The Principal Global Macroeconomic Risks to 2050 and their Consequences for UK Water Industry Investment and Operations CIWEM Office, 15 John Street London, 2012 Dr Steve Palmer

Global GDP growth: origins of demand side risk profile

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Agricultural mechanisation

Industrial mechanisation

Information Technology

The BRIC economies now the engines of global growth 50% Population increase by 2050 Food production needs to increase by

70% 30% of the global population

industrialising in 2 -3 decades

Speaker Notes

Slide 2 The first industrial revolution in the UK massively increased productivity and output as a result of widespread mechanisation. The same is now happening with the BRIC economies and China and India in particular- but compressed into a much shorter timespan over a much larger scale. The demand on global resources is consequently much larger- trough a period in which global population s also rising by 50%. Most global growth is being contributed by the BRIC economies and of these China and India are now the main engines of global growth.

Slide 5 The BRIC economies obtain significant productivity benefits from their industrial and associated infrastructure expansion. This means that in comparison to the mature industrialized OECD economies, they can afford to secure resources and accommodate higher prices than the OECD for resources because the returns are greater for them.

Slide 6 The BRIC economies obtain significant productivity benefits from their industrial and associated infrastructure expansion. This creates a strong demand profile even when costs are increasing – but does not mean that BRIC economies are immune to increasing costs.

Slide 7 Substitution will not work if other market incentives overwhelm the opportunity to exploit a substitute. For fossil fuels this includes write off of investment costs in exploration and also in production/processing and distribution infrastructure. There is a capital inertia that should be taken into account when a company with significant fixed long term capital assets is seeking to maximize return on investment to its shareholders and stakeholders

Slide 8 The International Energy Agency (IEA) in particular has both made an assessment of the level of global investment in energy infrastructure required to meet projected GDP growth demands and also to keep to the IPCC 450ppm carbon dioxide limit 50% probable to keep global warming to 2 degrees Centigrade. Currently, investment in energy infrastructure is below the level needed to meet GDP demands from fossil fuels and utterly insufficient enough to meet the IPCC 450ppm carbon dioxide limit (50% probable to keep global warming to 2 degrees Centigrade).

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Notes by Tim Evans, Technical Secretary FWR Wastewater Research & Industry Support Forum

Per capita GDP in the UK took off exponentially with agricultural mechanisation. GDP growth has driven energy consumption and despite increasing energy efficiency there is still a big increase in demand which is being satisfied mostly from fossil sources.

Cohen &Steers (2009) [slide 8] underestimated investment requirement for water because they did not factor in the water needed for electricity generation or for irrigation

Steve used the US Bureau index of chemicals for discounting the water industry’s costs The City has not yet recognised that some resources are not only limited but also non-substitutable, the City

still assumes that substitution will be possible when a resource becomes very scarce; clearly this is a fallacy for phosphorus.

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Demand side Risk profile

ENERGY: Significant Energy efficiency increases -but o In OECD, increases in efficiency significantly

due to export of heavy industry from OECD to

developing economies – where activity often less regulated and less energy efficient

o The global economy has a minimum manufacturing base requirement for its GDP

o Globalization has increased commodity and goods transportation and fuel demand

Efficiencies outweighed by demand : Net Energy demand increase 39% by 2030

Global emissions on track to exceed 2o C of warming FOOD o Direct &indirect competition between biofuels & food

production o P required for food growth, 1st & 2nd generation

Biofuel growth, synthetic biology feedstock's

Supply side: Food Risk Profile

FOOD

o Climate change increasing agricultural losses o No sustained recent increases being made in

per capita food production o Land area exploited likely to remain similar

to 2010 in 2050 o Food competing against Biofuel and

synthetic biology for land and fertilizer o Phosphorus, like oil and gas, switching

increasingly to non conventional sources due to demand

o Phosphorus supply hiatus in 2008 led to 700% increase in P-fertilizer price and increased food prices

SUBSTITUTION?: There is no substitute for Phosphorus

Supply side: Energy Risk Profile

ENERGY o Global energy mix and downstream processing predominated by fossil

fuels o Present fuel mix 80% fossil fuelled o Markets not meeting need for more renewable energy (probably due to

level of outstanding subsidies for fossil fuels-IEA) Why is demand for oil alone, so resilient?

