Council ownership

A standard popular argument for public or council ownership over private ownership is that private shareholders are too short-term focused, at the expense of longer-term value. 

It's an eminently debatable proposition. But as always, Demsetz would say 'as compared to what?'. We always need to compare how the alternative works in the real world.

Here's Oliver Lewis over at BusinessDesk:

To mitigate rates rises and fund services, Christchurch City Council will be asking its commercial arm to frontload dividend payments and provide $47 million extra over the next three years.

The move, endorsed by councillors at a meeting on Wednesday, drew a forthright warning from Christchurch City Holdings (CCHL), which controls assets worth more than $5 billion on behalf of the council.

CCHL chair Abby Foote – who has repeatedly spelled out the constrained financial position of the group and the need to start paying down its $2.3b of debt, $440m of which was taken on at the bequest of the council for the earthquake recovery – said the new request placed the CCHL board in an extraordinarily difficult position. 

'Do not add up' 

“We cannot pay down debt, grow dividends to council and invest in the resilience and growth of our critical infrastructure,” Foote said. “These things simply do not add up. We cannot do them all, and that is what we have been saying for the last 12 months.”

...

Explaining the request for extra dividends, interim council CEO Mary Richardson said she and chief financial officer Bede Carran met with CCHL last week.  Staff believed the request for additional dividends, which was supported by councillors at the meeting, was doable to help restrain rates increases and allow the council to deliver on its capital programme.

When we lived in Christchurch, it always seemed as though Council was underinvesting in maintenance and keeping up with depreciation at the Port. 

If a private company is excessively sweating assets to benefit current shareholders, there are a few potential disciplining mechanisms. Shareholders have incentive to watch over management practice; behaviour that reduces long-term value will ultimately hit shareholders. And takeovers always remain a possibility.

A market test applies. If management is taking the piss when arguing for lower dividends, shareholders can check. Management can be replaced. Analysts skilled at figuring this stuff out can buy out existing shareholders and increase value. Nothing in this world is perfect, but there's a correction mechanism here. 

What disciplining mechanisms kick in if managers of a council-owned company say that the council owners are insisting on sweating the assets too hard? If they're right, no alternative owners can come in and replace the current ones. There's no discovery process to find out whether they're right. 

There's some chance that Council is running down the port to help pay for the new stadium. Does that seem like an entirely good idea, or an advertisement for the merits of public ownership?

Asset sales and infrastructure funding

Christchurch's refusal to sell the Port during earthquake reconstruction was ridiculous. The city needed a pile of money for new infrastructure to cover uninsured losses. The Port had just received a giant insurance payout that, in some views, covered the harms of decades of deferred maintenance. There would never be a better time to sell the port than when it was set to be all fresh and shiny, before the next decades of deferred maintenance did their work.

Instead we had talk about not selling the family silver. Know when it's time to sell the family silver? When you need to rebuild the house because of a big stupid earthquake.

Auckland's position on asset sales hasn't been much different. Auckland needs a pile of new infrastructure to let it fund its continued growth. But it faces a strange debt constraint: rules on how much interest Council can pay as a fraction of its tax revenue. Debt-funded infrastructure then needs very quickly to provide a return well in excess of the debt's interest cost. Laying out trunk infrastructure with a century's lifespan that enables growth more than repaying the investment 10 years out doesn't work if it has to pay for itself faster than that. And that's part of the current mess.

Asset sales can then help. I covered it in last week's Insights newsletter. Subscribe at the link (it's free).

The macroeconomic effects of Auckland’s housing crisis are felt throughout the country. If Auckland could better accommodate growth, central government would reap the resulting income tax and GST revenues.

Immigrants pay more in tax, on average, than they receive in government services – but those estimates do not include the infrastructure costs that fall on local government. If Auckland’s infrastructure mess forces central government to close the door on immigration, that could easily be to the long-term detriment of central government finances.

