22 Oct 2012

The Cost of Privatisation

By Ian McAuley
Conventional wisdom says the private sector is more efficient and public debt is always a risk. What if both assumptions were stifling good policymaking? Ian McAuley on the right way to fund infrastructure
Which country has higher public debt — Spain or Germany?

The answer is Germany, with public debt at 80 per cent of GDP. Spain's is 70 per cent of GDP.

Germany can bear high public debt because its strong economic growth can service its debt. And more importantly, that debt has been used to finance productive assets — high speed rail systems, long-distance roads and metro rail systems.

Spain's problems relate not so much to public debt as to high private debt, which financed a housing boom, and it is becoming increasingly clear that much of that private debt will have to become public debt to keep the banking system afloat. While Germany's debt has financed up-to-date productive infrastructure, all that Spain has is a huge stock of unoccupied housing.

This comparison carries two simple messages. First, that there is nothing wrong with debt, provided it is used to fund productive assets, or, in accounting terms, so long as liabilities are matched by assets. Second, whether debt is private or public, it has to be repaid.

Here in Australia, we may look with envy at Germany's infrastructure. We have some glaring deficits — the public transport systems of Sydney, Melbourne, Brisbane and Adelaide, and our long-distance roads, such as the Bruce, Pacific and Duke's highways.

There is a strong case for using public debt to finance these infrastructure deficits. Our public debt, at all levels of government, is about 30 per cent of GDP, mostly in state governments. To put this figure into perspective, if we were to borrow another $300 billion for infrastructure, our public debt would be about 50 per cent of GDP, which is around the OECD average. And unlike the struggling European countries, we have plenty of leeway to raise taxes to repay debt, because we have some of the lowest taxes of all countries, as many economists and commentators, including Ben Eltham here at NM, point out. Better infrastructure contributes to economic growth and therefore our capacity to repay the debt — it's as simple as that.

Yet we are constrained by two obsessions. One, as mentioned above, is our public debt phobia, which has infected governments of all levels of both mainstream traditions. The other is an unquestioned assumption among policymakers that the private sector is intrinsically more efficient than the public sector. These obsessions reinforce each other, because we are too willing to use high-cost private debt when we would be better off using low cost public debt. Remember, whether the debt is private or public, we have to pay it off.

On Thursday last week the Productivity Commission released its draft report on electricity network regulation, which made news because it confirmed that network costs ("poles and wires") had accounted for more than half the rises in electricity prices over recent years (yet another voice contradicting Tony Abbott's rubbish about the impact of the carbon tax), and that we are paying dearly for the capacity to meet our peak demand spikes. Its other strong message was that remaining state-owned electricity assets should be privatised, as they have been in Victoria and South Australia.

The Commission rested its case on empirical evidence that state-owned transmission enterprises have higher operating costs, and it put these down to a host of factors which might be called poor management and poor governance. These included local procurement regulations, poor management of capital expenditure and cash flows (including dividend requirements), generous employee benefits and board appointments which are not necessarily based on merit.

I have no reason to gainsay the Commission's findings, and I know of some other case comparisons where similar results are found in private-public comparisons. (I can also cite cases where the opposite holds.) But does this establish an argument for privatisation?

A business principle, so basic that it shouldn't need stating, is that the first response to identified inefficiencies should be to reform. Imagine how shareholders in a listed company would feel if a company, having identified that it had mismanaged one of its divisions in a secure market, decided to sell it rather than to improve its performance, even though it would have to be sold at a discount. Yet that's what the Commission is essentially recommending.

The Commission acknowledges some costs with privatisation, including greater regulatory effort, and a higher cost of capital in the private sector, a point to which I will return. But in its suggestion that it can use regulatory mechanisms to provide incentives to require electricity network owners to cut costs, it is naively applying a simplistic economic model, overlooking the nature of business incentives.

The Commission points out that we do not need to expand our electricity distribution network: in fact excessive growth has been a reason for cost increases. Also, it's an industry with mature technology; hardly an exciting prospect for any gung-ho entrepreneur. Contrary to the simplified models in economic textbooks, firms seek growth — often at the expense of profit. Cost minimisation is not exciting, and encouraging customers to use less of your product just goes against the grain, even if there are financial incentives to do so. Such a set of requirements is surely more suited to the model of professional and conscientious public service management, rather than the growth-oriented private sector model.

