Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 23 - Marrying the Devil in Texas

Chapter 1. Introduction: Goldman Sachs Discussion and Class Agenda [00:00:00]

Professor Douglas W. Rae: Okay let’s get started. It occurred to me over the break that Goldman Sachs gets some bad press. Is there — has anybody read the piece in Rolling Stone? Okay can — these — where are the hand microphones? Do we have the hand microphones?

Student: Yeah, Matt Taibi of Rolling Stone called Goldman Sachs a — I might get this quote wrong, but it’s something along the lines of “A great vampire squid relentlessly jamming its blood funnel into anything that smells like money.”

Professor Douglas W. Rae: I think that’s an exact quote.

Student: Yeah.

Professor Douglas W. Rae: We should have tried that out on Paolo. Now it also reminds me of the passage in Richard Posner’s book, to the effect that we can no more blame the financiers for the wreckage of the credit markets than we could blame a lion for eating a zebra, and there’s an odd discontinuity here. When you look at Goldman Sachs internally, through the eyes of one of its very senior partners, the ethical component is big. There’s a huge component about integrity and meeting one’s obligations and delivering the highest quality product on the market, and at the same time, Goldman is vulnerable to the view that it took inordinate advantage of the taxpayers in the recent debacle.

Now how would they defend themselves? They would say — one thing they would say is, “We didn’t want to take the money. Hank Paulson told us we had to take the money,” because the stigma which would otherwise fall on the banks which took the money would cause further disruption and meltdown; that’s one thing they would say. Another thing — well, have you noticed what they’re doing to — in the way of charitable activities just lately? Anybody notice the announcement? $500 million dollars in help to 10,000 small businesses. Does that strike you as a big gesture or a little gesture? Tal, what do you think?

Student: Well as a percent of their revenues, profits, or even just the amount they pay out in bonuses every year, I would say that’s a very little gesture.

Professor Douglas W. Rae: That’s a very little gesture. I agree. From a public relations point of view, if they multiplied it by ten so it’s five billion, would it do them more good? Them, not the world, not the country, them.

Student: I think that adding a couple more zeroes would probably make a bit of a difference in public opinion, but I don’t know if it would fully make up for the perceived damage that they caused in the public’s consciousness.

Professor Douglas W. Rae: Okay so my own intuition is that it wouldn’t do them a lot of good. That the public doesn’t think quantitatively, some opinion leaders do, but most people $500 million sounds like an awful lot of money and five billion doesn’t sound like ten times as much, so they’re probably not far off in the number they chose if the object is public relations, which I think it is. How many — are there people here who think that the government ought to compel them to give back a bigger chunk of capital, put it out there in some charitable way or give it back to the taxpayers. Anybody of that view? Okay so you’re unanimous which is rare in a group this size. Does that mean that you think there’s no ought to it, or does it mean that the process by which the government would do that strikes you as not a good one? Who’s got a — rescue me here guys I’m drowning.

Student: There is a big difference between what you should do and what the government can make you do. I don’t think that there’s any reason any large corporation should be forced to donate to charity, unless it’s like a sort of ad hoc tax randomly applied to them, and that seems like a [inaudible] and we don’t want to go there.

Professor Douglas W. Rae: Okay so it probably would violate the Constitution if we created The Goldman Sachs Retribution Act. I agree with that. So we’re coming to the end of the course, and what I want to do is today to add one more case, one which allows us to look at the interface between capital, the environment, and government in the TXU v. EDF case which you’ve all looked at and which is structured so that you could invest a whole week in it if you were willing to trace out every strand in the web page. Then on Wednesday I’m going to do a recap of the course, as if on a motorcycle, and finish with a central case which will form the basis for your final exam essay, and since it’s going to count for 70% of the final, I’m sure we’ll have 100% attendance during the last twenty minutes of class, and I’ll give you the reading assignment in advance. It is the — Leasing the Rain, it’s the — the reading is the William Finnegan piece from The New Yorker about the privatization of the water supply of Cochabamba, Bolivia by an American corporation known as Bechtel. And the essay question — I’ll formulate it at the end of class Wednesday, asks you to work through that story as somebody who has learned something about capitalism in this course.