But councils coming cap-in-hand to central government for help face a fair bit of scepticism for the simple reason that councils have not been making some of the harder choices necessary to finance their own growth.

During the Christchurch earthquake recovery, some of Christchurch City Council’s pleas for more central government funding rang a bit hollow. National campaigned in 2011 on a programme including partial privatisation of state-owned enterprises to help fund other programmes. Meanwhile, Christchurch Council refused to consider privatisation of Lyttelton Port of Christchurch or a host of other Council-owned assets.

From a central government perspective, some of the calls for help sounded a bit like your kid asking for financial help while refusing to replace his flashy car with a more thrifty model – after you have already traded yours in.

Phil Goff’s willingness to consider partial privatisation of the Ports of Auckland is then a very welcome first step. But Auckland Council could be bolder. The land under Auckland Council’s golf courses alone is worth over a billion dollars. Selling that land for housing development would not just provide more houses. It would also provide funds to service further intensification and further greenfield development.

And if Auckland were doing its share, we would hope that central government might consider doing its bit as well by passing on some of the benefits it receives from a thriving Auckland.

Privatisation and information

Paul Walker ably surveys the literature on privatisation in the latest issue of NZEP.

Those suggesting, or objecting to, any particular privatisation ought to have a read through it for a handle on the base theory on this stuff. Whether privatisation is best depends a lot on which model you think applies. 

From Walker's conclusion

...there is an implicit assumption in the literature discussed above that economic efficiency is a major objective of privatisation but the, ex ante, conditions sometimes imposed by governments on the sale of assets often serve political rather than economic ends. Examples of such conditions are things like the New Zealand government’s restrictions on foreign ownership and the desire to sell to ‘Mums and Dads’, both of which restrict the number of possible bidders. Such conditions also result in fragmented ownership, making it difficult for owners to coordinate their efforts to effect the firm’s behaviour. In addition, given that each ‘Mum or Dad’ will own only a very small share of any of the firms, they have little incentive to become informed on the firm’s activities since they will only capture a very small amount of any improvement in performance they could bring about. These factors suggest that, in practice, little will change in terms of the behaviour of the SOEs: they will remain, for all intents and purposes, government-controlled entities. This contradicts the very reason for privatising SOEs in the first place.

Land giveaways?

If you counted up how much money NZ Lotto gives out to lottery winners and compared it to the amount those gamblers paid for their tickets, you'd conclude that Lotto were an unsustainable rort on the public. The government's practically giving away highly valuable assets, given the low low prices charged.

I attended Ann Brower's talk at this year's NZAE meetings on high country tenure review. The sessions are normally Chatham House rules, but I note that Chris Hutching reported on her paper in this week's NBR.

Ann and her coauthor show that high country estates that were sold to their lessees, and were then on-sold, increased a lot in value in the interim. Hutching cites Brower as reporting that 371,000 hectares were sold into freehold, with 73,685 hectares then on-sold. Some sections were on-sold for several hundred times' their initial valuation - and that that is especially true for sections overlooking lakes that became developments.

Now the problem here is twofold. First, you'll always run into trouble caused by selection bias in this kind of study. The sections where the leaseholder struck a fabulous bargain get on-sold with their values then included in the study; the sections where the Crown did far better are less likely to turnover in the short to medium term, so their lower prices don't get recorded.

But more importantly, in my view, is that the Crown was kinda selling lottery tickets. If you get freehold tenure over a section with lake views, you'll make a killing on it if you can get resource consent to develop it. But if somebody decides that those killer lake views make it an outstanding national landscape, well, you have a very beautiful section that maybe can't be used for anything.

And that's why I'm a bit worried about counting up the value of the winning lotto tickets.

It's perfectly plausible that the Crown messed up in its negotiations and charged below-market rates in some cases. It's also perfectly plausible that the Crown should be selling some of those leaseholds at below-market rates to reflect the sweat-equity contributed by the leaseholders over generations - though that's more debatable. But I doubt we can draw generalised conclusions about the process from the 20% of the land that was turned over shortly after tenure review. The other 80% might be relevant too.

