Climate Change: Winning While Losing

Is it possible to win while losing?

Yes, of course it is. Think about Sylvester Stallone’s character Rocky Balboa, for instance. He actually lost the championship match in his very first film. But the loss established and enabled the character — not to mention the actor who played him, the Academic Award winning movie, and the sport of boxing itself — to repeatedly win throughout the forty year run of the Rocky franchise.

And how about this year’s Presidential primary season? Bernie Sanders may soon be ready to cede the Democratic Party nomination to Hillary Clinton, but the progressive movement that he spearheads will probably thrive for years to come. Likewise, even if Donald Trump loses the November election, many experts believe that he will permanently transform the Republican Party.

This “winning while losing” phenomenon occurs in the business world as well. Consider, for example, what happened last week to Chevron and Exxon Mobil, the two global energy giants that are headquartered in the United States. Shareholder activists at both firms lost very similar fights at their corporate annual meetings. But while losing their immediate battles, they may have managed to achieve a victory for the long term.

So what were they fighting about? According to MarketWatch, the activists wanted to require the firms to perform annual “stress tests to determine the risk that … climate change pose(s) to their business.” Just as global banks in the United States perform stress tests to address risks in the world’s economy, these individuals hoped to require global energy companies to conduct similar tests to address climate change factors.

Their proposals were voted down by shareholders, but Chevron’s proposal drew 41% support, and Exxon Mobil’s drew 38% support. Apparently, these represent the highest climate proposal voting totals in the history of the firms. In fact, according to Sustainable Brands, Chevron’s 38% support total occurred after their “investors overwhelmingly rejected the (same) proposal at last year’s meeting with a 96.8 percent “no” vote.”

An increase in support from 3.2% to approximately 41% in one year? Now that is a win, even though any vote total less than 50% is recorded in the corporate records as a loss.

Either way, there’s an important lesson to learn from these events. Whether or not you believe that climate change represents an existential threat to the global environment, the number of investors who express concerns about the topic seems to increase each year.

And let’s face it. A stress test is merely, by definition, a hypothetical exercise. So why wouldn’t any global energy company (or any other organization, for that matter) consider engaging in such an activity? If there is no harm in doing so, and if 40% of its investor base might approve of it, why not give it a try?

Bank Stress Tests: Calling A Mulligan

Are you familiar with the concept of a mulligan? It’s a “do over,” i.e. an activity that erases the results of a previous action when a person performs it a second time.

Amateur golfers often perform mulligans to erase the effects of their damaging physical and mental gaffes. President Bill Clinton, for instance, employed mulligans on golf courses so frequently that commentators began to refer to them as billigans. But who could argue with a President who insisted on the right to replay a poor swing?

Mulligans are permissible in a few other settings as well. The Japanese children’s card game Pokemon, for example, incorporates a “do over” option. And any retailer that permits a customer to return a recently purchased item for a full credit towards a future transaction is effectively offering a mulligan on the initial sale.

So although “do overs” are somewhat rare, they indeed exist in a variety of circumstances. Recently, however, the Federal Reserve Bank of the United States (the “Fed”) decided to institute a mulligan policy in a manner that may raise concerns involving the public interest.

Stress Testing

The Fed’s new policy involves the practice of performing stress tests on global banking institutions. They began to apply such tests in the financial services sector after the global market crash of 2008 and 2009. After American and European governments bailed out the “too big to fail” banking institutions, their regulators began to require the banks to predict whether (and, if so, how) they would survive future economic collapses.

So how do these stress tests function today? On a periodic basis, regulators provide the global banks with theoretical descriptions of future crashes, and require the institutions to develop and defend their own hypothetical plans to survive those crashes. If the regulators determine that a bank’s hypothetical plan is not feasible, they announce to the public that the bank has “failed” its stress test.

Three weeks ago, in the aftermath of President Barack Obama’s Election Day victory, the Fed quietly announced a new “mulligan policy” for such stress tests. But how will this new policy be implemented? And will it serve the public interest?

Failure vs. Success

In accordance with its new policy, instead of simply announcing that a bank has failed a stress test, the Fed now intends to invite the institution to modify its (previously submitted) hypothetical plan in order to retroactively convert its failure into a success. For instance, if a bank had previously indicated that it would plan to maintain its dividend or stock repurchase policy during a crisis, the Fed will now permit it to modify its hypothetical future policy “just enough” to avoid failing the stress test.

It is important to note that the banks are not required to comply with any of their own hypothetical policy statements in the future. If any stressful scenario ever comes to pass, the banks will be free to ignore their prior stress test policy declarations as they see fit. In other words, both their initial “failed” policies and their retroactively defined “successful” policies represent theoretical declarations with no legally binding ramifications.

Therefore, with this new mulligan policy in place, it is difficult to envision any prospective scenario when a global financial institution might fail a meaningful stress test. And thus it is reasonable to wonder whether stress tests will serve the public interest at all in the future.

Pension Policy

A similar degree of skepticism can be expressed about recent policy revisions in the field of pension plan management. Until recently, most pension plan managers abided by the “rule of thumb” that investment asset balances that are available to pay current and future retiree obligations should never fall below 80% of the present value of those obligations.

For instance, imagine a plan that is obligated to pay current and future retirees $100 million in present value terms. Until recently, its managers would have been branded “failures” if they ever permitted the plan’s investment assets to fall below $80 million. And because asset values fluctuate on a day-to-day basis, its managers would (again, until recently) strive to maintain asset balances of $90 to $100 million, so that a traditional “bear market” decline of 10% to 20% could not reduce assets below $80 million.

