GOOD DERIVATIVES: A conversation with University of Minnesota alumnus RICHARD SANDOR

1. GOOD DERIVATIVES: A conversation with University of Minnesota alumnus RICHARD SANDOR April 24, 2012 The HELLER-HURWICZ ECONOMICS INSTITUTE is a new global initiative in the College of Liberal Arts at the University of Minnesota created to inform and influence public policy by supporting and promoting frontier economic research and by communicating our findings to leading academics, policymakers, and business executives around the world.

2. GOOD DERIVATIVES PRESENTATION BY RICHARD L. SANDOR, CHAIRMAN AND CEO OF ENVIRONMENTAL FINANCIAL PRODUCTS Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

3. ECONOMISTS’ VIEWS ON FINANCIAL INNOVATION AND DERIVATIVES Paul Volcker, Former Chairman of the Federal Reserve “The most important financial innovation that I have seen the past 20 years is the automatic teller machine…I wish someone would give me one shred of neutral evidence that financial innovation leads to economic growth. One shred of evidence.” Joseph Stiglitz, Nobel Laureate in Economics  "I cannot find a social good in complex derivatives. They were designed to manage risk, but they actually increased risk.” Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

4. WHO IS HENRY FORD? Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

5. WHO IS LUCA PACIOLI? Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

6. Henry Ford (1863–1947) was an American industrialist, the founder of the Ford Motor Company, and sponsor of the development of the assembly line technique of mass production. Luca Pacioli (1446-1517), author of Summa de arithmetica, geometria, proportioni et proportionalità, is the “Father of Accounting” "A Person should not go to sleep until the debits equals the credits!" Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

7. WHAT ARE GOOD DERIVATIVES Financial futures and options that are traded on exchanges • Transparent • Regulated (government or self regulated) • Centrally cleared (minimize counter party risk) These conditions are sufficient but not necessary Good Derivatives also include products such as interest rate and foreign exchange swaps which are not centrally cleared Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

8. WHAT ARE BAD DERIVATIVES? • Opaque • Insufficient capital for the risks involved • Unregulated Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

9. GREECE • 10-year Greek government bonds default spread (2005): 27 basis points • Yet, 50.6%*chance of defaulting! Greece has spent more than half the years since it became independent in 1829 in default. *According to a 2008 NBER paper by Kenneth S. Rogoff and Carmen M. Reinhart, "This Time is Different: A Panoramic View of Eight Centuries of Financial Crisis", Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

10. US REAL ESTATE • 1970s: ↓5% • 1980s: ↓13% • 1990s: ↓13% • 2006-2011: ↓41%* *Data from historical Case-Shiller index. Percentage declines reflects the largest peak to trough for each period Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

11. CREDIT RATINGS CREDIBILITY CHECK • Standard and Poor's rated over 16,907 securities AAA (2000-2008) • S&P rated 16 countries AAA (2000-2010) • Microsoft, ADP, Exxon and Johnson and Johnson are the only AAA rated American companies Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

12. HOW DO GOOD DERIVATIVES EMERGE? 7 Stages of Market Creation • A structural economic  demand for capital • Standardization • Evidence of ownership • The development of informal spot and forward markets. • The emergence of securities and commodities exchanges • The creation of organized futures markets (standardized contracts for future delivery on organized exchanges and options markets) and options (rights, but not guarantees, for future delivery of futures contacts) • The proliferation of over-the-counter markets (OTC)/deconstruction Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

13. GROWTH OF GOOD DERIVATIVES • 1970: Volume US futures trading=13.7 million • 1975: US dominated derivatives trading. Trading in Canada, UK, Australia and NZ constituted less than 7% of the world's total volume • 2010: 22.3 billion contracts traded on more than 78 derivatives exchanges in 36 countries • CAGR in the volume of futures and options traded was over 18% from 1970-2010. The industry doubled every 3.9 years • This exceeds the CAGR of airline passengers (5.1%) and passenger cars (3.2%) in the same period Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

