The climate change finance problem

There are some dangerous misconceptions associated with climate change finance. This post is a continuation of earlier posts here, here, here, and here. 

One, there are very few trade-offs involved in the pursuit of development and climate change adaptation and mitigation. Two, reducing the flow of carbon emissions is more important than lowering the stock of accumulated carbon emissions. Three, there is sufficient financing available to meet the ambitious and expedited agenda on climate adaptation and mitigation. Four, there are trillions of dollars of private capital that are waiting to finance climate change interventions. Five, the few hundreds of billions of public finance is sufficient to de-risk and leverage the trillions of private capital required. Six, the private sector can play the lead role in climate adaptation and mitigation projects, and governments should merely derrick projects for the private sector. 

I have a co-authored paper coming out on this soon where these misconceptions are discussed in detail. In the meantime, in a recent issue The Economist discussed the challenges associated with climate change finance policies. The Economist captures the challenge succinctly

From the panels of Davos to the pages of newspapers, it is increasingly argued that no trade-off exists between the economic development of low- and middle-income countries and reducing their greenhouse-gas emissions. This is partly because much of the rich world has successfully made some cuts in emissions while continuing to grow, and its leaders want more of the same. But more crucially, it is because governments and development banks with limited budgets struggle to admit that not all their goals can be reconciled, and that they must therefore choose between them.

Yet choose they must, because the trade-off is in plain sight. Growth is the best way to lift people out of poverty and improve average living standards. But in the developing world, more growth still leads to more emissions. Researchers at the IMF have found that in 72 developing countries since 1990, a 1% rise in annual GDP was on average associated with a 0.7% rise in emissions. By 2030, fast-growing India and Indonesia alone will have increased their annual emissions by the equivalent of over 800m tonnes of carbon dioxide—an extra Germany’s-worth of greenhouse-gas belching. In other big emerging markets such as Brazil, Egypt and the Philippines, emissions are rising, too...

The need to spend money decarbonising big developing economies that already offer citizens reasonable services threatens aid budgets which help pay for things like vaccines and schooling in the poorest parts of Africa. Unlike Brazil or India, say, such nations are unlikely ever to contribute significantly to global emissions. They lose out, however, when foreign aid and loans come with green strings attached. As well as facing stingier health-care and education budgets, they might find scant funding for expanding a gas-powered electricity grid, even though nobody stands ready to pay for the far greater costs of converting it to a green one. African governments rightly resent being told to cut emissions rather than help people in desperate need—especially given that Westerners continue to belch carbon.

Another article puts the trade-off in very stark terms

Suppose, for a minute, that you are a finance minister in the developing world. At the end of a year in which your tax take has disappointed, you are just about out of money. You could plough what little remains into your health-care system: dollars spent by clinics help control infectious diseases, and there is not much that development experts believe to be a better use of cash. But you could also spend the money constructing an electrical grid that is able to handle a switch to clean energy. In the long run this will mean less pollution, more productive farmland and fewer floods. Which is a wiser use of the marginal dollar: alleviating acute poverty straight away or doing your country’s bit to stop baking the planet?

... “How do I justify to voters taking away subsidies, school funding and health care to build a waste-processing plant or a big sea wall?” asks a finance minister. “In 20 years of course it will be useful, but it is the cost now that is concerning.” He reckons that the cost of building a school in his capital city has doubled in the past decade, because of the need to make facilities green and resilient. “What about when we have to choose between hospitals treating lung disease and swapping to electric buses?”

The financing gap is massive

The Grantham Institute, a think-tank at the London School of Economics, estimates that at this point poor countries will need to spend $2.8trn a year in order to reduce emissions and protect their economies against climate change. The institute thinks these countries will also need to spend $3trn a year on sectors like health care and education to keep tackling poverty. This figure could rise... In 2019, the latest year for which reliable data are available, just $2.4trn went on climate and development combined. According to the Grantham Institute, rich countries and development banks will have to stump up at least $1trn of the annual shortfall (the rest should come directly from the private sector, and from developing countries themselves). In 2009 rich countries agreed to provide $100bn a year in fresh finance by 2020. They have missed the target every year since, reaching just $83bn in 2020—with much of the money coming from development banks. Excluding climate finance and spending on internal refugees, aid from OECD countries has been flat over the past decade... Across the board, damage from climate change makes development more expensive—and halting climate change makes it more affordable.

To reach net-zero emissions by 2050, the International Energy Agency, an official forecaster, reckons developing countries would have to spend at least $300bn on renewable grids until 2030, five times their current outgoings.

This sorely inadequate finance is itself very skewed in its allocation.

 

According to researchers at the IMF, some $357bn will need to flow to three big middle-income countries (India, Indonesia and South Africa) each year until 2030 in order to phase out their coal-power plants by 2050... In 2021 less than a quarter of grants and cheap loans from development outfits went to the poorest countries, down from almost a third a decade earlier. Eighty poor countries, including Nigeria and Pakistan, together received just $22bn in mitigation and adaptation aid in 2021. Last year bilateral aid to sub-Saharan Africa fell by 8%.

For low income countries, the priority should be poverty alleviation and subsistence, and as the graphic below shows, their contribution to climate change is tiny (a US refrigerator alone consumes multiples of energy more than the average Kenyan human).  

Clearly Africa needs several times more energy. And the kind of energy its economies can sustain is on the non-renewable traditional thermal and natural gas kinds. 

International Energy Agency (IEA) pointed out that if Africa is to provide universal electricity access by 2030 it would have to almost double its total generation capacity from 260 GW (currently 3% of the global total) to 510 GW. Renewables could provide 80% of the increase, it reckons. Achieving that would be a mammoth task... The IEA thinks that total capital spending on energy between 2026 and 2030 in Africa would have to be nearly twice what it was between 2016 and 2020. Investment in clean energy would need to rise six-fold... African public finances are in a woeful state. Twenty-two countries are in debt distress or at high risk of it, according to the IMF. Those considering turning to international capital markets are facing eye-watering borrowing costs... the cost of capital... can be up to seven times higher in Africa than in America and Europe... pension assets in the ten most developed African countries (a bit more than $300bn) are only slightly greater than those of the California state teachers’ pension fund... investors complain of a shortage of bankable African projects. Coal or gas plants are relatively cheap to build, as most of their lifetime costs come from buying fuel. Solar- or wind-power projects, by contrast, are cheap to run but expensive to build. 

But it's difficult to attract private investors into the electricity sector without addressing deep-rooted political economy and governance problems. 

More than half of power utilities in sub-Saharan Africa cannot cover their operating costs—let alone fund investments... Many do not maintain equipment, stop illegal connections or bill properly... Most African utilities do not charge tariffs that reflect costs. At root this is a political problem... it has been “politically expedient” for regulators to keep prices low... Other governments directly subsidise electricity tariffs. Removing subsidies entirely is not easy.

It's important to bear in mind that the developed countries are the most important contributors to climate change both in terms of their stock of carbon emissions and also in terms of their flow contribution.