o EROI = ratio of energy output from fuel to energy needed to produce

it or find it. o Net level of energy return (EROI) from fossil fuels decreasing as new

sources require more energy input and cause more emissions – pushes fossil fuel cost upwards

o EROI for renewable power better (up to 300%) than for Fossil fuels but market not acting on this advantage

SUBSTITUTION? : Energy companies have huge capital investment (&write off risk) in fossil fuel infrastructure in exploration, production and distribution and a duty to maximize return to shareholders. Fossil fuel prices are presently high and margins good on low volume sales.

Example: OIL: OPEC countries seek prices minimum oil prices ~US$100/bbl. Global transportation and agriculture massively underpinned by ICE (internal combustion engine) technology)

EROI for bio-ethanol is 0.6-1.2 – it takes as much or more energy to produce than it delivers- but existing ICE market is huge

Supply side risk: Infrastructure Capacity and Capacity Development

Total global infrastructure market from 2010-2035: US$ 40 trillion

Example Investment Management Fund (Cohen &Steers, 2009) WATER

GLOBAL: US$ 22.61 trillion Underestimate- does not allow for increased agricultural demand for water -

need for more water reuse

ELECTRICITY GLOBAL:US$ 9 trillion FOR ENERGY, THESE ARE UNDERESTIMATES IEA estimates energy infrastructure spend to meet IPPC target of 450ppm

mean atmospheric carbon dioxide is US$ 33Trillion –much more than Mutual Funds are projecting for energy infrastructure. There is a higher infrastructure investment need than the market currently perceives and therefore a risk of a capital funding gap

IEA warning to ministers in 2009 after 2008 financial crisis: insufficient

investment in global energy capacity

Speaker Notes

Slide 10 Recent research (Rustad, 2012) shows global demand for a ranges of resources has shifted to exponential or beyond, to super exponential production- but only over the last two decades. This is consistent with globalization and the emergence of high rates of growth and resource demand for that production, for the world, principally based in the BRIC economies.

Slide 11 Price increases are common not only to energy, but a range of strategic commodities. If only price volatility were increasing, the amplitude of price change would increase but the underlying trend would be broadly neutral or reflect historic monetary inflation for periods and economies. Recent underlying trends across all key commodities reflect a general stress on resources and capacity- part of which is infrastructure demand based.

Slide 12 The UK provides an example of a state legislating for climate change regulation which also is exposed to the global pressures on energy costs and competition for resources. The UK is now a net energy importer. This has resulted in the inflation measure for consumption (CPI) increasing above the inflation metric for production (GDP deflator). This is because the UK is now a net importer of natural gas, which is principal fossil fuel for electricity generation. Some 26-32GW of generating capacity is required to meet UK needs by 2030 but HMG has already missed a 2010 target of 10% of electricity generation from renewables. Consequently, HMG introduced further legislation in 2011, including a carbon floor price as well as retaining a range of subsidies for renewable energy, to move the market towards the renewables provision it is seeking.

Slide 13 Inflation metrics include those for consumption and production. The UK metrics for consumption include the RPI, which is rarely used now due to its volatility, its redevelopment the RPI-X used for most UK infrastructure development and the HICP is the EU consumption metric (known as the CPI in the UK). For production, the GDP deflator is the inflation metric. The consumption indices are weighted indices based on individual cost of living and have no bearing on a corporate cost base apart from the traditional assumption that it is salary based. If the water industry corporate cost base is longer predominated by salaries, these consumption indices will NOT represent the true inflation risk profile for a water company.