Chapter 2. Marrying the Devil [00:07:58]

Okay so now, marrying the devil and the one difficulty with this case is that it’s full of acronyms, and these are the most important, or most immediately important of the acronyms, and can anybody here quickly recite the full names of every one of these? Who wants to be a show off? I’m sure there are fifty people who can do it. Okay I’ll — let’s put them into three bins. This is the most obscure, Texas Climate Initiative, and Jim Marsden who is the video star of the case is president of that, and he is the regional head of EDF, The Environmental Defense Fund for Texas, and The Natural Resources Defense Council is a — is parallel to the EDF; a little harder edge and important — then in the gray box in the middle we have the target firms in the private equity takeover. It’s just one firm really, it’s TXU, but the focus strategically is on TXU plus. It is on the expanded generation capacity that TXU has announced, and that expanded generation capacity is on the lower edge from an environmental point of view. It relies on conventional technology, which no one thought at the time, was the best available technology for coal-fired generation of electric current.

While we’re at it, the parts of an electric utility company are three: generation, transmission, and sales or distribution. Transmission is the long lines, and distribution is the last mile of lines, and the financial connection, the contractual connection with the customer. Then on the right we’ve got KKR and TPG and these are both large and very aggressive private equity firms. KKR is most famous for the Reynolds/Nabisco, RJR Nabisco takeover, which is characterized at length in Barbarians at the Gate, and Texas Pacific is actually the more interesting of the two, from the point of view of this case. Is there anybody who can snap to an obvious conclusion about the difference between the two? Okay we’ll draw it out in a few minutes.

Chapter 3. Marrying the Devil in Texas: TXU Expansion [00:11:58]

The TXU expansion 8,600 megawatts added, that’s a — just under a 50% increment to the firm’s total generating capacity. Ten or $11 billion dollars in costs, somewhere between $50 billion and $2 billion of that are budgeted to controls of pollution, and it’s pretty murky in the case and pretty murky in fact just how much of it — how much of the capital can be construed as pollution control. They promise a 20% cut in emissions — what do they mean by that? Who thought that one through? 20% cut in emissions, we’re going to add 47% to our total generating capacity, and we’re going to cut emissions by 20%, what exactly is the claim? Does it mean — yes.

Student: I’m not sure what TXU promised exactly, but there are two ways you can do that. You can artificially — you can buy carbon credits and reduce your emissions, like, technically on paper. You can also retrofit some coal plants and see — so that emissions are kind of sequestered underground, like there are certain technologies that allow you to do that, so that’s some ways that you can cut emissions.

Professor Douglas W. Rae: Okay. Those are both valid points, but I’m still a little unclear about how much soot is going to come out the end of the pipe. Yes.

Student: I guess the other potential difference is whether the 20% cut is in total emissions or if it’s per unit generated, so if it’s per unit generated there would still be a larger final percentage of emissions, but it would be like less per unit.

Professor Douglas W. Rae: Yeah I think it has to be normed in that way. It has to be a unit rate of emission so that these plants are, on average, quite a lot better than the old plants, though still not state of the art, and the claim is that we’re going to drive the aggregate emission rate per megawatt down by 20%. They’re using old sites. They plan to use old sites where they’ve already got a plant. Anybody figure out why they would say a thing like that? Well — yes.

Student: If you’re building a new site it requires a lot more regulatory approval to a green field site I guess.

Professor Douglas W. Rae: Yeah. A green field site, you’ve got a whole round of permitting, and there are a couple of other advantages. One is that the NIMBY politics, “not in my backyard politics,” are over in those areas. You’ve already been through it, and if you can come back to people and say, “This is a less disruptive plant than the old one,” that’s a pretty good start, and even if people aren’t much taken by that, if you’ve been — if the management has been intelligent they will have built a network of local relationships, which they would have to build anew on a green field site. Finally there’s an infrastructure reason, that the transmission lines required to transport the current produced will already be in place, and that’s both an economic and a political plus. Then at the end of this they throw in a 10% discount to their customers, and that discount is a non-sequitur in the environmental discussion, but it’s not a non-sequitur in the actual case, because TXU is in trouble on two political fronts at once. It is a monopoly seller of current and it has — it is — it has wired the state of Texas politically, and there is a populist revolt against that, and the populist revolt takes the form of criticizing the ultimate pricing at the household level.

