Mighty Foolish

Does anyone still think the share sales in state energy assets are a good idea?

by Gordon Campbell

It’s partner found, it’s partner lost
and it’s hell to pay when the fiddler stops
So we struggle and we stagger
down the snakes and up the ladder
It’s closing time – Leonard Cohen

Could the government’s partial asset sales policy possibly be in worse shape than it is right now? Even if the economy wasn’t depressed, the rationale for selling down the public stake in these high-earning assets – in order to spend the money simultaneously (a) on schools and hospitals and (b) on reducing our levels of government debt, was always poor to non-existent. Recently, at least three related problems have come to light.

Over the past fortnight, Prime Minister John Key has been struggling to find a politically viable resolution to the water rights held by Maori under the Treaty. This is something Treasury somehow failed to foresee, despite the fact that Mighty River Power (the first state asset due on the auction block) earns some 61% of its revenues from hydro power and 31% from geothermal, and counts a string of dams on the Waikato River as being its main assets. How hard could it have been to make sure that the ownership rights to such waters were unquestioned before the deadline to sell down the government’s stake was announced? If you were actively trying to scare off investors, you could hardly do worse. Key has now shelved the sale of Mighty River Power shares until March/June 2013 – but that timeframe still allocates only five weeks to the actual negotiations with Maori that are required to sort out the water rights issues. It looks far more like tokenism, than good faith bargaining.

If Mighty River Power was an isolated problem, it could be overlooked. But it isn’t. Take Meridian. Reportedly, the Tiwai Point aluminium smelter at Bluff accounts for 15% of New Zealand’s entire electricity consumption. It also provides a large slice of Meridian’s revenues. Under the contract negotiated in 2007, the price that the smelter pays for its power is shortly due to rise. Problem being, the smelter’s Rio Tinto owners in London have signaled that unless the price falls, the smelter could be closed – costing 800 jobs in Bluff, and unleashing a surplus of cheap power onto the New Zealand electricity market just as the selldown of the state’s electricity companies is due to come down to the wire.

Since last year, the Tiwai Point smelter has been up for sale. Ironically enough, Rio Tinto is reportedly in no hurry to sell this asset in a depressed market, where it would struggle to fetch a good price. That compelling logic has escaped the Key government, which is pressing on regardless in economic conditions that virtually guarantee the public will get less than top dollar for their stake. Here’s how Forbes business magazine put it in mid August:

We [Rio Tinto] believe that paying the price for power as stipulated in the contract is no longer possible for Rio as it battles a prolonged slump in the aluminium market. Also, Rio decided to cut production by 15% in July at this smelter so its energy requirements would be less, but the company would still end up paying for the higher quantity negotiated in the contract. The NZAS smelter was put up for sale last year but looking at the slump in the market, Rio is in no hurry to sell at the moment. Although NZAS reported a $46 million after-tax profit last year, that was only due to a one-off $65.9 million settlement of a long-standing insurance claim. Without that claim, it would have reported a second year of losses in the region of $20 million.

Reportedly, Meridian is facing a dilemma. Should it ‘take one for the team’ let the smelter off the hook over raising the price it pays for power, and absorb the financial hit that this would entail – or should it press on, and run the risk of losing the smelter altogether ? For now, Meridian’s chief executive Mark Binns is talking tough:

“There was a freely negotiated contract in 2007,” said Binns. “They weren’t wrestled to the ground. We would like them to stay, but we would like them to stick to the contract.” He refused to be drawn on the implications of the Rio approach on the government’s partial privatisation plans. Meridian is widely presumed to be the most likely second sale….In answer to a question about the threat of smelter closure, Binns said: “We are evaluating (our options) against the counter-factual…. It will take some time to complete the modelling.”

If closed, the smelter would leave a huge “overhang” in the local electricity market, where demand growth has stalled now for five straight years. It could see a plunge in the price of electricity and halt investment in new generation assets until national demand returned to levels equivalent to today’s, with the smelter operating.

Listen up, Mum and Dad investors. Does this sound like a secure place for you to be putting your retirement money? Last week, when releasing Mighty River Power’s latest annual report, chief executive Doug Heffernan drew an implicit comparison with Meridian’s situation when he told RNZ’s Business Report programme : “ The best position to be would be a renewable generator based in the North Island. And that’s exactly what Mighty River Power is.”