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Outcomes of Supply and Demand risks

o IMF Food and Energy Price indices converging o IMF Commodity Price index most affected by energy price

index

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IMF Commodity Price Index compared to IMF Energy cost

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IMF Food Price and Energy Price Indices 1992 -2011 Food Price Index Energy Price Index

Rustad (2012) :rates of production (and hence demand) of a range of commodities showing exponential to super -exponential growth in last 2 decades

Outcomes of Supply and demand risks: Price trends in the last decade

The UK Example of the Global trend: Operating cost Risks

Energy demand outpacing supply by 2030 Extra £100-200Bn investment required HMG-DECC: ‘market not reacting sufficiently to renewable

requirement’ 2011: New legislation- new subsidies and carbon penalties

The UK Example of Global trends: Inflation

Resilient (sticky) UK INFLATION Measures include consumption and production metrics Consumption includes CPI, RPI and RPI-X Production metric is the GDP inflator ‘Core inflation’ – has no common global definition. In UK it

excludes energy and food costs because they are considered too volatile//noisy and not a durable part of inflation

But what if they now are a durable and leading part of core inflation ?– their exclusion will mean the core inflation measure is NOT representative

These are all weighted cost indices- there is no CPI for a water company as a consumer

Until NOW

Open Letters If inflation moves away from the target by

more than 1 percentage point in either

direction, the Governor is required to

send an open letter to the Chancellor.....

Thirteen letters have been written since 2007

Speaker Notes

Slide 15 The water industry corporate cost base is longer predominated by salaries, so these consumption indices will NOT represent the true inflation risk profile for a water company (compared to cost of living for an individual). When the difference between the CPI and GDP deflator is compared, consumption inflation has begun to outpace production inflation. This is likely to be associated with UK reliance on energy imports when the global trend is to increasing fossil fuel price.

Slide 16 Median Water is a virtual water company with a virtual asset base consisting of virtual treatment works and hence generates operating costs, profits, returns to shareholders and a demand for electricity, materials and services and a corporate carbon footprint . Its asset base is based on the median of UK declared water company accounts from the UK water regulator, OFWAT.- hence the name of ‘Median Water’ for the model.

Slide 17 Challenging times demand careful strategy selection, to ensure the best return on capital while minimizing erosion of the bottom line(s). The problems need to be analyzed, potential remedial synergies identified and a manageable remedial program to meet the challenges on time, to a minimum budget, developed.

Slide 18 Delivering the most cost effective program of solutions requires a detailed understanding of the existing asset base and its strengths and weaknesses against the emerging risk. Minimizing investment costs requires an understanding of where the existing asset base strengths are and can built upon

Slide 19 The bulk of carbon is associated with the bulk of water and pollutant mass processed- which is at the small number of larger sewage works in a UK water company WWTW asset profile

Slide 20 Again, its mainly at the large assets

Slide 21 There are established limits to energy efficiency measures at contemporary medium and large sewage treatment facilities. To achieve energy neutrality, the bulk of the large works’ electricity budget needs to be met by on-site renewable energy generation

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UK Example of Global trends: Inflation

A model CPI for a UK water company as a consumer

For a UK water company,

consumption inflation is running 1.6x to 2.2xhigher than RPI-X and CPI respectively

Its becoming more expensive to consume

Since 2007, inflation in consumption has increased above production inflation

Probably due to more reliance on

energy imports and global energy

price trends (e.g. natural gas)

Virtual Asset base and operations

Virtual bottom line

Projecting the effects for the UK Water sector: a Model Water company

Rising Operating costs

Climate change and Carbon targets

Bottom line(s):

Operating margin

Return to shareholders

Retained profit

Competitive position

Capital initially more expensive and harder to obtain (2010-20?)

Median Water: the chief executives in-tray to 2050

Where do I even start?

IN

Understanding the asset base

o Median Water

Map the risks onto the asset base: Where’s the carbon

come from?

• Hot spots Wastewater treatment Electricity use

Integrated Solution: Energy neutrality at sewage works and systematic energy efficiency improvements at water and sewage works

o Median Water

o Largest works: OFWAT Category 6- small number of treatment works (40) responsible for 79% of GHG emissions

o Target: Long term carbon footprint reduction 80% by 2050

Focus the effort: minimize the number of projects

Energy efficiency measures have finite limits

Typically, on contemporary STW, energy efficiency only reduces

energy budget by 20-30%

This means 70-80%

of the STW energy

budget needs to be

met by renewable

energy to attain

Energy neutrality

Understanding the limits of interventions: Attaining Energy neutrality

Speaker Notes

Slide 23 UK power cost increases will be determined by the need for massive investment in the generating base from now to 2030- which is still significant even if the renewables investment is minimized. Even the maximum investment in renewable electricity generation considered by this and the previous government still only reduces the UK fossil fuel proportion from around 70% today to 55% in 2035- keeping it well above the recommendations of the UK Climate Change Committee