The way I know it's May

I know it's May when the Christchurch Press calls me seeking comment on Council asset sales. Georgina Stylianou quotes me in this morning's Press. Here's the full comment I'd sent her, not all of which could make it into her column.

“We’ve suffered from a lot of wishful thinking over the last three years. After the earthquakes, a lot of people really wanted to believe that we would have a sparkling new city funded by insurance payouts. And as each of us has had to come to grips with the difference between what we might have hoped our house insurance contracts covered and what the fine print actually says, the Council similarly has had to realise that it can’t budget based on wishful thinking about what they’d like to be owed in insurance payouts. Unfortunately, a lot of hopes were built up based on expectations of the larger payouts, and a lot of projects were mooted around those. It’s hard for politicians to step back from those, and doubly so when so many of us have had so many disappointments over the last three years. But where the real tradeoff is deciding between Council spending money on things like big stadiums or things like making sure we have overpasses and sewers that are safe and fit for purpose, well, I really hope we put more priority on the more boring core infrastructure.”

“Compounding the problem has been the regulatory and planning morass that has kept downtown from springing back to life. Vacant downtown lots do not return much to Council in terms of property tax.”

“I note that Minister Brownlee is questioning some of the figures in the report. I’m not an accountant and cannot vouch for the figures’ accuracy. But I do worry that things could yet be rather worse than the report suggests. The report explicitly notes that it makes no accounting for the costs that will be involved in fixing our now very flood-prone neighbourhoods. I doubt that Council will be able to avoid incurring pretty substantial costs in fixing places like the Flockton Basin and parts of Woolston.”

“The KordaMentha Report explains pretty reasonably what the Council’s options are. There’s little room to take on more debt, so we either have to spend less, increase tax revenue, or sell other assets. A mix of the three seems most appropriate. Sorting out the regulatory morass downtown so that we can again start having reasonable property tax revenues from downtown would be rather helpful on the revenue side. I think we should be considering cancelling the new stadium rather than just delaying it: too many property owners have to sit in limbo, under threat of expropriation, not knowing when or whether their businesses will be taken from them to make room for the stadium. And, again, we should be considering selling some of Council’s assets. Every May since the earthquakes we have talked about Council asset sales. And every year we’ve failed to do it. Council should be fully divesting itself of assets that are at least as well managed by the private sector in order that the funds can be put towards those things that are really important, like fixing our roads and drainage system. I worry that, if we do not sell assets like the Lyttelton Port of Christchurch, Council’s substantial financial pressures will instead squeeze excess dividends from those assets and run down their capital stock. And, in a decade’s time, we will have substantial problems arising from deferred maintenance and poor investment. Selling these assets off now may be the best way of ensuring their future. Selling the family silver so you can afford to re-pile your foundations and avoid having the house fall over is sad but sometimes necessary. What use is silverware if your house has fallen down?”

See this post for the general arguments around Council asset sales, and for the May 2011, May 2012, and May 2013 Press discussions around asset sales.

Debt for Dividends

Christchurch City Council refuses to sell Council-owned assets to help pay for the earthquake rebuild. They should sell some of those assets, so long as it's to pay for roads and sewers rather than for stadiums. But, a lot of folks just hate the idea of selling off the assets, and so it isn't happening.

Instead, Council-owned companies look like they'll be taking on debt to pay a higher dividend to Council.

The Christchurch City Council's investment arm may have to borrow to meet higher dividend commitments of $140 million over three years to the council.

Christchurch City Holdings (CCHL), which oversees the council's trading companies such as Orion and Christchurch Airport, promised to step up dividends after the earthquakes.

Its new statement of intent for the next three years from July 1 this year to June 30, 2016, forecasts dividends of $46m, $46m and $48m to the council.

