Entrepreneur Chris Cook works with the Nordic Enterprise Trust
Chris Cook, Nordic Enterprise Trust, UK
There seems to be something wrong with our bloody ships today”. So said Admiral Beatty almost a century ago at the Battle of Jutland, as thousands of his men died due to defective warship design. This combination of perplexity and insouciance perfectly illustrates the way in which the modern day captains of the financial industry observe the continuing destruction of the economy while their financial dreadnoughts steam for a safe harbour.
The foundations of our financial system are the ‘twin peaks’ of equity and debt. So ingrained is this foundational assumption that we simply cannot conceive that there might be any other legal and financial structure or ‘enterprise model’ for financing our economy. In fact, new alternatives are emerging which use partnership-based frameworks, and these are capable of revolutionising the financing of energy infrastructure and thereby the transition from a carbon-based economy.
Equity consists of shares in the Victorian vintage legal person, or corporate body, known as a Joint Stock Limited Liability Company. These shares have a par value, typically a pound sterling, and confer rights of ownership and control over productive assets. I refer to equity finance which comprises ownership of productive assets as ‘asset-based’ finance. The company enterprise model is entrenched in our language, to the extent that ownership by an individual or a company is what actually makes the private sector ‘private’ and distinct from public sector ownership by the state.
Debt, on the other hand which consists of interest-bearing credit created by credit institutions known as banks I refer to as ‘deficit-based’. This credit, which is supported by an amount of capital specified by banking regulators, is actually the money we use. It comes into existence when banks create interest-bearing loans and instantaneously create matching deposits in the system.
The problem is that too much credit has been created unwisely, thereby inflating the property bubble and banks’ capital is now being eroded by losses on these property loans. This has resulted in the current credit crunch and restricts banks’ ability to provide urgently needed new credit, particularly to the energy sector.
While the financial world has been focused upon innovations in bank credit/debt, a wave of innovation in the world of equity has been quietly taking place under the radar using legal structures that are based not upon Company Law, but upon Trust and Partnership Law. First in Australia, and then in Canada, corporations listed on stock exchanges placed part of their gross revenues into trusts which were then divided into units. When these units were marketed to long-term investors, particularly pension funds, they found an enthusiastic reception.
The reason? Risk-averse investors such as pension funds correctly perceived that these streams of gross income were much more certain than dividends from conventional shares that are distributed if at all out of companies’ net profits after overheads, such as management costs, have been deducted. Such Income Trusts and Royalty Trusts were hugely popular, but were rapidly throttled by the Australian and Canadian Treasuries for tax reasons.
However, other innovations in asset-based finance have been more permanent. Real Estate Investment Trusts (REITs) distribute virtually all of their income, and allow investors to invest directly in property simply and effectively. As a result they too have become hugely popular, particularly in Hong Kong and the US.
Finally, Exchange Traded Funds (ETFs) have begun to invest directly in all manner of assets, and tens of billions of dollars have flowed into ETFs invested in gold and commodities (known as ETCs). However, the introduction in the UK in 2001 of a new legal form the Limited Liability Partnership (LLP), now also introduced in the island of Jersey, Dubai, Qatar, Japan, and India – has created new possibilities.
Confusingly, despite its name, a UK LLP is not even technically a partnership. It is instead a corporate body that is to say it has a continuing legal existence independent of its ‘members’ and also confers limited liability on its members.
An LLP is the simplest and most flexible legal form in existence, because the LLP agreement between members is infinitely flexible, and need not even be in writing in which case certain default provisions based upon the law of partnership apply. The use of the LLP is increasing almost exponentially, and almost 48 000 have been incorporated in the UK but, since there is no reporting requirement, they are rather opaque and detailed information is scarce.
LLPs are emerging as a framework for a capital partnership, or co-ownership of productive assets by investors and users of the investment
LLPs are certainly in routine use in the private sector for joint ventures, such as First Hydro LLP, a pumped storage UK hydroelectricity project between International Power Plc and Mitsui & Company Limited. Moreover, they are also now being routinely used in the public sector as well, so we see the Scottish city of Glasgow has four joint ventures with private sector service providers: a simple new form of public/private partnerships.
Most importantly, however, has been the emergence of LLPs as a framework for a ‘Capital Partnership’ or co-ownership of productive assets by investors and the users of the investment.
