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The Determinants of Renewables Investment

Posted on November 13, 2017 | Policy Brief

20171112 Determinants of Renewables Investment 01

On the 24th of October, SITE held the first of its series of Energy Talks, replacing what for one decade had been known as SITE Energy Day. For this first edition, SITE invited Thomas Sterner, Professor of Environmental Economics at the University of Gothenburg to give a presentation under the headline of “Technological Development, Geopolitical and Environmental Issues in our Energy Future”. To comment on the presentation, Leonid Neganov, Minister of Energy of Moscow Region, and Karl Hallding, Senior Research Fellow at the Stockholm Environment Institute (SEI), had been invited. This policy brief reports on the important subjects presented by our guests as well as the discussion that took place during the event.

From climate change concerns to climate change targets

Thomas Sterner began his presentation by addressing the well-known issue of climate change, a constantly current topic.

Different versions of Figure 1 (below) have been used extensively by those discussing climate change over the last decades, most notably by the previous US President Al Gore in his 2006 documentary “An Inconvenient Truth”. It shows the concentration of CO2 (carbon-dioxide) in the atmosphere over the past 400,000 years. There is wide agreement within the scientific community that the emissions of greenhouse gases (GHG), such as CO2, methane and nitrous oxides, have led to the shifting weather patterns and increased temperature over the past century (NASA, 2017).

Figure 1. Level of CO2 in the Atmosphere

Notes: The vertical red line is the Keeling curve, showing how the concentration has changed since 1958. Source: Allmendinger, 2007.

Predicting the impact of these emissions is far from an exact science: the temperature increases are likely to be unevenly spread across the world as shown in Figure 2. Some areas are likely to be particularly afflicted, especially coastal lowlands susceptible to flooding and semi-arid areas where droughts can become more likely. Unless current emission levels start to decrease, we are likely to observe severe results of climate change within 20 years, such as displacement and increased migration in the wake of extreme weather (NIC, 2016). For instance, adverse health effects in China, or decreasing productivity in South-East Asia, have already become apparent due to current increased temperatures (Kan, 2011; Kjellstrom, 2016).

Figure 2. Predicted Temperature Increase

Source: IPCC, 2013.

To tackle this issue and its negative economic impacts, many policy makers have agreed to replace fossil fuels with renewables. Renewables is the collective term of energy sources that have a neutral or negative net-effect of GHG emissions and are extracted through resources that are continuously replenished, e.g. solar, wind and hydro power, and biomass energy.

As the issue of climate change is a global one, the transition to renewables needs to be global too. International climate agreements have hence long been the accepted norm to approach climate change issues. The Paris Agreement is currently the guiding principle, in spite of the announcement of the Trump administration to withdraw the United States. Though instrumental in creating a momentum in the transition to lower levels of GHG emissions, it comes with many flaws. Its goal of a maximum average temperature increase of 2°C might be considered radical given current levels. However, the policy instruments that the target depends on – the Intended Nationally Determined Commitments (INDCs) – shift the responsibility to individual nations and remove the global responsibility. As Thomas Sterner pointed out, the first three words of this acronym remove indeed any binding force, and elementary game theory tells us that it will be hard, not to say unlikely, for all signatories to remain cooperative in achieving the target of 2°C.

Investing in renewables: from political choice to competitive choice

As stated above, investing in renewables is a necessary condition to achieve climate change targets. Indeed, there are some countries that have pushed the development of renewables with the aim to reduce the fossil fuel dependency to a minimum level in a very near future (see Figure 3). However, most of these investments are currently driven by political will. A natural question is whether renewables technologies can be competitive.

It is a fact that costs of renewables have been severely decreased in the last decade (Timmons et al., 2014). However, as Thomas Sterner mentioned, the cost of renewables and of fossil fuels are still very place and time specific and depends on the scale. Investments in renewables are growing and solar and wind power have both seen production capacities increasing markedly yearly over the last years (GWEC, 2016; IEA, 2017a). However, coming from an initial low level, it will take some time before we will be able to rely on them.

Even with massive investments and decreasing generation costs, the intermittent nature of most renewable energies will still impede the competitiveness of renewables. Solar and wind power are the technologies where most of the development has been centred (Frankfurt School-UNEP Centre/BNEF, 2017). They are highly weather dependent and electricity production from these sources cannot be secured all of the time. This makes countries dependent on backup technologies. In some countries, the obvious answers to these challenges have been hydro and nuclear power. Both technologies have their respective drawbacks though.

Figure 3. World’s Top 10 Investors in Renewable Energy in 2016

Notes: New Investments $BN, Growth on 2015. Source: Frankfurt School-UNEP Centre/BNEF, 2017.

Hydro power requires a geography that allows for dams, which in turn change the nature markedly around them and may not be available during drought periods. Nuclear energy has surrounding safety aspects that most recently came to light with the 2011 Fukushima Daaiichi nuclear disaster, leading Germany to decide to shut down all of its 17 reactors by 2022 (25 % of the country’s electricity production). Moreover, it may also be technically difficult to have nuclear as a backup technology given the associated ramping and start-up constraints.

Two further remarks on the intermittency problem can be made. First, this problem is likely to become more severe when policymakers push for large-scale electrification (c.f. EU Energy Roadmap established in 2011). For example, the full electrification of transport or heating sector will drive up the demand for and consumption of electricity. As this happens, the need for something to secure constant energy access will increase.

Second, only the development of technologies that allow electricity storage could solve this issue permanently. However, the current technological progress regarding batteries’ capacity cannot yet offer the solution (J. Dizard, 2017).

Oil price, a reference price

Another important aspect stressed by Thomas Sterner was to take into account the significant role of fossil fuel prices. Although identifying an optimal oil price for a fossil-free future is not a straightforward procedure, as discussed during the event.

The high price of oil during the late 00s and early 10s stimulated the development of alternative technologies. As awareness of climate change and its effects increased among policy makers and the general public, there was a momentum to push for the development of renewables.

As investments in renewables went up, so did investments in another less green technology: hydraulic fracturing, or fracking. In the 10 years between 2005 and 2015, the United States alone saw the extraction of shale gas and oil to increase six-fold. (EIA, 2016) In part to maintain a market share, OPEC countries exceeded their own set production limits and oil prices tumbled from around $100 per barrel to around $50 (Economist, 2014).

With roughly three years behind us of somewhat stable and low oil prices, the question is what the implications of this are. It makes it more difficult to phase out fossil fuels as demand for them goes up, depressing efforts put into the research and deployment of renewables. Energy efficiency also becomes less important, driving up waste and stopping investments in energy conservation.

On the other hand, with low oil prices, investments in the fossil-fuels industry are also less likely to take place. Keeping resources in the ground becomes more palatable as profit margins are pushed down. This, in turn, is likely to have a positive effect on environment by decreasing the level of GHG emissions.

The invited guests, Leonid Neganov and Karl Hallding spoke more in depth about two central countries that contribute in shaping global environmental policy.

The local conditions, Russia and China examples

As the world’s fourth largest supplier of primary energy and the largest supplier of natural gas to the EU (IEA, 2017b), Russia presents an interesting case to observe as a country supplying fossil fuels. Leonid Neganov, Minister of Energy of Moscow Region, commented on the current policy direction of the country. He explained that non-renewable, GHG emitting energy sources make up a majority, roughly 60% of the Russian energy balance. The rest is provided by more or less equal shares of nuclear and hydro power. New renewable technologies make up a miniscule share of an estimate 0.2% of the current total.

According to Neganov, in the coming 20 years, we should not expect to see too much of a change. Though total output is expected to increase, the share of GHG-neutral energy will remain more or less constant, though the share of renewables are set to increase to 3% according to the current drafts of Russian energy policy. A more pronounced transition to other energy sources are more likely in a longer perspective towards 2050, even though circumstances may naturally change over the coming decades.

Other available information also points to that Russia has decided to tackle the shift in consumption of its major market in Europe by widening its geographic reach. Massive infrastructure investments, such as the Altai and TurkStream gas pipelines, will enable Russia to more easily reach markets that are currently beyond any practical reach.

With the Altai pipeline, Russia will be able to provide China with natural gas at a much greater level than before. China being by far the largest producer of coal sees an opportunity to shift away from the consumption of a resource that during winters causes its major cities to periodically become enveloped in clouds of smog and at the same time also decrease its GHG emissions. The environmental benefits of natural gas as opposed to coal should not be exaggerated though. Thomas Sterner pointed out that methane, the main compound of natural gas, is a considerably more potent GHG than CO2. A total leakage of an estimated 1% negates the environmental benefits, he said.

Karl Hallding, Senior Research Fellow at SEI, particularly stressed the need to look at China. It is the supplier of half of the world’s coal, extraction levels remain high. (BP, 2017) Domestic consumption is decreasing but consumption of Chinese coal is, however, more likely to shift geographic location rather than to be left in the ground, said Hallding. Through massive infrastructure investments, such as the New Silk Road, and in energy production in Sub-Saharan Africa, China spreads its influence (IEA, 2016). By exporting emissions, the impact at the global level will not change.

References

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Rewarding Whistleblowers to Fight Corruption?

Posted on October 23, 2017 | Policy Brief

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Whistleblower reward programs, or “bounty regimes”, provide financial incentives to witnesses that report information on infringements, helping law enforcement agencies to detect/convict culprits. These programs have been successfully used in the US against procurement fraud and tax evasion for quite some time, and were extended to fight financial fraud after the recent crisis. In Europe there is currently a debate on their possible introduction, but authorities appear much less enthusiastic than their US counterparts. In this brief, we discuss recent research on two commonly voiced concerns on whistleblower rewards – the risk of increasing false accusations, and that of crowding out other motivations to blow the whistle – and the adaptations these programs may need to fight more general forms of corruption. Research suggests that the mentioned concerns can be handled by an appropriate design and management of the programs, as apparently done in the US, and that these programs can indeed be a cost effective instrument to fight corruption, but only in countries with a sufficient quality of the judicial system and administrative capacity. They may instead be problematic for weak institutions environments.

Corruption and fraud seem to remain highly widespread in almost all countries. For example, a recent survey of over 6,000 organizations across 115 countries shows that one in three organizations, both worldwide and in the US, experienced fraud in the past 24 months, prevalently in the form of asset misappropriation, cybercrime, corruption, and procurement and accounting fraud (Global Crime Survey, 2016).

Whistleblower (protection and) reward programs are a possibly effective tool to combat fraud and corruption, at least in the light of the US successful experience, where for a long time whistleblowers reporting large federal fraud have been entitled to up to 30% of recovered funds and sanctions under the False Claims Act. The US Internal Revenue Service (IRS) also allows whistleblower rewards in the tax area, and the Dodd-Frank Act introduced them for financial and securities fraud, apparently also with success (c.f. Call et al., 2017, and Wilde, 2017).

In Europe and the rest of the world, instead, rewards are absent and whistleblowers are still poorly protected from retaliation from employers. Some countries have taken encouraging legal steps to at least improve protection, and a discussion is ongoing at the G20 level on how to further improve the situation (G20 report, 2011).

Although many praise whistleblowers, there has been a large range of objections raised against introducing rewards (and even against improving whistleblower protection); mostly by corporate lawyers and lobbyists, but also by regulatory and law enforcement agencies (see Nyreröd and Spagnolo, 2017, for an overview).

In the rest of this brief, we focus on two often voiced concerns, the risks of eliciting false/fraudulent reporting and of crowding out of non-financial motivation, on which recent research has shed light that should be taken into account in the current policy debate. We then discuss some problems linked to the use of whistleblower rewards programs in a more general corruption context.

Fraudulent reports

One concern commonly raised in the discussion of whistleblower rewards is that they may create incentives to fraudulently report false or fabricated information in the hope of receiving a reward. Although clearly an important concern to take into account, we only know of very few anecdotal cases of malicious or false reporting, and fraudulent reporting does not appear to have been a major problem in the US (see again Nyreröd and Spagnolo, 2017 for an overview of the empirical evidence).