Global temperatures depend on the stock of carbon in the atmosphere, not the current flow of emissions. On a per-person basis, the rich world has been disproportionately responsible for rising global temperatures and has more capacity to respond to them. Poor countries lack the resources to invest to cut emissions or adapt to climate change themselves. Yet relative to the size of their economies, they face the biggest costs.

A land derivative trading platform - the case of TDRs

A sector that could do with much more financialisation is land markets in developing countries. This post presents an idea about the exchange trading of Transferable Development Rights (TDRs) issued by municipal governments to landowners who give up their land for road widening and other public purposes. TDRs could be an addition to Real Estate Investment Trusts (REITs) in being an exchange-traded land-related financial instrument. 

These TDRs confer development rights to their owner over a pre-defined area and is therefore a derivative instrument on the underlying development right. This is a good compilation of the TDR policies of states across India.  

In a co-authored working paper, we proposed the idea of a tradable Floor Area Ratio (FAR) where the municipality fixes the permissible additional FAR and periodically auctions them. The idea can be extended to operationalisation of the market for TDRs, thereby eliminating the large cost incurred in land acquisition for road widening and the like. 

In the prevailing TDR regime offered by municipalities in many states, the person who loses his/her land is compensated with TDR equivalent to one to four times the basic/guidance value of the land extent that has been foregone. The TDR can be traded in specified parts of the city or, in some cases like Andhra Pradesh, anywhere across the state. The land loser is given a TDR certificate indicating the monetary value of the compensation. 

The TDR comes with certain benefits. In general, across states, it allows the buyer with three exemptions on the existing regulations – additional FAR beyond the permissible ratio, additional floors over and above the standard height restriction, and certain setback relaxations. In other words, the builder can develop significant additional floor space beyond that permitted by the existing building regulations in an area. All this makes TDRs a generous compensation scheme. 

However, its attractiveness depends on the land loser’s ability and ease in transacting the TDR. Unfortunately, this market matching suffers from information asymmetry and frictions. Currently, there’s no public disclosure of all the TDRs allotted in the state or city. All the transactions happen as informal private trade between the land loser and TDR purchasers, intermediated by brokers. The main TDR purchasers are builders. The land losers face prohibitive search and transaction costs in connecting with a buyer and selling their TDRs, enough to deter many from accepting TDRs. 

In due course, land acquisition payment in general could be substituted with TDRs. Even a small shift to TDRs would be a big step. In theory, this would enable tradeable monetization of land acquisition. Besides, once the market is established, it’s possible that the TDR certificates could even trade at a premium for use in certain areas, thereby allowing for higher compensation for land acquisition land losers. 

In this context, it might be a good idea to establish a state-wide TDR trading platform. This public platform could do the following:

1. Inventorize all the TDRs already issued in different cities and make them available in a user-friendly searchable manner. Ideally, also update the extent of utilization of those already issued. 

2. Processing and issue of new TDRs by all municipalities.

3. Management of utilisation and retirement of TDRs. 

4. Inventory of all the TDR transactions, with their issue and utilization details, including origin and destination. The information gathered from this can be invaluable decision-support for further refining the TDR policy design. 

5. Moderation of TDR trades and provision of all support services. The platform can be linked to the Registration and other Revenue Department websites so that registration and mutation can be done simultaneously. 

Currently, while some states have their portals that act as a window for applying, issuing, and storing information in a private view format (this and this are two examples), there is none that facilitates price discovery and allows for trading of these TDRs. The existing portals must be made public and converted into a TDR trading platform, and linked through APIs with the Registration and Mutation services of the Revenue Departments. 

Alternatively, the TDR could be registered as an Exchange Traded Instrument (ETI) and transacted through the combination of a depository and exchange. Once transacted, the state government's portal could help with Registration and Mutation services. 

This would help avoid the large expenditures being incurred on road-widening (and other) related land acquisition. It would also facilitate the monitoring of these TDRs and enable the simultaneous linkage to registration and mutation. Finally, this would be one more important step in formalizing and increasing the efficiency of land markets in the state. 

Such TDR trading is also a very useful urban planning instrument. It can help decongest a very dense area by shifting some development potential outside, and conversely helping densify certain other areas. With appropriate incentives and enablers, it can be an instrument to densify, de-densify, support transit-oriented development, catalyse urban renewal, etc.

The success of this initiative will depend on the volume and liquidity of TDRs available in the market at any time and the demand for them. It’s therefore essential to calibrate the supply of TDRs such that they command a premium on their allotment value. Over-supply can distort the market (and municipalities and governments with the incentive to minimise land acquisition costs could generate an over-supply). In order to ensure the credibility of the market, it’s also important to clean up the TDR database and ensure that it contains only genuine certificates when the trading starts. 

In the case of TDRs with utilization restricted to certain pre-defined areas, the TDRs will get differentiated and their prices will vary depending on the market supply and demand for each recipient area. This offers interesting possibilities for using TDRs to incentivise policy priorities like urban renewal and affordable housing. 

Such financialisation comes with its distortions and abuses. It's inevitable that buyers and sellers will game the market, especially given the likely arbitrage opportunities available in a market consisting of extremely entrepreneurial realtors. Land markets are anyways rife with several abusive and fraudulent practices. It's therefore essential that such trading be tightly regulated, especially in terms of where a TDR can be utilised (the recipient zone). This is a good example of a policy that needs to evolve iteratively. 

The Urban Development Departments of state governments could popularize the scheme through continuous engagement with Licensed Surveyors and Builders. This would increase awareness and credibility of the TDR trading model, and thereby reduce the reluctance among landowners to accept TDRs.

This is an example of an area where financialisation, albeit regulated and gradually and carefully phased in, can be promising in promoting urban development and minimising public expenditures on land acquisition. It's time to trade land like any other exchange-traded instrument. 

Weekend reading links

1. Commodity traders had a spectacular year in 2022 with eye-popping profits.

Talk about ESG investing and the phase out of mining stocks!

2. An example of restrictive land conversion laws in the US

There is an aging office building on Water Street in Lower Manhattan where it would make all the sense in the world to create apartments. The 31-story building, once the headquarters of A.I.G., has windows all around and a shape suited to extra corner units. In a city with too little housing, it could hold 800 to 900 apartments... But 175 Water Street has a hitch: Offices in the financial district are spared some zoning rules that make conversion hard — so long as they were built before 1977. And this one was built six years too late, in 1983.

“There’s nothing about that building — its construction, its mechanicals, its structural engineering — that prevents it from being converted,” said Richard Coles, the managing partner of Vanbarton Group, which has developed both conversions across the street. Vanbarton owned and thought hard about converting 175 Water, too... A mere stroke of a pen would do it, Mr. Coles said. But that idea died in the State Legislature this spring, along with the rest of the governor’s housing agenda. When Vanbarton concluded no change was coming, it sold the property.