It is a significantly higher level of ordinary dividends than before the quakes, when dividends ranged from about $30m to $35m each year.

CCHL's profits for the three years are forecast to be $33.1 m, $37.6m and $43.1m. CCHL will need to borrow $26.2m to meet its commitment to the council, unless it receives more dividends from the council's seven trading companies, increasing its profits.

CCHL chairman Bruce Irvine confirmed CCHL would borrow to meet the gap between its forecast profits and the dividends if needed.

I'm not a corporate finance guy, but it seems a bit odd to be borrowing to pay dividends to current shareholders. It's not something I'd expect would typically be recommended. Borrowing money to finance projects that yield a longer term rate of return in excess of the borrowing costs - that tends to be recommended. If firm shareholders have short term financial issues that mean they've a strong preference for having cash now, sensible Boards, I'd have thought, would have reminded those shareholders that they could divest themselves of a few shares if they needed a short-term cash hit.

When companies instead are borrowing to make their big shareholder happy about the current dividend flows, I start worrying about a whole pile of other ugliness that could be going on. Like, whether the company is making adequate investments in the maintenance of its physical assets or whether it's deferring maintenance to make the dividend payments. But again, I'm not an accountant or a corporate finance guy, and I've certainly not cracked open the CCHL books. It just smells a bit off. When a company is taking the dividend as a constraint against which to optimise instead of as the residual of what's left over after they've paid the bills, I wonder whether they really ought to have different owners.

But maybe a finance type who reads the blog can set my mind at ease here. Or maybe this is just standard practice when the government owns NZ companies. I remember something about something involving Solid Energy doing something like this.

Update:

• Apple has borrowed to cover dividends and share buyback. Borrowing for a share buyback is different: the firm gets to own more of itself. And Apple had tax reasons to borrow rather than to bring its overseas cash back to the US.
• Weird stuff can happen such that companies can't make a scheduled dividend payment while all is fine, or where a profitable company hits a liquidity constraint and so has to borrow despite profits in excess of the dividend payment. But here CCHL deliberately lifted the dividend payment to transfer more money to Council post quake. If they're doing that, why not just sell some shares in it instead?

Is it May already? Asset sales edition

It must be May. The Christchurch Press is reporting that Council is considering selling some assets to pay for the quake.

May 2, 2011: The Press wondered the same thing. I put up the general conditions under which Council should sell assets.

May 21, 2012: Another round of speculation about Council asset sales. Labour was outraged by that the City might contemplate selling dividend-paying assets. I pointed out that, unless there are really serious problems in asset markets, dividend flows get capitalised into asset prices. I'd written:

Cosgrove can only be right where the asset is more efficiently owned by local council, or where there are serious problems in IPO markets, or where the Council has a particular kind of stupidity.

If the asset is best owned by government, then the selling price will be less than the discounted value of the dividend flow. Otherwise, local Councils can do better by selling off the asset and taking the cash.

If there are serious problems in IPO markets, then things sell for less than fundamental value at IPO. But there's no particular evidence of this.

The last one might be more of a worry. Imagine a guy who has a trust fund that pays him a modest annual income. He generally is foolish in how he spends it, but he's always able to pay his bills. If he is given the investment as a lump sum, he blows it all on pop rocks and bungee jumping and has no income flow for the next year. That guy is probably better off not being able to sell off the dividend-paying asset. Is Christchurch Council that guy? Hopefully not. But post-quake, unless they're dumb enough to blow it all on stadiums, there are tons of productive ways they could be spending the money - roads, sewers, turning Red Zone into useful parks.

And, if Council is dumb enough to blow any divestiture returns on pop rocks and stadiums, are they smart enough to handle the asset properly if they own it in the first place? Note that an asset like the Lyttelton Port of Christchurch isn't like a hands-off trust fund; it requires annual decisions about asset maintenance versus dividends. Cosgrove talks about how the revenue stream from assets helped kept rate rises in check; what reports I'd heard on maintenance standards at the Port as of a few years ago suggested that Council was putting a fair bit more weight on current dividend flow than on maintaining the assets. Divestiture may be a bad idea if Council is prudent enough to manage the asset properly while they own it, but profligate if they're handed a lump sum of cash; under the current circumstances, with plenty of really pressing financial needs, I'm less worried about this one.

