Sovereign Technology Credit Obligations (“STCO”)

Sovereign Technology Credit Obligations (“STCO”)

A Facilitated Framework Dialogue Moderated by:

Dr. David E. Martin

Executive Chairman, M·CAM Inc.

Batten Fellow, Darden Graduate School of Business Administration, University of Virginia

Abstract

 Expanding discourse surrounding climate change has invited an unprecedented deliberation of financial and value assumptions.  While most public activism and dialogue has been reflexive – calling for crisis response – little consideration has been focused on the economic underpinnings of the environmentally degrading infrastructure responsible for the global challenge.  A confluence of three macro paradigms requires simultaneous consideration as they are covariates which, if handled in isolation, have distorting effects.  These paradigms involve: 1) sourcing innovation; 2) integrating innovation; and, 3) harnessing the economic potential of innovation.  Following a fresh look at the economic underpinning, we explore the emergence of a new model for Provident Wealth in the form of Sovereign Technology Credit Obligations (STCO).

Background

Prior to considering our STCO framework, it is important to understand a series of background assumptions which, while generally held as consensus, are inadequate. 

First, the public sector as a whole is the principle funding source for innovation coming in the form of direct sponsored research and publicly funded corporate contract research.  Ranging from academic institutions to state-sponsored laboratories to corporate procurements, the majority of publicly funded research never enters any form of civil or commercial deployment.  With over 97% of public funds supporting research that will not make it to market, creating public private partnerships for a priori prioritization aligned with social need and subsequent deployment enablement is vital.  Economic and legal researchers at Stanford and the University of California at Berkley report that less than 5% of all patents are ever associated with any monetary transaction or business use in the U.S. market – a statistic that has been mirrored in a number of studies dating back to the pioneering work done by John Horsted for the Danish government several years ago.  In the specific context of infrastructure, impulses to “fund research” to solve climate problems uniformly ignore the vast public estate of global innovation commons filled with solutions which have not been deployed for reasons that have nothing to do with their merit.  Rather they fail due to a failure-to-assimilate into incumbent use and distribution paradigms or their creation of non-fortuitous obsolescence.

An example may be instructive.  General Electric’s celebrated wind turbine business is built on an undiscussed platform of innovation having little to do with harnessing the wind’s power but on the technology to integrate variable wind speed power into an aging electric grid.  Much of the cost of current wind generator technology has nothing to do with turbines and generators but rather the requirement to add inefficiency to generators to assimilate them into grid distribution.  That’s right, we take the generous, free wind, and reject its full power so we can make it work at a predictable, reliable inefficiency.  Ironically, GE’s research and development in variable blade pitch controllers to limit the wind’s power, rate limiters and capacitors – all of which are open source in other fields – has often been double patented by GE and its partners in the field of wind power generation.  The cost of their “Smart Grid” program is significantly based on integrating multi-modal generation into incumbent inefficiencies rather than breaking the mold and going to distributed, suitable scale solutions.  Why would GE spend vast sums of money to make wind harnessing less efficient?  The answer is simple but profoundly consequential.  Their financial incentives are not aligned for efficiency but rather for the preservation of the incumbent grid-based paradigm upon which much of their revenue and all of their pensions depend. 

We will revisit the revenue and pension issues in greater detail shortly.  However, prior to that we must consider the financial procurement instrument.  For over 150 years, infrastructure has been increasingly financed through a depreciating asset debt instrument known as a bond.  At the purchase of a power plant, highway, or water treatment facility, the “asset” is considered to have its greatest value.  This value “depreciates” over time.  To finance the asset, debt is issued in the form of an investment which can be repaid by tax, tolls, or other tariffs.  Once purchased with its attendant financing, the asset is viewed as having a “useful life”.  Virtually no public procurement (at the municipal or sovereign level) considers any additional funding allocation for incentivizing obsolescence should a more efficient alternative emerge during the “useful life” horizon.  Reinforced by two economic dynamics – “investment grade” requirements for fixed income and pension investors and actuarial laziness – retrofits or upgrades are viewed as undesirable because they alter the nominal value of the bond and add transaction costs at a time where the useful life has depreciated. 