Perhaps the first example of this was an LLP framework which was used in the UK to enable the Hilton Group’s gross revenues from ten hotels to be shared proportionally between the Hilton Group (as ‘capital user’) and a ‘capital partner’ consortium consisting of a bank, a property developer and a hotel specialist. In a good year, the capital partners (who invested money, and ‘money’s worth’ of expertise, respectively) had a good year: in a bad year, they have a bad one as well.
The Capital Partnership is not an organization it does not own anything, do anything, employ anyone or contract with anyone. It is simply a framework within which the stakeholders self organize to achieve a common purpose, which may be the production of renewable energy megawatts, or indeed even energy savings, or ‘negawatts’.
By using such a framework, production, revenues from the sale of production, or even savings, may be ‘equitized’ in two complementary ways.
(1) Equity Shares non-redeemable, since there must always be 100 per cent proportional shares (e.g. millionths) in streams of production or revenues; and
(2) Units redeemable against units of production e.g. kWh, barrels of oil, or even the right to occupy land for a period of time.
Energy units – the investment proposition
Whether or not everyone yet buys in to the ‘peak oil’ theory that the level of production of crude oil may actually have peaked, it will be difficult to find many people who actually think that energy is going to get cheaper relative to money generally, and the dollar in particular.
That is the reason why China, for instance, prefers massive purchases of crude oil and other resources to further purchases of US financial assets. It is also the reason for the huge success of ‘Exchange Traded Funds’ which invest directly in energy markets through the purchase of futures contracts and other financial instruments.
The purchaser from an ‘Energy Pool’ of a unit redeemable in (say) ten kWh of electricity has a choice. Firstly, he may sell the unit to someone else for money, or even for ‘money’s worth’ of goods and services. Secondly, he may choose to redeem the unit against the supply of electricity to him through the pool.
The advantage for an investor compared to units in a conventional fund is that the price of units will always be related to the actual physical market price of electricity, which is determined by the continuous matching of supply and demand. This is because if the price of units falls below the price of electricity actually consumed then consumers will buy units and pay for electricity with them in preference to conventional money. Therefore consumers may actually lock in their electricity price through using units to ‘buy forward’.
The proposition of units for producers is equally simple. They are selling their production forward to investors, locking in a price, and receiving value now as an interest-free loan. Their obligation in return is to accept units from customers as and when presented in payment for electricity supplied. This means, of course, that if energy prices rise in future, then they are giving up the increase in value of this production.
Moreover, insofar as a producer has costs, then selling production forward may be risky if their costs rise and their income from sales is limited. It makes sense, therefore, for producers to enter into ‘Equity Share’ arrangements with suppliers. So a gas fired station could agree with a supplier partner that a proportional share of electricity production would be allocated to them in exchange for their gas.
Fuel cost is not an issue for a wind turbine of course, because fuel costs are zero, and the only requirement would be the sort of operating partnership arrangement such as that offered by Enercon where an equity share in electricity production is agreed in exchange for operation and maintenance.
Municipal Energy Pool
Nordic Enterprise Trust proposes the use of a partnership framework to create a ‘Municipal Energy Pool’ as follows, beginning with a couple of wind turbines in public ownership, but privately developed and operated.
The manager acts as developer, without putting any financial capital at risk, and has an interest in ensuring timely completion to high standards of quality because he has a stake in the outcome. Likewise, the contractors also have ‘skin in the game’, and the attraction for the council is that they too participate in the development gains.
The Municipal Energy Partnership framework may be used as a simple variation from an Energy Services Company (ESCO) to ‘pool’ all municipal energy projects. In addition to investment in renewable energy, it is also possible for investment to be made in energy saving projects, such as retrofitting combined heat and power, through making ‘energy loans’.
Interest-free loans are made by the Energy Pool to households in respect of investment either in their property or in a community of properties in which they are a member. These loans are made in sterling but denominated in energy e.g. a loan of 5 MWh.
The energy loan is made to the property and not the owner, and repayments are made through the repurchase of units from the Energy Pool at the market price of energy. So by way of example, a loan of £5000 ($8245) may give rise to an energy loan of 100 MWh at £50 per MWh/Btu equivalent.
This energy loan is then repaid through the purchase from the Energy Pool of units at the prevailing market price. These repayments, which are funded by the reductions in energy use arising from the investment, may be billed/collected by a utility as a form of ‘Hot Water Rate’.
Funding the Supergrid – a North Sea Energy Pool
Nordic Enterprise Trust recently proposed at the All Energy Show in Aberdeen the creation of a North Sea Master Partnership as a framework for investment in offshore wind and other energy production, and for the proposed North Sea HVDC Supergrid infrastructure.