This is the summary

We ask far more of buildings today than decades ago, including that they be accessible, sustainable, hurricane- and earthquake-proof, that they deter flying birds and provide public spaces. Each new goal, while worthy, widens the disconnect between buildings constructed decades ago and what regulation requires today. And we’ve developed over time more rigid ideas about the built environment: that housing should gain value indefinitely, that politicians should ensure that’s so, that property owners have a right to veto change around them. The cumulative effect today, if you want to turn an office into an apartment, or even turn your back porch into an enclosed home office? The building code says no. Or the zoning does. Or the neighbors do. Or a phrase in a decades-old state law does. Or the politicians asked to change that phrase decline to... 

Zoning rules in many cities say precisely how many parking spots are needed per hundred square feet of pawnshop (different from the parking needed per hundred square feet of furniture store). They spell out the architectural flourishes builders must apply, the minimum acreage a home can occupy, or the size of individual units in an apartment building... These rules impede conversions in particular. In New York, a hotel requires a 20-foot rear yard. But a residential building requires a 30-foot one. Does that mean developers should lop off the back of hotels to make housing? Why do we draw such fine lines anyway between buildings where people sleep short-term and those where people sleep permanently?

This statistic is stunning

“It’s pretty clear when you look at zoning codes — over the last century that zoning codes have existed — that they have only gotten longer and more complex,” said Sara Bronin, an architect and legal scholar who helped rewrite the zoning in Hartford, Conn. New York’s original 1916 code was about 14 pages. Today, it is nearly 3,500 pages. Cities have accumulated more prohibitions, more prescriptions, more appendix tables.

It's important that countries like India shed its legacy of copying US planning regulations and avoid adopting their regulations in the name of misguided catch-up and modernisation. 

This is a good multimedia article on the challenges associated with usage conversion in the US cities. 

3. US imports from China as a share of the country's imports has been declining since it peaked in 2018. 

Whoever said that President Trump's actions on China were blunt! While today it has become the norm to pursue policies that sanitise China's access to sensitive technologies, it can be argued that the reversal could not have happened without Trump.

4. Ruchir Sharma points to the remarkable resilience of emerging economies

Normally inflation runs much hotter in emerging economies but, excluding outliers, the median rate is now running at 5 to 6 per cent — no higher than in developed economies. That has not happened in four decades. Some central banks in the developing world have started to cut rates and many others are likely to follow soon. Emerging economies are on track to grow faster than 4 per cent on average over the coming year, or four times faster than developed ones.

5. Andrew Haldane cautions against tightening monetary policy prematurely and excessively, what he describes as monetary austerity,

Despite the headline inflation rise, inflation expectations remain anchored... A year from now, a reasonable view would see inflation at 3-4 per cent without any further tightening. At those levels, it is highly questionable whether those last inflationary drops need to be squeezed out at greater speed. At 3-4 per cent, inflation no longer enters the public consciousness. That is why there is essentially no evidence it would impose costs that are any greater than at 2 per cent. But the costs of lowering inflation those extra few percentage points, measured in lost incomes and jobs, are larger at these levels of inflation...

Imagine a doctor, uncertain about the nature and severity of a disease, who has administered a large medicinal dose which has yet to take effect. Prudence would cause them to pause to see how the patient responded before doubling the dosage. That principle is one central banks should heed now to avoid overdosing the economy. Over a decade ago, in pursuit of lower debt, the UK enacted fiscal austerity. This ruptured growth and was self-defeating for debt. Today, in pursuit of lower inflation, monetary austerity risks the same fate. It is time to steer the stampeding herd away from the cliff edge, for the sake of the financial security of millions of people and the credibility of our policy institutions.

6. Some snippets on Canary Wharf redevelopment

There are about 3,500 residents and 120,000 office workers in Canary Wharf, a 128-acre estate in London’s eastern Docklands area that is jointly owned by Canadian asset manager Brookfield and the Qatar Investment Authority. The district, which sprung out of London’s 1980s financial services boom to house big banks’ expanding trading floors, is now under pressure to reinvent itself as companies downsize their office space to adapt to hybrid working. Home to 30 office buildings, the area has been hit by high-profile exits in recent years, including law firm Clifford Chance and now HSBC, which this week said it would move its global headquarters out of the Canary Wharf tower that bears its logo to smaller premises in the City of London...

Canary Wharf’s history as a financial district dates back to the early 1980s when Michael von Clemm, chair of Roux Restaurants but also investment bank Credit Suisse First Boston, was scouting out the area of decrepit 18th-century warehouses as a potential site for a frozen food processing plant. Von Clemm realised the district would work better as a hub for back-office financial services jobs, with the dockside offering an attractive location for shops and restaurants. It also reminded him of his native Boston, whose own 18th-century warehouses had been through a similar rejuvenation. By the time work began on the development, a host of international banks including Morgan Stanley had signed up — and Canary Wharf would no longer be a base for administrative back-office jobs but a beacon of financial power containing the European head offices and trading desks of the world’s biggest banks...

The district is home to more than 300 retailers as well as eight supermarkets — including the country’s largest Waitrose — more than 70 restaurants and bars, and a cinema. The Elizabeth line, which opened last year, has contributed to a 40 per cent year-on-year increase in footfall in the retail area, where occupancy stands at 97 per cent, according to the estate. However, analysts warn such amenities are a byproduct of the concentration of offices and could vanish with them. “Canary Wharf is first and foremost a place for work and production as opposed to a place for consumption,” said Quinio of Centre for Cities. “Commercial space dedicated to consumption is only there to serve the needs of people who work there.”

7.  On Vietnam's success in school student learning outcomes compared to India

Vietnam’s children spend less time in lessons than Indian ones, even when you count homework and other cramming. They also put up with larger classes. The difference is that Vietnam’s teachers are better prepared, more experienced and more likely to be held accountable if their pupils flunk.

More on Vietnam

The latest data from the World Bank show that, on aggregate learning scores, Vietnamese students outperform not only their counterparts in Malaysia and Thailand but also those in Britain and Canada, countries more than six times richer. Even in Vietnam itself, student scores do not exhibit the scale of inequality so common elsewhere between the genders and different regions... Vietnam’s stellar performance. Its distinctive secret lies in the classroom: its children learn more at school, especially in the early years... 

In a study in 2020, Abhijeet Singh of the Stockholm School of Economics gauged the greater productivity of Vietnam’s schools by examining data from identical tests taken by students in Ethiopia, India, Peru and Vietnam. He showed that between the ages of five and eight Vietnamese children race ahead. One more year of education in Vietnam increases the probability that a child can solve a simple multiplication problem by 21 percentage points; in India the uplift is six points...

The biggest reason is the calibre of its teachers. Not that they are necessarily better qualified; they are simply more effective at teaching. One study comparing Indian with Vietnamese students attributes much of the difference in scores in mathematical tests to a gulf in teaching quality. Vietnam’s teachers do their job well because they are well-managed. They receive frequent training and are given the freedom to make classes more engaging. To tackle regional inequality, those posted to remote areas are paid more. Most important, teacher assessment is based on the performance of their students. Those whose pupils do well are rewarded through presitigious “teacher excellence” titles. Besides such carrots, a big stick is the threat of running foul of the ruling Communist Party. The party apparatus is obsessed with education. This percolates down to school level, where many head teachers are party members.