Chapter 4. Marrying the Devil in Texas: View from Austin I [00:16:49]

Now if we look at the case from Austin, Texas we’ve got all these small things, upper right, that are federal government, and we’ve got all these big things locally that are state politics and government. You’ve got Texas state government where — how’s TXU doing with Governor Perry during all this? Is Perry a populist who wants to beat up on them? No, they own Perry. I may overstate a little but they pretty much own Governor Perry. The Texas Business for Clean Air is a not all together surprising alliance of business groups which are opposed to TXU on this, on environmental grounds, sometimes for self serving business reasons and other times, I think, because it’s what senior management thinks is right. You’ve got Texans for Public Justice and they’re not so much about the environment as about the rates. You’ve got a state senator named Troy Frazier who is making a name for himself statewide by attacking TXU on the, mostly on the rate side, but he’s also willing to take up the environmental side. You’ve got The Texas Climate Initiative and the EDF, which are closely intertwined in the personality of Jim Marston.

What did you think of Marston? If you went all the way through the case you’ve heard him, I don’t know, five or seven times in video, seem like an able guy? Thumbs up if you think that, thumbs down if you don’t think that. Hmm…we’ve got ninety-five abstentions. He’s an able guy, he’s a very able guy, but he is a — he has a very soft style of argument. He never seems to be a jump ahead of you in the argument. He’s also, in a very laid back way, asking your opinion, as if he hadn’t really figured out where he wanted to go, and that may be partly for our benefit because he was working for the school of management in preparing for the case, but it’s also probably part of his natural style.

PUCT, Public Utility Commission of Texas, and Texas Commission on Environmental Quality; I almost missed that one myself. These are the two principle regulatory bodies in the case and Association of Electric Companies of Texas; you can imagine who they are and what the TXU’s role is. It’s a classic interest association and then you got populist —

Chapter 5. Video: TXU Gets You Hacking Merrill Does the Backing [00:20:23]

[Video 20:35-22:47.]

Chapter 6. Marrying the Devil in Texas: View from Austin II [00:22:49]

Okay so any of you guys ever done a protest of that type? You just don’t look like street theatre types. Do you think that’s effective? You’re shaking your heads and I think there are two sides to the question. Let’s start in the negative here.

Student: I mean, I just feel as though it’s not going to get the companies to change their positions really, so what’s — I mean, yes, it might stir up a little public disapproval for a couple of days, but that’s not really going to change behavior.

Professor Douglas W. Rae: Okay so as a direct strategy for changing the behavior of companies, it goes nowhere. We agree. Is there any other way in which it might be of service to the cause these people are pursuing? Here and then here.

Student: If you can get media coverage of it, it tends to have a more dramatic effect on public opinion. I was working on a political campaign where we sent out something that was short enough, a picture in The Washington Post, and so I at least from personal experience, think that it does have the potential. Probably not to affect the direct response of the people who you’re calling out, but that there can be larger implications for how other people view the situation.

Professor Douglas W. Rae: Okay so the clear — the media are the target and then who would we most likely influence with this sort of thing? Anybody want to elaborate further? Yes, Sasha.

Student: I think what the companies really worry about is that they’re clients are going to be sensitive to the negative press and change companies.

Professor Douglas W. Rae: Absolutely. That’s — TXU customer voter base is part of this and both of those nouns are important, and they are both voters and customers, and they may not have many places to go as customers but as voters, the perception within regulatory and legislative groups in Austin would be an important consideration. I personally don’t think that this kind of demonstration is hugely effective, but it does kind of raise the temperature of the issue and make it salient to decision makers in government.

Chapter 7. Marrying the Devil in Texas: View from K Street [00:25:40]

Now in — on the — if we switch from Austin to Washington, the actors get to be different and the EPA, and The Federal Energy Regulatory Commission, and the key people in Congress like Henry Waxman or Senators Bingaman and Boxer, become big players, and the EDF and the NRDF, Natural Resource Defense Fund, become well staffed. They would each have fifty or so staff people in Washington and become a major presence, and the question in front of KKR and Texas Pacific hinges on what? Why do they — why are they messing around with all these environmental groups? It would sound like, from a purely economic point of view, to be a waste of time and yet from an entirely rational economic point of view, it isn’t a waste of time. Why not?

Chapter 8. Marrying the Devil in Texas: View from Wall Street [00:27:05]

Well let’s look — let’s go to Wall Street. The private equity business in 2007 there were 794 large private equity transactions during that year, adding up to about $800 billion, so they average about $1 billion a piece. Explosive growth, they’re up about 450% to 500% from 2000 to 2007, and it’s a period when capital is abundant and cheap, so the — it is in every sense boom time for private equity. The — you’ve got three sets of players as seen from Wall Street. You’ve got private equity firms, the target firms, and the business services organizations, mainly investment banks which catalyze transactions of this kind and the takeover of TXU is a megadeal. It is the biggest transaction of its kind ever so it gets a lot of attention and offers to be very profitable.

