Scotland is about to be faced with an intense struggle to prevent
the privatisation of its water industry. Powerful voices have
already been raised in favour of moves towards privatisation – including a surprising statement by the Chairman of the Water
Industry Commission, that water should be freed from state
ownership. This article outlines the main pressures leading
towards water privatisation. Basic fallacies are uncovered
in the arguments used by the privatisation lobby and the key
challenges that are faced if privatisation is to be avoided. In
particular, the critical battleground will be in the campaign to
expose the flaws in the currently used method for setting utility
prices, namely the Regulatory Capital Value method.
The movement to privatise water in Scotland has been
unwittingly assisted by three crucial strategic mistakes made
by the Scottish Executive. Firstly, the Scottish Executive made
basic mistakes in the implementation of a new system of
financial control for the water industry in 2002, which meant
consumers were overcharged, (by about £1billion over the
period 2002-10). This also meant that the Executive could use
water charges as a new source of taxation, transferring funding
provision to other parts of the budget. The resulting shortage of
public expenditure provision is now impacting on the short-term
availability of capital investment for the industry, with adverse
effects on levels of service and customer satisfaction.
Secondly the Executive set up a centralised and bureaucratic
leviathan in the shape of Scottish Water. The intention was to
improve efficiency, and harmonise domestic charges however,
the reality has been that Scottish Water has not been capable of
responding adequately and flexibly to local requirements. It has
also, despite harmonisation, introduced a tariff
system with high fixed charges for
industry, which adversely affects
small firms. It has also
reduced local contractors
to a peripheral role in the
delivery of much of its capital investment programme, through
its approach of developing Scottish Water Solutions, an unusual
partnership with specific private sector companies, which
has had adverse effects on efficiency due to the loss of local
contractors detailed knowledge. The overall results have
been damaging to customer satisfaction and local economic
development.
Lastly the Scottish Executive sanctioned the implementation in
Scotland of setting water prices via the Regulatory Capital Value
(RCV) method, which leads, as we show below, to significant
overcharging and ultimately generates a substantial financial
surplus for the operating company. Because of the profits
generated by the RCV method, water is now regarded in the City
as being a rich source of corporate profits.
These mistakes have set in train powerful forces, which work
towards the privatisation of the water industry in Scotland.
Public dissatisfaction can be manipulated to blame problems
with water on Scottish Waters public sector status – and this
dissatisfaction can only get worse, as prices start to increase
rapidly again in 2010, inherent in the RCV approach. The Scottish
Executive in due course will come under severe temptation to
cash in on the financial surplus which the RCV method will
generate, by selling Scottish Water for a one-off gain of several
billion pounds and the City wants to get its hands on the profits
to be gathered from a privatised water industry.
These pressures towards privatisation are supported by the
widely held view that the Scottish Executive wont be able to
afford to maintain Scottish water as a public sector body in the
longer term, since water has been privatised down in England
and therefore there are no Barnett consequentials to benefit
the Scottish budget. It is unfortunate that this argument has
been too readily accepted – without, apparently, anyone
sitting down to do the arithmetic, which shows that the
argument is a myth with no validity.
At present the borrowing provision for water in
the Scottish Executive budget is £182 million
per annum. If we suppose that Scottish
Water has a continuing investment
requirement of £500 million per
annum in real terms, then
financial modelling shows that,
in the long run, Scottish Water
would need to borrow about
£120 million in real terms
and would have interest and
debt repayment charges
substantially below those
implied by the RCV method.
In other words, the Scottish
Executive could significantly
reduce its public expenditure
allocation for Scottish Water in the
long term while the industry could still afford
to maintain an investment programme on an ongoing basis at
its currently high level. In fact, the Executive would be unwise
to reduce its long term public expenditure allocation for water
as low as £120 million, since more than this would be required
if inflation increased.
A similar myth also exists that while it might not be necessary
for the Executive to sell off Scottish Water, the Executive might
judge that the money could be better spent on other priorities.