8. Edward Luce on the hypocrisy and non-relevance of the Ivy League admissions debate in the US following the US Supreme Court direction barring any affirmative action in higher education admissions.

Of the 31mn Americans aged between 18 and 24, just 68,000 are Ivy League schools undergraduates — about a fifth of a per cent. Of these, a varying ratio are non-white beneficiaries of affirmative action. Many of those are from privileged black or Hispanic backgrounds, as opposed to Chicago’s South Side or the wastelands of Detroit. That is the basis on which the Ivy League lays claim to being a deliverer of social change. It is an optical illusion. In that respect the Supreme Court has done America a favour. Any disruption to this status quo is a plus. But it is unlikely to trigger the soul-searching America needs. The US debate remains stubbornly monopolised by the ethnic breakdown of the tiny number of students who win the Ivy League lottery. The 19mn or so of those 31mn young Americans who do not progress beyond high school, and the roughly 12mn who go to less elite colleges, barely feature. Whatever tweaks the Ivy League has to make to keep its diversity ratios after last week’s ruling are thus largely irrelevant to the 99.8 per cent that will never get there.

Instead of expressing outrage, he suggests that the Ivy League do some of this,

The genuinely radical Ivy League option — spending their vast endowments to sharply increase student numbers — is unlikely to be entertained. The key to the Ivy League is exclusivity; a big expansion in intake would dilute that premium. We are thus likely to continue with a situation in which universities such as Harvard, with a $53bn endowment, or Princeton with $36bn, continue to get richer. Each of these fortunes could revolutionise financial aid at dozens of public universities. The second most radical option would be for the Ivy League to abolish what is called “ALDC” — athletics, legacy, dean’s list and children of faculty and staff. Forty-three per cent of Harvard’s intake come from one of these groups. The first, athletics, includes sports that can only be learned by the privileged, such as lacrosse, sailing and rowing. The generous athletics intake by universities is why so many recent admission corruption scandals, such as the FBI’s Varsity Blues sting operation, involved athletics directors. Contrary to popular opinion, most athletics scholars are not black basketball players. Sixty-five per cent are white. The second, legacy students, are the close relatives of alumni — the very definition of elite reproduction. Again, these are mostly white. The third, dean’s List, is a euphemism for the children of people who have donated a lot of money. An example of this is Jared Kushner, Donald Trump’s son-in-law, whose father, Charles, gave $2.5mn to Harvard. Finally, there are the children of faculty members and staff. Taken together, the Ivy League could as easily be construed as an affirmative action plan for wealthy white people, which is very far from the progressive brand it has cultivated.

9. Times has an article that highlights how exports to China is an important factor in the German economy and any shocks will invariably generate social and political tensions. Many mittlestand companies, located in small towns and contributing a disproportionately large share of the local labour force and central to the local economy, are deeply vulnerable to any trade tensions and resultant loss of Chinese market. Take the example of Hate Hydraulics,

In Kaufbeuren, a brightly painted Bavarian town nestled below the Alps, Hawe is a top employer. In the tiny village of Sachsenkam, 60 miles to the west, Hawe provides 250 jobs — the next largest employer is the local brewery, with a staff of 17... The archetypal Mittelstand company is based in a rural German town, making a piece of equipment few have heard of, but that is crucial for goods worldwide — like a screw needed for every airplane or passenger car. These companies... employ 60 percent of its workers, and make up 99 percent of its private sector — a higher percentage than in any industrialized nation in the world... Because that worked so well for years, they had no need to adapt to changes. But now, they need to adjust to the new economic reality. Even as the tech revolution and climate change added strain in recent decades, Germany’s model plodded profitably along. But the pillars it relied on to do that — cheap Russian natural gas and the Chinese market — are collapsing... 

Like its population, Germany’s business owners and entrepreneurs are aging — the average Mittelstand association member is 55. Some are resistant to adapting to new technologies and cling to a loyalty-based system that created lifetime employees — and customers. (Hawe’s very first client in 1949, a forklift producer, still buys from it today.)

10. Times article on how (automobile, in particular electric vehicles) repairs have become prohibitively expensive,

The average cost of making damaged cars good as new has soared 36 percent since 2018, and may top $5,000 by the end of this year, according to Mitchell, a company that provides data and software to insurance companies and auto repair businesses. That big increase is the main reason that insurance premiums have been soaring — up 17 percent in the 12 months through May. New sport utility vehicles and pickup trucks, including a rapidly growing number of electric models, have become so complex and luxurious that seemingly simple repairs can cost a small fortune, auto experts said. Insurers are often on the hook for much of those costs, leading them to raise their rates.

Materials designed to crumple or deform in a crash to protect pedestrians or passengers, for example, can be hard or impossible to repair. Many bumpers must be replaced after low-speed dings because the safety sensors embedded in them may no longer work properly after repairs. Other systems, even some that do not appear to be damaged, must be inspected or recalibrated.

This is part of the trend of businesses trying to maximise value capture. It's a sale plus O&M approach, where businesses seek to maximise their returns over the entire life cycle of their products.   

11. Critical minerals required for the energy transition are acutely deficient,

Achieving the energy transition will demand far more lithium and other minerals by 2030 than the world is on track to produce. Responsibly boosting global production is paramount. Avoiding critical minerals shortages will require some 330 new mines over the next decade, according to Benchmark Minerals, even assuming maximum progress on recycling. This includes 59 new lithium mines; the world currently has a couple of dozen.

Meanwhile automobile makers are striking deals either buying up Lithium mines or entering into long-term purchase agreements with mining operators. This is a throwback to the early stage of automobiles when Ford set up rubber plantations in Brazil to manufacture tyres. But the challenges are daunting,

Many countries with big reserves, like Bolivia, Chile and Argentina, have nationalized natural resources or have stringent currency exchange controls that can limit the ability of foreign investors to withdraw money from the country. Even in Canada and the United States, it can take years to establish mines.

12. On the rise of private credit

Private credit alternative lending has grown nearly six times across public and private markets over the past 15 years. Notably, the private credit market has expanded to become an asset class worth about $1.5tn, rivalling the syndicated loan market in size... The supply of credit from commercial banks has declined by more than 50 per cent in the wake of the global financial crisis, the Covid-19 pandemic and the 2023 turmoil in banking... As a result, in the past 18 months more than 90 per cent of leveraged buyouts globally were financed by private credit.

13. Eurostar's passenger traffic projections were wildly over-optimistic  

... since the first trains ran from London Waterloo to Paris and Brussels in November 1994. During construction of the Channel Tunnel between 1988 and 1994, forecasts had projected that the operation within two years would be handling 13mn passengers annually — a level that the cross-Channel operations have still never achieved. They projected it would be carrying 20mn passengers annually by 2004. The service carried only 3mn passengers in 1995, its first full year, and only 6mn in 1997.

