Infrastructure financing Models III

This post is a continuation from earlier posts here and here.

The privatization of utilities in the UK, based on the model that the private owner owns the assets (or Regulated Asset Base - RAB), operates them and delivers the service (OPEX), undertakes investments for network and capacity expansion (CAPEX), and also co-ordinates OPEX and CAPEX, is now coming under attack from various quarters. There appears to be a growing realization that the asset ownership should be separated from the operational and expansion dimensions. An example is that of France, where water utility assets are publicly owned while OPEX and CAPEX are auctioned off to franchises.

Oxford economist Dieter Helm has recently reviewed the experience of British utility privatization and come to the aforementioned conclusion. By drawing a clear distinction between the RABs and the operational activities, he focusses on the possibility of trading RABs and competitive tendering of the operational activities of the utility business.

These regulated utilities have been financed based on a split cost of capital assumption - a cost of debt for the purchased RAB, and a cost of debt and equity for the operating part of the business. Large utility service providers are natural monopolies which are capital intensive, long-lived assets and sunk costs. Further, the marginal cost is typically low when compared to average cost. This gives regulators and governments an incentive to expropriate by allowing marginal not average costs, especially after the RAB investments have been sunk.

In order to reassure the investors in utility networks, a Regulated Capital Value (RCV) is assigned to the clearly defined RAB, additional investments made are added to the RAB, and a rate of return is fixed for these assets. The return on the RAB is a charge on customers for the past (or sunk) investment. The risks associated with RABs on the one hand and OPEX and CAPEX on the other hand, are very different. The risk associated with RABs are mainly political and regulatory, whereas those with the later are more mangerial in nature.

Accordingly, their respective financing patterns varies. Since they have few assets to act as a collateral, the typical private sector comparator to OPEX, CAPEX and co-ordination, is financed by a mix of debt and equity, with equity dominating. The RAB, on the other hand, only has equity risk to the extent that it is exposed to regulatory and political risk, which can be mitigated with appropriate legal protection. Ideally, the RAB should be financed by the public sector, which has access to debt at the lowest cost, and which is best able to take on regulatory and political risks.

In the UK, under the existing regulatory framework, once the asset is formally in the RAB, its RCV is virtually guaranteed, thereby leaving little or no equity risk in the RAB investment. However, oblivious to this guarantee on equity, instead of limiting the guaranteed returns (or cost) on financing the RAB to the cost of the debt, the regulators continue to allow the calculation of the cost at the Weighted Average Cost of Capital (WACC), which takes into account both equity and debt.

This is an open invitation for financial arbitrage. Investors finance their purchase of RAB at the cost of debt, while they are guaranteed returns at WACC. This has led to investors buying off assets, replacing their equity with debt, and skimming off value worth over trillion pounds a year. The weak oversight on gearing ratios has only helped this equity exit.

The customers have been ultimate bearers of these premiums by way of cost pass-throughs in utility services. They are also exposed to the risks imposed by the high gearings (debt), by way of adverse external shocks. Further, given their limited equity, and having already made their profits, the operators have less incentive in effective opearation of the assets (OPEX) and especially CAPEX.

Helm however feels that this is an ideal situation for hiving off RABs and OPEX, CAPEX and co-ordination as separate entities. RABs can be securitized and traded as a separate financial product, and its price and true cost of capital can be determined by the market. These tradebale RABs would be similar to the infrastructure funds that are floated in the debt market to raise capital for creating specific infrastructure project assets. Customers would not need to pay for the non-existent equity risk. The OPEX, CAPEX and co-ordination would then be auctioned off to franchisees by competitive bidding, thereby helping consumers get the best deal in service pricing.

Martin Wolf argues that under this model, it becomes obvious that the public sector, with the access to capital at the lowest cost, appears best positioned to finance investments in assets. The most sensible solution would therefore appear to be for the public sector to finance the assets, with operating and investment activities contracted out.

Update

See this presentation from Dieter Helm.