This view may have had some validity at times in the past,
when water and sewerage were unexciting topics but this view
is emphatically ceasing to be the case nowadays, as water
emerges worldwide as a limited resource of key importance. It
would be folly for the Executive to give
up the Scottish peoples ownership
of water just as the comparative
advantage, which Scotland could gain
from its water resources, is becoming
clear.
Now the issue of RCV, which reveals
fundamental and damaging flaws in
this method and is in many ways the
nub of this paper. On the face of it,
there may appear to be little ground
for questioning the RCV approach,
after all, it is the established approach
to utility pricing supported by the
World Bank and major accountancy
firms and it is applied to a whole
range of utilities, not just in the UK
but internationally. But because the RCV method is widely applied does
not mean it is right – particularly
since, even at a superficial level, there
are a number of awkward questions
about the RCV approach.
For example, the RCV approach
is an application of current cost accounting. But why has
current cost accounting been abandoned everywhere else
in the private sector apart from the price setting for utilities?
And how, if the RCV approach is correct, can we explain the
massive profits earned, under RCV price setting, by the water
companies in England – where, for example, annual dividends
to equity owners have frequently run at a level of 30% or so of
the equity capital actually raised by the industry. Also, if the RCV
approach is indeed generating appropriate incentives, how can
the reluctance of the privatised water companies in England to
deal with chronic leakage problems?
The answers to these questions become clear when we probe
below the surface of how the RCV approach actually operates.
This modelling shows that the RCV method is fundamentally
flawed and has the effect of turning capital investment,
particularly long-term capital investment, into an activity, which
yields a substantial financial surplus for the utility.
For example, a company investing in a 30-year life asset, with
inflation at 2.5%, and interest rate of 5%, will reap under RCV
pricing a financial surplus of no less than 43% of the value of
the investment. Note that this surplus is of purely financial
origin- the company will reap the surplus whether or not the
underlying investment project actually makes an adequate real
return to the company: In the bizarre world of RCV, the company
would make a substantial profit out of putting up an expensive
100 year statue of its founder, provided it was allowed to class
this as capital investment. The RCV financial surplus leads to
overcharging, and to large profits for private companies but it
also distorts the investment programmes of the utilities and in a
way, which is consistent with their unconcern about leakages.
How could the RCV approach have gone so badly adrift? The
basic answer is that the RCV approach calculates consumer
charges on the basis of assumed costs of capital assets valued
at todays prices whereas, in reality, an industry with very long
lived assets, (as water is), operating in an era of even moderate
inflation, will face actual costs which
relate to the lower prices of capital
goods several years ago. The RCV
approach then makes a further
mistake, in attributing this difference
between assumed and actual costs as
a reward primarily to equity holders-
overstating, and over rewarding, the
equity holders contribution to the
finance of the business. This accounts
for the excess profits generated by
companies in England.
Faced with the above pressures,
the challenges to which we must
rise are to resist the move towards
privatisation, whether this comes as
an outright move; to mount an effective
intellectual campaign against the RCV
method and to campaign for much
greater democratisation of the water
industry in Scotland.
While privatisation is the issue, which
is liable to make the headlines, in many
ways the key strategic ground for the
struggle is the need to question the validity of the RCV approach.
If the RCV approach were abandoned, the excess profits to be
earned from a privatised water industry would no longer be
available- and most of the pressure for privatisation would
disappear. Conversely, if the RCV approach is maintained, even
without privatisation, then the Scots will still be overcharged for
water. So an important requirement now is to have a full, and
fully informed, debate on the RCV method.
Given the essentially technical nature of the issues involved in
constructing an effective critique of the RCV method, it will be
essential that those who are arguing on the anti-privatisation
side focus on the detail, not just on emotion: and that they put
sufficient resources into researching the technical aspects of RCV. The rewards of success, however, will be large. A successful
critique of the RCV method will have important implications not
just for Scotland but also for the international campaign against
the excesses of globalisation.
