The UK has led the way in the denationalisation of its critical infrastructure and our openness has meant most of our water and electricity assets are now owned by a wide range of international investors of various flavours. Whether this is a problem or not very much depends on the investors’ objectives and how they go about pursuing them. Unfortunately, in some cases, it has become a problem, and potentially a time-bomb.
Utility investors range from possibly the most famous global investor of all, Berkshire Hathaway, to various consortia of banks and private equity houses and even, in a few cases, public shareholders.
Diverse ownership, such as exists in publicly floated companies, has a number of helpful characteristics, generally driving moderation, via diverse interests, and transparency. Conversely, concentrated ownership has advantages that are the opposite: the ability to become more focused on a more narrow set of objectives and less need for transparency or accountability. However, this should not matter. Running the firm is the job of the management, and shareholders’ ability to interfere is limited to appointing (or de-appointing) the board.
However, this separation is not always as pure as theory would have it, least of all when ownership becomes concentrated into the hands of a powerful majority.
Public ownership enforces a transparency and accountability, the absence of which allows private owners to exploit more risky and “efficient” funding models – more efficient in this case generally meaning more debt accumulated, less tax paid and more profit returned to shareholders.
While these perils exist for any type of organisation, the natural forces that keep them in check do not exist with a privately owned but government-backed monopoly business, and the ultimate conclusion of this could be potentially devastating.
Back in the late 1980s our utilities needed investment and our government needed money. Privatisation provided an elegant solution to both problems by releasing a windfall for the government and simultaneously enabling the newly created companies to access cheap borrowing in order to fund necessary investments. Though a bit short-term, this was a pragmatic solution, if carefully managed.
Getting geared up
So, what happened? The government got its windfall and the newly created companies were bought and resold as successive investors realised what a great deal they were.
The other thing that happened was debt – lots of it. Thames Water is the poster child here. Its sale originally raised the government around £1 billion and in the time since, its debt has climbed from almost nothing to something in the order of £8 billion.
Today, Thames Water cannot easily borrow the money required to fund the Thames Tideway Tunnel, and the regulator has to allow the additional money to be included in customers’ bills.
This is not an investment need that appeared from nowhere. It has been over a decade in conception – a decade during which Thames Water delivered great shareholder performance, paid very little tax (none at all in 2012) and, it appears to the casual observer, failed to save up for a critical investment it knew had to be made.*
Thames Water is not alone in this. At privatisation, the government wrote off debts, meaning that our water companies began with only circa 5 per cent gearing (borrowing). By the mid-1990s this had increased to 25 per cent, which at the time was average.
However, the market decided that an asset-backed monopoly business could probably sustain higher gearing. So, onwards the market has pushed and will keep on pushing until something stops it. Some of the possibilities for that end are far less palatable than others but the potential for catastrophe is huge.
So how big is the problem? Thames, Anglian, Southern and Yorkshire represent a good slug of the UK’s water industry, and are all owned by various combinations of private investor. In our electricity networks the picture is similar: the only remaining electricity network that is publicly traded is SSE.
Interestingly and by way of contrast, the big six energy suppliers – of which SSE is one – are publicly traded. The energy retail market, like supermarkets or banks, is dominated in the UK by a small number of players that control most of the market. But despite their state-owned origins and the tough rap they get for energy prices, they are not monopolies. So, in theory, they have market competition as well as public investor scrutiny to keep them honest.
Neither of these natural controls exist for a water or electricity network business that is privately held – these businesses are monopolies and private ownership creates the necessary opacity for this to be fully exploited for the benefit of shareholders.
So the time-bomb is this: if an energy supplier goes bust and cannot fund its ongoing operations, its investors will be the biggest losers (along with its employees). Neither its customers nor the general public would expect to pay extra as a result and nor would they have to. Investors take this risk and the returns they get are their reward for doing so.
If, on the other hand, a privately owned utility business fails, its investors will generally lose relatively little (having made quite a bit already and organised things such that their risk is minimised). However, somebody would need to step in to keep the lights on or the water running. This would be the state and we, the taxpayers, would ultimately foot the bill – not only for keeping things going but also for any investments that had been deferred. Worse still, we would all have to swallow this knowing that some clever financial engineering had made a tidy profit out of our previous bills.
The analogy with the banking crisis is striking – if you think we need banks too much to let them fail, what do you think about water?
The reduced reporting burden that is afforded to a privately owned firm, combined with the “efficiency” of not having to reconcile numerous interests, creates the ability for great focus on the singular objective of shareholder value maximisation. This is (arguably) okay in a truly competitive market where shareholders will ultimately pay the bill if they do not invest for the long term and where customers can boycott a service if they do not like the way it is being run.
None of this is true for a monopoly public utility and therein lies the problem. Customers have no choice and the firm cannot be allowed to fail.
So is this just the market finding the most efficient funding model? It is certainly a reflection of private investors being afforded less transparency, less accountability, greater flexibility and therefore being able to operate more “efficiently” – unfortunately the last of these terms is used in a purely financial sense – that is, the business is not being run better or making better investment decisions, it is simply organising its finances in a way that makes more money for shareholders.
Arguably the actions of the companies in question are nothing other than entirely rational given the rules of the game established through privatisation. Unfortunately, however, the game was inadvertently rigged, allowing them to generate profit from risks that they were taking on our behalves.
Economists have a term that perfectly encapsulates the asymmetry of this situation – moral hazard: a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.
Difusing the bomb
So how can we avoid the utility bomb?
First, we must impose more transparency on these firms. Then, as we have done with banks, we need to think in terms of capitalisation and establish “safe” parameters within which these firms must be kept. Third, if the government is to effectively act as guarantor, it should be entitled to special rights that go along with this in the form of access to information or even voting rights on the board.
In a capitalist world, much is funded by asset-backed borrowing, enabling investment today to be funded by the promise of future income. Most of us buy our homes this way. But what are the limits of this?
As homeowners, we do not want to lose our homes and this acts as a check on our behaviour. There is no such check for the private owners of utilities and nothing to dissuade them from going too far. The result of going too far came to the housing market a few years ago and the world economy is still picking up the pieces.
Toby Ashong, head of infrastructure, Boxwood
Thames Water’s response
* Given the opportunity to respond, Thames Water said it took issue with this view, and had been investing heavily – £1.4 billion for 2015/16, more than the next two biggest water companies combined. It added that the Thames Tideway Tunnel should have no bearing on Thames Water’s finances because it is being built by a separately operated and regulated company, which is the preference of all stakeholders (government, Ofwat and Thames Water) because of the risk on day-to-day services and to ensure best value for its 15 million customers.