The trouble with incentives

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In science there is a theory called the butterfly effect. It could have a big impact on pension funds that have made renewable energy and other green investment a major part of their alternative strategy, and that are hopeful the administration of President-elect Barack Obama and a new Congress will promote policies and incentives to encourage growth of this new economic sector.

The butterfly effect suggests that a small change in conditions (e.g., a butterfly flapping its wings in California) can reverberate to cause unpredictable major changes throughout a system (e.g., a major storm on the East Coast).

In this case, the impact of a policy to promote alternative energy could have a cascading negative effect on other areas of the economy, revealing risks now masked, and harming pension fund portfolios that have a wide range of investments in both the traditional and alternative economies.

Investment in alternative energy is growing. Investment in infrastructure and technology to mitigate climate change, including alternative energy, is projected to reach $650 billion a year in the next 20 years, from the $148.4 billion in new investment in 2007, according to a DB Advisors research report released last month.

However, much of the growth is dependent on government incentives. As the report notes, “so long as regulatory support is there, renewals should outperform traditional energy sources in the long term.”

There is the rub.

Much of the alternative energy development is heavily driven by subsidies, providing downside protection for these investments. Eliminating federal incentives is politically very difficult, the report adds.

In fact, investors are counting on federal subsidies and other incentives to reduce cost of production to make such investments profitable.

Even the Troubled Asset Relief Program legislation, designed to revive the financial markets, contains provisions for alternative energy aid.

The trouble is, such subsidies distort the investment markets. Subsidies often lead to excess investment in an industry or sector. Free land led to an overbuilding of railroads in the 19th century, and many later failed. More recently, subsidies have led to excess investment in ethanol plants and the implied federal guarantee of Fannie Mae and Freddie Mac debt was one factor in the housing bubble.

The new administration and Congress, as well as investors, ought to consider the possibility of a butterfly effect in terms of the impact of subsidized alternative energy policies on other sectors of the economy, particularly the three big Detroit automakers, in view of an ambitious agenda to promote energy independence and mitigate global warming.

Not only do plans for alternative energy depend on subsidies, but also on high oil prices to make new, more expensive sources competitive. Perhaps this is one reason congressional leadership generally has opposed new drilling, offshore or elsewhere, and has stated its intention to reconsider an order issued earlier this year to open up new areas for production, while Mr. Obama has not been a strong proponent of more drilling despite his latent campaign position. A continued ban on drilling would keep the U.S. even more dependent on foreign imports from geopolitically uncertain sources, and keep oil prices higher than they otherwise would be.

Subsidies also are necessary to spur the development and sale of hybrid vehicles. They are expensive. With the economy reeling and investment portfolios in a meltdown, sales of the alternative-powered cars are likely at best to slow, just as sales of less expensive traditional cars already have fallen to one of the lowest levels in years.

General Motors Corp. is making a huge bet with its Volt electric cars, putting research-and-development eggs into one basket. It could not afford this R&D, as demonstrated by the $25 billion in federal aid for automakers Congress passed a few months ago for retooling to develop new vehicles. Perhaps the money poured into the Volt might have bought GM a few more months before it ran out of cash.

A growing fleet of electric or hybrid cars will require development of additional sources of electricity to meet the projected increase in demand. Mr. Obama campaigned for tougher environmental standards, which he acknowledged could cripple the use of coal-generation for electric power. At the same time, there is little if no support among congressional leaders or from the president-elect to promote more nuclear sources of generating electricity.

In short, any one of these policies could lead to unintended consequences for other areas of the economy, such as raising energy costs and vehicle costs, as a result slowing sales and slowing recovery, raising investment risk and/or reducing return.

Government incentives mask the true costs of development of alternative energy and mislead investors on risk. As a result, they distort the allocation of scarce resources, especially capital in this time of crisis.

Institutional investors should be wary of investing in alternative investments that rely on government subsidies, and should consider that impact of such alternatives and their subsidies on other investments in their portfolios.