And here we are, May 2013. In today's Press:

A Christchurch city councillor says the city could offload non-core assets, including its own offices, to help pay its share of big-ticket rebuild projects.

Cr Tim Carter said last night that less important assets were expendable if it helped ease the council's debt burden in funding anchor projects such as the new convention centre and roofed sports stadium.

...He was against selling strategic, money-earning assets such as Christchurch International Airport, Lyttelton Port, Orion, and Enable, which is installing ultra-fast broadband in Christchurch.

His comments come as Prime Minister John Key yesterday weighed into the council asset sales debate.

Key told Firstline it was up to the council to ask whether the people of Christchurch wanted "the nice-to-haves".

"Then they'll ask how are you going to pay? That could be through rates or asset sales," he said.

The case against selling the airport isn't that it's a money-earner. A money-earning airport will sell for a LOT of money at IPO. Rather, the case is that the local monopoly airport would be tempted to set fees to maximise its own profits without considering that reduced traffic into town might have some broader costs. It might even do things like charge really high fees to taxicab companies for the right to operate from the airport, increasing the costs of Christchurch as a travel or conference destination.

I still think that Council should fully divest assets that are managed at least as well by the private sector and don't have the kind of problem that the airport could have, partially divest other assets, and use the money for roads, sewerage, overbridges, and for topping up the costs of rebuilding and repairing Council facilities. But if John Key wants Council to sell off the Port to fund a big covered stadium or a huge convention centre, well, I discussed that case last year.

Present discounted value, explained slowly

Suppose that you own an asset that gives you $100 per year annual income net of any costs of ownership. Would you be a fool to sell that asset and forego that revenue stream? Well, it depends on how much money you would be given for the asset and what you would do with it.

If your best possible use of any raised funds is a RaboBank term deposit at 6%, and if the net earnings flows are comparably risky, then if somebody's willing to pay you at least $1667 for the asset, you're better off selling it. Otherwise, you're better off keeping it. If somebody offered you $1000 for it, you'd get $60 per year in interest. That's less than $100 per year. If somebody offered you $2000 for it, you'd get $120 per year in interest. That's more than $100 per year. Whether you should sell off the asset depends on how much somebody else is willing to pay for it.

So, what's somebody else willing to pay for your asset? That depends on what they could do with it. If others reckon they could earn more from your asset than you are, they could bid the price up to a point above $1667. If they think they could earn less, they'd offer less. So whether you should consider selling the asset really depends on whether somebody else could make more money from it than you can. If they could, they'll pay you for the privilege, and you'll both be better off.

This has, perhaps, been overly pedantic. But when folks' main objections to asset sales are losing the flow of dividends, pedantry seems necessary. Here's Christchurch Mayor Bob Parker.

The strategy does not propose the sale of any city-owned assets, including our shares in companies such as Port of Lyttelton, Orion or Christchurch International Airport Limited. This Council has recognised the importance of retaining these assets, which provide valuable dividends each year and offer an alternative revenue stream to rates alone.

As part of our usual business practice, the Council keeps an eye on the value of our assets and the returns they yield. At this stage, when you look at the annual revenue we receive from these companies, it just does not make financial sense to consider selling them for a short-term profit.

Where an asset is more efficiently owned by the public sector, then the one-off return from selling the asset will be lower than the value of the dividend stream. But how many assets really fall into that kind of category? Christchurch Council used to think private management of Lyttelton Port was a good idea; they wanted to bring in Hutchison Port Holdings as strong minority owner and manager of the Port. It wound up being blocked, if I remember correctly, when Lyttelton's main competitor, Port Otago, acquired a blocking interest to prevent the sale; they seemed to be worried that Lyttelton would be more competitive under private management.