Slide 24 Assuming HMG keeps to its current plan and reduces fossil fuel to 55% of generating fuel by 2035, the Scope 2 (electricity GHG emissions) for UK water companies will reduce to the plateau indicated. However, this will not reduce carbon costs for the UK water industry due to the introduction of the carbon floor price last year(2011). The recent Energy White paper set a generating threshold of 450g/kWh which rules out coal but allows modern gas generation There are substantial risks and issues with CCS technology (from cost; to carbon dioxide leakage to acidification of storage formation) that are still unresolved so CCS is unlikely to be delivered to retain coal as a significant fuel source. This means an increased reliance on gas as a fossil fuel- with its attendant price risks.

Slide 25 Even in 2010, typical water industry operating costs are no longer predominated by salary. By 2035, assuming 2002-2011 annual average rates of inflation for the different cost elements, increased operating costs will be predominated by energy and consumables.

Slide 26 The effect on the bottom line of increased operating costs are severe. Two extreme cases model the dilemma for Median Water in 2030: either Median Water can accept a 46% reduction in profit after tax, shareholder dividends and retained profit or they need to pass an extra £137MM per annum onto their customer base if they wish to keep these metrics (profit after tax, shareholder dividends and retained profit) at 2010 levels. The alternative is for Median Water to invest in resource recovery: energy efficiency and recovery to reduce operating costs at the largest sewage works combined with material resource recovery when a reliable revenue stream arises from it

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Median Water Projection of power cost risk:

OFGEM £120/MWh by 2020

Potentially rising to £230/MWh by 2030

Energy costs within CPI (HICP): 45% higher energy cost inflation 2002-11 than that for combined index

Understand the operating Cost Risk Profile: UK Power Costs

Carbon Costs

o Median Water projected electricity SCOPE 2 emissions from 70% fossil fuelled grid now to 55% fossil fuelled in 2030 OPEX issue: Reduced carbon emissions at generation do not mean significantly lower future

electricity carbon costs- due to 2011 carbon floor legislation (carbon costs=red line)

Present operating Cost Profile

Labour costs already less than half direct costs

2030 profile

Operating costs becoming dominated by energy and materials

Median Water : Operating Cost Profile Changes 2030

Bottom line affected

Modeling two extreme scenarios

Accept significant (46%) reduction in margin

and shareholder returns (above)?

Pass all costs onto customers (OFWAT allows?)

OR redevelop asset base to minimize operating costs…

Median Water: Operating Cost Impacts

Median Water: It’s strategy for mitigating operating cost risks and reducing

carbon footprint

Minimise number of projects by focussing on largest STW (OFWAT Category 6) – this provides a more manageable carbon reduction investment

programme Integrate sludge and carbon strategies Install technologies that can maximise energy recovery on a value for money basis

Implement systematic carbon reduction intervention programme for target list of STW

Identify a systematic programme for energy efficiency improvements on large STW and

WTW These actions improve Median Waters operating profit, retained profit and return

to shareholders by ~70% in 2030 and bring carbon footprint in line with HMG regulation

Speaker Notes

Slide 27 There are barriers to sustainable development and policy makers are not yet leading the challenge to them adequately or realizing the economic benefits of sustainable development Part of these arise from a misperception that sustainable development is an added cost. It is not- in a world with increasing population and GDP, it is a hedge against rising costs and the only sure route to sustainable economic growth with less pressure on prices – at least until global growth slows and/or global population decreases

Slide 29 Whole life costing is like any other form of analysis: false or misleading assumptions lead to wrong investment decisions Sensitivity analysis and more than one investment risk measure should be used on major capital projects

Slide 30 The right strategy will deliver success; but, the wrong strategy will increase project load and costs.