The numbers never even got close to 20 million

This has not stopped the operator who has struggled for commercial viability from making more optimistic predictions,

Eurostar merged last year with Thalys, which operates high-speed services from Paris to Brussels, Amsterdam and Cologne, to launch what former SNCF president Guillaume Pepy predicted would be a “new era” in high speed rail in Europe. The group is now aiming to double traffic from the 14.8mn people it carried in 2022 to 30mn people annually by 2030, according to Cazenave. The operation carried 8.3mn passengers on Eurostar trains and 6.5mn on Thalys in 2022.

This is the iron law of mega project over-optimism. Or strategic misrepresentation to raise financing?

Despite its problems, Eurostar has an 80% share of the London-Paris and Paris-Amsterdam rail and air markets. 

Thoughts on affordable housing III

This post on the housing market is in continuation to posts here and here. Emily Hamilton has an article in the latest Works in Progress that examines the success of Washington DC in increasing housing supply by promoting buildings around transit corridors. The post illustrates how urban planning decisions, while apparently not seeming to have much effect in the short-term, can have decisive long-term consequences.

San Francisco captures the housing market problems 

In a particularly important case, the San Francisco Bay Area, house prices grew 932 percent in the past 40 years while overall consumer prices increased by 329 percent... Four US metropolitan areas in particular – Los Angeles, San Francisco, New York, and Boston – have become increasingly expensive, thereby pushing out low- and middle-income families as higher-income in-migrants outbid them for a stagnant supply of housing.

The consequences of DC's decision to deviate from the trend and strike out on its own and ease zoning regulations more than half a century back are being felt today. 

DC’s relative success can be traced to a few decisions made decades ago. In the 1970s, policymakers in Arlington County made a decision to adopt what’s known as ‘transit-oriented development planning’ ahead of the opening of DC’s Metro Orange Line, which runs between Arlington and Prince George County, Maryland (via DC). Arlington policymakers identified that zoning for apartment construction in commercial areas could bring in property taxes and help balance the budget without the level of controversy of changing zoning in existing residential areas... Like most suburban localities, Arlington’s first 1930 zoning ordinance restricted development on the majority of its land to single-family development with lot-size requirements of 5,000 square feet or more. However, beginning in the 1960s, Arlington deviated from other suburbs of coastal cities and began creating new opportunities for apartment construction... Planners engaged residents and developed a ‘bull’s eye’ plan for permitting dense development around... the existing commercial centers in the Rosslyn, Court House, Clarendon, Virginia Square and Ballston neighborhoods... 

The quarter mile of land closest to the stations was intended for the most density. Today, several buildings stretching over 20 stories stand within these narrow radiuses... Today, much of Orange Line Arlington is surrounded with high-rise residential and office towers, but this transformation took time to emerge... In 1980, a Washington Post article bemoaned the difficulty of redevelopment in Clarendon, ‘a patchwork quilt’ of small parcels, many of them with long commercial leases. By the end of that decade, a large office building would flank the south side of the Metro station. Then, finally, in 2010, the entire block east of the Metro would be redeveloped with an award-winning Art Deco-influenced office, residential, and retail project... Like every locality, some of Arlington’s commercial developments became decrepit over time or are no longer the best use of their land. But the county’s zoning makes it possible to replace buildings in decline with more productive ones. For example, Arlington had a dead mall that has received an extreme makeover. It was the country’s first to have a multistory parking deck, but was suffering from high vacancy when a renovation plan was approved in 2015. The new mall includes many food- and experience-focused vendors – things customers can’t buy online – as well as 300 apartments... 

By planning for apartments in some of the commercial areas where it’s politically easiest to allow it, the Washington, DC, Metropolitan Statistical Area has facilitated more housing construction than most other ‘superstar’ regions in the US. It has seen more than twice the growth in its housing stock over the past 20 years of the Bay Area. In economics terms, the DC region has more elastic housing supply compared to most of its peers...

Among superstar metros, only Seattle has achieved a housing supply elasticity greater than DC’s, and then only slightly. Like DC, Seattle has pursued a transit-oriented development strategy with its Urban Villages plan, which has zoned for large apartment buildings in about two dozen neighborhoods throughout the city. Some of Seattle’s suburbs, including Bellevue, have also, like Arlington, been more open to apartment construction relative to the suburban jurisdictions surrounding other superstar principal cities.

This is a powerful factoid about the fiscal costs of single-family housing compared to apartments,

In 1957, the County Office of Planning identified a fiscal imbalance, following a period of rapid population growth. The county was not collecting enough tax revenue from its single-family housing to cover rising public expenditures. The report found that households living in apartments contributed 25 percent of the county’s revenues and required 21 percent of its expenditures, while people living in single-family housing contributed 48 percent of county revenues and required 68 percent of expenditures, with commercial development making up the balance of each.

Housing market suffers from several failures. The biggest problem is that supply is constrained by the fixed supply of land available to build, and allocation is distorted by the demand for the higher income group and for housing as investment. In the circumstances, the only way to meaningfully expand supply is to build upwards. 

Simultaneously, there should be efforts to tax the negative externalities. Accordingly, building permission fees and property taxes should be higher for individual housing units (say, beyond a threshold unit size), and they should decline progressively for more vertical developments. 

It's important to break-out of the immediacy trap of short-term fixes and adopt urban planning policies that seek to change behaviours and shape trends, so as to improve the future of urbanisation. Wicked problems like housing affordability have no immediate or single solutions. Instead they require a combination of different solutions and hunkered implementation over a long time. 

When the struggle is a strategic choice - inflation and wicked problems

Arguably the most important current macroeconomic debate is about the persistence of inflation. How persistent will it be? What should be done to address this persistent inflation?

The challenge facing policy makers in governments and central banks is that of engineering a soft landing and bringing inflation under control without engendering a recession. The critical part is bringing inflation under control. Economic orthodoxy has become wedded to the faith that inflation is under control when it's below 2%, and therefore as long as it stays higher than 2% inflation remains a problem. Policy makers are forced into accepting this orthodoxy by both the economists and monetary policy experts advising them as well as the market expectations of what constitutes stable inflation.  

There's a problem with this orthodoxy. As has now been widely exposed, there's nothing objective or sacrosanct about the 2% target. It was, for all practical purposes, arbitrarily pulled out of the hat by a group of experts based on the circumstances prevailing then. If the same set of people sat down today and were to fix a target, they are more likely to have fixed 4% (or some such higher target). 

Further, the 2% may have been fine for the near four-decade long Age of Moderation since the early eighties. This period coincided with the emergence of several factors that contributed to keeping inflation and interest rates down. They include globalisation of trade and finance achieved through economic and financial opening up of the world economy and the emergence of globalised value chains in goods and services aided by technological advances; the emergence of China (in particular) as the factory of the world supplying goods at cheap prices; and favourable demographics and other factors contributing to a global savings glut. The tailwinds from these forces were enough to create globally integrated markets for labour, capital, goods and services, thereby lowering the cost of production significantly and putting downward pressure on prices. 