Before the earthquake, with a different Mayor, Christchurch thought it a really good idea to sell off just shy of a controlling interest in the Port to a foreign specialist in ports. They saw opportunities for better management with specialist interested assistance. Now, after the earthquake, when Council's a bit more desperate for money, Mayor Bob Parker thinks it short-term thinking to sell off even part of Lyttelton Port? Remarkable.

If the quake has made it more expensive for Council to raise debt financing, then surely that also makes partial divestiture of some current Council assets more attractive. Council owns 75% of the airport. Is there something magical about 75% that made it the right ownership fraction both before the earthquake and afterwards? Mightn't it make sense to trade some of Council's ownership of the Airport, Port, and Red Bus for Council ownership of improved roading, sewerage, and water infrastructure? Or to help build a park and bike paths along the Avon that don't provide a financial return but improve quality of life? Or maybe to help them rebuild the torched kid's play structure in South Brighton Park that's been sitting behind a fence since January and otherwise ignored by Council but asked about by my children every single time we go to use the swings there?* Surely there are some current quality of life issues that are worth more than having an extra 5% of the airport. Am I a heartless neoliberal because I think it just might make sense on equity grounds to fund partial temporary rates abatement in the more earthquake affected parts of Aranui and Bromley by selling off a few percent of Red Bus and canning the plans for an expensive new stadium and convention centre?

Yes, selling Council-owned assets gives us money now and less money later if we spend it on current consumption or lower rates. That's a trade-off worth making after an earthquake so long as the selling price for the assets is reasonable.

* Update: The Christchurch Mail, in my mailbox this evening, reports Council's planning on starting work on it; it might be ready for next summer.

BERL and asset sales

The Greens commissioned BERL to look at the government's planned set of asset sales.

Recall that I've previously argued that the "but the bond financing cost is lower than the flow of dividends" argument is nonsense because it says the government should borrow to invest in the stock market where stock returns are higher than what the government pays in interest; it ignores that stocks are riskier assets than New Zealand government bonds.

What really matters is whether an asset is better managed publicly or privately. If the assets are more efficiently held publicly, the "loss of flow of dividends" critique can make sense: in that case, a private owner is willing to pay less for the shares than the flow of dividends is worth to the government. Otherwise, a high dividend flow just means the asset's selling price is bid up. If the private owner expects efficiency gains, competitive IPO markets push the asset's selling price to being higher than the discounted value of the current revenue stream.

So, how does BERL approach the problem? They assume that revenues from asset sales are used to build other assets that yield dividends equal to the returns on the sold assets but that time-to-build means a few years' delay in getting the flow of assets from the alternative stream. It's then not particularly surprising that they find that asset sales are a dumb idea. It would be hard to find anything other than "privatization is a dumb idea" given that starting point. They also assume that borrowing costs are lower than dividend yields and conclude that it makes more sense to borrow than to sell off assets. They do some year by year projections going forward on the basis of the assumptions, but all that time path depends on the question-begging at the outset; I'm not going to get into whether they got the time series right.

BERL also seems pretty worried about effects on the country's net external debt position. So they set up scenarios comparing asset sales, where buyers may be foreign or domestic, with a bond issue, where bonds are assumed to be bought only by domestic investors. On this basis, they find that the asset sales will hurt net foreign liabilities. Perhaps their conclusion would have changed if they considered that foreign investors do sometimes also buy our government's debt, or that domestic investors can on-sell government bonds to foreigners.

Further, when BERL makes the case for debt over asset sales based on the difference between the government's cost of borrowing and the dividend yield from state owned enterprises, they don't seem to adjust for that dividend yields tend to be higher because asset owners need a risk-based return. If it doesn't make sense to take out a mortgage on your house at 5% because you can buy stock in a company that usually pays 6% dividends, it probably doesn't make sense for the government to do it either.

