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The World According to Richard Sandor

Richard Sandor has been called “the father of financial futures” ever since the 1970s, when he helped develop the Chicago Board of Trade’s Treasury futures contract. A former professor at the University of California at Berkeley and a lecturer at Stanford, he has held senior positions at Kidder Peabody, Drexel Burnham Lambert, Banque Indosuez and the Chicago Board of Trade. He is currently the chairman and CEO of Environmental Financial Products, a Chicago-based company specializing in the environmental, financial and commodity markets. Sandor is also a senior adviser to PricewaterhouseCoopers on greenhouse gases emissions trading, a visiting scholar at Northwestern University, and chairman of the board of Hedge Financial, a subsidiary of CNA that seeks to bridge the gap between the reinsurance and capital markets. Sandor spoke with managing editor Robert Hunter in October.

Derivatives Strategy: Someone recently sent me an ancient clipping from the June 25, 1970, Financial Times in which you’re quoted as envisaging “the exchange of the future” hooked up by a “vast communications network” of computers with split-second order execution. It’s safe to call such an idea prescient.

Richard Sandor: I was working at Berkeley at the time, and it was a very fertile period in a very fertile intellectual environment. A lot of ideas came to the surface—some of which were ahead of their time and some of which were simply on time. I’ve spent the last 30 years trying to turn those ideas into realities.

So much of the earlier work done in the futures markets was to develop bellwether indices for large open-outcry exchanges. But electronic trading has allowed us to enter what could be termed a “deconstructivist” phase, in which there can be hundreds of thousands of small, Internet-based markets. We’re seeing a vast change, whether we’re talking about electricity, power, cement, steel or mortgages. The way financial and physical commodities are bought and sold is going to change dramatically in the next century. It’s happening already.

The next financial revolution will be in the convergence of the financial markets and the environment.

I am privileged to work with Battery Ventures, a top-performing technology-focused Boston venture capital firm. One of their companies, Altra Energy, trades spot propane, natural gas and electricity. It did $6 billion worth of transactions in 1998, and it controls 40 percent of the liquid natural gas market. Now it’s been launched as an Internet-based exchange for trading electric power in competition with Bloomberg, and it already has couple-thousand registered users worldwide for its products.

DS: A lot of these Internet-based exchanges don’t quite seem ready for prime time.

RS: I’m not sure. Let’s wait and see. Patience is critical. I worked on the concept of financial futures in the 1960s, but it wasn’t ready to explode until the 1970s. Then, in the 1970s, I worked on insurance derivatives, but that didn’t really take off until the 1980s and 1990s. These markets require a decade or more to mature. The next financial revolution will be in the convergence of the financial markets and the environment, and that’s what I’ve been spending most of my time on these days. The environmental area has interested me since the first Earth Day in Berkeley in April 1970.

About 10 years ago, following the development of the SO2 market, I became interested in trying to develop a market for carbon emissions trading—carbon dioxide being the principal greenhouse gas that causes global warming. I gave a paper on this in Rio at the Earth Summit in 1992, asking the question: “Could you develop market-based solutions to this major environmental problem?”

Since then, my company has acted as a consultant for the government of Canada to develop national protocols for emissions trading. And recently, we’ve announced the largest spot trade ever in greenhouse gas emissions. Ontario Power Generation, one of the largest utilities in North America, will be buying 2.5 million tons of carbon dioxide-equivalent from Zahren Alternative Power Company (ZAPCO).

DS: Why is this deal groundbreaking?

RS: It offers a glimpse of where the markets are heading. ZAPCO has a low-tech business. It sinks pipes into landfills and recovers the methane, which is a greenhouse gas that’s 21 times more potent than carbon dioxide. ZAPCO burns the methane and sells the power to local electricity producers. So ZAPCO is simultaneously cleaning up the landfill and developing sustainable power, because the landfill continues to produce methane. This reduces the amount of greenhouse gas in the atmosphere, and that reduction is being purchased by Ontario Power.

DS: So there’s a financial incentive to take care of the environment.

RS: Exactly. And there’s another way the environment and the capital markets are converging. I’m a principal in a company called SAM Sustainable Group, which manages $150 million in assets using a sustainability filter. The fund is called the Sustainable Performance Group. SAM operates under the assumption that shareholder value increases with corporate sustainability efforts, be they social, environmental or financial.

Two years ago, I had the responsibility of recommending to the portfolio managers at SAM Sustainable Group that they make an index to weight companies by their sustainability, including financial sustainability, social sustainability and environmental sustainability. We began working with Dow Jones, which decided to brand the index. In September we rolled out the Dow Jones Sustainability Group indices. We found the following: When we looked at financial performance, social performance, environmental performance, energy efficiency and so on, and balanced the portfolio the same way the Dow Jones Global Index does, the companies that were the most sustainable overall turned out to be the best stock performers. Take the oil industry. When you pass the sustainability filter through it, the best company to pick is British Petroleum—and its stock happens to be the best performer.

