coal to syngas. The syngas product is then extracted from a production well for downstream use. This has a number of uses. The syngas product can be used in a variety of industrial processes including power generation, liquid fuel production, and chemical manufacture. It is a suitable feedstock for gas turbine power generation and is ideal for the GTL process which works to produce cleaner liquid transportation fuels, such as diesel and jet fuel. Fertilisers, base oils, and waxes are all possible downstream products from UCG syngas. Linc Energy is focused on UCG for cleaner power generation and fuel production. Due to its ability to extract otherwise worthless coal, the use of UCG could potentially increase global coal reserves from 900bn tonnes to 1.5trn tonnes (World Energy Council, 2007).

At Chinchilla, the production of cleaner synthetic hydrocarbons from UCG syngas takes places aboveground in a GTL facility. UCG syngas is fed through a processing plant to clean the gas, removing contaminants. The key component of the GTL facility is the Fischer-Tropsch reactor. The Fischer-Tropsch reactor contains a catalyst to transform the clean gas into liquid hydrocarbons.

Synthetic liquid hydrocarbons can then be refined to produce high quality, zero sulphur, cleaner diesel and jet fuel. Due to the removal of impurities before the gas is converted to liquid and the highly paraffinic nature of the fuel, GTL products have superior properties in terms of combustion efficiency and emission characteristics.

GTL fuels are compatible with old, existing and future diesel engine technologies. This means that GTL fuels can be directly substituted for traditional fuels, negating the need for large scale vehicle and infrastructure fleet modifications. The air quality in our cities could be significantly improved with the use of GTL synthetic fuels from UCG syngas due to the lower tailpipe emissions or particulate matter and gaseous hydrocarbons.

In a carbon constrained world, UCG carries a number of environmental advantages. These benefits include a 25 percent decrease in greenhouse emissions for power generation; elimination of large scale soil and rock disturbance; elimination of dust, ash and slag generation; reduced visual impact; lower risk of surface water contamination; and a lower demand for water, as there is no need for coal dewatering or a coal preparation plant. For GTL operations, these include significant reductions in sulphur oxide, nitrogen oxide, heavy metals and particulate matter; and the reduction of solid waste.

To establish combined UCG to GTL technologies, modelling and prediction is highly important. Linc Energy has taken great measures to apply modelling applications to its trial operations to predict the nature of UCG and what actually happens underground. These models enable Linc Energy to significantly reduce the risk of groundwater contamination. With ten years of trials in Chinchilla, Linc Energy has never registered any groundwater contamination and maintains a rigorous monitoring and data capture programme. Subsidence models have also been prepared to minimise risk to the surface of the land. With the right geology, careful control of operating conditions and pillars deliberately left between different cavities, impacts can be minimised. Linc Energy is also working on a carbon sequestration project through Linc Carbon Solutions. The aim is to investigate a range of carbon dioxide reduction solutions, including carbon capture and storage and the commercialisation of photobioreactor technology to convert carbon dioxide into oxygen and biomass (algae).

Listing on the Australian Securities Exchanges in May 2006, Linc Energy now boasts a base of over 13,500 committed shareholders. A young company, Linc Energy has a solid coal resource position in Queensland and the US.

Options for the commercialisation of its UCG and GTL technologies are well underway. Drilling to locate UCG-suitable coal has taken place in Queensland’s Surat Basin and in the Arckaringa and Walloway Basins in South Australia. Results have indicated that the first UCG to GTL commercial operation will be established near the rural town of Orroroo, near Adelaide.

In preparation for UCG to GTL commercial operations and the production of 20,000 barrels of cleaner diesel per day, Linc Energy has a Memorandum of Understanding (MOU) with one of the world’s largest energy companies, BP Australia. This MOU defines BP Australia as Linc Energy’s first major customer, agreeing to purchase a minimum of 14,000 barrels per day of the product.

With its solid coal resource position in Australia, Linc Energy is also pursuing the commercialisation of its UCG and GTL technologies abroad. Locations in North America and South-East Asia are being evaluated for power and fuel production projects. In September 2009, Linc Energy completed the purchase of 94 coal leases containing over 92,000 acres in Wyoming’s Powder River Basin. A site office has been established in Wyoming to enable UCG trials to start for the production of UCG syngas. Linc Energy will also open a US head office in Denver to pursue other UCG and GTL projects.