In fact, the Commission did issue a fall-back recommendation, suggesting that if privatisation was to prove too difficult, presumably for political reasons, corporatisation, with enterprises kept in public ownership but at arm's length from government, would be a second-best option.

But there are stronger voices calling for privatisation. On the same day as the Productivity Commission reported, Infrastructure Australia released a report suggesting that $200 billion of infrastructure assets currently in public hands could be sold to the private sector, releasing funds for public investment in other assets. Its press release stated:

"Infrastructure Australia called on governments to examine the sale of commercially viable, publicly owned assets to the private sector, in order to fund critical, new infrastructure."

Water and electricity supply between them constituted the bulk of IA's identified projects.

Unsurprisingly, the superannuation funds, including the industry funds in which unions have a strong interest, were enthused by IA's recommendations. Regulated monopolies providing essential services are rather nice cash cows, to use Boston Consulting Group's terminology.

Such enthusiasm should ring alarm bells, however. Australian governments have strong credit ratings, and can borrow at low cost. The Commonwealth Government ten year bond rate is less than four per cent. Commercial enterprises have a much higher cost of capital — they have to borrow at higher rates — at least two per cent higher — and even for secure industries such as utilities have to rely on a significant proportion of more expensive equity finance. Their cost of capital is around four per cent higher than the government's.

As a first approximation therefore, privatising all our electricity and water assets would cost about $8 billion a year (4 per cent of $200 billion), and all we would have to show for it is a lower government debt, offset by a higher private debt — which we would still have to repay.

This is not a blanket case for public ownership, but it does apply to utilities where there are mature technologies, standardised commodities, natural monopolies and the need to constrain consumption. There is also a case for public ownership of most transport networks which have some similar characteristics, as well as strong "public good" characteristics — in itself another topic. Nor is it a case for retention of all utility functions in the public sector — tasks like construction and maintenance can be contracted out provided competitive conditions exist. Rather, it is a case for the application of common-sense economics to our decisions about public ownership and debt.

Among politicians in the big parties, the only sensible voice in recent days has been that of Jeff Kennett, who pointed to the low cost of public debt to finance public infrastructure. Kennett has had the challenge of managing a state economy, and has first-hand awareness of the threat to the competitiveness of our cities posed by inadequate infrastructure. Also, with his days of seeking public office behind him, and with no personal incentive to make a stag profit from privatisation, he is free to articulate commonsense economics.

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Evan
Posted Tuesday, October 23, 2012 - 14:36

Thanks Ian. The thing I don't understand (and I guess it is a political rather than financial question) is why pollies still push this line. Is it just because the sale gives them cash to spend?

After the extraordinary financial debacles of some high profile PPP's why do they still go in for this kind of thing?

This user is a New Matilda supporter. Marga
Posted Tuesday, October 23, 2012 - 15:33

Ian - thanks for a great article. You are just so right. Why do our politicians not want to see (they can't be that stupid that they cannot see) that public debt which equates to assets is acceptable. It is private consumer debt that is the killer, especially if that then requires public bailout.

Private goods and services and public goods and services each have their place in society. Infrastructure belongs into the latter category.

Homerjunior
Posted Tuesday, October 23, 2012 - 15:58

Good article.

The politicians are not much interested in running infrastructure. Not many come from an engineering/technical background. They would prefer the private sector to run it and governments to regulate.

Selling off infrastructure raised money and the high fees went to those managing any sale. The arguments in favour of privatisation were used to gain these outcomes.

Paul Keating was happy too. As the father of compulsory Super, he saw new investment opportunities for burgeoning funds. He referred to our power stations as '19th century kit'.

The government workforces were also off the books.

So much damage was done through following economic orthodoxy and disregarding everything else.

BTW, if we still had state electricity commissions, we could have a more effective strategy for reducing greenhouse gases.

jackal01
Posted Tuesday, October 23, 2012 - 20:59

Great article Ian McAuley

Now could you talk about the benifits, for or against, to the economy of having a Public company with a high number of workers and a lot of middle Management types being trained up to become upper management and of course the Apprenticeships offered by the public system to improve our knowledge base and to aid consumption with shop owners. (We know what happened to towns like Junee when Governments destroyed both the Rail and the RTA.)

Then copare that to Private companies who have a small group of overpayed Senior executives who treat the companies like their own private thiefdoms and a smaller number of actual workers on lower wages, mostly, which restricts consumption and dumbs down the Nation overall.