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o INACCURATE WHOLE LIFE COSTING – THE BARRIERS ARE FINANCIAL, NOT TECHNOLOGICAL o Whole life cost assessment needs to properly describe risks

• WLC needs to include operating cost risk assessment scenarios • Sensitivity analysis on operating costs now essential

o OPERATING COSTS:

• Labour costs only part of the cost and a diminishing fraction • Energy (Electricity and fuel) increasing –use recent trends for power (not RPIX) • Chemicals and materials increasing –use recent trends for chemicals (not RPIX)

Understand Barriers to Investment Risk Mitigation- Inadequate investment

risk profiling

Example:150,000PE STW with sludge imports upgraded to energy neutral status

The usual stuff

DELEGATE !

Rising Operating costs

Climate change and Carbon targets

Bottom line(s):

Operating margin

Return to shareholders

Retained profit

Competitive position

Capital initially more expensive and harder to obtain (2010-20?)

Median Water: the chief executives’ desk in 2050

IN

OUT

Addendum: Global Long Term Trends CIWEM Office, 15 John Street London, 2012

Speaker Notes Slide 33 Price changes result from imbalances in supply and demand as well as monetary inflation. However,

that is not just based on absolute supply: when rate of demand does not match rate of supply, price increases

Slide 34 The Kaya identity shows how three these factors are linked…and also has profound implications for price. We have even had a recent demonstration of the strength of the Kaya Identity. Global CO2 emissions, shown in the left hand graph, recently dropped for the first time in recent history. The cause was the 2008/09 financial crisis and the contraction in global GDP it caused. Population is rising: anticipated to followed the medium scenario in this UN projection, to over 9 billion by 2050. That is in turn driving GDP, particularly in BRIC economies: China and India are the engines of global economic growth. These economies are investing heavily in infrastructure to drive up their productivity per capita- and the energy needed to fuel that development.

Slide 35 Recently a gap in economic knowledge has been pointed out by an EU sustainability commissioner. The commissioner- an economist – notes how some key classical economic assumptions no longer can be maintained. Classical economic theory presumes commodities to be unlimited and if they become so, to be exchanged by the market for another. That is a false assumption with regard to Phosphorus depletion – it is a commodity that cannot be substituted for food production – or fertilized crop based bio-fuel production

Slide 36 The global water industry was concerned enough about the level of chemical cost inflation to fund and investigation in 2009. Global macroeconomic trends were at the root of increased chemical costs, according to suppliers surveyed

Slide 37 As operating costs increase, the predominance of CAPEX recedes. However, the picture is more nuanced because (i) Of competition: Market capital has recently moved low cost, quick return projects, especially in finance instead of infrastructure capacity for maintenance of current GDP in OECD economies (ii) Daniel Kahneman’s Prospect theory now has formally defined human behaviour in regard to risk and return: People make decisions based on the potential value of losses and gains rather than the final outcome (iii) Lower availability of capital plus competition for it combined with increased global infrastructure demand for it, could cause increases in its cost as well as a capital bottleneck for investment in GDP capacity supporting infrastructure 32

Characteristics of Water Industry Assets

o The water industry has to operate and maintain

substantial capital assets

o That asset base has a long asset life, typically 20-60 years for some mechanical

and civil assets; • Assets built now will continue working as designed now for decades into the

future • Assets have seen regulation change during their active life, requiring upgrades

in asset capability as well as capacity • Asset development requires substantial asset extension for a mature asset

base

o The asset base has high write-off costs so wholesale replacement of assets with a viable life for one regulatory driver is not cost effective

Carbon and Climate Regulation

and

compliance

Costs: Rising Operating costs; Increased Cost of Capital also means increased need for value for money

Commodities: Strategic, some depleting- which effects price

Water Industry: Global Macroeconomic Risks to 2050

Population: Stress on Food, water and energy supply

How are these trends linked?