In Vietnam, Linc Energy is working with VINACOMIN and Japan’s Marubeni Corporation to develop a trial UCG project in the Red River Delta. This region is in much need of power and if the trial is successful, a commercial UCG power project will supply over six million households with electricity. Combined UCG and GTL technologies and the products generated, present a compelling, alternative energy solution for Australia and other locations.

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WEF: Swiss precision

The World Economic Forum returns to Davos-Klosters, Switzerland, between January 27-31. Since its inception in 1971, the forum has met annually in Switzerland with the aim of presenting international political leaders, select intellectuals and journalists the opportunity of discussing the most pressing issues facing the world, including global health issues and the environment.

It is the forum’s key belief that improving the state of the world requires catalysing global co-operation to address pressing challenges and future risks. In turn, global co-operation requires stakeholders from business, government, the media, science, religion, the arts and civil society to collaborate as a community. To this end, for the last four decades the World Economic Forum Annual Meeting has convened at the start of the year with the aim of engaging world leaders from all walks of life to shape the global agenda.

Climate change

A World Economic Forum task force has presented world leaders gathered in New York with proposals to accelerate private sector investment and innovation in the fight against climate change. Eighty business leaders and over 40 environmental and scientific experts outlined a plan for stimulating a ‘clean revolution’ in the private sector within the next few years even as governments continue negotiations on a climate policy framework in the UN.

Food and agriculture

In the past year, food security and economic crises have highlighted both the urgent need and the potential for developing sustainable agri-food systems. Over one billion people, or one out of six globally, do not have access to adequate food and nutrition today. By 2050, the global population will grow to a projected 9.2 billion people, and demand for agricultural products is expected to double.

The World Economic Forum’s Consumer Industries Community is championing an initiative through multi-stakeholder engagement in developing a shared agenda for action to meet food security, economic development and environmental sustainability goals through agriculture. The new vision for agriculture initiative engages high-level leaders of industry, government and international institutions and civil society – with support from leading experts – to define joint priorities, recommendations and opportunities for collaboration.

Global health

The Global Health Initiative (GHI) was launched in 2002 by the World Economic Forum and its partners, to improve global health through three key activities: advocacy, dialogue and partnerships. Its focus has been on Africa, India and China and on communicable diseases (HIV/AIDS, TB and malaria) as well as on strengthening health systems.


The primary objective of the GEI is to raise awareness and support the implementation of relevant, sustainable and scalable national education sector plans on a global level through the increased engagement of the private sector. Through its unprecedented partnerships with UNESCO and Education for all fast track initiative, and the continuous commitment and support of the partners and members of the World Economic Forum, the GEI aims to scale education partnerships globally.

In its six years of existence, the GEI has impacted over 1.8 million students and teachers and mobilised over $100m in resource support in Jordan, India, Egypt, the Palestinian territories and Rwanda.

During the past year, the initiative continued supporting the country level work in Rajasthan, and Egypt, restarted the multi-stakeholder collaboration efforts in the Palestinian territories and launched the Global Education Alliance model with a pilot in Rwanda.

Humanitarian relief

The frequency and impact of natural disasters and conflict are increasing worldwide, causing losses of over $200bn and over 180,000 deaths in 2005 alone. The result is the need for an unprecedented level of humanitarian relief. While the private sector has been increasingly generous, corporate response to humanitarian emergencies generally has been reactive, limiting its overall effectiveness and efficiency.

The Humanitarian Relief Initiative aims to increase the global impact of private sector engagement in humanitarian relief. The HRI develops public-private partnerships that match the core competencies of the private sector with the priority needs of the global humanitarian community in advance of humanitarian crises.

Convention project

The wave of financial crises in the last decade has generated a consensus that the international financial system needs to be reformed. But there remain profound disagreements among policy makers and the private sector concerning how far and deep the reforms should go.

To capitalise on this opportunity for progress, the WEF and the Reinventing Bretton Woods Committee, in co-operation with selected finance ministries and central banks of G20 countries, are organising a two year series of public-private roundtables on the future of the international monetary system. This project seeks to provide input into the deliberations of policy makers by convening them for off-the-record sessions with some of the world’s leading private sector and academic authorities.

