Financial Services and Electricity - Show Me the Money
In the first edition of this blog, I noted that “the electric sector underpins every other essential industry sector, and it also relies on many of them. I…think of the overlaps like the Olympic rings – all interlinked, with some overlapping more than others.”
For the next several editions, I’ll continue to focus on each critical infrastructure sector in relation to the electric sector because electricity – which began to be deployed as a service close to 150 years ago – has enabled the progress, convenience and abundance that are hallmarks of modern life. Thereafter, I’ll get into the overlapping policy issues in more detail.
As is the case with several of these overviews, I will pause for a definition, this one once again from the federal government. I do this to contextualize these discussions specific to the thinking around criticality rather than commercial value or another parameter. With that (hopefully) clear, according to the Department of Homeland Security’s Critical Infrastructure Security Agency (CISA):
The Financial Services Sector includes thousands of depository institutions, providers of investment products, insurance companies, other credit and financing organizations, and the providers of the critical financial utilities and services that support these functions. Financial institutions vary widely in size and presence, ranging from some of the world’s largest global companies with thousands of employees and many billions of dollars in assets, to community banks and credit unions with a small number of employees serving individual communities.
This is a broad definition, covering a significant part of the modern economy. The kernel from which this sector started, however, is relatively simple. When bartering for goods and services eventually became too unwieldy (and as land and sea transportation became easier as described in the third edition of The Essentials, thereby enabling goods to move longer distances), metal and then minted coins were used to serve as a proxy for tangible goods. It was a lot easier to carry a bagful of coins than to haul a camel and herd five sheep to the next town to pick up a bushel of wheat.
With this change, people needed places to keep their excess money to prevent it from being stolen and, when lacking money, they needed a place to borrow it. Archeologists believe that metal was first used for money about 7,000 years ago, but the concept of banking as a trend came to prominence a bit later than some of the other critical infrastructure sectors we have discussed – about 4,000 years ago rather than 5,000-6,000 years ago like some. That is most likely because ancient banking built upon the evolution of these other sectors – particularly communications (described in the Fourth Edition of The Essentials) and transportation.
I will now pause for a public service announcement: There are many rabbit holes I could go down with this critical infrastructure sector – the history of money is fascinating (I alluded to it in the communications edition of this blog), the history of insurance and financial risk management, etc., but I am going to focus primarily on the banking and international monetary elements to tie into the investments needed in the electric sector and the reliance on access to capital.
Back to our regularly scheduled programming…According to Investopedia.com and Wikipedia, with further citations, the concept of lending began in ancient Sumer, Assyria, and India as well as, distinctly, in China, around 2,000 B.C. From this time, into ancient Greece and Rome, temples became the repository for money and also the place where lending, with interest, took place. References to moneylending occur in the Bible, with a reference from Exodus dating to about 1,500 B.C. indicating it was already a common practice at that point. Temples of all sorts were natural places for such deposits to occur because of 24/7 occupancy by priests and adherents and the assumption (not always correct, of course) of a certain moral code that would prevent most from undertaking fraud.
And, of course, the Romans eventually capitalized (ha!) on what came before them by creating a system of banks divorced from the temples. They enabled the concept of institutional banking, with all government lending and borrowing flowing through their banks, in addition to private transactions. With the fall of the Roman Empire in 476 A.D., banking throughout Europe, the Middle East and parts of Africa made little progress until several centuries later. However, in China, progress was made from 600-1,000 A.D., with the invention of checks that could be cashed by third parties and in far-flung locations. Their first paper currency in the world was likely issued in 1024 in the Sichuan province.
Back in Europe and on to a fascinating tidbit for any lovers of Dan Brown’s books – the Knights Templar made some of the same progress in the 11th century A.D. as had the Chinese over the previous several centuries. Yes, those Knights Templar. As the guardians of the tens of thousands of pilgrims traveling thousands of miles to Jerusalem and back, they realized that their jobs would be a lot easier if those pilgrims weren’t carrying loads of cash around to finance the food, lodging, and transportation they would need on their trip. So they developed a workaround. According to BBC.com:
“A pilgrim could leave his cash at Temple Church in London, and withdraw it in Jerusalem. Instead of carrying money, he would carry a letter of credit. The Knights Templar were the Western Union of the crusades. We don't actually know how the Templars made this system work and protected themselves against fraud. Was there a secret code verifying the document and the traveler's identity?”
As mentioned, the Chinese had developed this concept earlier, but that was a government supported effort while the Knights Templar’s innovation leaned more toward a public-private partnership, with support from various European royalty and the church, but initiated based on market conditions and in response to a need.