The institutional investors, shown upper left in the blue box, are limited partners in the funds created by organizations like KKR and Texas Pacific, and from their point of view, this is one of the highest yielding asset classes in their portfolio, and David Swenson, for example of Yale, one of the things he did with the Yale portfolio which made it grow so much faster after he came then it had grown at any time in the university’s history, was to shift a great deal of capital away from publicly traded securities into private equity funds which differ — they differ — the biggest difference between how well investment companies do with stocks and bonds on the one side, and private equity on the other, is the difference between the smart money and average money. In the stock market the difference between very smart money and fairly dumb money is a few percentage points. The difference in private equity between the smartest money and fairly dumb money is enormous, and so if an institutional investor like Yale, Harvard, or the big pension funds, can get into private equity with smart money, hire smart management, invest with people like Texas Pacific and KKR, the opportunity to beat the market in a big way is a very ripe one and that’s the heart of this deal.

Chapter 9. Marrying the Devil in Texas: Two Worlds of Strategic Rationality [00:30:43]

Now from a sociological point of view, the people who run these companies are pretty far away from the green world, which centers in major metropolitan areas, and is populated by well to do activists, and their 501(c)(3) corporations, of which the ones in play today are examples. Now, the Pacific Group is a little different from KKR in its relationship to those groups, because it has one key player in William Riley, who had been the head of the EPA before and who is agreeing, and he gave — he gives Texas Pacific a relationship to this world which KKR pretty much doesn’t have. David Bonderman, who is one of the founders of Texas Pacific, is Harvard educated and kind of part of this world. If you begin tracking personalities in these funds, Frances Beinecke, she of Yale fame, is the head of Natural Resources Defense Fund — I don’t know why I put C’s instead of F’s on the end of this — the slides. She’s the head of that, and a terrifically potent leader, and the reason the privileged access to do this case came to the Yale School of Management, has something to do with that particular connection.

There is a cultural divide here, it is — these are quite different views of the world and if we compare 501(c)(3) corporations with regular public or not publicly — publicly traded or not publicly traded corporations, we get some sharp contrasts. The business corporations are pursuing profit. The 501(c)(3)’s are pursuing a cause. The attitude to risk is far more aggressive among the businesses. The boards are accountable to, mainly to major investors on the business side, and to donors on the 501(c)(3) side except that in the really big old 501(c)(3)’s; they’re accountable to no one because the donor is dead. The Carnegie Corporation, for example, where my wife is a chief investment officer, Andrew Carnegie hasn’t paid any attention to their ledgers in some time, and it actually creates an enormous amount of free play at top management and board levels.

The management culture on the business side is far more aggressive than on — among the non-profits and top management compensation in — particularly in private equity is high and variable and Jim would — Jim pointed out to me that — Jim Alexander pointed out to me this morning that when I say high and variable the variability may or may not be well-tied to actual performance. You can get a lot of compensation for just sitting in the right chair during a bull market and many people have. On the non-profit side it — the compensation is relatively modest and more or less invariant with performance. Take for instance, Beinecke, there was a to do in this same year because somebody published — their top salaries are also published and her salary of $252,000 was published, and there was a populist outcry. Now by private equity standards that’s not a lot of money.

Even by not — people on the investment side in organizations like this make three or four, or ten times that, but the general norm in non-profits is — how many — are there people here who plan to become non-profiteers? Maybe? Okay, well the one thing you have to do is take a zero off when you think about compensation. More or less it’s — that’s about the ratio and its considerable, so these are two very different classes or organizations. Here we have Fred Krupp of The Natural Resources and Henry Kravitz, and I’ll bet not one of you is in doubt about which is which. The pictures are — they get the point across, and why on earth would people on this side be so interested in participation from people on this side? Sasha, again.

Student: If you ask them to do something with the business that makes them more money ultimately, then it’s a good deal.

Professor Douglas W. Rae: You nailed it, and not one iota of direct concern for the environment is required to back that up. Right? So what’s the biggest problem about TXU? Why is it — what — if you’re going to sit down and calculate the risks from KKR and Texas Pacific’s point of view of taking over this firm, what would the main risks be? They would be — would they be that the technology will fail? Would they be that consumer demand for electric power will suddenly go away? Would they be that a new entrant will come in; a large new entrant will come in, and begin to compete with lower prices? None of those things are imaginable. None of those are imaginable. So why isn’t this just a license to print money? The answer to that is that the regulatory risk is substantial at both the federal and state levels, much more substantial at the federal level, and that the process by which the environmental groups would in effect bless or kosher the transaction is a way of limiting political risk.