Now that all these tailwinds have disappeared and some have turned to become headwinds, it's only natural that inflationary pressures mount and interest rates rise from their previous normal. At the least, a return to the low inflation and ultra-low interest rates of the last decade and more will be almost impossible. Therefore, there are strong reasons to argue in favour of raising the inflation threshold to say, 4%. The IMF endorsed it as early as 2010,

A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.

Olivier Blanchard, first as the IMF Chief Economist and subsequently, has been a consistent advocate. The likes of Kenneth Rogoff have earlier advocated a much higher target of 6% for the US, mainly to inflate away some of the accumulated pile of public debt. There's the precedent of post-war debt example of inflating away public debts in many developed countries. This is another strong case made out for a higher inflation target.

However, for policy makers to disown the orthodoxy and adopt a higher inflation target is not easy. While raising the inflation target to 4% citing the aforementioned logic might have stood a chance of being accepted in good times (though it's unlikely that any economist would have had the courage, leave aside foresight and wisdom, to break-away from entrenched academic faith and support such choices when things are going well), it becomes stigmatised in bad times and will be seen as a panic stricken response. It's similar to imposing capital controls in response to capital flight as against doing the same when times are good. The market reactions to the same set of actions will be very different.  

This would go against the advice of experts and the prevailing technical expertise-based narrative. It's widely perceived that it will not be taken kindly by the markets and will result in market convulsion that would destabilise the economy. This risk is also perceived as being higher given the several fault lines in an economy that had become addicted to low interest rates for a long period of time. There's a self-reinforcing dynamic to this - experts spout the orthodoxy, markets internalise this belief, policy makers shy away from making choices that go against the experts, market expectations get reinforced, the beliefs get entrenched, and on it goes.

In the circumstances, a prudent strategy may be to let things be. Policy makers should be seen to be doing everything possible to bring down inflation, but stopping short of triggering a recession. This is a fine line that nobody knows and would therefore necessarily involve actions that will be perceived by at least some as being half-hearted and muddled. That may well be the requirement. 

Instead of moving decisively to tighten and stop inflation (with the risk of a hard landing and recession) or moving equally decisively in the other direction to raise the inflation target to 4% (with the risk of a market backlash and recession), the circumstances demand that the system find its way to the soft-hard landing and higher inflation target. The path dependency (to reach 4% or some other target and the soft-hard landing) is important. The system has to collectively (the market perception in particular) undergo the tortuous struggle of trying and exhausting all options of achieving a soft landing before it becomes ready to accept the new inflation target. The struggle is the solution. 

This is a teachable instance in dealing with wicked problems, or those that are so complex and beset with incomplete, changing and contradictory requirements, as to have no clearly defined solutions. Inflation today and raising inflation target are wicked problems. 

The solutions to wicked problems can be considered as being path dependent. Their resolution depends on the nature of the collective struggles and its accumulated set experiences (especially the difficult and bitter experiences). Therefore the solution, to the extent it can be called a solution, is the struggle. The struggle generates its dynamic, creates the conditions, clears the fog of uncertainty, and shows the path for bringing down inflation. It's apt to recollect this quote attributed to E L Doctrow in some other context,

'Writing is like driving at night in the fog. You can only see as far as your headlights, but you can make the whole trip that way.'

The struggle to address wicked problems should embrace this strategy. The challenge then is to steer the struggle by intervening at opportune moments. It's not to avoid the struggle, but to minimise the pain from the struggle by steering the course.  

This framework is useful to explain several issues in public policy and international development. Consider the issue of aid and international development. It's common to find external experts suggesting innovative solutions to deep-rooted social problems like poverty alleviation, poor student learning outcomes, improving public health etc, in low income countries and donors and philanthropic organisations supporting those innovations. 

Such transplanted and reductive prescriptions are a serious obstacle to sustainable development. They prevent these countries and their societies from undergoing the difficult struggles to face up to the reality of their situations and the enormity of the challenges ahead, make conscious and collective decisions, craft solutions appropriate for their contexts, prioritise the allocation of scarce resources, create the systems required to implement their decisions, and generally feel the ownership of the solutions and the need to generate value for money from these expenditures. 

Sometimes we need to accept that there are no clear solutions. And the pathway to a solution is to embrace the collective struggle. This can be difficult, even profoundly unsettling, for human mind to accept. But that may be the reality. 

Update 1 (07.07.2023)

Inflation status across the world

Weekend reading links

1. Paul Krugman has a nice oped on Taylor Swift's concerts. She makes around $11-12 million from her concert ticket sales, and even in this age of digital streaming concert tours are the major source of revenues for music artists.  

2. Interesting channel of discontent with monetary policy in UK

One of the most direct ways that monetary policy affects demand is through the rates people pay on their mortgages. But unlike in the late 1980s, when about 40 per cent of all households in England had mortgages, by 2021/22 the proportion was just 30 per cent. Meanwhile, the number of people who own their homes outright has climbed sharply as baby boomers have retired, from about 26 per cent in the late 80s to 35 per cent by 2021/22... people may begin to see this tightening cycle as uneven and unfair. The pain of sharply higher mortgage rates is falling on the shoulders of fewer people this time around — and mortgage-holders are overwhelmingly working people, which means they are more exposed to any Bank of England-induced downturn in the labour market too. In contrast, two-thirds of those who own their homes outright are retired. It is easy to see how this could reignite intergenerational resentments. In the decade of super-loose monetary policy, young people lost out because house prices moved further out of reach, while delivering rising levels of wealth for older homeowners. In this new era of sharply rising rates, younger working people with mortgages may come to feel that they are once again absorbing the pain on behalf of society as a whole.

3. President Biden gave a speech last week at Chicago that unveiled a new economic policy making paradigm, Bidenomics.

The economic vision for this country: the economy that grows the economy from the middle out and the bottom up instead of just the top down. When that happens, everybody does well. The wealthy still do — (applause) — everybody does well. The poor have a ladder up, and the wealthy still do well. We all do well. 

This vision is a fundamental break from the economic theory that has failed America’s middle class for decades now. It’s called trickle-down economics — fundamental economics, trickle-down. The idea was — it’s the belief that we should cut taxes for the wealthy and big corporations... I’m tired of waiting for the trickle-down. It doesn’t come very quickly. Not much trickled down on my dad’s kitchen table growing up. And it’s a belief that we should shrink public investment in infrastructure and public education — shrink it; that we should let good jobs get shipped overseas. And we actually have a tax policy that encourages them to go overseas to save money. We should let big corporations amass more power while making it harder to join a union... Under trickle-down economics, it didn’t matter where you made things, as long as you helped the company’s bottom line, even if that meant seeing jobs and industries go overseas for cheaper labor... Trickle-down also meant slashing public investment on things that helped drive long-term growth and helped America lead the world in innovation...