The next big innovation in Europe came with the advent of the Italian banks in the late medieval/early Renaissance Era. The interpretation at the time of Christian prohibitions on usury (charging interest on loans) caused some Christian groups to get creative about how to enable lending with interest without undermining their beliefs or getting crosswise with the church. Contrastingly, Jews following the Old Testament had no such prohibitions, except with each other – some Christians wanted to make inroads into this space. Families in Northern Italy did so by creating workarounds like, according to Wikipedia, developing a method “to offer money without interest, but also to require that the loan be insured against possible loss or injury, and/or delays in repayment.”Once these methods were developed, the Italians became central to European banking and arguably set the stage for much of the exploration and colonization to come in the next several centuries. The Medici family was the most famous of such Italian bankers, but only dominated the scene for about a century – from the late 1300s to the late 1400s. An Italian bank established in 1472, Banca Monti dei Paschi di Siena, is still in service today and is considered by most to be the oldest bank in existence.
Another major innovation came in the 16th and 17th centuries, when the Dutch developed the concept of “fractional-reserve banking,” which is now the default for all modern banks. It is such an embedded function that it’s hard to believe it had to be invented – but it is the concept that banks are required to hold a portion of their deposits in liquid reserve while the rest is available to lend to other borrowers.
Other innovations occurred along the way, but it’s now time for us to get to the more recent past. As with all other critical infrastructure sectors, pivotal changes took place starting in the late 1600s and continuing until today, with the first banks, and banking systems, recognizable as “modern” beginning to form during this time. The Bank of England became one of the first to issue “bank notes” in the late 1600s. Eventually, national currency and bank notes became one and the same, but initially, the notes were promissory in nature – paper money that could be redeemed by the bearer for its face value at the issuing bank. The 1700s produced more banking services such as overdraft protections and clearing houses for banks to compile their checks at the end of the day and exchange them for cash. In the 1800s, a formal bank clearing house was established in London called, logically, the “Bankers Clearing House.” While the Chinese had developed their banking system on a parallel track for much of their history, in the 1800s, their system overlapped with that of the British, and the Japanese ultimately emulated the French banking methodologies.
In the 1400s, the Italians, Spanish, Dutch and Germans all laid the groundwork for central banks via municipal banks that accepted cashless payments for international transactions. In 1664, the Swedish Central Bank became the first national bank providing such services and then the Bank of England in 1691. The trend caught on more fully in the 1800s, with Napoleon’s creation of a French national bank and subsequently the Bank of Finland in 1812. The United States resisted bank centralization until the 1900s, when it created the Federal Reserve system in 1913. Most non-colonized countries had their own central banks or banking systems in place by the mid-1930s, with countries that gained independence in the 1900s quickly putting their own central banks into place to facilitate trade, stabilize their currency and help control inflation. Some of the functions of central banks as they have evolved over the past 300 years or so, according to Investopedia.org are:
Central banks carry out a nation's monetary policy and control its money supply, often mandated with maintaining low inflation and steady GDP growth.
On a macro basis, central banks influence interest rates and participate in open market operations to control the cost of borrowing and lending throughout an economy.
Central banks also operate on a micro-scale, setting the commercial banks' reserve ratio and acting as lenders of last resort when necessary.
During the last 200 years of the Industrial Revolution and post-Industrial Revolution technological revolution, several other specializations and/or significant events have occurred. Debate about the best global or regional or national monetary standard or benchmark continued well into the 1900s, with the gold standard being used then abandoned by various nations or regions during this time, with most settling on paper currency after the 1944 Bretton Woods agreement.
Prior to that, from the early 1800s to the 1919, initial forays into a truly global financial market took place, with groups of countries forming monetary unions which were charged with enabling currency exchange among such countries and between them and other monetary unions. This era is marked by a bottom-up approach that resulted in relative global financial stability, even when large individual countries such as England or the U.S. had a financial “panic” or recession, it did not result in a cascading global event.
Post-WWI, a number of factors contributed to the Great Depression, a worldwide phenomenon that resulted in the failure of over 1,300 banks in the U.S. alone and, arguably, was a major factor spurring WWII. It resulted in extremely high unemployment rates and poverty for several years after the 1929 market downturn. One positive consequence of this global collapse in the U.S. was the creation of commercial banks and credit unions that catered to everyday people and small businesses rather than just large companies and governments. This, combined with the creation of the Federal Deposit Insurance Corporation to support these commercial banks, the federal mortgage interest rate deduction, the G.I. bill and the global monetary policy established by the Bretton Woods Conference in 1944, spurred massive middle-class growth and prosperity in the U.S. and elsewhere. It also bifurcated the banking system by enabling a class of banks now known as “investment” banks, that cater to large companies, industries like critical infrastructure sectors, governments, and institutional investors.