But when the market crisis of 2008 and 2009 imposed far greater declines on asset values than traditionally experienced in bear markets, this 80% rule of thumb became a more challenging guideline. So how have pension managers responded to this new challenge? They have simply rewritten the guideline; in fact, many now accept coverage ratios of 70% or less.

In other words, stress test bankers and pension plan managers are now redefining “success” and “failure” in a fashion that redefines yesterday’s failures as today’s successes. If measurements of success and failure can be redefined in such a manner, though, what purpose is served by defining these measurements at all?

Stress Testing: As Asinine as Wells Fargo Claims?

Three weeks ago, Wells Fargo Chairman Richard Kovacevich blasted the federal government for relying on “asinine” stress tests to make business decisions regarding the billions of dollars in capital that it has invested in banks. Last week, the government used similar analyses to reject the business recovery plans of General Motors and Chrysler as “untenable,” thereby leading to the firing of GM CEO Rick Wagoner and a proposed shotgun marriage between Chrysler and Fiat.

Stress testing models can be quite complicated; as complex, in fact, as the economic models that (supposedly) sophisticated investors relied on when deciding to purchase huge quantities of mortgage backed derivative securities during the past decade. But when applied correctly, with a significant degree of healthy skepticism, stress tests can help us diagnose the financial problems that afflict firms.

In fact, the performance indicators that lie at the heart of stress tests have been in existence for almost a century; we can trace their roots back to the very birth of the modern business corporation. It might be helpful to revisit their origins to gain a bit of perspective on the uses of the stress tests of today.

Eureka! Smokeless Gunpowder!

The turn of the 20th century produced a steady stream of industrial inventions. The portable motion picture camera. The automobile. And smokeless gunpowder.

Smokeless gunpowder? Yes, smokeless gunpowder. It revolutionized blasting techniques and facilitated large-scale construction projects in major urban areas. And, somewhat sadly, it revolutionized the development of tremendously lethal war munitions as well.

This new product supported the rapid growth of DuPont Corporation, a Delaware based firm that contributed mightily to the industrial growth of the United States in the 1900s and 1910s, as well as the militarization of the American economy during the first World War. During that era, DuPont’s Chief of Financial Operations (and later President) Pierre du Pont organized the firm into a modern hierarchical and divisional business structure, and popularized the use of returns as performance indicators of firm success.

Three Indicators For Three Functions

For instance, du Pont believed that modern manufacturing organizations should focus on building three distinct functions. First, they should hire property development specialists to purchase land and construct factories. Second, they should hire salesmen to sell products to customers. And third, they should hire plant managers to produce the products in the factories.

Pretty basic stuff, isn’t it? Pierre du Pont’s great insight, though, is that the managers of each of these three functions should hire very different people with distinctly different skills and backgrounds. In fact, the officers who manage these functions don’t necessarily need to know each other at all in order to tend to their own divisional business. They don’t need to work in the same location, or to mingle at company meetings. As long as the property development team is visiting prospective factory sites, the sales team is backslapping customers, and the plant management team is supervising factory operations, the firm should be able to achieve prosperity.

Thus, the performance of each function within this triumvirate can be judged on the basis of its own outcome statistic. Over the past century, many different versions of outcome statistics have been developed; for instance, here is a “common sense” example of a Return on Equity (ROE) indicator:

> The property development team’s goal is to maximize the amount of property developed in comparison to the size of the firm; thus, its goal is to maximize the value of the fraction Assets / Equity.

> The sales team’s goal is to maximize the amount of products that are shipped and sold from the factories that are constructed by the property development team; thus, its goal is to maximize the value of the fraction Sales / Assets.

> The plant management team’s goal is to minimize the cost and thus maximize the profits that are earned by producing the products that are shipped and sold; thus, its goal is to maximize the value of the fraction Profits / Sales.

What happens if we multiply these three fractions together? Well, the Assets & Sales numbers cancel out of the numerators and denominators, leaving us with the fraction Profits / Equity …

… which you might recognize as the investment community’s favorite statistic, Return on Equity (ROE)!

Stress Testing

Pretty clever arithmetic, isn’t it? Because these three fractions are multiplied together to calculate ROE, we can immediately estimate how any changes in future business conditions might impact all three organizational functions, as well as the firm as a whole.

For instance, is the sales team slacking off? That wouldn’t impact the property development team’s fraction, but a decline in sales would obviously harm the sales team’s fraction … and it would likely damage the plant management team’s fraction as well. That’s because, due to a large portion of a manufactuer’s costs being fixed in nature, profits would likely drop more than sales on a percentage basis.

How badly would this impact ROE? Should investors be alarmed? On the back of an envelope, the CFO could easily multiply the three fractions together and estimate future ROE. In other words, by using these performance outcome statistics, the CFO could engage in a fair amount of instant analysis.

What if the members of the property development team protest that they deserve bonuses because they did their jobs well, despite the “screw ups” who are responsible for the other functions? That would necessitate a judgment call on the part of the CEO and CFO, but if the firm decides to reward them for their good work, they would be able to rely on these performance statistics to establish appropriate bonus levels.

Richard Kovacevich might indeed find this process asinine, and Rick Wagoner may not be particularly impressed by it either. Nevertheless, after a century of use in corporate settings, it is doubtful that performance indicators and stress tests will be fading into history any time soon.