The EDF is all about the cause of the environment and their claim is that lobbying work they’ve done in the years from 2001 to 2008 will diminish diesel pollution by nearly 90% by 2030, and that’s their business. Their business is to get the government to compel companies to pollute less. Fred Krupp at Davos in the year of the case, this is not in the case: “The smartest companies can see over the horizon and anticipate consumer demands. That’s why the EDF has been able to team with — team up with ALCOA, DuPont, Caterpillar, GE, Duke Energy, BP America, and others on a plan that could cut greenhouse gas emissions by 60% to 80% by 2050. The plan is a jobs winner as well as an environmental winner.” So organizations like these are brokers in which they cut deals with businesses, and the businesses they cut the deals with are ones which have a higher than average capacity to withstand tighter regulation.

For example, GE with Eco Imagination, you’ve all heard of that? If you watch television for any period as long as an hour you have been saturated with that message, and why can GE do that? Well why does it have to do it? What’s GE’s long-term reputation for environmental pollution? It is that they filled the Hudson River with PCB’s fifty years ago, and it’s important to them to get us off that topic and to think of them in a different way. Second, they compete in Europe for the manufacture of electrically powered equipment, and the regs in Europe are much tighter than they are here from an environmental point of view, so they have developed a technology to meet much higher standards. They’ve got it already in the kit, and so from their point of view, it is actually a corporate strategy play to encourage the feds to raise the bar.

Cap and trade, I’m running out of time here, cap and trade diagram — the interesting side fact that cap and trade in the EU basically fizzled, and it fizzled because the caps that were put on the countries were not low enough to make people go out and buy credits. They were set in a very gentle political way and the market for cap and trade depends on people having to break the caps and buy credits to make up for that, and the caps were set so high that it didn’t produce the desired effect. I don’t know why that slide is there. Now let’s think about outcomes. We’ve got on the vertical dimension, Green World, and on the horizontal dimension Green Paper, and the four big quadrants — the four quadrants of this space define points we could think about in looking at what the risks and possibilities of this are for these two classes of organizations.

Down here, emissions are high and profits are low is a catastrophe on both dimensions and the likelihood of both of those things happening is very small. The story where you have both high emissions and high profits, this is the most worrying category from the point of view of the EDF. This would constitute green washing which has become a really important epithet in the politics of the environment, where they’re blessing something which is a pretend benefit to the environment, and here is the disaster from the point of view of KKR and Texas Pacific, where you have both low emissions and low profits and do you think KKR and Texas Pacific enter into this relationship fearing the risk that EDF and The Natural Resources Defense Fund will encourage the imposition of standard so Draconian that they can’t make a living? Well no, they wouldn’t have chosen EDF as the lead agency if EDF were of the same temperament as the street theatre we saw in the video. They chose EDF because they think they can cut a plausible and constructive bargain with them which leads, not upper left but upper right in the diagram, for emissions decrease in a substantial degree and profits remain high. This slide is in the — is from the case and it’s the full inventory of exactions that Jim Marston and EDF people consider in looking at the case, and they call it the blue sky concessions, because it’s perfectly clear they’re not going to get all of these, but they want some of them and they get some of them, and they also get quite a lot of symbolic buy in so that by the current year 2009, KKR is offering an investment portfolio which it calls the green portfolio, and this consists not of companies that are going to devote themselves to producing environmental products, but rather to companies which produce other products.

For example, in Biomet, produce medical devices but where they sign onto the proposition that they will make their production process far greener than it was before, so that I as an investor can buy into the green fund, and expect market rates of return and think that on the side I’m doing a little bit of good for the environment. [Video 46:37-47:08.] Okay so — and they all went to the beach and had a swell afternoon. The — okay so that’s the last case we’re going to do, except the one for your final, and what I hope you’ll do for Wednesday is read the Finnegan piece with some care. He’s a brilliant writer. I got to know him personally when he came to write about violent kids in New Haven twenty years ago, and it’s a beautifully written piece and it’s a compelling story, and also begin reviewing your notes for the big picture flow of the course.

[end of transcript]

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