This insidious dynamic is preserved under an untenable social compromise.  Assume that society wants cleaner fossil fuel power plants.  However, the same society has its retirement investments and pensions in the 30-year bond funding the polluting plant.  The same society’s banks have their reserve investments in investment grade bonds and their revenue is heavily subsidized by the issuance and trading of this amortized debt instrument.  No other present paradigm contemplates an accountable mechanism in which a depreciating asset, debt, useful life artifact can be replaced or re-engineered to align the social value of ecology with the financial incentive to preserve incumbency.  In short, in the interest of our collective fear of future financial uncertainty, we concede the futility of inviting obsolescence – even that which would save our planet and our communities.  

So, we have the following conditions.  We have vast, unutilized innovations which, while offering solutions, fail at integration or stimulation of transformation.  Thousands of these exist in the unprotected global innovation commons and are available for generic use.  We hold consensus financial instruments which obstruct incumbency-threatening alternatives to grids, legacy infrastructures, or financial innovation.  And our response to these conditions is to turn to the most abusive, risk equity models to investment in a future that we’re unwilling to question at its foundation.

While over $1.5 trillion of investments have been made into intellectual asset based infrastructure businesses since 1998, PricewaterhouseCoopers reported in 2005 that 57% was allocated in North America, 28% was allocated in Europe, 10% was allocated in Asia and the remaining 5% went to enterprises in the Middle East, Africa, and South America combined.  During this same period, unprecedented innovation booms took place in China, India, South Korea, Taiwan, Singapore and other non-aligned countries with little to no visibility to the global market.  When compared to 2003, Singapore and India were the only Asia Pacific countries to see their Top 20 country rankings improve by 2005 and joined Germany, Spain, Netherlands and Sweden in being the only advancers over this tumultuous market period. It is notable that this increase was driven, in large part, by intellectual asset backed transactions.

Due to a lack of adequate capital access, small and medium sized innovators and enterprises (SME) from Bavaria, to Scandinavia, to the ASEAN countries cannot participate in the global market place. The global market for SME investments has been constricted since the late 1990s.  Central to the market failure is the lack of public support of procurement from innovators.  Remember that Sharp became a global leader in silicon solar photovoltaics not because of its innovation but because of the Japanese government’s preferential funding and procurement practices.  After all, to this day, the majority of solar PV innovation artifacts are held by Canon.  It is procurement commitment, not investment, that leads to commercial success.  However, as we feel impotent in our ability to command obsolescing technology integration aligned with social values, we resort to inefficient capital in the form of private equity in a vain hope to fund innovation to a scale which allows it to enter the incumbent grid.    Additionally, valuation expectations in the private equity market are considerably more reasonable than they were in 1999 given the decreasing access to public markets for SME emerging enterprises.

To fill the capital shortfall from the banking and equity markets, governments have stepped in to fill some of the void. In an independent report to the European Commission in January 2006, the following ominous warning was made:

“Europe and its citizens should realize that their way of life is under threat but also that the way to prosperity through research and innovation is open if large scale action is taken now by their leaders before it is too late.”

This call to action was met with a resolution that the EU would target moving R&D investments from 1.9% of GDP to 3% by 2010.

Singapore’s Economic Development Board has funded SEEDS Capital, a fund matching public and private investment in business ventures offering “substantial innovative or intellectual content”. This infusion of several billion additional euros and millions of SG dollars into the pipeline creates interesting downstream challenges. Most notably, the greatest challenge facing government sponsored research and development is the less than 2.5% conversion rate from bench success to balance sheet economic impact.

The global economy has seen growth in sovereign procurements for technology dependent infrastructure projects.  From energy to infrastructure, from financial security to logistics, from communications to health care, trillions of dollars are allocated every year for the purchase of solutions to increasingly complex requirements.  Given the complexity and scale of these procurements, prime contract managers have turned to post-award acquisition of 3^rd party capabilities or companies to deliver vital technologies and services to meet the deliverables to which they have obligated their performance.  Small best-of-breed corporate technology developers and suppliers are frequently precluded from demonstrating financial capability to scale or deliver prior to contract.  This dynamic places significant contingent risk (and cost) to prime contractors who realize that it will be their capital at risk post grant to assimilate or acquire developers and suppliers precisely at a time when these entities will expect premium valuation.  While only one of their components may be required, their valuation expectations may include numerous non-core components for which a premium is charged.  While this dynamic provides a windfall to private equity holders, it adds unnecessary capital costs to prime contractors.

The term ‘Infrastructure’ refers to the fundamental facilities, systems, services, installations and capital equipment required for an industrial economy to function.  Examples include transportation systems (air, rail, roads, etc.), telecommunication networks, power production and distribution, and water storage and distribution. Infrastructure systems tend to be very high-cost investments, but this cost has been historically justified by the wider enablement of economic activity and overall improvement of life and security. 