Scotland is about to be faced with an intense struggle to prevent
the privatisation of its water industry. Powerful voices have
already been raised in favour of moves towards privatisation – including a surprising statement by the Chairman of the Water
Industry Commission, that water should be freed from state
ownership. This article outlines the main pressures leading
towards water privatisation. Basic fallacies are uncovered
in the arguments used by the privatisation lobby and the key
challenges that are faced if privatisation is to be avoided. In
particular, the critical battleground will be in the campaign to
expose the flaws in the currently used method for setting utility
prices, namely the Regulatory Capital Value method.
The movement to privatise water in Scotland has been
unwittingly assisted by three crucial strategic mistakes made
by the Scottish Executive. Firstly, the Scottish Executive made
basic mistakes in the implementation of a new system of
financial control for the water industry in 2002, which meant
consumers were overcharged, (by about £1billion over the
period 2002-10). This also meant that the Executive could use
water charges as a new source of taxation, transferring funding
provision to other parts of the budget. The resulting shortage of
public expenditure provision is now impacting on the short-term
availability of capital investment for the industry, with adverse
effects on levels of service and customer satisfaction.
Secondly the Executive set up a centralised and bureaucratic
leviathan in the shape of Scottish Water. The intention was to
improve efficiency, and harmonise domestic charges however,
the reality has been that Scottish Water has not been capable of
responding adequately and flexibly to local requirements. It has
also, despite harmonisation, introduced a tariff
system with high fixed charges for
industry, which adversely affects
small firms. It has also
reduced local contractors
to a peripheral role in the
delivery of much of its capital investment programme, through
its approach of developing Scottish Water Solutions, an unusual
partnership with specific private sector companies, which
has had adverse effects on efficiency due to the loss of local
contractors detailed knowledge. The overall results have
been damaging to customer satisfaction and local economic
development.
Lastly the Scottish Executive sanctioned the implementation in
Scotland of setting water prices via the Regulatory Capital Value
(RCV) method, which leads, as we show below, to significant
overcharging and ultimately generates a substantial financial
surplus for the operating company. Because of the profits
generated by the RCV method, water is now regarded in the City
as being a rich source of corporate profits.
These mistakes have set in train powerful forces, which work
towards the privatisation of the water industry in Scotland.
Public dissatisfaction can be manipulated to blame problems
with water on Scottish Waters public sector status – and this
dissatisfaction can only get worse, as prices start to increase
rapidly again in 2010, inherent in the RCV approach. The Scottish
Executive in due course will come under severe temptation to
cash in on the financial surplus which the RCV method will
generate, by selling Scottish Water for a one-off gain of several
billion pounds and the City wants to get its hands on the profits
to be gathered from a privatised water industry.
These pressures towards privatisation are supported by the
widely held view that the Scottish Executive wont be able to
afford to maintain Scottish water as a public sector body in the
longer term, since water has been privatised down in England
and therefore there are no Barnett consequentials to benefit
the Scottish budget. It is unfortunate that this argument has
been too readily accepted – without, apparently, anyone
sitting down to do the arithmetic, which shows that the
argument is a myth with no validity.
At present the borrowing provision for water in
the Scottish Executive budget is £182 million
per annum. If we suppose that Scottish
Water has a continuing investment
requirement of £500 million per
annum in real terms, then
financial modelling shows that,
in the long run, Scottish Water
would need to borrow about
£120 million in real terms
and would have interest and
debt repayment charges
substantially below those
implied by the RCV method.
In other words, the Scottish
Executive could significantly
reduce its public expenditure
allocation for Scottish Water in the
long term while the industry could still afford
to maintain an investment programme on an ongoing basis at
its currently high level. In fact, the Executive would be unwise
to reduce its long term public expenditure allocation for water
as low as £120 million, since more than this would be required
if inflation increased.
A similar myth also exists that while it might not be necessary
for the Executive to sell off Scottish Water, the Executive might
judge that the money could be better spent on other priorities.