A recent paper by Buccirossi, Immordino and Spagnolo (2017) analyzes this concern within a formal economic model and shows that it is not a ground (or an excuse) for not introducing appropriately designed and managed protection and reward programs in countries with sufficiently effective court systems. In these countries, stronger sanctions against lying to the court can (and should) be introduced to balance the incentives for manipulation that may be generated by large bounties. Most legal systems already have defamation and perjury laws, which means that a whistleblower is already committing a crime by fraudulently reporting false information, that can easily be strengthened where necessary without giving up whistleblower rewards. According to this study, the balancing of incentives is what allows the US to effectively use large financial incentives for whistleblowers, besides a very strong protection from retaliation, with little problems in terms of fraudulent reports.

However, the study also shows that this is only possible if the precision (effectiveness, independence) of the court system is sufficiently high. Where court systems are imprecise, the interaction between courts’ mistakes in the legal case based on the information reported by the whistleblower and in the following case for perjury/defamation against the whistleblower if the first case is dismissed, incentives for fraudulent reports, and courts’ adaptation of the standard of proof to account for these incentives, make it impossible to appropriately balance the two incentives. Therefore, whistleblower reward programs should not be introduced in environments where the law enforcement system is ineffective, independently from why it is so (bureaucratic slack, incompetence, political interference, corruption, etc.).

Crowding-out non-financial motivation

Another concern is that whistleblower rewards may have a “crowding out” effect on intrinsic motivation. The problem is that “the commodification of whistleblowing via the provision of bounties may render would-be whistleblowers less likely to come forward by reducing the moral valance of the wrongdoing” (Engstrom, 2016:11). Recent experimental evidence suggests that this concern is overstated. In particular, Schmolke and Utikal (2016) investigate the effects of whistleblower rewards in an environment where one subject may increase his payoff at the cost of harming the group, and find rewards to be highly effective in increasing the number of crimes reported. Data from that experiment suggests a little role for crowding out of non-monetary motivation, if any. Another recent study by Butler, Serra and Spagnolo (2017) investigates if and how monetary incentives, expectations of social approval or disapproval, and the salience of the harm caused by the reported illegal activity interact and affect the decision to blow the whistle. Experimental results show that financial rewards significantly increase the likelihood of whistleblowing and do not substantially crowd out non-monetary motivations activated by expectations of social judgment. The study also finds that public scrutiny and social judgment decrease (increase) whistleblowing when the public is less (more) aware (aware) of the negative externalities generated by the reported crime. All in all, most the recent studies we are aware of suggest that crowding-out of non- financial concerns is not a first-order problem for whistleblower reward schemes as long as there is a clear perception of the public harm linked to the illegal behavior reported by the whistleblower.

Whistleblower rewards and corruption

Although whistleblowing can occur in any sector, firm, or government, an area of particular interest is corruption. Corruption in public procurement is estimated to cost the EU 5.3 billion Euros annually. Hence, corruption deterrence through increased whistleblowing could save the EU significant resources annually (EC Report, 2017).

Contrary to fraud, corruption always takes at least two parties, a bribe taker, typically a government official or politician, and a bribe giver, which may be a firm or an individual. The fact that at least one additional party is involved than in the standard case of fraud, should make whistleblower rewards programs even more powerful since they may deter corruption by increasing the fear that a (potential or real) partner in crime may blow the whistle, even when no third party witness observes the illegal act (Spagnolo, 2004).

When the reported wrongdoer is an individual, as is often the case with corruption, there may be an issue in the use of rewards for whistleblowers linked to the funding of the rewards (c.f Nyreröd & Spagnolo, 2017b for an overview).

In the current US schemes, rewards for whistleblowers are ‘self-financing’, as they constitute a fraction of the funds recovered thanks to the whistleblower or/and of the fines paid by the culprits. An individual and a government official involved in a corrupt deal may, however, not be wealthy enough for the fines and the recovered funds to amount to a sufficiently strong incentive to blow the whistle, given the loss of future gains from the corrupt relationships and the various forms of retaliation whistleblowing may lead to. This problem is of course also relevant for fraud when an individual with few or well-hidden assets is the culprit, rather than a corporation, but it seems particularly relevant for corruption.

Whistleblower reward programs are also malleable to the concerns at hand. If the priority is to combat higher-level corruption, then setting a monetary threshold for when a claim is to be considered is appropriate to limit administrative costs for the program. Indeed, a concern with utilizing whistleblower rewards programs for combating lower-level corruption is that the administrative burden required looking through the whistleblower claims and the costs of limiting abuses may outweigh the benefits gained in detection and deterrence. This concern is also valid for small fraud and tax evasion, which is why all the US programs have a minimum size for cases eligible to whistleblower rewards, but the problem is likely to be more relevant to the case of ‘petty’ corruption. These programs are more suited for ‘large cases’ in which the amount of funds recovered is large enough to pay for rewards and administrative costs, making these programs self-financing even without calculating the benefits for the deterrence/prevention of future infringements. However, when focusing on large corruption cases, other issues become relevant.

An issue particularly important for the case of ‘grand’ corruption is how independent the judicial system is from political pressure, and how able it is to protect whistleblowers against politically mandated retaliation. If corrupt politicians can importantly influence courts, the police or other relevant administrative agencies, then protection can hardly be guaranteed and inducing witnesses to blow the whistle through financial incentives may put their life at risk, although sufficiently large rewards can partly compensate for this risk and help escaping part of the retaliation.

Conclusion

On the whole, whistleblower rewards, in general and in the corruption context specifically, remain a promising tool to detect and deter crime. Careful design and implementation are necessary, because as for any powerful tool, these programs can be well used to do great thing, but also misused to do great damage. As the US experience has shown, along with sufficiently independent and precise courts and an effective administration of law enforcement, well designed and administered whistleblower reward programs hold the promise of greatly improving fraud and corruption detection and of being self-financing through recovered funds and fines.

Of course, even in a very good institutional environment, a poor design and/or implementation can lead to poor performance and do more harm than good (c.f. the case of leniency policies in China discussed in Perrotta et al., 2017). Moreover, in poor institutional environments, where the court system is not sufficiently precise and independent and other law enforcement institutions are not effective, even well-designed and implemented whistleblower reward schemes may bring more problems than benefits. Whistleblower rewards, as any other high-powered incentives, need good governance to ensure that the potentially very high benefits they can generate will be realized. Third parties like international courts and organizations could potentially provide for some low institution environments, the independent safe harbor necessary to protect whistleblowers and a check on court effectiveness for the award of financial incentives.

References

  • Global Economic Crime Survey, 2016. Available at: https://www.pwc.com/gx/en/economic-crime-survey/pdf/GlobalEconomicCrimeSurvey2016.pdf
  • Buccirossi, P., Immordino, G., and Spagnolo, G., 2017. “Whistleblower Rewards, False Reports, and Corporate Fraud”. SITE Working Paper No. 42, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993776
  • European Commission Report, 2017. Estimating the Economic Benefits of Whistleblower Protection in Public Procurement, Milieu Ltd.
  • Engstrom, D., 2016. “Bounty Regimes”, in Research Handbook on Corporate Criminal Enforcement and Financial Misleading (Jennifer Arlen ed., Edward Elgar Press, forthcoming 2016)
  • Butler, J., Serra, D., and Spagnolo G., 2017. “Motivating Whistleblowers.” Unpublished manuscript.   Available at: https://www.aeaweb.org/conference/2017/preliminary/1658
  • Schmolke, K.U., Utikal, V., 2016. “Whistleblowing: Incentives and Situational Determinants.” FAU – Discussion Papers in Economics, No. 09/2016. 2016. Available at: https://ssrn.com/abstract=2820475
  • Call, A.C., Martin, G.S, Sharp, N.Y., Wilde, J.H., 2017. “Whistleblowers and Outcomes of Financial Misrepresentation Enforcement Actions.” Journal of Accounting Research, forthcoming.
  • Wilde, J.H., (2017). “The Deterrent Effect of Employee Whistleblowing on Firms’ Financial Misreporting and Tax Aggressiveness”, The Accounting Review, forthcoming.
  • Nyreröd, T. Spagnolo, G., 2017a “Myths and evidence on whistleblower rewards”, SITE Working Paper No.
  • Spagnolo, G., 2004. “Divide et Impera: Optimal Leniency Programs.” CEPR Discussion Papers 4840, 2004.
  • Nyreröd, T. Spagnolo, G. 2017b. “Whistleblower Rewards in the Fight against Corruption?” (in Portuguese), forthcoming in the book  Corrupção e seus múltiplos enfoques jurídi
  • Berlin-Perrotta, M., Qin, B. and Spagnolo, G., 2017. “Leniency, Asymmetric Punishment and Corruption: Evidence from China,” SITE Working Paper. Available at:https://ssrn.com/abstract=2718181 or http://dx.doi.org/10.2139/ssrn.2718181
  • G20 Anti-Corruption Action Plan, Protection OF Whistleblowers Study on Whistleblower Protection Frameworks, Compendium of Best Practices and Guiding Principles for Legislation, 2011. Available at: https://www.oecd.org/g20/topics/anti-corruption/48972967.pdf
  • Wolfe S., Worth M., Dreyfus S., Brown A.J., 2015. Breaking the Silence, Strengths and Weaknesses in G20 Whistleblower Protection Laws, 2015. Available at: https://blueprintforfreespeech.net/wp-content/uploads/2015/10/Breaking-the-Silence-Strengths-and-Weaknesses-in-G20-Whistleblower-Protection-Laws1.pdf

Financing for Development: Two Years after Addis

Posted on June 12, 2017 | Policy Brief

20170611 Development Day

At the Third International Conference on Development Finance in Addis Ababa on July 13—16, 2015, the world committed itself to an action agenda to raise resources to realize the 2030 sustainable development goals. The question is how much progress the world has achieved two years down the road, when the initial enthusiasm and commitments are no longer in the immediate spotlight. This policy brief reports on the discussion from a conference on this topic, Development Day 2017, held in Stockholm on May 31.

The year 2015 has been lauded as a landmark year for sustainable development. As many as three major global agreements were negotiated and signed: the 2030 Agenda for Sustainable Development; the Paris Agreement on Climate Change; and the Addis Ababa Action Agenda (AAAA) on Financing for Development. The latter may be less known, but is essential to the ambition to achieve the first since it concerns how to finance the necessary investments to achieve the Sustainable Development Goals (SDG). The AAAA identified seven action areas spanning both the public and the private sectors, and involving both domestic revenues and international transfers (domestic public resources, domestic and international private business and finance, development cooperation, trade, debt and debt sustainability, systemic issues and science, technology and innovation). This event focused primarily on international commercial private capital flows, and indirectly on development cooperation as a facilitator and catalyst for such private transfers.

Combining good business and good development

A major theme of the conference was combining good business with good development. Should private companies also take responsibility for environmental and social sustainability, or is the “only business of business to do business”? If firms do engage in sustainability investments, does it eat into profits or does it rather create a competitive edge? Reading business journals, it is easy to get the impression that there is a win-win situation. This picture is, however, based on rather limited information and the relationship is fraught with methodological challenges as both profitability and sustainability investments may be driven by other factors (such as competent leadership), and firms performing well may have the capacity and feel the obligation to invest part of their surplus into corporate social responsibility (CSR). Hence, there may be a question of reverse causality.

At the conference, new research was presented using data on investments in low and middle-income countries from the International Finance Corporation that includes both measures of financial rates of returns and subjective ratings of environment, social and governance (ESG) performance. Simple correlations suggested a significant positive relationship, or a win-win situation. However, once care was taken to identify a causal effect from ESG on profits, the results became insignificant. That is, the causal effect of ESG investments on profits seemed neither positive nor negative. However, when looking at broader measures of private sector development, the results suggest that both profits and ESG investments have a positive impact on sector development. This implies that there are good reasons for the public sector to encourage ESG activities even beyond the direct sustainability benefits through for instance public-private partnerships but also regulations that encourage good behavior.

How should results like these be interpreted? The presentation spurred an interesting debate on what are reasonable expectations and whether “the glass is half full or half empty”. It was emphasized that systematically beating the market should not really be expected from any group of investments, so a half-full interpretation seems more plausible.