But wait, there’s more. What about Solid Energy and the future price of coal? Reportedly, the slump in global coal prices has put a $200 million hole in Solid Energy’s revenues. Last week, the state energy company spelled out the consequences:

Struggling state-owned enterprise Solid Energy has announced major job cuts and suspended operations at its Spring Creek Mine on the West Coast.

Around 230 workers are employed by the mine. Solid Energy also announced 63 jobs will go at Huntly Mine in the Waikato, and 60 “mainly contracting roles” will go at the mine’s ventilation upgrade project. The company issued a statement this afternoon and says the restructuring was in response to “extremely challenging” market conditions.

Quite a turnaround, given that only a few months ago, analysts were touting Solid Energy’s coal reserves as making it the one state-owned energy company most likely to attract serious foreign investment – ie from China. Critics have already interpreted Solid Energy’s actions as being driven by the desire to tidy its books and make its bottom line that much moré attractive to potential (foreign) investors, even if it means cutting jobs for New Zealand miners. The slump in coal prices, however, is genuine, and a sign of flat demand in the global economy overall and in China in particular. This slowdown is probably only temporary – and liable to turn around in 18 months or so. For that reason, West Coast local body politicians have been calling for the government to issue a credit line and keep the miners in work, rather than allowing short term decision-making to drive the miners and their expertise away for good, to the better pay and conditions available in Australia.

In sum, there are some substantial problems facing Mighty River Power, Meridian and Solid Energy, on top of the generally depressed conditions in both the local and the international economy, There could hardly be a worse time in which to try and sell down these assets. That’s assuming of course, the government is interested in getting a good price, and is not merely trying to unload the shares at bargain prices to its mates.

One unintended consequence of the Treaty water rights issue is that it has diverted attention onto whether the government will be able to meet its self imposed deadline for the Mighty River sale. A good deal less time and energy has been spent on evaluating whether the asset selldowns make good economic sense. They don’t. This conclusion is not simply the one you would expect from a liberal left perspective. It is also the view of leading private sector financial analysts, such as Brent Sheather (pictured left). Last year, Sheather in a column available here and NZ Herald business columnist Brian Fallow in an article here raised significant concerns about the economic logic of the asset selldowns, and these arguments were also analysed here on Scoop.

Today, the economic arguments being put forward by the government are in no better shape. In a devastating piece written last week for the NZ Herald, Sheather began by pointing out the three grounds routinely cited by the government as its rationale for the asset selldown programme :

To reduce debt
To achieve efficiency gains within the SOE’s sold
To kick-start the stock market

None of these reasons, as Sheather went on to demonstrate, are valid.

Reduce debt. For most of 2012, Finance Minister Bill English has consistently made the point that avoiding further Crown debt via borrowing is responsible economic management on his part. Greece and Spain are held up as the scary outcome of going down the borrowing road – even though New Zealand’s level of government debt is in no way comparable. English is remarkably inconsistent however, about the significance of our current levels of government debt. On occasions, our relatively low levels of Crown debt – which English inherited from its predecessor – is something that English routinely cites to foreign audiences as being a plus, and a source of comparative advantage for New Zealand. At home though, English has just as regularly cited our circa 30% ratio of government debt to GDP as being a cause for concern, and a driver of the asset selldowns.

Well, hello. As Sheather and others have pointed out, several equally highly credit-rated European countries have government debt level ratios that are two or three times as high. The real point is not whether it is virtuous to avoid borrowing – it is whether more borrowing is a better option or a worse option than the selling down of the assets. On that score, Sheather is in no doubt that more borrowing makes far more sense. His analysis rests on two related points : that interest rates are very low and likely to stay that way for the foreseeable, and that government can always borrow at cheaper rates than the private sector.

Incidentally, this second point all but demolishes the rationale for public/private partnerships (PPPs). Because the private sector cannot borrow as cheaply, it has little option but to pass on that extra cost of capital to the public, in the form of higher prices. Here’s Sheather’s argument for why more borrowing makes more sense than selling down the energy company assets :

The electricity SOE’s like Mighty River Power are going to be sold at valuations whereby the net profit as a proportion of the share price is around 7 per cent after tax. Today the Government can borrow for 10 years at just 3.45 per cent so it doesn’t take a finance degree to work out that the
Government could retain the asset, service the debt out of the 7 per cent return and pay off debt with the balance. In cash flow terms the contrast is even more stark – the companies like Mighty River Power have substantial depreciation charges so the cash flow yield at which the companies are sold could be 8, 9 or 10 per cent – much higher than the government’s cost of borrowing.