As a fun robustness check, they compare their results against a scenario where the new investments yield lower dividends than the new investments. Unsurprisingly, they find that privatization is then even worse!

I'll agree with BERL that some of the benefits of partial privatization seem overwrought. I've been critical of partial privatization, and especially of starting with the energy companies. But if this is the best case against partial privatization that the Greens can come up with, it sure isn't convincing.

Previously:

• Perils of partial asset sales
• Partial Privatisation: Hazledine (vs?) Crampton edition.
• Selling assets to pay for the quake
• Optimal quake financing
• Don't sell the lines company, sell the Port.
• Sell it already
• Seamus: Justification for partial asset sales
• Seamus: Should Meridian be Privatised
• Me in response to Seamus: Voter Preferences and Electricity

Sell it already

Christchurch Council is again being encouraged [see also NBR] to consider selling off some of its holdings to help pay for the earthquake rebuild. Labour is predictably outraged:

Labour Party SOE spokesman and Christchurch-based MP Clayton Cosgrove said Carter's comments on Sunday "proved beyond doubt central government’s intention to see Canterbury’s assets sold off."

“This issue was raised over a year ago when the CERA legislation was before Parliament. This was not a part of the deal. The Minister’s rationale - that councils should sell down infrastructure to survive - is ludicrous," Cosgrove said.

“These are revenue generating assets which have sizable returns for the whole community. Selling these off to fulfil National’s agenda is foolish," he said.

"This is a nationwide issue. Selling revenue generating highly profitable assets which are providing a solid rate of return at a local level is about as logical as National’s plan to sell our revenue generating state-owned assets.

“Canterbury’s profitable assets have kept local rates in check. To hear the Minister say that he would rather give up that revenue stream to pay for the disaster that has befallen our City makes a mockery of the Government’s commitment to Canterbury’s recovery," Cosgrove said.

Cosgrove can only be right where the asset is more efficiently owned by local council, or where there are serious problems in IPO markets, or where the Council has a particular kind of stupidity.

If the asset is best owned by government, then the selling price will be less than the discounted value of the dividend flow. Otherwise, local Councils can do better by selling off the asset and taking the cash.

If there are serious problems in IPO markets, then things sell for less than fundamental value at IPO. But there's no particular evidence of this.

The last one might be more of a worry. Imagine a guy who has a trust fund that pays him a modest annual income. He generally is foolish in how he spends it, but he's always able to pay his bills. If he is given the investment as a lump sum, he blows it all on pop rocks and bungee jumping and has no income flow for the next year. That guy is probably better off not being able to sell off the dividend-paying asset. Is Christchurch Council that guy? Hopefully not. But post-quake, unless they're dumb enough to blow it all on stadiums, there are tons of productive ways they could be spending the money - roads, sewers, turning Red Zone into useful parks.

And, if Council is dumb enough to blow any divestiture returns on pop rocks and stadiums, are they smart enough to handle the asset properly if they own it in the first place? Note that an asset like the Lyttelton Port of Christchurch isn't like a hands-off trust fund; it requires annual decisions about asset maintenance versus dividends. Cosgrove talks about how the revenue stream from assets helped kept rate rises in check; what reports I'd heard on maintenance standards at the Port as of a few years ago suggested that Council was putting a fair bit more weight on current dividend flow than on maintaining the assets. Divestiture may be a bad idea if Council is prudent enough to manage the asset properly while they own it, but profligate if they're handed a lump sum of cash; under the current circumstances, with plenty of really pressing financial needs, I'm less worried about this one.

Previously:

• Perils of partial asset sales
• Selling assets to pay for the quake
• Optimal quake financing
• Don't sell the lines company, sell the Port.

Prison economic illiteracy

There are good arguments against privatizing prisons. Labour's Charles Chauvel doesn't use them here:

Labour's justice spokesman Charles Chauvel said Wiri was expected to cost the taxpayer about $1 billion over 25 years but its "indirect" costs were becoming clear and were "disturbing".