This debate also came up in a panel discussion on institutional investments in developing countries, and where the growing success of green bonds was presented. Though still small in absolute size (1-2% of the bonds coming to the market are green bonds), there has been an impressive growth in the last 3-4 years. Currently, the Swedish bank SEB is cooperating with the German government in developing a green-bond market in emerging markets. Some of the lessons emphasized from the green-bond market were the importance of being clear towards investors about the motivation and the value proposition, to package the information in a credible way emphasizing independent verification, and to continuously monitor and give feedback to investors.

From the institutional investor side, it was mentioned how important it is to tell investors a compelling story. This may be easier with regards to environmental sustainability relative to social sustainability, both in terms of conveying the urgency and in developing indicators that can be monitored and communicated. It was also argued that even though there are initiatives out there, emphasizing how sustainable investments can be competitive in terms of profitability (such as green bonds), it would also help to change the relative price on the other end of the spectrum, i.e. through regulations, taxes or other instruments that can make investments with particularly negative externalities less profitable.

Finally, an overarching theme of the discussion was the challenge to have institutional investments reach the places with the most needs, i.e. the fragile and least developed countries. If this is to happen, pension funds and insurance companies have to be allowed to take on more risks, and it would be essential to reduce the corporate risk in public-private partnerships (more on this below).

In a second panel discussion, different Swedish corporate initiatives, emphasizing sustainability, were showcased. For example, the Swedish steel producers’ association, Jernkontoret, showcased the Swedish steel industry’s vision 2050 with the target of domestically based steel production using hydrogen and with zero CO2 emissions. Another example is the Sweden Textile Water Initiative, launched in 2010 by major Swedish textile and leather brands together with the Stockholm International Water Institute, has created the first guidelines for sustainable water and wastewater management in supply chains. Currently working with 277 suppliers in 5 countries, the initiative features clear win-win situations and is now self-sustaining and in the process of going private.

Skandia, a major Swedish insurance company, emphasized the business costs of socially unsustainable situations with examples from the costs in Sweden of sick leave, and the costs for protection and security for Swedish retailers and mall developers. Positive preventive work focusing on rehabilitation and the development of blossoming and inclusive neighborhoods were featured. These examples showcased how the SDGs are feeding into the thinking and planning of the private sector in Sweden, and how important it is to identify the business cases for thinking about sustainability in order for this to become mainstream.

However, the case for private capital to be the panacea for reaching the SDGs is by no means obvious. The non-governmental organization Diakonia pointed out that for every dollar flowing into a developing country, more than two dollars are lost. The biggest loss is coming from illicit financial flows, and within this category, tax evasion is the biggest problem. While the private sector is key to development, the main contributions this sector can do for development is to pay taxes where they are due, abide by international standards, and be transparent and accountable to the citizens and governments in the countries where they operate.

Swedwatch, used two examples from Borneo and what is now South Sudan, to illustrate how investors at times turn a blind eye towards human rights and environmental abuses by private multi-national companies. Transparency, due diligence in evaluating human rights risks prior to investment decisions, and a readiness to push for compensation and remedy if abuse is still unearthed were pointed out as key components to avoid this type of malpractice.

Development cooperation as facilitator for private flows

The second main theme of the day dealt with the ability to use development cooperation as a catalyst for private investments.

Swedfund, the Swedish government’s development financier, emphasized the need to move fast and find a business model in which one dollar spent becomes ten dollars on the ground. Based on a business model around three pillars (societal impact, sustainability and financial viability) Swedfund focus on areas with relatively high risk and where private capital are in short supply, with the hope to foster job creation, inclusive growth and poverty reduction.

Sida, the Swedish main aid agency, showcased their guarantee instruments. Through partnerships with bigger actors such as the International Finance Corporation (IFC) of the World Bank group as well as local banks in developing countries, Sida can shoulder part of the default risks involved when trying to reach more high-risk investors (such as small and medium sized enterprises) with great potential development impact. In this way, one dollar from the public aid budget can lure a multiple of dollars in private capital towards sustainable development.

The OECD Development Assistance Committee (DAC) emphasized that governments generally lack a policy for how to deliver official development assistance (ODA) in a sustainable way and a strategy for how to enable capital flows from the private sector. A DAC initiative to better track all financial flows going towards development, beyond just ODA, was presented.

From the Center for Global Development, the case for using public resources to facilitate private sector insurance mechanisms against human disasters was presented (concessional insurance). Benefits emphasized from explicit insurance contracts included faster and better-coordinated payouts, more certainty that compensation will come, incentives to invest in disaster prevention (to reduce premiums) and involvement of commercial insurance professionals.

Importantly, though, it was emphasized that it is crucial that aid money are truly complementary in the sense that they crowd in private investments that otherwise would not have taken place (and not end up subsidizing private investors in donor countries). It was also emphasized that donors must not forget about the focus on the poorest and people in fragile states.

In some environments donors must shoulder 100% of the risk to lure private capital. In those cases alternatives must be considered. Sida emphasized the importance to match financial instruments with the appropriate context, i.e. there is a need to identify where different instruments should be used. For instance, big institutional investors need investments that are manageable, predictable, and of a reasonable size. Aid agencies can help through subsidized risk management, but also by helping build strong institutions in partner countries that can work as counterparts, and encourage public-private collaborations to package investment deals and reduce information asymmetries.

Where are we now?

Turns out that this is not a simple question to answer. The Ministry for Foreign Affairs presented the Swedish government’s priority areas – strengthening the implementation of SDG 5, 8, 14 and 16 (all goals can be found here: https://sustainabledevelopment.un.org/?menu=1300) – and reported from a recent follow-up meeting at the UN.

In principle the Addis Agenda identifies action areas and connects areas and actors, which makes it possible for systematic follow-ups, and an inter-agency task force produces an annual report of the general state of the implementation of the Addis Agenda. The Swedish government has produced a report on the implementation of the AAAA covering all seven action-areas with examples of progress. This initiative was commended at the UN meetings, and together with the private sector engagement, as showcased during the 2017 Development Day, it paints a rather positive picture of progress and engagement in Sweden.

However, globally, there are many uncertainties and challenges. The Center for Global Development reported on the budget proposal of the US president, which among other things includes a 32% cut to topline funding for the Department of State and Foreign Operations. There are also plans to eliminate the Overseas Private Investment Corporation and to zero out US food assistance. On the other hand, in this fiscal year, the US Congress (controlled by the Republicans) increased the amount going into foreign aid compared to what previous president Obama suggested. What will eventually come out of the current president’s budget proposal for the coming fiscal year is thus highly unclear.

Participants at the conference

  • Rami AbdelRahman, Sweden Textile Water Initiative
  • Frida Arounsavath, Swedwatch
  • Owen Barder, Center for Global Development
  • Eva Blixt, Jernkontoret
  • Magnus Cedergren, Sida
  • Penny Davies, Diakonia
  • Raj Desai, Georgetown University and the Brookings Institution
  • Ulf Erlandsson, Fourth Swedish National Pension Fund (AP4)
  • Måns Fellesson, Ministry for Foreign Affairs
  • Charlotte Petri Gornitzka, OECD-DAC
  • Anna Hammargren, Ministry for Foreign Affairs
  • John Hurley, Center for Global Development
  • Lena Hök, Skandia
  • Måns Nilsson, Stockholm Environmental Institute
  • Mats Olausson, SEB
  • Anders Olofsgård, SITE
  • Anna Ryott, Swedfund
  • Elina Scheja, Sida

Intimate Partner Violence, Norms and Policies

Posted on March 6, 2017 | Policy Brief

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Violence against women has been called by then UN Secretary-General and Nobel Peace Prize laureate Kofi Annan, “perhaps the most shameful human rights violation. And, it is perhaps the most pervasive.” Although the spread of domestic violence is difficult to quantify precisely, this is uncontroversially an issue worthy of policy concern. As is often the case, the developing world lags behind. What can development cooperation do? A growing body of economic research, including our recent results, shows that improving women’s economic opportunities matters.

It is not easy to put a figure on the prevalence of violence against women. A recent review (Alhabib et al., 2010) reports that “the prevalence of lifetime domestic violence varies from 1.9% in Washington, US, to 70% in Hispanic Latinas in Southeast US.” As the quote shows, most of the currently available studies were conducted in the US or Europe, although the focus on the developing world is rapidly growing. Besides the geographic bias, the nature of data available on the matter further limits the precision of our knowledge. Surveys (used by the vast majority of studies), crime statistics and administrative health data each suffer from different limitations. One detail, though, consistently emerges in the big picture: the largest share of violence against women is perpetrated by a cohabiting partner or other family members, what is commonly referred to as intimate partner violence or domestic violence.

In addition to the human costs, a growing body of research shows that domestic violence has huge economic costs, including the direct costs of health, legal, police and other services. There are also broader social costs, more difficult to quantify. Domestic violence is likely to reduce women’s participation in productive employment and education, and has also been shown to affect the welfare and education of children.

Legislation and policy

While specific domestic violence laws were uncommon just a few decades ago, many countries have, over the past two decades, adopted or revised legislation. In 2008, the United Nations (UN) launched a dedicated initiative advocating for universal ”adoption and enforcement of national laws to address and punish all forms of violence against women and girls, in line with international human rights standards.”

Even though issues of implementation and enforcement are more important than the letter of these laws, it is still crucial that laws are there. In such an area where culture and social norms play a big role, legislation can function as a signal of what a society deems acceptable and coordinate behavior to ultimately change social norms. This is why for example the recent law change in Russia was strongly criticized, regardless of the alleged advantages of the new formulation in terms of practical implementation. [A/N: The reform decriminalized and reduced the punishment for attacks that result in “minor injuries”, as long as they do not happen more than once a year, from two years to 15 days in prison. Proponents claimed that declassifying this form of violence from criminal to administrative offense would lower the threshold for reporting, and avoid misapplication by the police for extortion purposes.]

Besides legislation, a broad range of policies in different areas play a role for the prevalence of domestic violence and the fight against it. The knowledge gaps in terms of prevalence hinder the investigation of the factors that amplify or dampen the incidence of domestic violence, and as a consequence make it more difficult to draw implications for policy strategies. Whatever improves the parity between genders and the status of women in a society is however likely to work in the right direction, at least in the long run. Among the policies with established effects in this direction are legal rights for women (for example in terms of political representation); the introduction of role models (for example through cable TV); an improved balance of economic resources within the household (see Jayachandran, 2015 for an overview of the literature).

Development policy

As for many other areas, developing countries tend to lag behind in this respect. In Sub-Saharan Africa (SSA), domestic violence is considered a barrier to sustainable development, with 36%-70% prevalence (Garcia et al., 2005) and an estimated cost of 1.2%-3.7% of GDP (Duvvury et al., 2013). These estimates take into account a broad range of consequences for women and children. Besides direct and indirect health and life expectancy consequences, distorted outcomes for women include lower autonomy, affecting economic and financial decisions, effectiveness of home production, freedom of movement, education and labor market participation and healthcare decisions. Children are affected by distorted reproductive decisions, for example in regard to birth spacing, resulting in lower birth weights and worse chances of survival, and rearing decisions in general. Still these costs can be thought of as a lower bound, given the conservatism of the methodology and the gross under-reporting of violence. Although the main responsibility for policy lies of course within the country, we might still wonder what the international community can do to help, within the framework of development cooperation.

Aid and domestic violence

Even though the donor community agreed, in Addis Abeba in 2015, on a ”beyond aid” agenda to reach the 17 sustainable development goals (see UN, 2015), the main tool of development cooperation is currently still foreign aid. In recent research with Anders Olofsgård and Evelina Bonnier, we investigate the impact of aid on gender-related outcomes, and among them domestic violence. There are three reasons why we expect an impact of development aid on these outcomes. First of all, there may be a direct effect of aid-financed projects on the intended beneficiaries. Many aid projects have nowadays an explicit component targeting women and girls. Moreover, donors also agreed to gender ”mainstreaming” (Beijing Platform for Action, 1995), which implies that gender concerns should be integrated into all policy and program cycles, and that governments should engage in a dialogue on gender and development. This is because women and girls are seen as particularly vulnerable in situations of poverty and conflict, but also potentially instrumental in the general process of development (Duflo, 2012).