Private investments in infrastructure are gaining prominence rapidly. This outcome has been spawned by a confluence of several factors:  Although many infrastructure investments were once considered the province of public investment via taxes, bonds, and other sovereign funding, they are rapidly emerging as opportunities for private investment.  Public funding capacity for such investments in OECD countries is declining.  OECD estimates that government spending on gross fixed capital formation as a share of total general government outlays fell from 9.5% in 1990 to 7% in 2005.  A significant cause of this decrease is rapidly increasing social expenditures which rose on average from 16% to 21% of GDP.  Spending on public health and long-term care could increase from its current level of 6.7% of GDP to 12.8% by 2050, with pension costs rising around 4% during the same period, leaving even less room for infrastructure investments in the future.[1]

This decline in public funding capacity is converging with a massive and increasing need for investment in infrastructure development and refresh.  Among the 30 OECD countries, in which foundational infrastructure systems are already in place, large expenditures on maintenance and upgrading of existing infrastructure will be required in addition to needed expansions. 

Average OECD investments in electricity transmission and distribution are projected to rise from $38B (2005) to $62B in 2015, with average investments in water services climbing from $425B (2005) to $490B in the same period.  Average investments in road infrastructure are rising from 2000 levels of $100B to a projected $160B by 2010, and rail investments are projected to rise from $26B to $31B during the same period. Growth in each of these sectors is projected to be significant through 2030 (see figure 1). 

In emerging-market countries, the requirement for new infrastructure will drive investment volume.  For instance, China will increase its investment in water and wastewater treatment to $182B by 2015 and $247B by 2025,[2] and rail passenger and freight volume will grow by 4.8% and 4.5% annually through 2035.[3]  OECD concludes that "Traditional sources of public finance will not suffice to meet future infrastructure needs, which are huge and growing." [4] 

Private investment in infrastructure therefore represents one of the largest-volume investment targets in the next 20 years.  Sustained demand for essential, every day services drive revenue for infrastructure investments.  Because of this, they offer consistent demand throughout the economic cycle, predictable, sustainable cash flow, and long-term stable returns.  Existing infrastructure companies also have low variable costs and stable operating models.  The long-term stability of infrastructure investments led OECD to recommend that policymakers "encourage the investment of pension funds and other large institutional investors in infrastructures.”[5]

These large-scale, stable investments also allow the possibility of capital growth through intelligent infrastructure optimization.  Because of the scale of the costs involved in the operation of infrastructure, even incremental improvements in performance can boost profits significantly.  Optimizing the functional performance of infrastructure companies, in terms of efficiency, effectiveness, resilience and environmental impact allows untapped potential to be realized within stable investments. 

An Invitation to a New Table

A new paradigm has emerged.  It is called the Sovereign Technology Credit Obligation (STCO).  At its core, the STCO is the integration of innovation and providential wealth.  Rather than a scarcity-based, diminishing useful life view of an aging asset, the STCO is aligned for prospective fruitful engagement of best-of-class, innovation-incentivized efficiency integrated with social consequence accountability.  It achieves this by harnessing the value of the forward receivable emerging from infrastructure utilization and encouraging constant innovation to deliver ever more efficient integral (both economic and ecosystem) cost-savings to infrastructure users. 

The following is a simplified description of the STCO structure.  For description, we shall follow a hypothetical $100 million desalination facility which will supply water to 1 million users.  For the purpose of this example, we will assume that a community expects to have this utility provided at a breakeven within 10 years or less.  Further we will assume that the desalination plant involves a water pumping system, a desalination process, and a distribution network, and an IT controlling system in equal proportions of attributable value with each component being 1/4 of the cost.  Finally, we will assume that 50% of the cost of the facility is technology and 50% is management and materials. 