Bidenomics is about building an economy from the middle out and the bottom up, not the top down. And there are three fundamental changes that we decided to make with the help of Congress and been able to do it: first, making smart investments in America; second, educating and empowering American workers to grow the middle class; and third, promoting competition to lower costs to help small businesses... We’re supporting targeted investments. We’re strengthening America’s economic security, our national security, our energy security, and our climate security... We’re now investing in key industries of the future, making targeted investments to promote domestic production of semiconductors, batteries, electric cars, clean energy... Biden economics means the industries of the future are going to grow right here at home... addressing the 40-year decline in unionization by supporting project labor agreements, collective bargaining, prevailing wage laws, that’s the reason today Americans’ support of unions is higher than it’s been in 60 years.

Manufacturing investments have taken off, almost doubling in the last two years.

4. India labour market facts of the day,

Roughly half a million young people took the annual preliminary test for the Bihar Public Services Commission in February, for a total of 281 jobs. For every batch of 2,000 hopefuls, 1,999 will walk away with nothing. The odds are nearly as bad on the national level. From 2014 to 2022, Indians filed more than 220 million job applications with the central government. Of those, just 720,000 — less than one-third of 1 percent — were successful, a government minister told Parliament.

Contrast this scramble for government jobs with jobs remaining unfilled in manufacturing,

If the government has far more potential workers than it needs, Mr. Ramesh has far too few. To make complicated aluminum castings that perform precisely at 200 miles per hour, he needs workers who are willing to stay put, learn and earn. But he says he cannot find enough who are capable and reliable, from the country’s more impoverished north or anywhere else. So he was a week away from partially automating his plant — turning to machines in the hope of employing fewer humans... Mr. Ramesh, the managing director at Alphacraft, the auto parts manufacturer, is optimistic about almost every aspect of his business. Orders are going up and shipping costs are being streamlined, and he sees growth prospects on three continents. His only problem: a work force he cannot count on “because they are all coming from distant parts of the country.”

There's also the wage problem - people looking for jobs, but unwilling to work at the wage being offered, especially if it's a factory floor job.

5. Being obese is a sign of credit-worthiness in Uganda

Elisa Macchi, an assistant professor of economics at Brown University, conducted tests with 238 loan officers at 146 financial institutions in the capital city, Kampala. She asked them to review applications from fictionalized potential borrowers whose accompanying photographs were manipulated so they appeared thin or fat. It is not uncommon in Uganda for people to include a photo of themselves when submitting a loan application, and it can be one nugget of information that a loan officer uses to decide whether to even grant an applicant a first interview, Ms. Macchi said. She discovered that loan officers were more likely to rate the applicants as more creditworthy and more financially sound when the obese version of the photograph was attached. “The obesity premium is large, equivalent to the effect of a 60 percent increase in borrower self-reported income in the experiment,” or an additional asset like ownership of a car, the study concluded.

6. Martin Wolf examines the new industrial policy of the US Government. The share of manufacturing and industry in the labour force has declined by more than half since 1970. 

China has rapidly overtaken US as the manufacturing superpower of the world.

7. More evidence that price markups are a major driving factor behind the current inflation, this time from the IMF research (paper here) on Eurozone area. 

The higher inflation so far mainly reflects higher profits and import prices, with profits accounting for 45 percent of price rises since the start of 2022. That’s according to our new paper, which breaks down inflation, as measured by the consumption deflator, into labor costs, import costs, taxes, and profits. Import costs accounted for about 40 percent of inflation, while labor costs accounted for 25 percent. Taxes had a slightly deflationary impact. In other words, Europe’s businesses have so far been shielded more than workers from the adverse cost shock. Profits (adjusted for inflation) were about 1 percent above their pre-pandemic level in the first quarter of this year. Meanwhile, compensation of employees (also adjusted) was about 2 percent below trend.

8. Simon Kuper looks at the changes to global tourism map,

Some beach destinations — the Maldives and bits of the Caribbean — will vanish beneath the waves. In the Med too, especially on the African coast, the rising sea is eroding beaches. It’s also becoming unbearably hot... summer will linfllose its place as peak tourist season. First, it will increasingly be too hot to travel for pleasure. Second, a growing number of childless people aren’t bound by the long school summer holidays. Third, as tourism booms, popular destinations are running out of space in peak season. Expect beach resorts to refocus on spring, when they can offer northerners their first soft rays of the year... Winter skiing holidays will start to die out. Forty per cent of the world’s skiing visits are now to the Alps, where lack of snow is one of the main reasons hundreds of resorts have closed. Almost all Alpine glaciers could disappear this century. In the US, across a number of resorts, the skiing season contracted by an average of 34 days between 1982 and 2016, write Xubin Zeng of the University of Arizona and others. Ski towns have begun trying to remake themselves as summer hiking and cycling destinations.

9. Foreign car makers are a declining presence in China.

And the Chinese EV makers led by BYD threaten to become important sellers in Europe. 

In the first five months of the year, BYD alone sold nearly 1mn of its battery and plug-in hybrid vehicles in China, accounting for 38 per cent of the country’s new energy vehicle market, according to data from Automobility, a Shanghai consultancy. By contrast, Volkswagen, one of the first European companies to enter the Chinese market in the late 1980s, had just 2 per cent of EV sales.

10.  The Indian software firms have missed all the major opportunities to move up the value chain - IoT, big data, and cloud computing. And now they look set to miss the Generative AI wave.

Water privatisation unravelling in the UK

The UK is ground zero on the problems with the private equity-led infrastructure financing model. In early 2018, Carillion, the country's largest outsourcing provider, which provided different services to hundreds of public facilities in the UK, collapsed into compulsory liquidation. The entity had 19500 UK employees and 28500 pensioners had £5 billion in liabilities. The government was forced to step in and assume management of the schools, hospitals, and other public facilities being managed by Carillion. 

Now comes news that Thames Water, the country's largest water utility, serving London and south-east of England and privatised in 1989, may be close to collapse and necessitate a public rescue. As interest rates have risen, the company's ability to service its £14 bn of debt is coming under strain. Besides a new rule mandates that from April 2025 regulated entities could not pay dividends if their credit rating falls below a certain threshold. The parent company, Kemble Water Holdings, 2026 bond plunged as much as 35 pence to 50 pence and distressed territory. The Chief Executive quit abruptly this week, leaving the government to consider the possibility of renationalisation. 

The shareholders, consisting of a dispersed set of infrastructure, pension and sovereign funds, have failed to make good on the £1.5 billion of equity injection promised a year ago. Apart from skimping on investments, the utility, along with other UK water utilities, has come under the scanner for dumping sewerage into rivers and the sea. The FT's verdict on who's to blame is instructive,

Previous owners Macquarie, which helped grow Thames Water’s large debt pile, deserves blame.