Second, aid projects are typically intended to benefit whole communities, and there are often positive externalities that extend beyond the immediately targeted beneficiaries and beyond the stated objectives of the project. Think for instance of immunization drives against infectious diseases (Miguel and Kremer, 2004). When a big enough group of school children are treated against, for example, intestinal worms, far larger communities are also protected due to the now lower probability of contagion, and also the indirect benefits extend to them. Projects targeting livelihoods and jobs can also increase aggregate demand in the community, benefiting those not directly involved in the projects. The ultimate level of spillover goes through economy-wide growth and development. Research shows that gender relations tend to become more equal with economic development and that women tend to gain more than men (Duflo, 2012).

Finally, beyond economic opportunities, positive spillovers can come through transmission of information and attitudes, changing social norms through personal networks, including both direct beneficiaries and others.

Figure 1. Effect of aid on domestic violence

Source: Berlin et al., forthcoming

Figure 1 is based on our empirical investigation linking the most recent Demographic and Health Surveys (DHS) in Uganda and Malawi to information on the geographical coordinates of aid projects placement, provided by AidData. Men in the areas exposed to aid (which we define to be within a 15 km radius of at least one aid-financed project) are 11% more likely to share the opinion that beating one’s wife is not justifiable, as compared to men not exposed to aid. This difference is even larger than for women (4%). Most importantly, women exposed to aid are less likely to have experienced some form of violence, physical (–3%), emotional (–9%) and in particular sexual (–24%). We think this might be connected to the improved status of the woman in economic terms. In fact, we find much more modest impacts from exposure to specifically gender-targeted projects (examples of which include “Community participation and development”, “Support for vulnerable groups”, “Improvement of outpatient, maternal and child health services”, “Women’s empowerment for peace”, and “Anti-trafficking for women and children”). We also find that aid presence affects labor market participation for women, but do not find this effect from gender-specific aid. This is consistent with the idea that women’s relative status within the household improves as a consequence of better economic opportunities, in this case induced by aid. Evidence supporting this mechanism is piling up, see Aizer (2010), Bobonis et al. (2013), Heath (2014), Anderberg et al. (2016), Hidrobo et al. (2016), to cite just a few. The types of activities that fall under our definition of gender-specific aid, instead, do not seem to contribute in this respect.

Conclusion

Summarizing recent research, the World Development Report 2015 called for development policy to focus on norms and mental models. These are often highly persistent and hard to change. We know that gender-related norms are important for outcomes that deeply affect the lives of women and girls. We do not know a lot about how to change them, but improving the status of women and girls in society seems to be one important piece of the puzzle. Our recent findings about the impacts of aid imply, echoing the WDR 2015, that this should be an important goal for development cooperation.

References

  • Alhabib, Samia; Ull Nur; and Roger Jones. 2010. ”Domestic Violence Against Women: Systematic Review of Prevalence Studies”, Journal of Family Violence, 25, pp 369–382.
  • Aizer, Anna, 2010. ”The Gender Wage Gap and Domestic Violence”, The American economic review. 100(4),1847-1859.
  • Anderberg, Dan; Rainer, H., Wadsworth, J., & Wilson, T., 2016. “Unemployment and Domestic Violence: Theory and Evidence.” The Economic Journal 126.597, pp 1947-1979.
  • Berlin, Maria P.; Evelina Bonnier; and Anders Olofsgård, forth. “The Donor Footprint and Gender Gaps”, UNU-WIDER Working Paper Series.
  • Bobonis, Gustavo J.; Melissa González-Brenes; and Roberto Castro, 2013. “Public Transfers and Domestic Violence: The Roles of Private Information and Spousal Control.” American Economic Journal: Economic Policy 5, no. 1
  • Duflo, Esther, 2012. “Women empowerment and economic development”, Journal of Economic Literature, 50(4), 1051-79.
  • Duvvury, Nata; Callan, A.; Carney, P.; and Raghavendra, S.; 2013. ”Intimate partner violence: Economic costs and implications for growth and development.” Women’s Voice, Agency, & Participation Research Series, 3.
  • García-Moreno, Claudia; Jansen, H. A. F. M.; Ellsberg, M.; Heise, L.; and Watts, C., 2005. ”WHO Multicountry Study on Women’s Health and Domestic Violence against Women: summary report of initial results on prevalence, health outcomes and women’s responses.” World Health Organization. Geneva.
  • Jayachandran, Seema. 2015. “The roots of gender inequality in developing countries.” economics 7.1, pp 63-88.
  • Heath, Rachel, 2014. “Women’s access to labor market opportunities, control of household resources, and domestic violence: Evidence from Bangladesh.” World Development 57, pp 32-46.
  • Hidrobo, Melissa; Amber Peterman; and Lori Heise, 2016. “The Effect of Cash, Vouchers, and Food Transfers on Intimate Partner Violence: Evidence from a Randomized Experiment in Northern Ecuador.” American Economic Journal: Applied Economics 8.3, pp 284-303.
  • UN, 2015. ”Transforming our World: The 2030 Agenda for Sustainable Development.” United Nations – Sustainable Development knowledge platform.

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Does Product Market Competition Cause Capital Constraints?

Posted on November 14, 2016 | Policy Brief

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At the very center of Schumpeter’s (1934, 1942) notion of creative destruction is firms’ access to bank capital, which helps to fund the innovation in competitive product markets that drives out less productive firms in favor of those with more profitable ideas. However, competition is a two-edged sword and may result in firms being unable to fund all of their otherwise economically profitable investments. Using unique survey data from 58 countries, Bergbrant, Hunter, and Kelly (2016) find that product market competition increases capital constraints and has a greater effect than banking sector competition. Further, we show that quantity-of-capital constraints negatively impact firm growth.

Capital and creative destruction

At the very center of Schumpeter’s (1934, 1942) notion of creative destruction is firms’ access to bank capital, which helps to fund the innovation in competitive product markets that drives out less productive firms in favor of those with more profitable ideas. While product market competition may be the fundamental driver of the innovation envisioned by Schumpeter, it may also impede access to the very source of capital that is supposed to fund that innovation. More intense product market competition can affect firms’ ability to finance their projects either by increasing the price of financing or by inducing capital constraints, whereby firms are unable to obtain the quantity of capital needed to fund all their positive net present value projects.

Recent research has focused on the price side of financing, showing that product market competition increases the cost of equity (Hou and Robinson, 2006) and the cost of debt (Valta, 2012). In this brief we examine the quantity side of financing; that is, whether product market competition increases capital constraints.

Isn’t it obvious that competition causes capital constraints?

Actually, no. There is a familiar argument that firms are reluctant to disclose commercially valuable information when competitors are more likely to exploit this information. Theory predicts that it is not optimal for creditors to respond to the resulting asymmetric information by raising interest rates; instead, restricting capital is more appropriate (Stiglitz and Weiss, 1981). However, competition may have the very opposite effect because a competitive environment lowers owners’ cost of monitoring and measuring managerial performance. Theory and recent empirical tests indicate that lower cost of monitoring managers induces greater disclosure by owners.

Whether or not product market competition makes banks restrict the supply of loans is arguably more important than whether it influences the cost of debt. Greenwald, Stiglitz, and Weiss (1984) show that firms’ investment behavior is not particularly sensitive to the interest rates they pay, consistent with the notion that increases in the cost of debt may reduce investment, but only at the margin; i.e., projects change from generating economic profits to generating economic losses (net present value changes from positive to negative). By contrast, increased capital constraints can lead to underinvestment by forcing firms to abandon projects which generate economic profits (net present values are positive), thus hindering investment and preventing firm innovation and growth (see Harford and Uysal, 2014).

What does the research tell us?

Recent research by Bergbrant, Hunter, and Kelly (2016) uses survey data obtained from the World Bank’s World Business Environment Survey, conducted among non-financial firms from around the world. Capital constraints are the response to a question about the extent of the obstacle to operations and growth posed by capital constraints that managers and owners rank from 1 (No Obstacle) to 4 (Major Obstacle). Competition is represented by an index constructed from eight individual forms of competition reported by firms.

The empirical evidence indicates that the intensity of product market competition significantly increases capital constraints. Table 1 shows the marginal effects of a change in the intensity of competition on capital constraints. For instance, the first row shows that a small (instantaneous rate of) increase in product market competition leads to an increase in the likelihood that capital constraints are a “major obstacle” (4 on a four- point scale) at a rate of 18.9%. Similar results hold when competition is assessed at a one-standard-deviation (3rd row) increase or when competition changes from 0 to 1 on a version of our competition index which ranges from 0 to 1 (5th row).

Table 1: Effect of competition on capital constraints

For a change of:

 

 No obstacle

(1)

 Minor obstacle

(2)

 Mod. obstacle

(3)

 Major obstacle

(4)
Marginal -0.147 -0.052 0.010 0.189
p-value (0.000) (0.000) (0.062) (0.000)
+SD -0.042 -0.017 0.000 0.059
p-value (0.000) (0.000) (0.925) (0.000)
0 to 1 -0.145 -0.059 0.008 0.196
p-value (0.000) (0.000) (0.165) (0.000)

Note: The table reports the marginal effects “for a change of” product market competition of varying amounts on firms responding that capital constraints pose one of the four levels of “obstacle” for their operations.

The above results are qualitatively similar when the competition index is replaced by any one of its eight individual components. In addition, competition increases not only a measure of general capital constraints, as employed in the above analysis, but also specific forms of capital constraints. These include the credit constraints that firms experience when, as a precondition for lending, banks require that borrowers have special connections in the banking sector, pledge collateral, satisfy banks’ bureaucratic need for business documents, and pay bribes to corrupt bank officials. Further, the evidence is not unique to domestic bank capital as more intense product market competition also impedes firms’ access to nonbank equity, foreign bank capital, special export financing, and lease financing.

To further validate our main result we account for two well-established strands of research that contend that banking sector competitiveness is among the most important determinants of access to credit and that banking sector structure can also affect the competiveness of non-financial firms’ industries. The evidence reported in Table 2 shows that while (one of three measures of) banking sector competition and the degree of bank freedom affect capital constraints, in general the regulatory structure of the banking sector does not. More important, our main finding is unchanged when controlling for banking sector structure. Finally, it is important to note that in all our models we control for any cost-of-debt (higher-interest-rate) effects.

Table 2: Accounting for banking sector structure

Competition (10 separate models) +ve signif.
Lerner bank competition index +ve, signif.
Bank concentration ratio insignif.
Boone indicator of banking sector insignif.
private credit as a fraction of GDP insignif.
restrictions on nonbank activities insignif.
fraction of bank applications denied insignif.
bank freedom from gov’t interference -ve, signif.
existence of a credit registry insignif.
foreign bank share of banking system insignif.
government share of banking system insignif.

Note: We augment our main model with the above banking sector variables, one at a time, to determine their impact on the significance (signif. or insignif.) of product market competition.

Capital constraints hurt firms’ growth and so we expect our measure of capital constraints to be negatively associated with growth. We confirm this in the data, after controlling for the direct impact of competition on growth. We also find that the quantity-of-capital effect has a greater impact on expected firm growth than the cost-of-capital effect.

Conclusion

Our research indicates that the intensity of product market competition increases capital constraints even in the presence of controls for banking sector competition. Our work suggests several policy recommendations. First, the implementation of a product-market competition policy, for instance by several Central and Eastern European countries in the 1990s (Fingleton et al., 1996; Dutz and Vagliasindi, 2000), should contemplate the possibility that such action is likely to have negative externalities for firms’ access to capital. Second, banking sector reforms aimed at creating a more competitive banking system in order to improve access to capital should not be pursued in isolation and should take into consideration the existing competitiveness of the product market. Third, given that the quantity-of-capital effect has a greater impact on firm growth than the cost-of-capital effect, policymakers should exert at least as much effort in easing quantity constraints as they do to reduce the cost of capital.