2010 objectives

The Annual Meeting 2009 theme was “Shaping the post-crisis world”. The intent was to absorb the early lessons from the financial crisis and to understand how risks interconnect, to encourage longer-term thinking and to consider the unintended consequences of various calls for action. The learning and transformation will continue into next year along with increasing expectations for positive change.

In response to today’s global priorities, the theme for 2010 is a call to action, namely: Improve the state of the world: Rethink, Redesign and Rebuild. Driving the rethink at the 40th annual meeting will be the Network of Global Agenda Councils, comprised of over 1,000 experts active in over 70 councils, created to advance solutions to the most critical challenges facing the world today.

The impetus behind the Rethink, Redesign and Rebuild agenda is clear. The global credit crisis and ensuing recession, having raised serious questions about the future of the global economy, have at the same time provided insights into economic interdependencies, governance gaps and systemic risks that go hand in hand with globalisation. These revelations in turn compel the forum to rethink business models, financial innovation and risk management.

Rethinking also triggers attempts at redesign. National legislatures, supervisory authorities and international organisations are now redesigning institutions, policies and regulations with the aim of closing governance gaps, preventing systemic failures and restoring growth. However, these efforts need common vision, collaborative innovation and public-private partnerships for their long-term success. The success drivers are themselves predicated on the individuals and institutions empowered to take action having the trust of stakeholder communities.

Decision makers, therefore, must rebuild trust, not only to establish the legitimacy of their redesign but also to instil confidence in their future success. Rethink, Redesign and Rebuild are invariably complex, as values, norms and incentives change and, in turn, reshape stakeholder communities, social networks, governance structures and industry models worldwide.

In addition the pressure to Rethink, Redesign and Rebuild is increasing in line with the increasing concern over the current state of the world. The fiscal and monetary prescriptions to ease the pain of global economic shocks are now fuelling anxieties about the creation of new economic bubbles.

Furthermore, the demographic, behavioural and technological changes linked to the collapse in global demand are challenging basic assumptions about the nascent recovery. Major industries are still contending with cyclical and structural threats to their business models. In addition to all this, weaknesses of governance systems, exposed by the financial crisis, are mostly unchanged with respect to looming global risks such as climate change, nuclear proliferation and pandemic.

Redesign discussions at the forum will aim to leverage the ongoing work of the Forum’s Global Redesign Initiative, a multi-stakeholder dialogue focusing on adapting structures and systems of international cooperation to the challenges of the 21st century.

Managing mega projects

But evidence suggests that such mega projects are usually money pits where funds are simply swallowed up without delivering sufficient returns.

Faced with the worst global recession since the Second World War, governments all over the world are considering a stark choice: pump billions of dollars into public spending to help stimulate their economies, or risk a rise in unemployment and a fall in output from such particularly recession-hit industries as manufacturing and construction.

A number of major publicly funded initiatives have already been given the “green light” to help kick-start their national economies and throw a lifeline to “at risk” industry sectors. In November 2008 China announced an internal economic stimulus package of USD586bn for infrastructure projects, Italy announced an €80bn capital injection plan and Russia announced an economic stimulus package of USD20bn. India has also earmarked USD475bn and in February 2009, the US announced a USD787bn stimulus package aimed at improving its own infrastructure, as well as boosting the national economy and keeping unemployment levels down. Most European countries have also announced funds for infrastructure projects. In February France earmarked EUR4bn for national infrastructure improvements, and Germany has approved its biggest economic stimulus plan for over 60 years, worth around EUR50bn.

In fact, even before these recent announcements, investment in massive infrastructure projects has never been so high. During 2004-M2008 China spent more on infrastructure in real terms than in the whole of the twentieth century, with the country building as many miles of high-speed rail as Europe in two decades. Furthermore, of the estimated USD22trn that is going to be spent on infrastructure improvements globally over the next decade, half are for projects in emerging economies. It is the biggest investment boom in history.

But governments may be throwing these vast sums down the drain if the harsh lessons from other mega infrastructure projects are not learnt. The Channel Tunnel cost double its original budget and only returned a profit 20 years after the project started. Denver’s international airport saw its eventual cost triple from what had originally been planned, and Sydney’s Opera House – as amazing as it might look – still holds the world record for worst project cost overrun at 1,400 percent over budget. Its construction started in 1959 before either drawings or funds were fully available and when it opened in 1973, 10 years later than the original planned completion date and scaled down considerably, the building had cost AUD102m rather than the meagre AUD7m  budgeted.