Few will be aware of it but the transfer of interests in North Sea oil and gas fields already takes place within a legal framework known as the MasterDeed. This framework to which all North Sea oil and gas participants are signatories is based upon UK Trust Law. While this mechanism remains somewhat archaic, complex and cumbersome, it vastly improves the legal disaster zone which preceded it.
Nordic Enterprise Trust’s Master Partnership concept extends this legal framework to include all of the stakeholders, and in particular to include direct investors in energy production. Proportional equity shares and redeemable units created in accordance with these enterprise agreements will be recorded in suitable transaction and title registries nominally held by the custodian. Accounting of transfers of units and currency would be administered by a suitable operator financial service provider.
The investment necessary to create the Supergrid’s proposed 10 GW of production, HVDC connections and associated infrastructure is estimated to be of the order of £25 billion. The extent of risk capital necessary for development credit depends upon the rapidity of implementation by the developer/operator partners.
As wind energy production comes on stream, the pool of actual, rather than potential, production thereby created is sold to risk-averse, long-term investors thereby releasing the development credit.
It is estimated that the sale in this way of between 30-40 per cent of the pool of future production of the turbines will repay their development cost. The outcome is that the pool will rapidly propagate because the production of two turbines finances four, which in turn finances eight, and so on.
The point is that provided investors in future production can be found and literally tens of billions of dollars are currently invested in energy funds this model allows the exchange for value now of units which will cost nothing to redeem in the future. Therefore, free North Sea energy is effectively being monetized. When complete, the North Sea Energy Pool will provide a flow of renewable energy, which will be shared between the public sector as an energy dividend, and a service provider which operates this utility infrastructure.
Reversing the Polarity
In order to make the transition from non-renewable carbon-based energy to renewable energy we are relying upon two deficit-based financial mechanisms to fund the trillions of pounds/dollars/euros of investment necessary. Firstly, the system of interest-bearing credit created by private banks is unlikely due to a shortage of capital to be in a position to provide the necessary finance within the next ten years, if ever.
Secondly, the likelihood of success of the proposed financing system of emissions trading and carbon credits is perhaps best summed up by a quote from a recent traders’ conference: “If you want to keep a donkey healthy, you don’t regulate what comes out of it: you regulate what goes in”. In other words, it makes more sense to monetise the intrinsic energy value of carbon, rather than attempting to monetise, by government fiat, intrinsically worthless carbon dioxide.
The creation of a new asset class of units redeemable in energy may enable an evolution of both of these dysfunctional deficit-based financing mechanisms in a simple but elegant process of transition to an asset-based system. For instance, perhaps the most straightforward way of releasing development credit is simply to refinance existing debt relating to, or secured against, existing North Sea production and infrastructure.
Energy market participants are dis-intermediated within a partnership framework because energy investors are connected directly or ‘peer to peer’ to energy investments. There will be a transition from intermediaries competing to maximize transaction profits to a role as service providers collaborating to maximize the shared creation of energy production. The beauty of this for the intermediaries is that they no longer have to put any more capital at risk beyond the minimal amount of working capital needed to cover operating costs.
So maybe, a 100 years on from the Battle of Jutland, the North Sea might see a new fleet: and perhaps this time we will get the design right?
Chris Cook is a former market regulator, latterly as a director of the International Petroleum Exchange, and an entrepreneur, market commentator and consultant in the area where internet and markets converge. In recent years he has been working with the Nordic Enterprise Trust to develop new partnership frameworks for peer to peer investment and credit.
The Nordic Enterprise Trust’s Municipal Energy Pool:
- Custodian turbines remain in public stewardship, either directly or via a community interest company.
- Council invests value of land, and/or permissions and receives a proportional equity share in the production of the completed turbines, plus Renewable Obligation Certificates, carbon reduction commitments, etc.
- Contractor may invest costs, but must invest profit margin in return for redeemable units.
- Financial invests funds necessary to cover costs, in return for redeemable units.
- Manager receives a proportional equity share in the revenues from the sale of production.
The North Sea Master Partnership:
- Custodian the legal form and jurisdiction would require careful consideration, but a trustee under an amended MasterDeed agreement is a possibility.
- Nations each North Sea nation would transfer all national rights to North Sea energy production to the custodian, retaining certain veto rights of governance.
- Investors and Operators would share with nations the North Sea Energy Pool of production within the overall Master Partnership framework through a network of project-specific sub-partnerships as recorded in enterprise agreements.