References

  • Bergbrant, M.; D. Hunter; and P. Kelly, 2016. “Product Market Competition, Capital Constraints and Firm Growth”. Available at SSRN: https://ssrn.com/abstract=2594218.
  • Dutz, M. A.; and M. Vagliasindi, 2000. “Competition policy implementation in transition economies: An empirical assessment”. European Economic Review 44, 762-772. Fingleton, J.; E. Fox; D. Neven; and P. Seabright, 1996. “Competition policy and the transformation of central and eastern Europe”. Working paper. CEPR, London.
  • Greenwald, B.; J.E. Stiglitz; and A. Weiss, 1984. “Informational imperfections in the capital market and macroeconomic fluctuations”. American Economic Review 74(2), 194-199.
  • Harford, J.; and V. B. Uysal, 2014. “Bond market access and investment”. Journal of Financial Economics 112, 147-163.
  • Hou, K.; and D. Robinson, 2006. “Industry concentration and average stock returns”. Journal of Finance 61, 1927-1956.
  • Schumpeter, J.A., 1934. “The Theory of Economic Development”. Harvard University Press, Cambridge, MA.
  • Schumpeter, J. A., 1942. “Capitalism, Socialism and Democracy”. Harper and Brothers, New York, NY.
  • Stiglitz, J.; and A. Weiss, 1981. “Credit rationing in markets with imperfect information”. Amer. Econ. Review 71, 393-410.Valta, P., 2012. “Competition and the cost of debt”. Journal of Financial Economics, 105(3), 661-682.

Will New Technologies Change the Energy Markets?

Posted on October 24, 2016 | Policy Brief

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With an increasing world demand for energy and a growing pressure to reduce carbon emissions to slow down global warming, there is a growing necessity to develop new technologies that would help addressing demand and carbon footprint issues. However, taking into account the world’s dependence on hydrocarbons the question remains – can new technologies actually change the energy markets? In this policy brief, we highlight challenges and opportunities that new technologies will bring for energy markets, in particular wind energy, smart grid technology, and electromobility, that were discussed during the 10th SITE Energy Day, held at the Stockholm School of Economics on October 13, 2016.

The expanding world population and economic growth are considered the main drivers of the global energy demand. Up to 2040, total energy use is estimated to grow by 71% in developing countries and by 18% in the more mature energy-consuming OECD economies (IEA, 2016). In parallel, many countries (including the world’s biggest economies and largest emitters: USA and China) have signed the Paris agreement – the first-ever universal, legally binding global climate deal that aims to reduce emissions and to keep the increase in global average temperature from exceeding 2°C above pre-industrial levels.

Meeting a growing global energy demand, and at the same time reducing CO2 emissions, cannot be achieved by practicing ‘business as usual’. It will require some fundamental changes in the way economic activity is organized. In this context, the development of new technologies and how it will affect the energy sector is a crucial element.

Wind power, smart grid, and electromobility

With technological progress and support schemes to decrease CO2 emissions, wind energy is now a credible and competing alternative to energy produced from coal, gas and oil. In 2015, wind accounted for 44% of all new power installations in the 28 EU member states, covering 11.4% of Europe’s electricity needs (see here).

This new technology has triggered a downward pressure on energy prices because of a “Merit order effect” (i.e. a displacement of expensive generation with cheaper wind). While consumers may appreciate this development, Ewa Lazarczyk Carlson, Assistant professor at the Reykjavik University (School of Business) and IFN, stressed that the increasing importance of wind energy challenges the functioning of electricity exchange. First, a lower price has reduced the incentives to invest in conventional power plants necessary when the wind is not blowing or when it is dark. Moreover, with the renewable energy intermittency, the probability of system imbalance and price volatility has increased. In turn, this has led to an increase of maintenance costs for conventional generators due to their dynamic generation costs (i.e. start-ups and shut-down costs).

Digital technology has gradually been used in the energy sector during the last decades, changing the way energy is produced and distributed. With smart grid (i.e. an electricity distribution system that uses digital information) energy companies can price their products based on real time costs while customers have access to better information, allowing them to optimize their energy consumptions. Sergey Syntulskiy, Visiting Professor at the New Economic School in Moscow, stressed that smart grids have had at least two effects. They have made the integration of renewable energy to the system easier and have allowed for prosumers, i.e. entities that both consume and produce energy. The next step is to develop new regulatory incentives to optimize energy systems as well as to provide a legal framework for the exchange of information in the energy sector.

One of the main pollutants has long been the transport sector that accounts for 26% energy-related of CO2 emission (IEA, 2016). Electromobility – that is, use of electric vehicles – is often considered the solution for this problem. When this technology is widely adopted, a major switch from oil to electricity is expected for the transportation sector. Mattias Goldmann, CEO of Fores, argued that even if electromobility will improve air quality and reduce noise levels in cities, its positive impact relies on smart grids and locally produced energy. Moreover, the environmental benefits will be ensured only if electric energy is produced from renewable and clean sources.

Toward a carbon-neutral energy system?

The Nordic countries are currently pushing for a near carbon-neutral energy system in 2050. Markus Wråke, CEO at the Swedish Energy Research Centre, emphasized that the Nordic Carbon-Neutral Scenario is only feasible if new technologies allow for a significant change of energy sources and a better interconnected market (see report by IEA 2016 b).

To cut emissions, a decrease in oil and gas consumption in energy production and within the transport sector is needed (see Figure 1). The adoption of electric vehicles (EVs) and hybrid cars is very likely to drastically increase in the next decades (EVs may have a share of 60% of the passenger vehicle stock in 2050, IEA 2016b).

Figure 1. Nordic CO2 emissions in the CNS

slide1Source: IEA, 2016.

There are currently limited technology options to reduce emissions for big industrial energy consumers. Moreover, there is a concern that those industries may choose to relocate if the Nordic emission standards are too strict. It is therefore important to have low and stable electricity prices. This can only be achieved if cross-border exchanges are improved (which means that the electricity trade in the Nordic region will have to increase 4-5 times by 2050). It is unclear however how policy makers will create a regulation that incentivizes energy companies to build interconnections and increase trade both between the Nordic countries, and the Western and Eastern European countries.

Figure 2. Electricity trade 2015 and 2050

slide2Source: IEA, 2016.

Energy producers

Another concern is that energy-exporting and energy-importing countries may have opposing attitudes towards investing and developing new energy technologies. Countries among the biggest energy producers and exporters depend on a stable demand and price for energy. For example, Russian GDP growth depends between 50-92% on the oil price, depending on the variables used for calculations, as mentioned by Torbjörn Becker, Director of SITE. For large exporters of hydrocarbon, new energy technologies may be seen as a threat because of a potentially reduced energy demand and an increased price volatility that will, in turn, create fundamental issues to balance state budgets and improve living standards.

Figure 3. The Relationship between Russian GDP and oil price

slide3Source: Calculations by Torbjörn Becker, October 13, 2016

The challenge of security of supply

To summarize, new energy technologies will drive energy companies towards optimizations and cost cutting, bring previously unseen connectivity to energy markets and make energy markets more complex. Samuel Ciszuk, Principal Advisor at the Swedish Energy Agency, stressed that interconnected, more complex and interdependent energy systems might increase the vulnerability of energy systems to external threats and intimidates to decrease the security of supply. Technological change and increased competition with lower profit margins will force companies to minimize their expenditure on energy production, storage and transmission and to find cheaper financing options. Optimization and searches for cheaper financing instruments will push energy companies towards selling some of the company assets to financial investors. These changes will create a more decentralized energy market, with more players. Such energy systems will become harder to govern in times of an energy crisis and external threats. Policy makers will have to design new and more complex regulations to fit the needs of the transforming energy markets.

References

  • Fogelberg, Sara and Ewa Lazarczyk, 2015. “Wind Power Volatility and the Impact on Failure Rates in the Nordic Electricity Market”, IFN Working Paper 1065.
  • IEA, Annual Energy Outlook, 2016a.
  • IEA/OECD/Norden, 2016b. “Nordic Energy Technology Perspectives” (see here)
  • Speaker presentation from the 10th Energy day, 2016 (see here)

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Expanding Leniency to Fight Collusion and Corruption

Posted on October 3, 2016 | Policy Brief

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Leniency policies offering immunity to the first cartel member that blows the whistle and self-reports to the antitrust authority have become the main instrument in the fight against cartels around the world. In public procurement markets, however, bid-rigging schemes are often accompanied by corruption of public officials. In the absence of coordinated forms of leniency for unveiling corruption, a policy offering immunity from antitrust sanctions may not be sufficient to encourage wrongdoers to blow the whistle, as the leniency recipient will then be exposed to the risk of conviction for corruption. Explicitly introducing leniency policies for corruption, as has been recently done in Brazil and Mexico, is only a first step. To increase the effectiveness of leniency in multiple offense cases, we suggest, besides extending automatic leniency to individual criminal sanctions, the creation of a ‘one-stop-point’ enabling firms and individuals to report different crimes simultaneously and receive leniency for all of them at once if they are entitled to it.

Leniency provisions to fight corruption

It has been noted that leniency policies and other schemes that encourage whistleblowing — such as reward and protection policies — should work in the fight against corruption as it does in the fight against collusion (Spagnolo, 2004; Spagnolo 2008; Buccirossi and Spagnolo, 2006). Cartels, corruption, and many other types of multi-agent offenses depend on a certain level of trust among wrongdoers, which is precisely what leniency programs aim to undermine by offering incentives for criminals to betray their partners and cooperate with the authorities (Bigoni et al., 2015; Leslie, 2004).

Of course, for offenses not covered by antitrust law, such as corruption, relevant authorities may have their own ways of granting leniency and encourage reporting, such as plea bargaining, whistleblower reward programs, deferred prosecution agreements (DPAs) and non-prosecution agreements (NPAs). On the other hand, some countries have recently introduced explicit leniency programs for corruption (for example, Brazil and Mexico). Yet, we observed that those instruments do not always cover all types of sanctions, are seldom integrated with antitrust leniency, and are often under the responsibility of multiple law enforcement agencies. Hence, improvements in the legal frameworks seem to still be necessary.

Leniency in a multi-offense scenario: the case of corruption cartels

Cartel offenses may be connected to other infringements. A particularly frequent and deleterious example of a multiple offense situation is the simultaneous occurrence of collusion (bid rigging) and corruption in public procurement (OECD, 2010). While cartels are estimated to raise prices by 20% or more above competitive levels (Connor, 2015; Froeb et al., 1993), corruption may add 5–25% to total contract values (EU, 2014; OECD, 2014b). Since public procurement is a market amounting to 13–20% of GDP in developed countries (OECD, 2011), it is clear that collusion and corruption represent a serious waste of public funds, negatively impacting the quality of public infrastructure and services provided by a state to its citizens.

Authorities face then two distinct, yet inter-related, challenges to guarantee the effectiveness of public procurement: ensuring integrity in the procurement process and promoting effective competition among suppliers (Anderson, 2010). Considering that success in deterring cartels and corruption depends largely on the incentives provided to infringers to self-report, the interaction between leniency provisions for cartels and the legal treatment of corruption adds a powerful new channel to the above-noted interdependence and thus should be — and already is — a concern to antitrust and anti-corruption authorities (OECD, 2014a).

A member of a corrupting cartel that blows the whistle on the cartel and applies for leniency to the antitrust authority will likely have to disclose information on the other infringement. Such information may then be used by the relevant law enforcement authority to prosecute and punish the applicant. Thus, the risk of prosecution for other cartel-connected offenses (corruption in this case) may reduce the attractiveness of reporting the cartel (Leslie, 2006). This kind of uncertainty works against the leniency policy’s deterrence goals and may even stabilize the cartel by providing its members with a credible threat to be used to prevent betrayal among them.