In fact, nine out of ten projects routinely overrun on costs – a shocking figure that has been largely constant for 70 years. And the problem is global. Major projects examined from around the world have all suffered from the same drawbacks – poor project understanding, poor risk management, and poor leadership resulting in a major mis-match between expectation and reality. According to project management consultancy PIPC’s Global Project Management Survey released in February 2008, 94 percent of respondents from the UK and Europe say project-based working is of critical importance to their business success, yet just 30 percent say they successfully deliver projects. US companies seem to fair marginally better. Fifty-five percent of US companies state that project management is not regarded as critical to business success, yet 40 percent of projects undertaken are successfully delivered. Meanwhile, 21 percent of businesses in the Asia Pacific region believe project management to be critical to their business success, but projects initiated are unlikely to deliver the desired results: only 18 percent are delivered to time and only 23 percent to budget.

So why do projects go so badly wrong? There are three main explanations. The first is that the data which the assessment is being based on is inadequate – or just plain wrong. “Sometimes project teams pick up an idea and run with it before critically evaluating the desired outcomes and alternatives – they are just being too keen to get started,” says Mark Westcombe, a lecturer at Lancaster University Management School. “Even when they stop and think first, this often gets forgotten once a contract is handed over from senior management to a project manager,” he adds.

The second reason is due to what is called “optimism bias”, whereby people are overly optimistic about what can be achieved with the resources and deadlines available and talk up the benefits of what the project will achieve, rather than look at what it will take to get the project to deliver. “We naturally believe we can achieve more, in less time, than historical data demonstrate,” says Dr Cliff Mitchell, senior fellow and deputy director of the BP Managing Projects Programme at the Manchester Business School at the University of Manchester. “There is also a Western bias towards unrealistic macho management: we can get it done – we just need to drive harder.”

The third reason is “strategic misrepresentation” – in other words, deception. “There are perverse incentives and rewards for making the project look good on paper in order to win the contract, so companies deliberately provide clients with ambitious and unrealistic cost estimates and delivery timetables in order to win the work,” says Professor Bent Flyvbjerg, director of the BT Centre for Major Programme Management at the University of Oxford’s Saïd Business School.

Experts say that failure for poor project management and delivery rests squarely with management and its inability to plan sufficiently or define what project “success” actually means. Dan Hooper, director of Piccadilly Group, a business and technology advisory group specialising in risk management and independent assurance, says that a major obstacle is that very few companies know how to define and agree on what the success criteria of a project should be or how to measure that “success”, such as the benefits the project was sold on.

“Each stakeholder will have different requirements and perceptions of what a project should deliver,” says Hooper. “As a result, the majority of stakeholders will feel the project failed to deliver their expected benefits. This is due to not being able to prove the project was a success in tangible terms, such as producing cost savings, or in terms the stakeholders can understand.”

Hooper also says that organisations still tend to opt for the cheapest bid, rather than service quality, because they believe that the operations they want to contract out are simple to perform. He cites organisations outsourcing their call centres as an example. “A company outsources its call centre and makes an operational saving of 50 percent. But, because of the poor service, the company suffers from high customer turnover leading to a true cost that is greater than the initial saving due to lost revenue. As a result, the project is then deemed a failure.”

Keith Braithwaite, head of technology at consulting firm Zuhlke Engineering’s Centre for Agile Practice, believes that the leading cause of project failure is poor or misunderstood requirements from the outset. In his experience of managing IT projects, he says that “it is not so much that programmers do a bad job of writing the code (although that does happen) but that they write the wrong thing.”

He adds: “One response to this syndrome is to try to ‘fix’ or ‘nail down’ requirements before designing a solution to address them. On very small projects this can almost be made to work, but on large projects the time spent doing requirements engineering has the unintended consequence of increasing the probability that the wrong thing will be built. All the while that requirements are being gathered and analysed the world is moving on. With very large projects this can result in a system being built to address (at best) the needs of an organisation from several years in the past.”