There is more to a cake then its name and its color.

We know why the Government just changed its policies on Private Health insurance in the latest Budget. Private health Insurance was holding the government to ransom. Electricity Providers are starting to do the same thing, despite the fact that they knew and were told the Carbon Tax was coming before they payed for the electricity assets.

Private enterprise did not want to provide the Transport needs of the Sydney Basin in 1958 when the CBD moved out to Parramatta, hence the Government had to buy up a lot of Privates at huge cost to create the PTA and now that the Privates know how much the UTA makes of Pittwater Road they want in, they are pushing for Privatisation, but will those clowns want the none profit service runs that are being payed for by the high Profit runs on Pittwater Road etc.

The human body is far more then just skin and Bones, same with the economy, the state, the nation, the people.

Greedy grubs have always captured or created the debates about economic Pro's and Con's and swung markets or assets in their favour.

Read up on the Transport needs of the City of Chicago back in 1958, the removal of the light rail, the rorts and rip-offs that happened.

Ask yourself why do rich people all want to own high earnings capable Soccer, Footy or Cricket clubs. Why don't they want to own Track and Field, or Swimming sports etc.. Earning Potential.

Private Health Insurance is a rip off and could you please explain how Private Enterprise feeds the economy, when Business feeds of consumers and 77% of all of Aust. Population and that includes Business feeds of the Tax Purse, which is mostly fed by exports.

So why bother with a whole heap of Sole Traders who are only Bottom Feeders anyway and would never survive if it wasn't for the consumer who mostly earn their income of the Tax Purse. Most small Business's are started with Government grants or assistance, as per the Pink Batts scandal by the Labour Government.

bill hartigan
Posted Wednesday, December 5, 2012 - 11:02

Bill Hartigan
Ian McCauley is half right.Privatisation does not necessarily produce lower prices to the users of newly privatised State assets.
A privatisation proposal should meet a number of tests before adoption.
(1)Will it be structured to operate in a competitive environment?
(2)Will the interest saved through debt retirement be greater than the State revenue foregone in the privatisation?
(3) Has the Government made genuine efforts to improve productivity in the Government Owned Corporation before privatisation to properly test (1) and (2).

The argument on the use of debt to fund infrastructure rests on the use of debt to fund recurrent capital investment in "public goods" areas such as schools, hospitals, which see users receive free services funded by the taxpayer (at least in the medium to the long term).
As Professor McCauley notes Australians could pay higher taxes to fund such recurrent capital expenditures- or they could reduce wasteful expenditure in the public sector, both in higher cost wages and conditions, overmanning and politically motivated wedge programs using public funds.
His reference to practices in Europe, Japan, USA with higher public debt levels than Australia does not show an understanding of the effect this addiction to debt has had on the social and econnomic structure of those countries rather than supporting higher levels of unfunded Government debt in Australia.
Of even more concern is the fall in investment and employment in major tradeable sectors as mining construction declines and manufacturing with high local value added is disappearing.
Impacts on our competitiveness such as internationally high interest rates supporting high exchange rate, out of control wage and condions increases in the non tradeable sector e.g. public sector, construction
industry as well as the debt funded move into non tradeable employment
.
Unless Governments begin to understand the global economic environment in which we find ourselves and respond to that condition, australia is moving towards almost irreversible decline. Our international competitors are using import quotas, tariffs, domestic subsidies, interest rates and exchange rates to protect their economies. While most of these actions will have long term adverse effects, Australian tradeable sectors will be trampled to death. The Automotive industry with it's high value added and high levels of technology is in collapse, steel is in trouble as is aluminium, while textile and foot wear are long gone.
Yet there are things that can be done, once we start getting public debt under control.
Interest rates should track the rest of the world and the RBA should be intervening in the Australian dollar exchange rate
The fight for control of areas of Government responsibilty between State and Commonwealth should cease- Health and education should be returned entirely to the States- after all the same voters vote in both elections. The GST should be expanded to cover all transactions with pensions adjusted upwards.
The Commonwealth has enough to do with defence, communications, trade, income taxes and redistribution and foreign affairs.
he Commonwealth needs to support key industrial sectors with long term grants to foster investment in new high tech manufacturing
Our so called defence manufacturing industries -ships, submarines, armoured cars to name a few, are barely assembly programs, with all high tech components imported,
that provide no real independant defence capacity.
In that regard, we would be much better off importing such equipment and using the billions saved to boost the manufacture of uniforms, footwear, light fully Australian light military vehicles ' light weapons, small naval vessels and helicoptera , with possible spin offs to domestic civilian markets.
There is, after all, no global free trade, nor likely to be. Every nation with which we compete will operate in their own perceived best interest as reflected in the political cycle.
So far Australia has avoide the worst impact of decades debt funded vote buying in Europe , USA, Japan. But we should avoid the temptations, to which Labor in both State and Federal Governmens have succumbed, to use det to fund unsustainable growth in numbers and salaries in the public sector.
Our focus MUST be on a diversified , strong tradeable sector