Existing leniency provisions for corrupting cartels

Antitrust leniency provisions are very similar worldwide, differing mainly in terms of whether cartels are only considered administrative infringements or are also criminally liable offenses. Where there is individual criminal liability, leniency programs should cover it. Surprisingly, Austria, France, German and Italy, where cartel, or at least bid rigging, is a criminal offense, do not follow this guideline. In these jurisdictions the co-operation of an individual with the antitrust authority during the administrative proceedings may be considered a mitigating circumstance, reducing imposed penalties or even allowing a discharge, but at the discretion of the court or the prosecution, which is likely to greatly reduce the propensity of wrongdoers to blow the whistle.

On the other hand, countries do not usually have specific leniency programs for corruption. Nonetheless, self-reporting and cooperation in bribery cases are usually given great importance by authorities and may lead to leniency and even immunity, through other mechanisms such as plea agreements, no-action letters, NPAs or DPAs, but those instruments rely on prosecutorial or judicial discretion. Brazil and Mexico do have formal leniency programs for corruption, providing more certainty and thus being more attractive to an applicant, although restricted to administrative liability. Individual corruption-related criminal provisions are laid down in each country’s criminal code and follow the recommendations made by the United Nations, in the 2003 Convention against Corruption, and by the Organization for Economic Co-operation and Development, under its 1997 Convention against Corruption of Foreign Public Officials in International Business Transactions.

Since enforcement authorities for collusion and corruption differ in most cases, such an arrangement demands that the infringer seek non-prosecution through at least two separate agreements, one with the antitrust authority and the other with the anti-corruption agency. The difficulty in coordinating such agreements is an obvious issue and will vary according to the number of authorities involved and to the proximity among them, that range from divisions of the same agency, in the case of the United States (Antitrust and Criminal Divisions of the Justice Department), to organizations from different government branches (Executive and Judiciary) in most jurisdictions.

In Brazil and the United States, antitrust leniency programs can provide protection for non-antitrust violations, committed in connection with an antitrust violation. While in Brazil, this provision does not currently include corruption infringements, in the United States it does, but only binds the Antitrust Division and not any other federal or state prosecuting agencies, i.e. leniency agreements may not prevent other authority from prosecuting the applicant for the non-antitrust violation.

How to improve the current legal framework

Countries should follow Brazil and Mexico’s example and create ex ante, non-relying on prosecutorial or judiciary discretion leniency programs for corruption infringements. Unlike these programs, leniency should also cover individuals, especially in terms of criminal liability for bid rigging and corruption. The protection from lawsuits for managers and directors could then become a primary incentive for them to blow the whistle on their and their companies’ illegal acts.

Additionally, it is advisable not to depend on collaboration between law enforcement groups, but to establish clear legal provisions to allow wrongdoers to report all illegal acts simultaneously and to be confident that they will escape sanctions upon co-operation with the authorities and presentation of evidence, i.e. the creation of a ‘one-stop point’.

This ‘one-stop point’ should be available for applicants at every law enforcement agency and must prevent other agencies from prosecuting the leniency applicant. In other words, when someone approaches—as an individual or as a representative of a legal person—any authority to report crimes he is involved in, it is important to allow him to report any other crimes that he knows about in exchange for lenient treatment. In order to prevent conflicts among agencies, the authority first contacted by the wrongdoer must be obliged to immediately involve any other one who may be competent over other possible reported infringements. The self-reporting wrongdoer must be reasonably certain that he will be granted leniency for all reported wrongdoings, provided that he fulfills the legal requirements for each infringement, obviously. Failing to report all known involvement in infringements may be a reason to reduce or even revoke leniency altogether, creating a penalty plus-like provision over different areas of law and a more powerful incentive to a thorough self-report.

Information about the possibility of reporting several illegal acts at the same time, and of obtaining leniency for each one, must be consistently disseminated to minimize detection and prosecution costs, as well as to contribute to the deterrence of future criminal behavior.

Finally, we note that companies and individuals from jurisdictions where leniency provisions for corruption are highly discretionary or non-existent would be less inclined to report cartel behavior abroad when bribing foreign public officials. Despite existing confidentiality rules on leniency programs, they might not want to risk being prosecuted for corruption at home. This would possibly block antitrust leniency agreements by removing the incentives to self-report, undermining the ability to catch international corrupting cartels. To prevent that, laws should be amended to allow leniency for a company or someone that self-reports abroad, and further coordination and collaboration between agencies from different countries would be necessary to avoid stabilizing criminal collusion and undermining the effectiveness of leniency programs.

Conclusion

The fight against cartels and bribery requires efforts on a national level as well as multilateral co-operation.

Creating leniency policies to fight corruption, including foreign, and coordinating them with antitrust leniency policies, emerges as an important priority. The absence of formal leniency programs for corruption, besides hindering anti-corruption enforcement, reduces wrongdoers’ incentives to blow the whistle and collaborate in corrupting cartel cases through the risk of criminal prosecution for the corruption offense. These programs must be carefully designed, however, to avoid opportunistic behavior and thus to achieve their goal of deterrence.

In order to increase the effectiveness of leniency programs in multiple offenses cases, we suggest the creation of a ‘one-stop point’, enabling firms and individuals to report different crimes simultaneously and obtain leniency, provided that they offer sufficient information and evidence for their partners in crime to be prosecuted.

References

  • Anderson, R. D.; Kovacic, W. E.; Müller, A. C., 2010. Ensuring integrity and competition in public procurement markets: a dual challenge for good governance, in The WTO Regime on Government Procurement: Challenge ond Reform (Sue Arrowsmith & Robert D. Anderson eds.).
  • Bigoni, M., Fridolfsson, S.O., Le Coq, C., Spagnolo, G., 2015. Trust, Leniency and Deterrence, 31 J. LAW ECON. ORGAN., 663.
  • Buccirossi P.; Spagnolo, G., 2006. Leniency policies and illegal transactions, 90 J. PUBLIC ECON., 1281.
  • Connor, J. M., 2014. Cartel overcharges, in The Law And Economics Of Class Actions (James Langenfeld ed.).
  • European Commission, 2014. Report from the Commission to the Council and the European Parliament—EU Anti-Corruption Report 2014.
  • Froeb, L. M.; Koyak, R. A.; Werden, G. J., 1993. What is the effect of bid rigging on prices?, 42 ECON. LETT., 419.
  • Leslie, C. R., 2004. Trust, Distrust, and Antitrust, 82 TEX. L. REV. 515.
  • Leslie, C. R., 2006. Antitrust Amnesty, Game Theory, and Cartel Stability, 31 J. CORP. L. 453.
  • OECD, 2010. Global Forum on Competition Roundtable on Collusion and Corruption in Public Procurement.
  • OECD, 2011. Public Procurement for Sustainable and Inclusive Growth – Enabling reform through evidence and peer reviews.
  • OECD, 2012. Improving International Co-Operation in Cartel Investigations.
  • OECD, 2014a. 13th Global Forum on Competition Discusses the Fight Against Corruption, Executive Summary.
  • OECD, 2014b. OECD Foreign Bribery Report: An Analysis of the Crime of Bribery of Foreign Public Officials.
  • Spagnolo, G. 2004. Divide et Impera: Optimal Leniency Programs, CEPR Discussion Paper nr 4840, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=716143
  • Spagnolo, G., 2008. Leniency and Whistleblowers in Antitrust, in Handbook of Antitrust Economics (Paolo Buccirossi ed.), Cambridge MA: MIT Press.
  • Stephan, P. B., 2012. Regulatory Competition and Anticorruption Law, 53 VA. J. INT. LAW 53.
  • Waller, S. W., 1997. The Internationalization of Antitrust Enforcement. 77 BOSTON U. LAW REV. 343.

Culture and Interstate Dispute

Posted on May 30, 2016 | Policy Brief

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The debate on the impact of culture on the conduct of international affairs, in particular on conflict proneness, continues. Yet, the question of whether markers of identity influence conflicts between states is still subject to disputes, and the empirical evidence on Huntington’s clash of civilizations thesis is ambiguous. This policy brief summarizes a recent study where we employ an array of measures of cultural distance between states, including time-varying and continuous variables, and run a battery of alternative empirical models. Regardless of how we operationalize cultural distance and the empirical specification, our models consistently show that conflict is more likely between culturally distant countries.

In his controversial “The Clash of Civilizations” thesis, Samuel Huntington argues that cultural identity is to become the principal focus of individual allegiance and could ultimately lead to an increasing number of clashes between states, regardless of political incentives and constraints. In the post-Cold War world in particular, Huntington (1993) argues that the main source of conflict will not be ideological, political or economic differences but rather cultural. In other words, fundamental differences between the largest blocks of cultural groups – the so-called “civilizations” – will increase the likelihood of conflict along the cultural fault lines separating these groups.

According to Huntington (1996, p.41), a civilization is “the highest cultural grouping of people and the broadest level of cultural identity people have.” Huntington argues that the world could be divided into discrete macro-cultural areas: the Western, Latin American, Confucian (Sinic), Islamic, Slavic-Orthodox, Hindu, Japanese, Buddhist, and a “possible African” civilizations. As the list makes clear, the central defining characteristic of a civilization is religion, and in fact, conflicts between civilizations are mostly between peoples of different religions, while language is a secondary distinguishing factor (Huntington, 1996).

This brief summarizes the findings of our paper (Bove and Gokmen, forthcoming), which offers an empirical analysis of the relationship between identity and interstate disputes by including measures of cultural distance in the benchmark empirical models of the likelihood of militarized interstate disputes. By moving beyond simple indicators of common religion or similar language, our findings suggest that conflict is more likely between culturally distant countries. For example, the average marginal effect of international language barrier on the probability of conflict relative to the average probability of conflict is around 65%. Overall, we find that the average marginal impact of cultural distance on the likelihood of conflict relative to the average probability of conflict is in the range of 10% to 129%.

Measuring cultural distance

To effectively capture cross-cultural variations between states, we employ five different indexes along linguistic and cultural distances. First, to capture the linguistic distance between two countries, we use the language barrier index (Lohmann, 2011). It ranges between 0 and 1 where 0 means no language barrier, i.e. the two languages are basically identical, and 1 means that the two languages have no features in common (e.g., Tonga-Bangladesh). Since more than one language is spoken in some countries, we employ two alternative indexes: the basic language barrier, which uses the main official languages, and the international language barrier, which uses the most widely spoken world languages.

Second, we adopt Kogut and Singh’s (1988) standardized measure of cultural differences, as well as an improved version provided by Kandogan (2012). Although the degree of cultural differences is notably difficult to conceptualize, Kogut and Singh (1988) offer a simple and standardized measure of cultural distance, which is based on Hofstede’s (1980) dimensions of national culture. In particular, Kogut & Singh (1988) develop a measure of “cultural distance” (CD) as a composite index based on the deviation from each of Hofstede’s (1980) four national culture scales: power distance, uncertainty avoidance, masculinity/femininity, and individualism.

These dimensions of culture are rooted in people’s values, where values are “broad preferences for one state of affairs over others […]; they are opinions on how things are and they also affect our behavior” (Hofstede, 1985). As such, by explicitly taking into account the values held by the majority of the population in each of the surveyed countries, these dimensions can effectively capture differences in countries’ norms, perceptions, and ways to deal with conflicting situations. Higher cultural distance pertains to higher divergence in opinions, norms, or values.

Third, to cross-validate our empirical findings on cultural distance and to duly take into account societal dynamics and changes in the composition of societies, we use another popular quantitative measure of cultural distance based on The World Values Surveys (WVS). From 1998 to 2006, we use the composite value of two dimensions of values, traditional vs. secular-rational values and survival vs. self-expression values, which account for more than 70% of the cross- cultural variance (Inglehart and Welzel, 2005). The traditional vs. secular-rational values dimension captures the difference between societies in which religion is very important or not. The second dimension is linked to the transition from industrial society to post-industrial societies. Societies near the self-expression pole tend to prioritize wellbeing and the quality of life issues, such as women’s emancipation and equal status for racial and sexual minorities, over economic and physical security. Broadly speaking, members of the societies in which individuals focus more on survival find foreigners and outsiders, ethnic diversity, and cultural change to be threatening.