The Kaya Identity CO2 Emissions = Population × (GDP/Population) × (Energy/GDP) × (CO2 /Energy)

Environmental and macroeconomic risks are linked and feed back into each other

Relationships ; Consequences

Resource supply, demand and price volatility

McKinsey 2011 Report

Water Industry Consumables Costs

CHEMICALS; WERF/UKWIR/AWWA/WRF (2009) Supply of critical drinking

water ands wastewater treatment chemicals: A White Paper for understanding

Recent Chemical Price increases and shortages

Average 2008/09 UK price increases for principal chemicals : 9% (Chlorine) to

175% (Phosphoric acid)

Supplier explanations for high 2008/09 prices: Rising energy and fuel costs Increased global demand (especially BRICs- China & India) Manufacturing capacity limitations Exchange rate variations Increased cost of raw materials Increased demand from other sectors (e.g. agriculture (fertilizers for

biofuels)

CASE STUDY: Upgrading 150,000PE STW with sludge imports to maximise renewable energy from

sludge

Capital costs no longer dominate whole life costs for energy neutrality when operating costs are at present levels Capital inertia: Deferred investment increases losses from OPEX increases and renders carbon targeting

more difficult

Understand the new investment paradigm: The downshift

in significance of capital in whole life costs

Speaker Notes

Slide 39 It’s a complex picture which classical economics does not yet accommodate. Slide 40 The scenarios used by Meadows et al in the World3 model demonstrated that exceeding ecological

footprint (which is composed of resource exploitation factors) led to a drop in economic activity, standards of living and welfare as a result of exponential population growth exacerbated by exponential economic growth and resource exploitation combined with increased pollution

Slide 41 Unfortunately, recent trends reported from different global sectors provide a chain of evidence for economic and environmental factors described in World3 in 1972 and now re-stated in the 30 year update of the project.

Slide 42 Classical economics simply is not currently equipped to see the risks to the global economy and global

growth over the next 4 decades and how they are related. Some of these risks were outlined in the ‘Limits to growth’ analysis conducted by Meadows, Meadows and Randers in 1972 and after 30 years their model projections have been confirmed by global trends. New developments in economics (Ecological economics; Ayres et al) are introducing these concepts to economics; many economists are taking these factors seriously but unfortunately, mainstream economics and policymakers are NOT taking note of the risks they have been appraised of.

Slide 43 Economics has initiated the right developments- but the mainstream now needs to urgently adopt the

risk profile identified by ecological and environmental economics so that policymakers are presented with a more accurate risk profile for 2010-2050 and begin to manage those risks

Slide 44 If you don’t know what a risk looks like, you won’t see it. If you don’t see it, the chances of it manifesting itself increases, because no mitigation is being considered.

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How are these issues linked?:

How are these trends linked? Limits to Growth. (1972)Meadows, Meadows and Randers.

11 scenarios modeled by systems analysts from environmental and economic backgrounds. Publically available as World 3 Model

All that fail to balance ecological footprint show similar outcomes

How are these trends linked?

2011-12: Global oil supply – no increase despite global demand exceeding supply. OPEC countries have minimum price targets to balance budgets

RECENT GLOBAL TRENDS

2010: Mckinsey report shortages in capital for capacity development

2011: Mckinsey’s report commodity and resource shortages

2008: Biofuels crops competing with food for land-space and fertilisers (global grain –bio-fuel 11% in 2010)

2012: Rustad: Supply of a range of commodities increased to super-exponential growth since 1990

2000-onwards: Global energy costs rising

2008: Phosphorus prices reach global high during supply hiatus

1990s-Kaya Identity derived 2000: Ayres- GDP and energy

How are these trends linked? Global demand now shows unprecedented infrastructure and energy demand intensity (~30% of global population fully industrialising over a period of only 2-3 decades)

Classical economics assumes industrial productivity increases are a consequence of technology- without defining technology in precise technical terms . Ecological economics has demonstrated (Ayres) this to be false- energy is the enabler of mechanical productivity increases

How are these trends linked?

Classical economics also assumes that because previous supply shocks short term, so current supply imbalances are also temporary. This is not true for 2010-2050

Classical economics assumes resources are in effect infinite, via Substitution and fails to recognize market barriers to substitution arising from Technology Dominance (e.g. ICE and fossil fuel demand) or non-replaceable resources

Classical economics strips what is perceives to be volatile elements from inflation – such as food and oil- without consideration of the balance of long term supply and demand . Inflation is now being driven by food and fuel in the long term

You can’t see a risk if you don’t recognize it

There are economic icebergs ahead, but policymakers are not looking for ice bergs