Such examples abound in long-term public sector IT and defence projects due either to the original technology becoming rapidly outdated during the project’s lifecycle, or the client wishing to update other systems and equipment with the same technologies as an extension of the project. In its report released on 12 March this year the UK government’s spending watchdog, the National Audit Office (NAO) found that the National Offender Management Service’s (NOMS) plan to build a single offender management IT system for the prison and probation services had not delivered value for money in the five years it took to build. The NAO found the project had been hampered by poor management leading to a three-year delay, a doubling in project costs and reductions in scope and benefits. In fact, the core aim of the original project of a single shared database of offenders will not be met.

The project to provide an IT system to support a new way of working with offenders was to be introduced by January 2008, and had an approved lifetime cost of GBP234m to 2020. By July 2007, GBP155m had been spent on the project, it was two years behind schedule, and estimated lifetime project costs had risen to GBP690m – nearly triple the original estimate. The NAO found that the project “suffered from four of the eight common causes of project failure in full and three in part”.

Other European countries have also suffered a drain on the public purse through poor planning and over-optimism. In January 2003, Toll Collect—a consortium of DaimlerChrysler, Deutsche Telekom, and Cofiroute of France—was scheduled to start tolling heavy trucks on German motorways for the Federal government. Within 12 months the project was falling apart. The developers had been too optimistic about the software that would run the system. The government was losing toll revenues of EUR156m a month, caused by delays, and estimated to total EUR6.5bn before problems could be fixed. For lack of funds, all new road projects in Germany and related public works were put on hold, threatening 70,000 construction jobs. The German transport minister cancelled the contract with Toll Collect and gave the company two months to come up with a better plan, including how to fill the revenue shortfall.
Experts say that the ultimate responsibility for project failure – and success – is down to management, especially their role in the leadership of the planning and implementation stages. But what can often happen – and is evident in high profile failures – is that senior management tends to defer responsibility to a project manager once the deal has been signed off. Peter Andrew, principal consultant at management consultants EA Consulting Group, says that “once projects get the green light, senior management tend to take a back seat and leave it to a project management team that were not party to the negotiations and have no relationship with the contractor to manage. There also tends to be a culture that any problems that occur during the project’s lifecycle are the fault of the project manager, because senior management drew up the actual plans which only need to be followed and implemented. It is little wonder, therefore, that problems are not flagged up, or are not flagged up in time.”

Alistair Maughan, partner at international law firm Morrison & Foerster, largely agrees. “If managers spent half the time actually looking at whether the project is necessary or whether the figures are right rather than the legal details of the contract, a lot of grief would be saved,” he says.

“There is a tendency for executives to spend more of their time hammering out the details of the contract rather than actually plan what the project is actually supposed to deliver, and why these deliverables are necessary,” says Maughan. “As a result, the plan can be fatally flawed from the outset, but the terms and conditions of what the contractor is supposed to be doing – even if they’re wrong – are just about written in stone. This means that senior management could be handing some poor project manager – who was not party to the negotiations – some total turkey that he is responsible for delivering and could easily take the blame for if (or when) it goes wrong. The governance of these projects, both in the initiation and in the delivery, are often poor and are key areas where they often fail.”

Professor Flyvbjerg says that there are ways to improve the situation. He says that institutions proposing and approving large infrastructure projects should share financial responsibility for covering cost overruns and benefit shortfalls resulting from misrepresentation and bias in forecasting, which helps align incentives.

The UK has already wised up to this after criticism of central government departments’ inability to manage large-scale projects. The Department for Transport now has a requirement for all large infrastructure projects that ask it for funds to have a minimum local contribution of 10 percent (25 percent for light rail) of the gross cost in order to gain program entry, upon the belief that “if an authority has a financial stake in a scheme, this provides a clear incentive to ensure that the right structures and resources are in place to bring it to fruition to time and budget.” It has also started to put a halt to planned projects that have inaccurate budget forecasts.

On top of that, local authorities are liable to pay 50 percent of any increase in the cost of the scheme over the quantified cost estimate up to a designated approved scheme cost. So, for example, if a project is estimated to cost GBP100m but the Department for Transport has agreed that the project could go as high as GBP140m, then the projected GBP40m overspend would be shared equally between the government and the local authority. However, if the project ended up costing GBP180m, the Department for Transport’s share of the GBP80m overspend would still be capped at GBP20m (half of the original agreed overspend limit) – leaving the local authority to pick up the remainder.

