More on lessons from the UK infrastructure privatisation

The UK's privatisation drive in the eighties and nineties has formed the empirical basis for infrastructure privatisation across the world since. There is now more than enough evidence to suggest that the privatisation has been a definitive failure. This is my earlier co-authored oped on the balance sheet of UK's infrastructure privatisation. This is a long paper which also discusses the challenges with infrastructure privatisation.

Dieter Helm, a Professor at Oxford and one of the most credible experts on infrastructure regulation, has this assessment of water privatisation

What has gone wrong? Pretty much all that could. There is too much pollution, too little investment, too high returns, and grossly excessive executive salaries. All this and no clear efficiency advances over most of the European public sector comparators... Privatisation was advertised as the way to “unleash” private investment, outside the public sector borrowing requirement, with ungeared (strictly cash-positive) initial balance sheets to carry the investment so that current customers would not have to pay. It would be pay-when-delivered, rather than pay-as-you-go. The water industry was to be the poster example of the greatest efficiency, so that the efficiency gains would comfortably offset the higher returns that customers would pay for...

We could have had a properly regulated private sector, with: clear and accountable ownership structures; fairly paid executives; a lack of regulation-induced financial engineering; more investment utilising the balance sheets for what they were designed for; reasonable returns; and clear, honest and open environmental reporting, performance and delivery. For all the talk of the need to recruit world-class managers and pay FTSE100 or indeed world corporate salaries and bonuses, the performance of many of the new privatised managers has been poor and, in some cases, dire – though of course with some notable exceptions. Diversifying into things that they had no knowledge of in the early days, trying to build global businesses, merging with energy networks, and becoming a merger and acquisition (M&A) pass-the-parcel exercise in maximising leverage, all have little to do with actually delivering the services that we, the public, and we, the customers, actually want. The water companies have not even been good at maintaining the assets and fixing the leaks.

The model is well and truly broken... The water companies have lost public trust (if they ever had it) and no longer have a social licence to operate. So bad is the public regard, that most prefer re-nationalisation.

This is a more detailed and slightly older assessment of water privatisation, with pretty much similar conclusions.   

His assessment of the railways privatisation

There is little doubt that the privatisation of British Rail was badly botched, and it is not surprising that it has been slowly unwound back towards nationalisation. Back in the 1990s, there were two core objectives in privatisation. The first was to deal with an industry assumed to be in decline, and hence the task was to manage that decline. The second was to transfer more of the costs from taxpayers to rail passengers.

The first objective was to be met by breaking up the industry and trying to inject more competition, on the assumption that this would lead to sharp efficiency gains, and reduce the ability of the unions to organise national strikes. Breaking up British Rail involved the creation of leasing companies for the rail stock (the rolling stock companies, ROSCOs), creating franchised rail operating companies, introducing the possibility of entrants bringing on competitive rail services, and Railtrack to provide the core rail network infrastructure. Behind this lurked an entirely inappropriate model – that used in electricity and gas. And as with electricity and gas, it was deliberate that there would be no one responsible for the system as a whole, no “fat controller”, and not even a national ticketing system.

The second objective meant that rail ticket prices would go up, and the result would be amongst the highest ticket prices in developed countries. This further suppressed demand, reinforcing the sense of decline. Like the Royal Mail, the response to weaker demand was to raise prices.

It is no accident that the three last great privatisations of the 1990s were all very badly designed, badly implemented and all fell apart. The Royal Mail, British Energy (the nuclear assets) and British Rail are all sorry shadows of what they once were. It is hard to argue that any of these privatisations improved their industries, and easy to point out obvious failures. 

A couple of observations and takeaways 

1. It's not as though infrastructure regulation is impossible. I feel these are about weak contractual provisions and accountability and even weaker regulatory enforcement. The problems revolve around non-compliance with contractual obligations and asset stripping (pass the parcel). 

The former involves lower service quality than in the SLAs, skimping on investment obligations, and just-in-time operations and maintenance without the requisite slack for resilience. The latter involves loading up excessive leverage, excessive dividend payouts, running down and/or not paying into pension funds etc. 