14. GLOBAL FINANCIAL FUTURES & OPTIONS VOLUME 1975 2010 Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

15. MARKET CAP OF TOP 5 US AIRLINES(APRIL 2012) American Airlines: 0.165B United/Continental Airlines: 6.99B Southwest Airlines: 6.35B Delta Airlines: 8.67B US Airways: 1.26B Total 23.4B Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

16. MARKET CAP OF US DERIVATIVES EXCHANGES (APRIL 2012) CME Group: 18.91B CBOE: 2.43B IntercontinentalExchange (ICE): 9.87B Total 31.21B Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

17. GOOD DERIVATIVES IS A MIDWESTERN STORY • Financial futures • Event-based derivatives • Environment Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

18. DRIVERS OF GROWTH • New products • Electronic trading • Demutualization Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

19. 1969 SYSTEMS FLOW CHART:ELECTRONIC TRADING (Left) Preliminary Design for an Electronic Market for the for-profit Pacific Commodities Exchange Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

20. 33 YEARS LATER….“THE WAGNER PATENT LAWSUIT” Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

21. EXCHANGE ORGANIZATION & ELECTRONIC TRADING 20-30 YEARS LATER • Most exchange IPO’s occurred between 2000 and 2007 • Most exchanges became electronic1985 and 2000 • Growth of demutualization between 1990 and 2008 Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

22. FIRST INTEREST RATE FUTURES First GNMA Mortgage Interest Rate Futures Contract Seller must deliver a $250,000 face amount of 6.5% GNMAs with a 4.0 percent tolerance, that is, $240,000 to $260,000. The minimum price increment or tick size was established at 0.01 percent of par or $25 per contract. The trading limit was set at 0.5 percent of par above or below the previous day’s settlement price, or $1,250 per contract. Final GNMA Futures Contract $100,000 market value of GNMA’s had to be delivered under the assumption that the interest rate was 8%. Tick size was set at $31.25 per contract. Trading limits was set at three quarters of a point, or $750 per contract, above/below settlement prices.  23 subsequent drafts! This was an iterative, interactive process! Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

23. APPLICATION OF GOOD DERIVATIVES: HOUSING • Futures markets drove the spread to 1/32 • Average savings for a US homeowner: $5,959.27 • (2010) $269,843,750 in savings in the primary market, and $9,343,750,000 in savings in the secondary market • These benefits would go to pension funds, mutual funds, insurance companies, dealers…etc. Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

24. APPLICATION OF GOOD DERIVATIVES:GOVERNMENT DEBT U.S. 10-year Treasury Note Futures Contract (Most Widely Traded) The launch of 10-year T-note futures narrowed the big-ask from 1/8 to 1/32 Primary issuance savings: $245M Secondary market savings: $5.6B Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

25. APPLICATION OF GOOD DERIVATIVES: TRANSPORTATION Southwest Airline’s Fuel Hedging Program • Hedging fuel allows the airline to purchase fuel at prices agreed upon in advance • This allows the airline to avoid fuel price volatility • Lower ticket prices for you and me! Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

26. APPLICATION OF GOOD DERIVATIVES: ENVIRONMENT (Left) Chicago Board of Trade, March 1994 (Photo Source: Mainichi Evening Eye) Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

27. SO2 MARKET BENEFITS US Clean Air Act 1990 Acid Rain Program annual benefits (2010): $122B Costs (2010): $3B • This is a 40-to-1 benefit/cost ratio Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

28. SO2 REDUCTIONS Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

29. APPLICATION OF GOOD DERIVATIVES: HEALTH US Clean Air Act 1990 • EPA estimated the annual avoidance of about 32,000 and 42,000 premature deaths in 2010 and 2020, respectively • Other benefits: reduced aggravation and incidence of heart and lung ailments, increased productivity, reduced absences from school/work, and visibility improvement in some parks Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

30. APPLICATION OF GOOD DERIVATIVES: ADDITIONAL FARM INCOME Dairy farms could now produce two joint products: Milk and Renewable Energy Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

31. APPLICATION OF GOOD DERIVATIVES: FOOD • Farmers could hedge crop prices to keep the cost of raw agricultural commodities, like corn, low • Mitigate or avoid food shortages (Right) Max Naylor, a farmer The Jefferson Bee, Jefferson, Iowa, May 6, 1974 Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