This raises another issue and that is the fact, also highlighted by Professor [David ] Hall [of the University of Greenwich Business School] that the cost of capital of a privatised asset is much higher than a publicly owned asset. Financial economics says that a higher cost of capital requires a higher return of capital which means higher prices for consumers, pure and simple.

It is a lose/lose situation for the public, the current owners of the assets, The government will lose revenues they could be using to provide better public services. Our current stake in the assets will be diluted, and there is every liklihood we will then be facing higher electricity prices so that the investors, consultants and senior management can extract profits and bonuses from its virtually captive pool of electricity consumers – who are being encouraged to shuttle around between electricity retailers, in search of temporary shelter from the inexorably rising tide. These price hikes can hardly be justified as the unavoidable cost for future generation facilities either, since electricity demand has been flatlining for five years and – as mentioned – if the Bluff smelter closes up shop, New Zealand could well be awash with spare electricity capacity. Moreover, as Sheather explains below, energy companies happen to enjoy high depreciation advantages, and could fund their own capital investment in future from that source, and not by levying higher prices from the consumer.

Efficiency Gains. Despite the evidence to the contrary from the global financial crisis, a few diehard ideologues still believe that state energy companies would benefit from the infusion of the alleged ‘disciplines’of the private sector. On the contrary, Professor David Hall of the University of Greenwich Business School – cited above by Sheather as an authority – has been a leading critic of the belief that the private sector is intrinsically more efficient and inherently more innovative than the public sector. The research evidence, Hall insists, says otherwise. Several of Hall’s videos on related subject went up on Youtube, among them these:


The European Union research evidence for what Hall is saying can be found here.

Last month on Werewolf, I outlined the mounting evidence of failures of PPPs in the health and education sector in Britain and the alacrity with which the British Treasury is trying to extricate itself from them.

One of Hall’s findings from the EU evidence was that the private sector displays no greater efficiency, or higher productivity gains than the public sector. This conclusion, as Hall says, may be something of a surprise even to critics of privatisation, who have tended to concede the claims of private sector superiority, even after the global financial crisis gave them ample reason for doubt. As Hall says:

There’s now years of experience of privatization. Quite serious comparative studies have been done between public operators and private operators in the same sector, across countries, and across time. The consistent message coming out of all those studies now in all sectors – in water, in electricity, public transport, prisons, in auditing…is that there’s no significant difference in efficiency. Productivity growth in the private sector is overall no better, no worse than the public sector. And that’s really quite astonishing ….because it undermines the single syrongest and most important supposed argument for privatisation. And it isn’t true. The private sector doesn’t deliver higher efficiency.

As with efficiency, so with innovation. If anything, the public sector has a stronger record of important innovation. Hall again :

Innovation is another thing. [Supposedly] the private sector is always out there inventing new things to make money, because they’re driven by this great creative money-making urge. Surely they must be more innovative. But look at the big, life changing inventions, the big inventions that literally changed the world and start listing them out : think of things like computers. Computers were invented in the public sector. The Internet wasn’t invented by Microsoft…. The Internet was invented in the public sector, through universities and the defence establishment..We invented space travel in the public sector with all the things that spin off from that… thanks to public sector innovation. Penicillin, probably the biggest single medical advance of the 20th century. [It] was invented in public sector research laboratories.

As the asset sales process demonstrates, even those who do remember the lessons of history can still be doomed to repeat it. To many people, it may still seem counter-intuitive that it could possibly be more financially responsible to borrow more, than to sell down some of the assets. Surely, I asked Brent Sheather, given the spectre of Greece that is constantly before us, how could this possibly be true ?

“Beeause Greece is highly indebted, but we are not.’ Sheather patiently. replies. “The superficial analysis of saying that we should sell assets to pay debt, ignores price and yield. The bottom line is that if we did sell Mighty River, our ability to service the debt that was left over would be reduced. It is better to retain the asset and pay off the debt, rather than sell the asset pay off one lump of the debt, and have a reduced ability to service the residual debt.”