So, to summarize, we have:

  Water Pumping            -            $25mm            -            $12.5mm in technology

  Desalinizer                        -            $25mm            -            $12.5mm in technology

  Distribution                        -            $25mm            -            $12.5mm in technology

  Controllers                        -            $25mm            -            $12.5mm in technology

The first step is to review the specification for all holders of proprietary and open source solutions which can be integrated into the project.  These vendors are contracted under one of two structures.  They can either be paid from the use of a factored future receivable issued by the STCO or they can have an annuity participation in the STCO (which will be described in more detail shortly).  All vendors stipulate their current productivity output for their technology in terms of a cost per cubic meter of fresh water.  They are contracted in revenue per unit volume with a savings-sharing program in which they retain half of the annuity value arising from the cost savings they produce – either through new innovation or facilitated collaboration.  In each technology sector an optimal vendor may be identified and obsolescing alternatives are selected and are presented with a financed efficiency challenge.  Participation in the annuity receivable of the public utility of fresh water is directly linked to accelerated innovation integration which lowers the all-in cost while increasing the socially derived benefit and the investment efficiency.  When innovation requires funding, a factored forward receivable for the participating innovators is monetized where, in lieu of equity or conventional debt, the investing STCO purchases future production from all investees at a discount to the future sale price.  Not unlike a commodity, the internal factored return is constructed with two critical market elements – a disclosed and transparent discount factor and a repayment from future productivity.  When the STCO becomes the customer of the technology, it actually is benefiting from a negotiated future discount on an actuarially higher rate AND reinforcing the vendor company with a qualified customer reference. 

In its simplest case, the project above, using conventional bonds, costs the community $108mm.  In a STCO, the community places $100mm in forward purchases of potable water into a receivable instrument.  When a vendor (under the old paradigm – the supplier of a depreciating asset) achieves an efficiency which inures to the all-in efficiency interest of the community, the community benefits from a lower cost and the vendor participates in a greater return as a participant in the STCO.  Should a receivable factoring instrument be in place with a vendor, the community sees the cost of the utility decrease by the factored discount.  So, if a filter manufacturer achieves 50% greater all-in efficiency, their providential future value increases their revenue at a proportion to their cost savings consequence.  The community, seeking a more ecosystem-affirming utility gains in the applicable future factoring rate and participates, when monetized, in the discounted utility interest it holds in the vendor. 

So, in our example, let’s assume that we have the desalinizer technology achieving a 50% efficiency, the water pumper achieving a 25% efficiency, distributor with a 10% efficiency.  In this case, the nominal cost of the utility is oversimplified but generally summarized as:

$100mm – ($6.25mm_DESAL - $3.1mm_PUMP - $1.3mm_DIST) – (∑ Discounts on commodity sales)

As a vendor is a member and beneficiary of the success of the STCO generally, the vendors achieving efficiency gain an omnibus increased annuity value the more they obsolete themselves or align with obsolescing parties.

Please note: we do not propose that efficiency means “cheaper” in monetary terms alone.  An efficiency may mean more financially costly but more aligned with a social value. 

Under the STCO model, best-of-breed technology suppliers are presented with the ability to receive a present value on some or all of their revenue participation over the life of the contract by selling their receivables and providing the STCO an equity option on the technology (deliverable or in development) for use in other contracts.  Unlike dilutive equity, the instrument of investment is a pre-negotiated discounted participation in the sale of future production or delivered value.  Somewhat similar to infrastructure leasing programs, the STCO invites accelerated innovation assimilation to increase the fruitful value of the remaining annuity.  This aligns the interest of the company, the investor, and the utility consumer and removes the impediment to fear of premature obsolescence.    

Under current deployments, we have used this model to deal with sovereign procurements where incumbent large systems integrators have historically passed private equity acquisition cost overruns to the infrastructure purchaser.  Using STCO forward factoring of the receivable, not only is there no need for a private equity change order cost overrun but there is an internal incentive for a prime contractor to increase efficiency and innovation engagement.  Additionally, we are working with a number of countries to align innovation incentive participation with resolution of Trade Credit Offsets from multi-national procurements where innovation accelerating technology transfer can accelerate the satisfaction of the offset obligation thereby allowing the vendor to recognize revenue more quickly.  In these instances, the resulting revenue recognition value can be used to provide additional deployment capital to STCO infrastructure projects.  M·CAM has also added the Global Innovation Commons platform to the STCO model to insure open source is fully used to further reduce the cost of capital.

[1] Organisation for Economic Co-operation and Development (OECD),  Infrastructure to 2030: Volume 2 – Mapping Policy for Electricity, Water and Transport  Telecom, Land Transport, Water and Electricity, June 2007, p. 15 [http://www.oecd.org/document/49/0,3343,en_2649_36240452_38429809_1_1_1_1,00.html]

[2] Ibid., 289.

[3] Ibid., 329.

[4] Ibid., 14.

[5] Ibid., 36-9.