DS: Why do you think that’s the case?

RS: The sustainability filter might be a surrogate for good management. There’s a real latent demand for sustainability. People are recognizing that it’s not just P.R.—if you sincerely run your company with a notion of sustainability and efficiency and are environmentally sensible, it turns out that not only do you feel positive about it, but it maximizes shareholder value. The numbers back this up. The U.S. component of the Dow Jones Sustainability Index during the last five years yielded a 274 percent rate of return, compared with 177 percent for the comparable Dow Jones Global Index in the Americas. If you compare it with the Standard & Poor’s 500, you get 25 percent higher returns per year and only a 1 percent pickup in volatility.

Soybean farmers, by changing their tillage practices, can sequester carbon in the soil and grow two crops—soybeans and carbon. You could increase net farm income by $4 billion to $6 billion.

I think this index is going to have an enormous impact on the debate about global warming. Markets are going to motivate behavior. As it becomes common knowledge that this approach is not simply for tree-huggers—but that it makes sense from the point of view of how you run your business and your share prices—I think the markets are once again going to play a critical role in behavior. Ethical behavior and environmental behavior lead to maximizing shareholder value.

DS: And the same thing is happening in carbon trading?

RS: In real estate, it’s location, location, location. In carbon trading, it’s price discovery, price discovery, price discovery. We’re finding that the $250 a ton forecast cost of carbon that’s ascribed to economists and prominent consulting firms is way too high relative to the market. And if we can discover the price of mitigating greenhouse gas emissions, it’ll get done. If we can discover that the price impact of environmental behavior is positive on equities, we’ll get the changes in behavior that serve the environment.

DS: How big can a market like that become?

RS: The possibilities are enormous, for two reasons. First, these markets will ultimately be all electronic, which will open up access that never existed before. Second, sulfur is a small emission compared with carbon, which would be the mother of all environmental markets. Worldwide, every major corporation, not to mention agriculture, would be involved.

The companies that are the most sustainable overall turn out to be the best stock performers. Take the oil industry. The best company to pick is British Petroleum—and its stock happens to be the best performer.

Consider this: Soybean farmers, by changing their tillage practices, can now sequester carbon in the soil and, in effect, grow two crops—soybeans and carbon. We reckon that you could increase net farm income by $4 billion to $6 billion by having the farmers produce this new carbon crop. In the future, they’ll be able to sell those two crops forward the same way—via Internet exchanges. So you have a market that could be $10 billion or $20 billion, which could create a futures market trading 100,000 contracts a day.

DS: Ultimately, this could be as large as, say, the weather markets.

RS: Bigger. And it’s interrelated to the weather markets. If you have a hot summer, for example, fuel prices go up, more fuel is burned and more carbon is emitted. So there’s a tie-in with energy, weather derivatives and environmental derivatives. They become inseparable. More important, the public utilities of the future will start to look a lot like banks. They’ll have variably priced outputs, some with positive prices, some with negative prices—that is, environmental emissions—and variable priced inputs such as fuel. So the utility of the future is basically an asset-liability manager.

DS: So in 10 years, you envision a market that is based entirely on Internet-based trading of gas, power...

RS: Gas, electricity, emissions, power—the whole works. The Internet allows us to trade electricity in a thousand different locations efficiently, just as it will allow us to trade weather derivatives in 50 or more cities. The transaction cost in environmental products is going to be de minimus. If you were to ask to the Chicago Board of Trade or the Chicago Mercantile Exchange to spend $5 million to build a plywood pit and develop market-makers in order to set up a market that’s going to trade 1,000 contracts a day, the answer from a cost-benefit point of view would be that it doesn’t pay. But if you put it on the web, simply posting bids and asks, it’s a different story. E-Bay conducts 2 million auctions a day electronically—why can’t markets do the same?

This will give you an idea of how far the world has come. As part of the advisory group work we do for the United Nations, we ran a simulated trading session in Moscow recently, giving out carbon allowances and creating a fictitious market. Can you imagine the kind of surrealism this created, running simulated trading of environmental derivatives in a U.N.-based Moscow-located forum? Paraphrasing the old television commercial, derivatives have come a long way, baby.

And there’s still so far to go. We recently received requests from the Brazilian states of Amapá, located at the mouth of the Amazon River, and Amazonas, also located on the river, to develop position papers advising them on how to securitize their energy efficiencies and protect their tropical rainforest. If you reforest an area where a rainforest has been chopped down or otherwise destroyed, you can sequester and capture carbon in the trees to sell as emission offsets into developed countries’ markets. We have some of the biggest states in Brazil asking us how we can save the rainforest through environmental derivatives. This is really exciting stuff.

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