Surely, isn’t that argument predicated on the assumption that the government will be able to borrow at 3.5% in perpetuity? “ No, it is predicated on being able to borrow at 3.5% for ten years, which we can do today. And if the government was going to come out and say ‘We’re issuing a 20 year bond’ my guess is that we would be able to borrow for 20 years at under 4 %. And that would effectively lock in the differential between the earnings yield of Mighty River, and the 4% borrowing cost.” And we’d still come out ahead? “Absolutely. “

Well, if full retention and borrowing are such self evident virtues, why does Sheather think the government is not acting accordingly ? ‘I would have to think that their decision making is being dominated by the thought that reducing government debt is paramount, and kick-starting the stock market is another critical variable. But I don’t happen to think it is the responsibility of the government to make attractive assets available for listing on the stock market. The private sector should be doing that.” In any case, he adds, the government could achieve the same goal of attracting investors onto the share market by selling only 10% of the assets in question.

Electricity price rises look like being a feature of the landscape for these companies in the short term at least – so what, in his view, will be the main drivers behind the looming price hikes? ‘Theoretically,“ Sheather replies. “if you’ve got an owner who requires a higher return on investment, that should drive prices higher than would otherwise be the case if you had an owner with a lower cost of capital. Obviously, you’ve got the possibility that private sector people are going to want more in the way of price rises than the public sector is going to want. That’s a risk that we can’t really quantify.”

Even so, it is not as if the public has been getting any mercy on electricity prices from having full ownership of the energy companies in question. On the contrary – the likes of Meridian have been happy to stress that they’ve been behaving just like private sector companies already. What is likely to change is that these lean, mean state energy companies will now become tricked out with all the blatant inefficiencies of the private sector and its related cost structures. “There will be increased costs associated with the [greater] private sector involvement, “ Sheather agrees. “The directors are going to want more money. You can bet your boots that the chief executive is going to get some sort of share scheme whereby he gets issued shares at one cent to motivate him and will walk away with three, four or five million dollars in share gains – as we’ve seen happen with the New Zealand Stock Exchange, NZX.”

Finally though, if demand in this area has been flatlining for the past five years, there shouldn’t be very much pressure to raise electricity prices in order to fund capital investment, should there? No, Sheather says. “I certainly don’t think we need to be swayed by any argument that says we need to sell things because we need to spend a lots of money on them in the future.” So any price hikes that come in the wake of this package can’t be justified by any claimed need to finance capital investment? “No, certainly not. If we look at the depreciation charges, they’re huge with the electricity companies…” That, he says, should be cover any foreseeable capex needs in future. And besides…”If they had big capital expenditure requirements further down the track, they wouldn’t be able to pay the government huge dividends like they have been doing.” So they can readily fund their own capex? “I don’t think there’s any worry about that.”

In conclusion, the asset selldown is already costing, big time. In its annual report, Mighty River Power noted that it had spent $3.8 million in preparing the company for the selldown, with more still to come. The Green Party, for its part, has calculated that the asset selldown has so far cost some $16 million, before the sales process has even begun, and with more costs waiting in the wings :

The Government has a further $96 million budgeted to spend on the sales and there are huge unbudgeted costs such as hundreds of millions for the share giveaway. These results also point to the huge cost in lost dividends if asset sales proceed. If Mighty River had been sold already, the Crown would have lost nearly $60 million in dividends last year.

Late last year, it was revealed that the Australian bank Lazard would be paid around $100 million for its role in the share sale process.

The brokerage costs envisaged are unknown but are likely to run into the hundreds of millions, if even a normal 1- 3% fee gets charged to the government for managing transactions worth $6 billion.

The best attempt at the relevant arithmetic was done by the NZ Herald’s Brian Fallow last year. In terms of dividends foregone, Fallow calculated that – taking the previous five years dividends-to-government average on the energy companies and making a reasonable estimate of $20 million for the 23% stake for Air New Zealand, the dividends from these assets would total $449 million. Take away 49% of that away in foregone dividends from the selldown, and it comes to $240 million, or 4% of the $6 billion expected to be generated.

In trying to get a comparative figure for the cost of servicing a comparable rate of borrowing, it would seem quite reasonable to base the relevant sums on the cost of borrowing at the current rate of 3.5% available for the next 10 years and – in all likelihood – at 4% for the next 20 years. On $6 billion, a 4% rate of borrowing would cost $240 million in interest. So if you sell down the shares (and forego a chunk of the dividend stream accordingly) or you borrow the money at 4% instead, the numbers come out exactly the same, at $240 million a year !

But that’s before you factor in the $100 – $300 million costs involved in consultancy and brokerage charges and opportunity costs, for doing something for which there is no measurable gain whatsoever. Go figure why the government seems so wedded to this nonsense.