The financial engineering that juiced up returns for investors has come at the cost of the utility's financial health, 

Its net debt to ebitda ratio was 14 times at operating company Thames as of September 2022. For Kemble that figure was 22 times. Operating profits did not equal interest costs, with interest cover at 0.6 times and 0.3 times respectively. A high share of index-linked debt hurts, while indexed water rates lag behind interest payments. Whether Thames makes outsized returns is difficult to measure. Cash transferred from the operating company to investors via interest payments and dividends over the past decade comes to about £4.1bn, according to S&P data. Peers United Utilities and Severn Trent have paid out similar amounts. The difference at Thames is that three-quarters of that cash flow went as non-taxable interest payments to debtholders.

This summary of water privatisation in UK makes disturbing reading,

After being sold with almost no debt at privatisation three decades ago, UK water companies have taken on borrowings of £60.6bn, diverting income from customer bills to pay interest payments. The entire sector is now under pressure from rising inflation, including soaring energy and chemical prices and higher interest payments on its debts. S&P, the rating agency, has negative outlooks for two-thirds of the UK water companies it rates — indicating the possibility of downgrades as the result of weaker financial resilience. More than half of the sector’s debt on average is inflation-linked. Ofwat said in December that it was concerned about the financial resilience of several water companies: Thames Water, Yorkshire Water, SES Water and Portsmouth Water. ​ In 2021, Southern Water, which serves 4.2mn customers across Kent, Sussex and Hampshire, was rescued from the brink of bankruptcy after Australian infrastructure investor Macquarie agreed to take control of the company in a private deal with Ofwat.

In this context, FT has a long read which examines the role of Australian infrastructure fund, Macquarie in pioneering PE investments in infrastructure. The article points to two Macquarie UK infrastructure case studies (including Thames Water) that also highlights the problems with the model.

Macquarie first dipped its toe into the UK’s waters in 2003, with its shortlived acquisition of South East Water. After buying the company for £386mn from the French conglomerate Bouygues, Macquarie sold its final stake three years later for £665mn. During that period, debt — some of which was raised via a Cayman Islands subsidiary — increased more than fourfold from £87mn to £458mn. The increase in borrowing was used to pay investors more than £60mn in dividends as well as to pay off most of the costs of acquiring the company so that the final sales price was mostly profit... it was a loss for customers because a greater proportion of their bills — up from 8.7 per cent of turnover in 2002 to 14 per cent in 2006 — began to go towards paying the interest on debt.

... it and its co-investors acquired Thames Water, which now has 15mn customers in London and the Thames Valley, from German utility RWE for £4.8bn in 2006. One of the Macquarie consortium’s first acts was to arrange for Thames Water to pay a £656mn dividend in a year in which profits were just £241mn. Within six years, the group of companies managed by Macquarie had recovered all the money it and co-investors had spent on the acquisition, by borrowing against its assets and paying out dividends. By the time Macquarie sold its final stake in Thames Water in 2017, the company had spent £11bn from customer bills on infrastructure. But far from injecting any new capital in the business — one of the original justifications for privatisation — £2.7bn had been taken out in dividends and £2.2bn in loans. Meanwhile, the pension deficit grew from £18mn in 2006 to £380mn in 2017. Thames Water’s debt also increased steeply from £3.4bn in 2007 to £10.8bn at the point of sale, a sum still being paid off with interest by customers long after Macquarie has moved on.

The article sums up the problem of private finance in infrastructure

Now, more than three decades after privatisation first became popular, governments are faced with a conundrum: how they can use private finance in infrastructure in a way that delivers adequate returns for shareholders and deliver high quality services for the people — their voters — who are paying for them. “This is the issue of the decade,” says Folkman. “We know we want lots of investment to transition to net zero and even just to repair what’s failing. But if we want to make it work for investors as well as the public we need to figure out how to do it better and soon.” 

The first article points to Thames Water's ownership structure

And this graphic highlights the complicated holding structure.

Such complexity serves a purpose from the perspective of the private equity business model. But they distort incentives and set up the entity for failure. 

Note the nature of the shareholders and their widely dispersed shareholdings, and the opacity of ownership and accountability added by the complex ownership holding structures. None of the investors have any water sector expertise. Nor do they have any interest in building an enduring and efficient water utility. All of them are playing the pass-the-parcel game. They are impersonal investors for whom Thames Water sits in their big portfolios as just another investment. Even the holding company, Kemble Water Holdings, is part of the pass-the-parcel game. There is nobody with the long-term stakes to take the life-cycle view and build an efficient water utility that serves its customers. 

There is something to be said about ownership, and long-term at that, for such monopoly assets. It is essential for life-cycle management of such assets, especially those that are monopolies and deliver critical public services. Even if privatised, as the Europeans have done, the asset should be owned for the long-term by a physical company with expertise in the area and which can be held accountable by the government and customers. Regulators should take note of how the complexity of the holding company distorts incentives and comes in the way of life-cycle management of monopoly assets like utilities.  

The problem with private equity in infrastructure should now be obvious. It's largely regulated and as an asset category is characterised by low but stable returns. Private equity firms seek to maximise returns. The returns profile of infrastructure assets do not allow for meeting the objectives of the PE firm and infrastructure funds.

In the circumstances, I am increasingly convinced that the likes of Macquarie are not the right kind of investors for regulated infrastructure assets (like roads and utilities). The returns expectations of their limited partners and the incentives of employees are so badly skewed. In the aggregate and over long run, these structures end up doing more harm than good. 

Start-ups with perceptive entrepreneurs and Boards try to be selective about the nature of their investors . They avoid certain kinds of investors who prioritise returns maximisation above all else. Such investor screening is even more important in essential public service sectors like infrastructure. Private equity and infrastructure funds are not the desirable kind of investors in case of most infrastructure projects. 

Update 1 (02.07.2023)

More on the UK water utilities from a FT Editorial

Thames is the most highly leveraged company in the sector, but the regulator Ofwat last December flagged resilience concerns at four other suppliers too. The simple explanation for the sector’s troubles is that what are in essence simple businesses became playgrounds for financial engineering. Predictable revenue streams made water companies easy to leverage, and so appealing to buyout funds. All but three of England’s originally publicly-quoted water companies have been taken off the market (Scotland and Northern Ireland remain in the state sector, and Wales now has a not-for-profit entity). 

Companies and the regulator tout sizeable efficiency gains since privatisation that they say have kept bills lower than they would otherwise have been; Ofwat says investments have “roughly doubled”. But buyers often adopted complex structures to maximise leverage and minimise tax, and companies have paid out more than £72bn in dividends while a sector that was debt-free three decades ago has run up debts of £60bn. Environmental standards were for too long poorly enforced.

Update 2 (13.08.2023)

UK water privatisation facts of the day

After being privatised without debt in 1989, and given a £1.5bn government handout to make improvements to the network, water companies had ramped up £60bn in borrowing by March 2022 and paid out more than £70bn in dividends while presiding over leakage and pollution failures, including unknown quantities of untreated sewage pouring into coastal waters and rivers.