These are difficult but not impossible to monitor and regulate. I mean how could Ofwat not have noticed that the UK utilities cash flow from customers could have financed all investments undertaken and the borrowings went into rewarding shareholders? Or the egregious leveraging up and dividend payouts by Macquarie-led Thames Water investors? Is it very hard to monitor pension pots not being paid into and/or being raided?  Why were such exorbitant executive compensation packages allowed at all for boring utility companies? This is the same story as happened with Silicon Valley Bank, where regulators did not bother to exercise even cursory oversight. 

All this happens when contracts are deliberately vague on their terms, without explicitly calling out the specific non-negotiables, and regulatory forbearance is very high. Sample this from Helm,

Surprising as it may seem, there really is no clear set of objectives for the industry... The EU directives themselves are very general: they need flesh on the skeletons, and much is better described as aspiration... Worse, the water company licences are vague and general. Try reading one of them, if you can find it. You will not find clear requirements, and hence it is hardly surprising that it has been all but impossible to take legal action against the companies.

With all this in mind, the first and obvious thing to do is to set out clear objectives, which are measurable and enforceable. These are distinct and separate from milestones and targets. For example, reducing storm overflows is an instrumental and intermediate target, not an objective. The objective is clean discharges and biodiverse rivers. Once the objectives are set, these require detail. What exactly is going into our rivers? The water companies do not precisely measure what is in their discharges of treated water, let alone the raw stuff. Nor is there any baseline of what else is going into the rivers and was already there before the water companies’ discharges.

Instead contracts should have these repeatedly observed problems captured explicitly, safeguards clarified unambiguously, reporting requirements and standards made very clear, and the whole thing should be monitored strictly. To reinforce the point, exclusions and common misinterpretations should be explicitly pointed out as such in the contract. 

It's also useful to have the important terms presented unambiguously and separately in the voluminous contract document, instead of being obfuscated by legalese and/or hidden somewhere deep inside, and thereby diluted into irrelevance. It helps to have everyone sharply focused all the time on the easily understood headline terms of the contract. 

In the absence of these, there's an adverse selection. The investors are aware of the contractual ambiguities and regulatory weakness and tolerance (not to mention the ease of regulatory capture) which in turn attracts them to bid for these projects. 

2. This brings to the second point that by any logical reasoning such regulated assets with their low but stable returns should not be attracting returns maximising private equity investors in the first place, except as a pure portfolio diversification asset. The corporate incentives of PE investors and infrastructure funds floated by them are skewed toward returns maximisation. This is evident from their compensation and incentive structures. 

In sectors like education and health, several countries have restrictions on the nature of private investments. Is there a case for such regulation in infrastructure? Should an investor with PE-type financial incentive structure and executive compensation be allowed to invest in such regulated assets which provide essential services? Should certain corporate structures which are primarily aimed at hiding returns, dodging taxes, and evading accountability be disallowed in infrastructure contracting? Should there be some cap on actually realised returns or a telescoped profit sharing structure to clawback windfall profits?

Yes, these restrictions will cost in terms of reducing investments in infrastructure. But they will also ensure the right selection of investors. The costs may be more than off-set by the life-cycle savings in terms of avoiding the wrong kinds of investors. 

Two comparisons here

1. Unlike in the UK and US, where private equity and their infrastructure funds dominate, continental European privatisation is mostly through large public-private companies like Veolia (now Engie), RWE, EDF, GDF, Iberdola, Enel, Orsted etc. The contracts are also simpler long-term concessions. Rarely are the fancy, complicated, and opaque financial engineering and corporate structures. Is it any surprise then that we do not come across similar pervasive examples of asset stripping?

2. Another example, though unrelated but relevant, is how the Reserve Bank of India (RBI) regulates Indian banks. It's a boring and painstaking slog of parsing and auditing the books (though here too, they need to do more of this). It has led to a banking system that is generally unexciting and stable. 

In my opinion, the buccaneering spirit of American capitalism that has also captured the regulators may be the real problem with the failure of infrastructure privatisation in UK and US.