bill hartigan
Posted Wednesday, December 5, 2012 - 11:03

Bill Hartigan
Ian McCauley is half right.Privatisation does not necessarily produce lower prices to the users of newly privatised State assets.
A privatisation proposal should meet a number of tests before adoption.
(1)Will it be structured to operate in a competitive environment?
(2)Will the interest saved through debt retirement be greater than the State revenue foregone in the privatisation?
(3) Has the Government made genuine efforts to improve productivity in the Government Owned Corporation before privatisation to properly test (1) and (2).

The argument on the use of debt to fund infrastructure rests on the use of debt to fund recurrent capital investment in "public goods" areas such as schools, hospitals, which see users receive free services funded by the taxpayer (at least in the medium to the long term).
As Professor McCauley notes Australians could pay higher taxes to fund such recurrent capital expenditures- or they could reduce wasteful expenditure in the public sector, both in higher cost wages and conditions, overmanning and politically motivated wedge programs using public funds.
His reference to practices in Europe, Japan, USA with higher public debt levels than Australia does not show an understanding of the effect this addiction to debt has had on the social and econnomic structure of those countries rather than supporting higher levels of unfunded Government debt in Australia.
Of even more concern is the fall in investment and employment in major tradeable sectors as mining construction declines and manufacturing with high local value added is disappearing.
Impacts on our competitiveness such as internationally high interest rates supporting high exchange rate, out of control wage and condions increases in the non tradeable sector e.g. public sector, construction
industry as well as the debt funded move into non tradeable employment
.
Unless Governments begin to understand the global economic environment in which we find ourselves and respond to that condition, australia is moving towards almost irreversible decline. Our international competitors are using import quotas, tariffs, domestic subsidies, interest rates and exchange rates to protect their economies. While most of these actions will have long term adverse effects, Australian tradeable sectors will be trampled to death. The Automotive industry with it's high value added and high levels of technology is in collapse, steel is in trouble as is aluminium, while textile and foot wear are long gone.
Yet there are things that can be done, once we start getting public debt under control.
Interest rates should track the rest of the world and the RBA should be intervening in the Australian dollar exchange rate
The fight for control of areas of Government responsibilty between State and Commonwealth should cease- Health and education should be returned entirely to the States- after all the same voters vote in both elections. The GST should be expanded to cover all transactions with pensions adjusted upwards.
The Commonwealth has enough to do with defence, communications, trade, income taxes and redistribution and foreign affairs.
he Commonwealth needs to support key industrial sectors with long term grants to foster investment in new high tech manufacturing
Our so called defence manufacturing industries -ships, submarines, armoured cars to name a few, are barely assembly programs, with all high tech components imported,
that provide no real independant defence capacity.
In that regard, we would be much better off importing such equipment and using the billions saved to boost the manufacture of uniforms, footwear, light fully Australian light military vehicles ' light weapons, small naval vessels and helicoptera , with possible spin offs to domestic civilian markets.
There is, after all, no global free trade, nor likely to be. Every nation with which we compete will operate in their own perceived best interest as reflected in the political cycle.
So far Australia has avoide the worst impact of decades debt funded vote buying in Europe , USA, Japan. But we should avoid the temptations, to which Labor in both State and Federal Governmens have succumbed, to use det to fund unsustainable growth in numbers and salaries in the public sector.
Our focus MUST be on a diversified , strong tradeable sector

wesley123
Posted Tuesday, June 25, 2013 - 16:31

The overall picture is even more distressing when compared with other regions of the world. Social and economic indicators of development have shown some weakest performance. - Wesley Upchurch

aaronchris42
Posted Friday, September 27, 2013 - 17:58

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