Impact of culture on militarized interstate dispute

We estimate the benchmark model of Martin et al. (2008), which uses a large data set of military conflicts in 1950-2000. We choose this model over other alternatives as it possibly has the most exhaustive list of controls that can potentially affect the probability of militarized interstate disputes (MIDs). We assess the impact of our cultural distance measures on conflict. All five measures of cultural distance have a positive effect on conflict involvement. In other words, culturally more distant states fight more on average. In column (i) of Table 1, we see that Language Barrier positively affects conflict, although insignificant. When we take into account International Language Barrier in column (ii), however, it has a positive and significant effect on conflict involvement. This should not come as a surprise as the part of the culture of a country that is reflected in a language should be more related to the spoken languages rather than the official ones.

To assess the magnitude of the effects, we calculate for each model the standardized marginal effect as the average marginal effect of a cultural distance variable on the probability of conflict relative to the average probability of conflict, which is about 0.0066. This effect is sizeable for International Language Barrier and is around 65%. When we use the Cultural Distance (Kogut) measure, instead, the results are qualitatively similar. The standardized marginal effect, however, is reduced and is now about 14%. The standardized marginal effect of Cultural Distance (Kandogan) on conflict probability is similar at 11. The effect of Cultural Distance (WVS) is also positive and significant. However, the large standardized marginal effect should be interpreted with caution, as the number of countries that are in the WVS is limited due to data availability. All the results from our cultural distance measures considered together, evidence suggests that cultural distance increases the likelihood of interstate militarized conflict.

Table 1. Cultural distance and International conflict

Slide1Additionally, in Figure 1, holding all other variables constant, we see a 25% and 19% increase in the odds of conflict for a one-unit increase in Cultural Distance (Kogut) and Cultural Distance (Kandogan) variables, respectively; while the same increase in Language Barrier raises the odds of conflict by 52%.

Figure 1. Odds ratio of coefficients in Table 1

Figure1Note: Cultural distance (WVS) is scaled down by 100 for the sake of readability.

Discussion and conclusion

Samuel Huntington’s thesis on the “Clash of Civilizations” is one of the most fascinating and debated issues in the field of international relations, and has sparked a long-lasting debate about its validity among academics, practitioners and policy-makers. The scholarly literature on international studies has long grappled with how to define, characterize, and analyze his thesis. Although some of the seminal works provided little support to Huntington’s thesis, later studies seemed to partially confirm it. While most of these studies use Huntington’s measure of the concept of civilizations, his classification was tentative, imprecise and difficult to operationalize. Moreover, previous studies rely on a “dichotomization” of civilizations, which is a continuous concept, and treat it as an immutable object, while it is certainly subject to variation over time.

Political events in recent years, such as the NATO-Russia confrontation over Ukraine, Russia’s attempts to resurrect its cultural and political dominance in the former Soviet sphere, the unprecedented rise of Islamic extremism in the Middle East, the foundation of an organization like ISIS with a declared aim to build a Muslim caliphate and wage war on Western civilization, or the rise of independence and anti-EU movements in Europe, have been attributed by many political observers to cultural clashes. We argue that whether and how identity impacts the likelihood of MID hinges crucially on the definition and operationalization of “civilizations” or cultural similarity.

We therefore introduce a number of ad-hoc measures of cultural distance in the benchmark empirical models on the likelihood of MIDs. Regardless of how we deal with the definition of cultural distance, the empirical evidence points consistently towards the importance of cultural distance in explaining the odds of interstate conflict. Although the extent of evidence for an effect of cultural distance on conflict clearly depends on model specification and data considerations, in particular the size of the effect, our results suggest that conflict is more likely between culturally distant countries.

Our study highlights the importance of the awareness of the impact of culture in international relations. Culture can be an important determinant of foreign policy as pronounced differences in social norms and behaviors of collective groups might create frictions between states and shape the way they interact. Thus, educating people in cross-cultural sensitivity should be a policy priority. That is to say that the knowledge and acceptance of other cultures are important to avoid tensions and potential conflicts.

References

  • Huntington, Samuel P. 1993. “The clash of civilizations? Foreign affairs”, 22–49.
  • Huntington, Samuel P. 1996. “The clash of civilizations and the remaking of world order”. Penguin Books India.
  • Inglehart, Ronald, & Welzel, Christian. 2005. “Modernization, cultural change, and democracy: The human development sequence.” Cambridge University Press.
  • Kandogan, Yener. 2012. “An improvement to Kogut and Singh measure of cultural distance considering the relationship among different dimensions of culture.” Research in International Business and Finance, 26(2), 196–203.
  • Kogut, Bruce, & Singh, Harbir. 1988. “The Effect of National Culture on the Choice of Entry Mode.” Journal of International Business Studies, 19(3), 411– 432.
  • Lohmann, Johannes. 2011. “Do language barriers affect trade?” Economics Letters, 110(2), 159–162.
  • Martin, Philippe, Mayer, Thierry, & Thoenig, Mathias. 2008. “Make trade not war?” The Review of Economic Studies, 75(3), 865–900.

Time to Worry about Illiquidity

Posted on May 16, 2016 | Policy Brief

At a time when central banks have injected unprecedented amounts of money, worrying about illiquidity may appear odd. However, if poorly understood and unaddressed, illiquidity could be the foundation of the next financial crisis. Market liquidity is defined as the ease of trading a financial security quickly, efficiently and in reasonable volume without affecting market prices. While researchers find that it has been positively correlated with central bank’s liquidity injection, it may no longer be the case. The combination of tightly regulated banks, loosely regulated asset managers, and zero (or negative) policy rates could prove toxic.

One recent volatile day on the markets, an investor called her bank manager asking to convert a reasonably small amount of foreign currency. The sales person was quick to respond: “I will hang up now and we will pretend this call never happened”. In other words, the bank was not ready to quote her any price. The typical academic measures of market liquidity, such as bid-offer spreads, remained tranquil on Bloomberg, there was no transactions taking place.

When the investor was finally forced to exchange, the result was messy: currency price gapped—fell discontinuously—causing alarm among other market participants and policymakers. All that due to a transaction of roughly $500,000 in one of the top emerging market currencies in the world according to the BIS Triennial Central Bank Survey at an inopportune moment.

Markets becoming less liquid

Post crisis, G-7 central banks have embarked on unconventional monetary policy measures to boost liquidity and ease monetary policy at the zero-lower-bound, while tightening bank regulation and supervision. On net, however, the ability to transact in key financial assets in adequate volumes without affecting the price has fallen across a range of markets, including the foreign exchange markets that are traditionally assumed to be the most liquid compared to bonds, other fixed income instruments and equities.

Financial market participants have reported a worsening of liquidity, particularly during periods of stress. Event studies include the 2013 “taper tantrum” episode, where emerging markets’ financial assets experienced substantial volatility and liquidity gapping that did not appear justified by the Fed’s signal to reduce marginally its degree of monetary policy accommodation, as well as the recent shocks to the US Treasury market (October 2014) and Bunds (early 2015).

Banks are retreating

Market-makers (international “sell-side” or investment banks as in the introducing example), which used to play the role of intermediators among buyers and sellers of financial assets, are now increasingly limiting their activities to a few selected liquid assets, priority geographies and clients, thus leading to a fragmentation of liquidity. Market-makers have also been reducing asset holdings on their balance sheets in a drive to reduce risk-weighted-assets, improve capital adequacy and curb proprietary trading. As a result, they are less willing to transact in adequate volumes with clients.

In the past, leverage by banks has been associated with higher provision of market liquidity. Loose regulation and expansionary monetary policy has been conducive to higher leverage by banks pre-2008. It is therefore puzzling that, now, at the time of unconventionally large monetary expansions by central banks, sell-side banks are unwilling to provide market liquidity. The answer may lay in tighter bank capital and liquidity regulation as more stringent definitions of market manipulation. Risk aversion by banks has also become harsher, a trader stands to lose a job and little to gain on a $2 million swing in her daily profit and loss, while in the past a swing of $20 million at a same bank would have hardly warranted a telling-off. Banks have become safer, but can that also be said about the financial system?

Asset managers growing in importance

Ultra-accommodative and unconventional monetary policies have compressed interest rates across all maturities. In a world where US Treasuries at two-year maturity do not even yield 1%, and Bunds are yielding negative rates even beyond 5 years, investors in search for yield are looking at longer (and less liquid) maturities and riskier assets. If banks are unable to meet this demand, others will: assets under management (AUM) by non-bank financial institutions, specifically real asset managers have expanded dramatically in recent years. Total size of top 400 asset managers’ AUM was EUR50 trillion in 2015, compared to EUR35 trillion in 2011 according to IPE research, with the largest individual asset manager in excess of EUR4 trillion. A fundamental problem arises when such asset managers are lightly regulated and very often have similar investment strategies and portfolios.

In the industry jargon, these asset managers are called long-only or real-money. Why the funny names? Long-only means they cannot short financial assets, as opposed to hedge funds. For every $100 collected from a range of individual investors’ savings via mutual funds, pension and insurance fund contributions, a small share (say 5%) is set aside as a liquidity buffer and the rest is invested in risky assets. Real money refers to the fact that these managers should not be levered. However, that is true only in principle as leverage is related to volatility.

Performance of real-money asset managers is assessed against benchmark portfolios. For emerging markets, the portfolio would typically be a selection of government bonds according a range of criteria, including size of outstanding debt, ease of access by international investors, liquidity, and standardization of bond contracts. Investors more often than not do not hedge foreign currency exposure. The benchmark for emerging markets sovereigns could have 10% allocated to Brazil, 10% to Malaysia, 10% to Poland and 5% to Russia, for example. India, on the contrary, would be excluded, as it does not allow foreign investors easy access to government bonds.

Benchmarks and illiquidity dull investor acumen

Widespread use of benchmarks among institutional asset managers can steer the whole market to position in “one-way” or herding, contributing to illiquidity and moral hazard risks. Benchmarks by construction reward profligate countries with large and high-yielding stocks of government debt.

While each individual portfolio manager may recognize the riskiness of highly-indebted sovereigns, benchmarking makes optimal to hold debt by Venezuela, Ukraine or Brazil as each year of missed performance (before default) is a risk of being fired, while if the whole industry is caught performing poorly, it is likely that the benchmark is down by as much.

Furthermore, real-money asset managers have become disproportionally large relatively to the capacity of sell-side banks (brokers) to provide trading liquidity. In fact some positions have de-facto become too large-to-trade. Even a medium-sized asset manager of no more than $200bn under management (industry leaders have $2-$4 trillion AUM) that attempts to reduce holdings of Ukraine, Venezuela or Brazil at the signs of trouble, is likely to trigger a disproportionate move in the asset price. This further reduces incentives to diligently assess each individual investment. In such environment, risk management has become highly complex, stop losses may no longer be as effective, while more stringent cash ratios would put an individual asset manager at a disadvantage to others.

Conclusion

Anecdotal and survey-based measures from the market demonstrate that liquidity is scarcer and less resilient during risk-off episodes. While regulation has made banks stronger, it may have rendered the financial system less stable. Lightly regulated real asset managers are increasing assets under management, are often positioned “one-way” and are becoming too-large-to-trade.

Nonetheless, systemic risk stemming from illiquidity in the new structure of the market remains little researched and poorly understood by policymakers and academics. Most models of the monetary transmission mechanism and exchange rate management do not incorporate complexities of market liquidity.

While regulatory changes have been largely driven by policy makers in the developed markets (naturally since they were at the epicenter of the global financial crisis), it is the emerging markets that in my view are most at risk. They tend to have less developed and less liquid domestic financial markets, and be even more prone to liquidity gaps with higher risks of negative financial sector-real economy feedback loops.