This view may have had some validity at times in the past,
when water and sewerage were unexciting topics but this view
is emphatically ceasing to be the case nowadays, as water
emerges worldwide as a limited resource of key importance. It
would be folly for the Executive to give
up the Scottish peoples ownership
of water just as the comparative
advantage, which Scotland could gain
from its water resources, is becoming
clear.
Now the issue of RCV, which reveals
fundamental and damaging flaws in
this method and is in many ways the
nub of this paper. On the face of it,
there may appear to be little ground
for questioning the RCV approach,
after all, it is the established approach
to utility pricing supported by the
World Bank and major accountancy
firms and it is applied to a whole
range of utilities, not just in the UK
but internationally. But because the
RCV method is widely applied does
not mean it is right – particularly
since, even at a superficial level, there
are a number of awkward questions
about the RCV approach.
For example, the RCV approach
is an application of current cost accounting. But why has
current cost accounting been abandoned everywhere else
in the private sector apart from the price setting for utilities?
And how, if the RCV approach is correct, can we explain the
massive profits earned, under RCV price setting, by the water
companies in England – where, for example, annual dividends
to equity owners have frequently run at a level of 30% or so of
the equity capital actually raised by the industry. Also, if the RCV
approach is indeed generating appropriate incentives, how can
the reluctance of the privatised water companies in England to
deal with chronic leakage problems?
The answers to these questions become clear when we probe
below the surface of how the RCV approach actually operates.
This modelling shows that the RCV method is fundamentally
flawed and has the effect of turning capital investment,
particularly long-term capital investment, into an activity, which
yields a substantial financial surplus for the utility.
For example, a company investing in a 30-year life asset, with
inflation at 2.5%, and interest rate of 5%, will reap under RCV
pricing a financial surplus of no less than 43% of the value of
the investment. Note that this surplus is of purely financial
origin- the company will reap the surplus whether or not the
underlying investment project actually makes an adequate real
return to the company: In the bizarre world of RCV, the company
would make a substantial profit out of putting up an expensive
100 year statue of its founder, provided it was allowed to class
this as capital investment. The RCV financial surplus leads to
overcharging, and to large profits for private companies but it
also distorts the investment programmes of the utilities and in a
way, which is consistent with their unconcern about leakages.
How could the RCV approach have gone so badly adrift? The
basic answer is that the RCV approach calculates consumer
charges on the basis of assumed costs of capital assets valued
at todays prices whereas, in reality, an industry with very long
lived assets, (as water is), operating in an era of even moderate
inflation, will face actual costs which
relate to the lower prices of capital
goods several years ago. The RCV
approach then makes a further
mistake, in attributing this difference
between assumed and actual costs as
a reward primarily to equity holders-
overstating, and over rewarding, the
equity holders contribution to the
finance of the business. This accounts
for the excess profits generated by
companies in England.
Faced with the above pressures,
the challenges to which we must
rise are to resist the move towards
privatisation, whether this comes as
an outright move; to mount an effective
intellectual campaign against the RCV
method and to campaign for much
greater democratisation of the water
industry in Scotland.
While privatisation is the issue, which
is liable to make the headlines, in many
ways the key strategic ground for the
struggle is the need to question the validity of the RCV approach.
If the RCV approach were abandoned, the excess profits to be
earned from a privatised water industry would no longer be
available- and most of the pressure for privatisation would
disappear. Conversely, if the RCV approach is maintained, even
without privatisation, then the Scots will still be overcharged for
water. So an important requirement now is to have a full, and
fully informed, debate on the RCV method.
Given the essentially technical nature of the issues involved in
constructing an effective critique of the RCV method, it will be
essential that those who are arguing on the anti-privatisation
side focus on the detail, not just on emotion: and that they put
sufficient resources into researching the technical aspects of
RCV. The rewards of success, however, will be large. A successful
critique of the RCV method will have important implications not
just for Scotland but also for the international campaign against
the excesses of globalisation.
For more information visit www.cuthbert1.pwp.blueyonder.
co.uk .
__Jim Cuthbert was formerly Chief Statistician at the Scottish
Office. Margaret Cuthbert is an economist.__