Besides making local decision-makers more accountable for managing projects, Professor Flyvbjerg says that there are established methodologies now to massively improve project forecasting. For example, he says, organisations can make wider use of reference class forecasting (RCF) to improve due diligence at the start of the project and throughout its lifecycle. RCF is a benchmarking tool which seeks to raise comparisons between the current project and those of a similar class and scale. Once these projects are compared, the organisation can get a better view of the probable budget, timeframe and actual deliverable benefits.

RCF was first used – and successfully – in the construction of the Edinburgh tram system in 2004 whereby cost estimates and delivery times were studied in 46 comparable rail projects. By examining their outcomes, planners could get a clearer indication of the potential problems they could face and get a more realistic idea of what the eventual budget would be. As a consequence, the original estimate was increased by over a third and the project was realised within the revised budget. RCF is now mandatory in some UK government projects, such as UK Treasury projects that cost over GBP40m and Department of Transport projects costing more than GBP5m. The system is also used in The Netherlands, Denmark, Switzerland and South Africa.

However, such forecasting methods are still not used widely, and where they are used, they are mainly restricted to relatively low-cost projects (though it is being used on the GBP16bn Crossrail project). Therefore, one can still expect a slew of mega-projects to continue to fail, and trillions of dollars to vanish.

Asia’s water power

Founded 15 years ago with only a handful of employees, Puncak Niaga Holdings Berhad (Puncak Niaga) has today emerged as one of the leading water and wastewater solution companies in the region, with more than 5,000 full-time employees. Headquartered in Shah Alam, capital of State of Selangor, about 35km from Kuala Lumpur, Puncak Niaga Group ensures that the population of 7.5m people in the State of Selangor, Kuala Lumpur and the federal government’s administrative centre of Putrajaya receive an uninterrupted supply of safe affordable treated drinking water.

Listed on the Malaysian Stock Exchange since 1997, Puncak Niaga is the nation’s largest water supply concessionaire, operating, managing and maintaining 29 water treatment plants with a total average production capacity of 1,930m litres per day.

During Malaysia’s water crisis in 1998, Puncak Niaga was entrusted by the government to finance, design and construct the Wangsa Maju Water Treatment Plant at a cost of $38.6m. This water treatment plant was completed in a record time of six months.

The water distribution system in Selangor, Kuala Lumpur and Putrajaya was in a dire state for many years, leaving the state and federal government without choice other than to embark on a privatisation scheme. Puncak Niaga’s excellent track record in carrying out water projects fits the bill. It was then in late 2004, Puncak Niaga’s subsidiary, Syarikat Bekalan Air Selangor Sdn Bhd (SYABAS) was granted a concession for a period of 30 years, commencing January 1, 2005 whereby SYABAS had assumed all duties and functions of the state government in the area of water supply and distribution of water to the consumers within the State of Selangor and the Federal Territories of Kuala Lumpur and Putrajaya. This is the largest privatisation scheme for water supply system in Malaysia.

Apart from treating and supplying water, Puncak Niaga also manages and operates three dams: Sg Langat, Tasik Subang and Klang Gate Dams, all situated in the State of Selangor.

Puncak Niaga’s foray into the regional water and wastewater industry began with Chennai Water Supply Augmentation Project in Chennai India in 2005, and was awarded for O&M service for five years. Puncak Niaga also has via a joint-venture with Singapore based company, Environmental Holding Pte Ltd (EHPL) for the water and wastewater concession projects in China.

As highlighted by Tan Sri Rozali Ismail, Puncak Niaga’s quest for foreign projects does not mean that the company is exiting the Malaysian market. In fact Puncak Niaga is actively participating in tenders for local water projects including water treatment and supply operator for many states in Malaysia. One of Puncak Niaga’s advantages in bidding for new projects locally and overseas is lower project cost through its homegrown expertise.

Moving forward, Puncak Niaga is eyeing the possibilities of diversifying from its core water and wastewater, into the oil and gas industry.

Transforming the system

In the past five years, Puncak Niaga has relentlessly improved and upgraded the water distribution system in Selangor, Kuala Lumpur and Putrajaya. In addition to the application of new engineering and technology services, its 100 percent owned subsidiary, SYABAS established the state-of-the-art 24-hour customer service centre, PUSPEL.