References

  • Sahay, R., et.al., “Emerging Market Volatility: Lessons from the Taper Tantrum”, IMF SDN/14/09, 2014 http://www.imf.org/external/pubs/ft/sdn/2014/sdn1409.pdf
  • Shek, J., Shim, I. and Hyun Song Shin, (2015), “Investor redemptions and fund manager sales of emerging market bonds: how are they related?” BIS Working Paper No. 509, http://www.bis.org/publ/work509.pdf
  • “Market-making and proprietary trading: industry trends, drivers and policy implications”, Committee on the Global Financial System, CGFS Papers, no 52, November 2014. www.bis.org/publ/cgfs52.pdf
  • “Fixed income market liquidity”, Committee on the Global Financial System, CGFS Papers, no 55, January 2016. www.bis.org/publ/cgfs55.pdf
  • Hyun Song Shin, “Perspectives 2016: Liquidity Policy and Practice” Conference, AQR Asset Management Institute, London Business School, 27 April, 2016. https://www.bis.org/speeches/sp160506.htm
  • Fender, I. and Lewrick, U. “Shifting tides – market liquidity and market making in fixed income instruments”, BIS Quarterly Review, March 2015. www.bis.org/publ/qtrpdf/r_qt1503i.htm
  • Tobias Adrian, Michael Fleming, and Ernst Schaumburg, “Introduction to a Series on Market Liquidity”, Liberty Street Economics, Federal Reserve Bank of New York, August, 2015.

Global Inequality – What Do We Mean and What Do We Know?

Posted on April 24, 2016 | Policy Brief

A black and white image of man begging for help in a dark tunnel representing global inequality

Concerns about global economic inequality have become central in today’s policy debate. This brief summarizes what is known about the development of inequality globally, emphasizing the difference between the developments within countries and between countries. In the former sense, inequality has risen in most countries in the world since the 1980s, but in the latter sense inequality, has (most probably) dropped. To ensure future progress in terms of continued decreasing global inequality, fighting increasing inequality within countries is likely to be central.

In recent years, the distribution of income and wealth has emerged as one of the most widely discussed issues in societies everywhere. US President Barack Obama has called rising income inequality the “defining challenge of our time”, the topic has been on the agenda at meetings of the World Economic Forum in Davos, and studies by the IMF and the OECD (e.g., OECD, 2014, and IMF, 2014) have associated income inequality with lower economic growth. Thomas Piketty’s best-selling book “Capital in the Twenty-First Century” (2014) has placed the topic center-stage well outside academic and expert circles. At the same time, some have argued that all the talk about increasing inequality is in fact wrong and that it misses what they perceive as the more important story, namely, the decreasing global inequality. So, which is it, and what conclusions can be drawn?

Different Ways of Viewing the Facts About Global Inequality

When people talk about global income inequality there are a number of things that could be referred to. First, one might think of the inequality within countries across the world. From this perspective, the question in need of an answer would be: “How has inequality within individual countries changed globally in recent decades?” The short answer is that it has increased in most places. This is certainly the case in most of the developed world since the 1980s, while in emerging markets and developing countries (EMDCs) there are greater differences across time and regions. Looking at disposable incomes at the household level (the most commonly used measure in international comparisons) most countries in Asia and Eastern Europe have seen marked increases of inequality, while the trend seems to have been the opposite in Latin America and in large parts of Africa. In level terms, the development has been one of convergence since, on average, the countries in Eastern Europe and Asia started at much lower levels than those in Latin America and Africa. The development has resulted in that inequality levels are today on average at similar levels, with a Gini coefficient of between 0.4 and 0.45, in Africa, Asia, and Latin America (see figure 1 below and IMF, 2015) The same is true for the average across OECD countries where inequality has increased the most in percentage terms in countries starting at low levels, with the US being an exception in that inequality has increased even though the level has always been at the higher end among developed economies (e.g., OECD, 2015). The European average is today around 0.3 while the household disposable income Gini in the US is just below 0.4.

Figure 1. Change in the net Gini Index, 1990-2012

JR_fig1

Source: IMF, 2015.

Looking at other income inequality measures, such as top income shares, the picture is similar: inequality has increased in most countries for which we have data since the 1980s. While it is important to recognize that top income shares are a very different measure of inequality, it has been shown that there is a close relationship between top income shares and the Gini coefficient in terms of capturing both level differences across countries and trends in the development (e.g., Leigh, 2007 and Morelli, Smeeding and Thompson, 2015). This together with one of the main strengths of the top income measure, namely, the length of the time series, allows us to put the recent developments in a historical perspective.

Figure 2 shows the income share of the top decile group for a number of mainly developed countries over the 20th century, illustrating the surprisingly common trends over the past 100 years (but also important level differences). On average, top shares (driven mainly by what happened in the top 1 percent) dropped from the beginning of the century until about 1980 after which it has risen in a fanning-out fashion. The point of the figure is clearly not to illustrate any individual country but rather to illustrate the overall long-run trend. For details of the historical development of income as well as wealth distribution, see Roine and Waldenström (2015).

Figure 2. Top 10 percent income share over the 20th century

JR_fig2Source: World top income database (WTID).

While the overall picture of rising inequality in most countries over the past decades is pretty clear, the development between countries is less so. There are two main reasons for this. First, it depends on what is considered the unit of observation and how these units are weighted. Second, it depends on what one assumes about the vast gaps in data availability, in particular in EMDCs (see e.g., Lakner and Milanovic, 2013, for more details).

As explained by for example Milanovic (2012) there are essentially three different ways in which one might think about the global distribution of income: 1) Treat every country as one observation and use a country’s GDP per capita as the measure of income; 2) do the same as in 1) but give different weight to each country according to its population; 3) Treat individuals (or households) as the unit of observation regardless of where people live. In all three cases it is possible to line up all observations from the poorest to the richest (and, hence, also to calculate a Gini coefficient). In the first way of looking at the world, we treat everyone in each country as being represented by the country’s average income and we also give the same weight to Luxemburg and India. In the second case, we recognize that more people live in India and weight it accordingly but we still, by construction, force everyone in each country to have the country average, thus ignoring within country inequality. Only in the last approach do we actually take into account both relative population size and differences in development within countries. This clearly seems the most satisfactory way to look at what has happened, but it is also the most demanding in terms of data.

In terms of the first two approaches, inequality in the world has fallen in the past decades. This is especially clear when weighting countries by population size. Rapid growth in China and India has caused average incomes in the world’s most populous and initially poor countries to increase faster than the global average, implying a reduction in global inequality. Some may think that this is not surprising and only to be expected since these countries start at such low levels, but in fact, this development marks the reversal of a 200-year trend toward increasing global inequality. Even “catch-up growth” is certainly not to be taken for granted.

Now the real question is this: What has happened to the global income distribution if we take into account the recent increasing inequality within many countries, including China and India? The answer turns out to complicated and uncertain (see Lakner and Milanovic, 2013 for details) but in the end most of the evidence points to decreasing global inequality in this sense too. As François Bourguignon puts it in a recent article in the Foreign Affairs: “…the increase in national inequality has been too small to cancel out the decline in inequality among countries” (Bourguignon, 2016, p. 14).

To understand both of these counteracting forces it is illustrative to look at real income growth across the global income distribution. Figure 3 below is taken from a presentation by Branko Milanovic, organized by SITE in 2014 (and available online here). It shows the real income growth for different percentile groups in the global distribution over the period 1988-2008. Moving from left to right the figure shows positive but modest growth for the very poorest individuals in the world, and much higher growth for the groups just above, with rates increasing toward the middle of the global distribution. In the range of about 5 dollars/day (in PPP adjusted terms) growth has been the highest. By developed-country standards, these people are still very poor, but globally they are truly the “middle class” in the sense that they make up the middle of the global income distribution. Moving further right we see a sharp drop in real income growth at a level around the 80th percentile. This part of the distribution is mainly populated by the lower middle classes of the developed world, and here income growth has been essentially zero over the past decades. Moving further right we again see a sharp increase in real income growth illustrating the large gains going to individuals in the top of the global income distribution.

Figure 3 summarizes much of what has happened: the left part showing the rapid growth of income among most of the world’s relatively poor, while the right shows the increasing inequality in the developed world, with the top of the distribution gaining the most.

Figure 3. Real income growth at various percentiles of the global income distribution, 1988-2008 (in 2005 PPPs).

JR_fig3

Source: Lakner and Milanovic (2013).

Why This Matters and What Should Be Done About Global Inequality?

The forces that explain what has happened are of course complex and differ over time and across countries but one thing seems clear, the growth of real incomes in developing countries as well as the relative decline of incomes in the lower end of the income distribution in developed countries have at least in parts been shaped by the same intertwined processes of globalization and technological development. Overall, these processes are powerful positive developments, but at the same time it is easy to see how those who perceive themselves as losers in these developments may try to resist them using their political voice. It is important to remember that globalization is the result of a combination of technology and political decisions, and consequently not an inevitable process. After all, the globalization backlash in the period 1914-1945 did not happen because the technological feasibility of the process suddenly disappeared.

The appropriate government responses are of course also likely to be different across countries, but here there are also some common factors that stand out. In the developing world, the most challenging aspects will have to do with maintaining state capacity and the ability to tax increasingly mobile tax bases. In many developing countries taxation will also be key, but here the challenge is more about creating a capable and accountable state in the first place. As succinctly and, I think, correctly put by Nancy Birdsall in a review of Thomas Piketty’s “Capital in the Twenty-First Century”: “(I)n the developing world, the challenge is not, at least not yet, the one Piketty outlines — that an inherent tendency of capitalism is to generate dangerous inequality that if left unchecked will undermine the democratic social state itself. The challenge is the other way around: to build a capable state in the first place, on the foundation of effective institutions that are democratically accountable to their citizens.”

References

  • Atkinson, Anthony B. 2015. “Inequality – What can be done?” Harvard University Press.
  • Birdsall, Nancy. 2014. “Thomas Piketty‘s Capital and the developing world”
  • Ethics & International Affairs / Volume 28 / Issue 04 / Winter 2014, pp 523-538.
  • Bourguignon, François, and Christian Morrison. 2002. “Inequality among World Citizens: 1820-1992”, The American Economic Review, Vol. 92, No. 4. (Sep., 2002), pp. 727-744.
  • Bourguignon, François. 2016. “Inequality and Globalization. How the rich get richer as the poor catch up”, Foreign Affairs, Volume 95, Number 1, pp. 11-16
  • Lakner, Christoph, and Branko Milanovic. 2013. “Global Income Distribution: From the Fall of the Berlin Wall to the Great Recession.” WB Policy Research Working Paper 6719, World Bank, Washington.
  • Leigh, Andrew. 2007. “How closely do top income shares track other measures of inequality?”, The Economic Journal, 117 (November), 589–603.
  • OECD (2015), “Growth and income inequality: trends and policy implications”, OECD Economics Department Policy Notes, No. 26 April 2015.
  • OECD. 2011. Divided We Stand: Why Inequality Keeps Rising. Paris: OECD Publishing.
  • OECD. 2012. “Reducing Income Inequality While Boosting Economic Growth: Can It Be Done?” In Economic Policy Reforms: Going for Growth. Paris: OECD Publishing.
  • Ostry, Jonathan David, Andrew Berg, and Charalambos G. Tsangarides. 2014. “Redistribution, Inequality, and Growth”, IMF SDN, February 17, 2014
  • Milanovic, B. 2013. “Global Income Inequality by the Numbers: in History and Now.” Global Policy 4 (2): 198–208.
  • Morelli, Salvatore, Smeeding, Timothy, and Jeffrey Thompson. 2015. “Post-1970 Trends in Within-Country Inequality and Poverty: Rich and Middle Income Countries”, Chapter in Atkinson, A.B., Bourguignon, F. (Eds.), Handbook of Income Distribution, vol. 2A, North-Holland, Amsterdam.
  • Piketty, Thomas. 2014. “Capital in the Twenty-first Century”. Cambridge, Massachusetts: Harvard University Press.
  • Pritchett, Lant. “Divergence, Big Time.” Journal of Economic Perspectives, Summer 1997, 11(3), pp. 3-17.
  • Roine, Jesper, and Daniel Waldenström. 2015. “Long-Run Trends in the Distribution of Income and Wealth”, Chapter in Atkinson, A.B., Bourguignon, F. (Eds.), Handbook of Income Distribution, vol. 2A, North-Holland, Amsterdam.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.