The meeting of representatives from 44 allied nations at Bretton Woods, New Hampshire, in 1944 established gold as the basis for the U.S. dollar with other currencies pegged to the U.S. dollar’s value. The Bretton Woods agreement also established the World Bank and International Monetary Fund. While this agreement effectively collapsed in the early 1970s when then-President Nixon of the U.S. announced he was not exchanging gold for U.S. currency, the IMF and World Bank remain today.
The Post-Bretton Woods System now governing global financial markets relies more heavily on a market-based approach. It has spurred increased globalization and China’s entry into the global marketplace as well as phenomenal technological advancements, but has also resulted in major volatility and a global economic crisis in 2008 – causing some to call for a reboot of Bretton Woods. The COVID-19 pandemic, the response of nations and financial markets to that crisis, global supply chain concerns and 40-year high inflation have spurred additional evaluation of global monetary policy and structures.
The other big change in the banking/financial services industry has been the rapid deployment of digital technologies and their related online services, which have transformed customers’ interactions with banks and the financial markets. Like with the electric sector, these technologies bring with them serious cybersecurity risks that must be managed indefinitely.
Banking and monetary policy (as well as insurance and risk management) underpin the ability of electric utilities and power producers to operate. Again, it is no coincidence that the last 150 years of electricity’s use and expansion have coincided with the increased sophistication of banking and financial markets, enabling access to capital for such a highly capital-intensive industry. According to Jenny McArthur of King's College London in her 2019 paper entitled “Infrastructure Finance: Historical Perspectives and the Evolution of Financial Instruments:”
"Infrastructures are usually identified as large physical assets or networks, but it is their relational characteristic, providing connectivity or supporting flows, that qualifies them as infrastructural in nature. In the context of finance, this duality translates into physical assets (things) that can be leveraged as collateral, and flows (the relations between things) that are typically treated as potential revenue streams.”
In the electric sector, three main types of infrastructure exist – power plants, high-voltage transmission lines with bulk power transformers, and lower voltage distribution lines with distribution transformers. All require initial large capital investments to construct and ongoing operation and maintenance – some power plants cost billions of dollars.
In the U.S., there are three primary types (or business models) of electric utilities or entities that build electric infrastructure, as discussed in the second edition of The Essentials – private for-profit (investor-owned utilities or independent power producers), private not-for-profit (rural electric cooperatives), and public not-for-profit (publicly owned utilities, often called “munis”). Because of their tax status, each of these entities accesses different types of financial instruments to raise capital, but they all need banks to enable this access or to provide the capital themselves, to invest their profits or reserves, and to provide lines of credit and alternative financing in times of crisis (such as happened to some utilities after Winter Storm Uri in 2021). Healthy financial markets and lower costs of capital (low inflation) enable utilities to invest in their infrastructure while minimizing rate impacts on customers. Alternatively, higher costs of capital can put upward pressure on rates, thereby flowing through the whole economy.
Here are some other ways that the financial services sector and the electric sector overlap:
Reliance on transportation. Ultimately, money or gold must be transported at various times for liquidity, audits, etc. Digital systems have enabled online banking and, therefore, less need for physical currency and future financial instruments may eliminate the need altogether, but for now, transportation is still an element. Electric utilities transport coal, but also must ensure deliveries of critical grid components, bucket trucks, copper wire, poles, and the list goes on…
Reliance on critical manufacturing. Money itself must be manufactured and the digital systems enabling online banking must be as well. Electricity powers both manufacturing facilities and needs the output of some of those facilities to operate.
Environmental regulation/climate change. This is less direct for financial services, but banks have certainly weighed in on the ESG (“Environmental, Social and Governance”) positions of electric utilities as a criteria some deploy when evaluating lending or creditworthiness. This area may be more tangential, but there should at least be situational awareness between the two sectors.
The use of natural gas. Natural gas comprises approximately 40% of domestic electricity generation, and it is used for heating in many parts of the country. Price volatility in natural gas markets can impact electricity markets in major ways, in turn causing utilities to eat into their profits or operating reserves. This is a different lens than we have seen with other critical infrastructure sectors I have already touched on.
Workforce challenges and the knowledge drain that has resulted from retirements in recent years.
Supply chain constraints that impact every aspect of infrastructure deployment and maintenance.
How to best use technology to create efficiencies and minimize expenses.
How to manage the cybersecurity risk that comes with those technology deployments. This is huge for both industries – both of whom have done very well in assessing those risks and understanding mitigation, but who could and should keep learning from each other. Good collaboration already exists on cybersecurity and should be supported and encouraged.