This award-winning customer service centre has enabled Puncak Niaga Group to revitalise the water services industry in Selangor, Kuala Lumpur and Putrajaya, within a period of three years after SYABAS assumed the entire responsibilities from the Selangor state government. Today, the water services industry has improved with the public giving full cooperation reporting cases leading to interruptions.

River pollution

The improvements made to water treatment and the supply system does not mean that the industry is on track for smooth growth. Challenges remain enormous. One of which is the continuous pollution of raw water resources and destruction of water catchments areas in the developed areas of Selangor, Kuala Lumpur and Putrajaya. Puncak Niaga has taken proactive measures in setting up its own Water Resources and Environmental Surveillance Unit (WRES) which works in close collaboration with the Department of Environment and other agencies in mitigating pollution issues which have direct impact on the operation of Water Treatment Plants (WTP).

Puncak Niaga has also collaborated with one of the world’s leading R&D institutions, DHI Water Environment Health of Denmark (DHI) and Universiti Putra Malaysia (UPM), one of Malaysia’s leading universities for human capital development, training and other activities.

Water king
On its expansion trail, Puncak Niaga has the advantage over its competitors with its strength in technology, lower construction and maintenance costs, as well as efficient after sales service. All these can only be accomplished with skills, expertise and commitment, engineered by its founder, Tan Sri Rozali Ismail, Malaysia’s headline marker for water industry. The water tariff in Selangor, Kuala Lumpur and Putrajaya is one of the lowest among major Asian cities, and water consumption is about 240 litres per day, a whopping fivefold of the UN’s requirement of 50 litres per day. Notwithstanding the above, Puncak Niaga Group should be lauded for its efforts in bringing the water industry to a higher level, at par with developed nations. All these were made possible thanks to the visionary stewardship of Tan Sri Rozali Ismail, the founder and Executive Chairman of Puncak Niaga Group.

Tan Sri Rozali Ismail is Malaysia’s “Water King” where he has, for 15 years, worked hard in revitalising the water services industry. With his experience involving various companies, dedication and commitment, he was entrusted by the state government of Selangor to manage water treatment plants, and also the water distribution systems through SYABAS. Today, Puncak Niaga is not only the top in Malaysia, but also ranked as 25th world leading water and wastewater companies by Global Water Intelligence magazine.

Tan Sri Rozali Ismail is also a strong advocate of environmental protection where his corporate social responsibility programs include the River Rescue Brigade, instilling awareness among school children on the importance of conservation of rivers for both upstream and downstream. His sensitivity towards environment is also shared through his articles in local and international media. Apart from that, he has been lending strong supports for events on sustainable environment and water resources.

In addition, Tan Sri Rozali Ismail is the President of Selangor, Kuala Lumpur and Putrajaya Water Association (SWAn), where SWAn has played a major role in promoting issues pertaining to sustainability of the environment, covering the Asia Pacific region.

He has also been appointed by His Royal Highness, the King of Malaysia, as Colonel, Regiment 60 Water Management Specialist to ensure the tools and basic equipment are in perfect condition and functioning in times of emergencies or whenever needed in any mission.

Tan Sri Rozali Ismail is also known for his personal contribution to community development programs and he is a committee member of FELDA Community Social Development, Yayasan Budi Penyayang Malaysia, a Trustee of Perdana Leadership Foundation, Yayasan WAQAF Malaysia (YMM) and Secretariat of Malaysia Prihatin, to name a few.

He is instrumental in championing management excellence and best practices for water, wastewater and environmental sectors and is the Pro-Chancellor of Universiti Putra Malaysia (UPM). As a business community leader, he is the President of the Malay Chamber of Commerce for the State of Selangor Chapter (DPMMS), Advisor of Malay Student Association of Peninsular Malaysia (GPMS), and Governor for Malaysia of Asia Pacific Marketing Federation (APMF) Foundation.

Tan Sri Rozali Ismail has been conferred with stacks of awards and is among the prominent few to have received the Fellowship Award by the Institute of Marketing Malaysia, Asia Water Management Excellence Award, and recently the Recipient of Vocational Excellence Service Award 2009, Induction as Honorary Rotarian and Conferment of the Paul Harris Fellow Award by Rotary International Malaysia.

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