32. APPLICATION OF GOOD DERIVATIVES: INTEREST RATE RISK MANAGEMENT • Interest rate hedging lowers the interest rate risk at commercial banks and allows loans to be made at little to no risk • Provides capital to small businesses • Job creation Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

33. APPLICATION OF GOOD DERIVATIVES: PRICE SIGNAL Isaac Berzin, Founder of Greenfuels • In 2008, Berzin was named to the Time 100 Most Influential List • Used CCX carbon prices to estimate the return on his investment. • Financed his process with a CCX member who gave him $10 million Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

34. APPLICATION OF GOOD DERIVATIVES: PRICE SIGNAL Methane capturing project on Kerala, India (Right) A huge event was held in Kerala to distribute the first CCX checks Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

35. WHAT IS CHICAGO CLIMATE EXCHANGE (CCX)? A voluntary, market-based, solution to climate change Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

36. CCX MEMBERS Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

37. CCX Baseline Emissions Greater than Largest EU National Allocation Plan Size of Live, Emerging, Possible GHG Trading Markets 2003 start 2009 2012 Reproduction or quotation of this material is expressly forbidden without the consent of the Author.

38. CCX FAMILY OF EXCHANGES Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 38

39. CCX PRICES: HISTORY OF US CLIMATE CHANGE LEGISLATION Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

40. ENVIRONMENTAL RESULTS OF CCX Entity-wide emission reductions in excess of Program requirements, with no hampering of Membership’s economic growth Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

41. CALIFORNIA- A LEADER • Facebook • Apple • Seatbelt Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

42. CA CARBON ALLOWANCES TRADING ACTIVITY • 4,054,000 contracts traded on ICE from Aug 2011 to March 2012 • Total open interest was 1,055,000 by the end of March 2012, or $16,088,750 (given $15.25 settlement) Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

43. New Markets • China has largest SO2 Emissions in the World, 3X larger than U.S. • U.S. Allowance Market Value (2007) of U.S. SO2 emissions: $2.8bn • Annual value of SO2 futures trading could range from $28-$84 billion 2005 Annual SO2 (Million Tons) $2.8bn Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC 43

44. NEW RISKS Fukushima Disaster Economic Cost (World Bank Estimates, March 2011): $235B Insured Losses (RMS Estimates, April 2011): $21-34B Hurricane Katrina Economic cost: $125B Insured Losses: $66B Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

45. US INSURANCE INDUSTRY UNDERCAPITALIZED United Nations estimates disasters to cost the world a record figure of more than $380B in 2011 Over $110B of insured losses in the last 12-24 months Net worth of US insurance companies as of March 2011: $564.7B

46. Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

47. FOOD FOR THOUGHT • 1787 Constitution of the United States 6 pages • 1913 Federal Reserve Bank Act: 25 pages • 1974 Commodity Futures Trading Commission Act: 148 pages • 2002 Sarbanes-Oxley Act: 66 pages • 2003 CCX rule book 200 pages • 1990 Clean Air Act Amendments: 800 pages Portion devoted to SO2: 15 pages • 2009 ACES Act: 1,427 pages • 2010 Dodd- Frank: >2,000 pages Longer than the Old Testament, New Testament and the Koran, combined

48. THE NEXT 40 YEARS- A WORLD OF OPPORTUNITIES New Geographies (structural demand coming from Asia, Latin America, Africa) • Are the regulations in place in these new geographies? Challenges ahead • Developed financial markets can help the growth of the real economy in countries such as Brazil, India, China Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

49. THE NEXT 40 YEARS- A WORLD OF OPPORTUNITIES New Products – where will innovation come from? • Public goods – air, water, health, biodiversity • Infrastructure • Events • IP (how does one hedge innovation) • Existing Commodities (electricity, rice…etc.) • Capacity Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC

50. CENTRAL LESSONS • Good derivatives create value for society and prevent systemic breakdown of financial institutions and capital markets • Financial innovation and its actors are often overlooked • Markets do not exist by themselves but have to be created • Markets can be designed to solve social and economic problems Reproduction or quotation of this material is expressly forbidden without the consent of the Author. 2012 Environmental Financial Products LLC