"National seems to have made a decision that, rather than refurbish many regional state-owned institutions, it will simply close them. Prison closures will be a big blow to regional economies. Job losses will be significant."

The proposal made "little economic or social sense".

The National-led Government should invest the $1 billion in improving existing state assets instead of boosting the bottom line of a private company, he said.

 A few of the problems:

• Prison guard jobs are a cost, not a benefit; if we could guard them for free, that would be better.
• Closing old prisons and opening a newer one will mostly mean job transfers, not job losses. 
• Viewing prisons as an economic development initiative is a quick route to bad outcomes; imprisonment becomes a good rather than a bad.

While Shleifer raised some really good points against prison privatization, those are mostly arguments about making really sure to get the incentive contracts right. Private prisons can too easily chisel on margins that reduce costs but brutalize prisoners and increase re-offending. But that doesn't seem to be the case here. 

The private manager of the prison facilities is subject to a re-offending target, according to the Press article:

Serco is expected reduce reoffending by more than 10 per cent and will face financial penalties if it fails to meet the target. 

And, Serco is the company that manages Mt Eden prison, where they found it cheaper to treat prisoners kindly and thereby save on guard costs. 

I have no view on whether total costs are reduced by closing the old prisons and building a new one; I've not looked at the numbers. But Labour's not making a particularly good case against the move.

Idiotic? Perhaps not.

Optimal financing for the Christchurch rebuild involves a mix of spending cuts elsewhere, debt now, and future tax increases. But what about asset sales? Gordon Campbell says forcing Council to divest assets would be idiotic: you'd only get fire-sale prices in the current environment. 

Big picture, he's almost right. Unless privatization comes with an increase in firm profitability, there's an equivalence between the value of the flow of dividends coming from the asset and the selling price of the asset. In that case, fire-sale prices reflect the real reduction in value that comes from holding a damaged asset: it's worth less either to Council or to a private firm. So it doesn't make much difference whether Council borrows against the flow of earnings from its holdings or sells its holdings. It's not idiotic to sell off assets, but it doesn't do a lot of good. Unless the privatization increases value. Or, unless Council faces financial market constraints on borrowing. I'd explored things in more depth a year ago.

So I'm not sure there's much case for selling off the Council's power lines company, Orion. We'd have to replace monopoly Council ownership with regulation of a natural monopoly; I can't see a whole lot of gain to be had either way. It's sure not the first place I'd look for potential privatization.

But what about Lyttelton Port of Christchurch? An insurance-funded rebuild of the Port's capital stock could put it in better shape than it was prior to the earthquake; there's a good case to be made for privatization bringing efficiencies to port operations. It's (as best I understand things) the threat of those efficiencies that had Port Otago block Christchurch Council Holdings' attempt to sell the port to Hutchison Port Holdings five years ago. It wouldn't be crazy to argue that Council might never get a better price for the Port than when it's all bright and shiny with fresh infrastructure, so long as LPC is able to get insurance settled. If the Port can earn greater returns under private ownership than under Council ownership, then privatization is far from idiotic. At latest share prices, it's worth about $200 million. 

Partial privatisation

Auckland's Professor Tim Hazledine and I argued partial SOE privatisation on Radio New Zealand's Morning Report Wednesday morning, with minor unintentional contributions from a rather vocal Eleanor.


Tim and I are likely around 90% in agreement. We both think partial privatisation a bit of a nonsense; you get little of the potential efficiency benefits of full privatisation but add downside risk. I don't think it will wind up making a ton of difference; Tim puts more weight on the potential downside outcomes. I think we'd both agree that there's more potential downside risk than upside; he'd have the left tail fatter than I would. I think we both agreed that the "foreigners might buy shares" wasn't much of an issue.

Even if we're considering full privatisation, New Zealand's power companies would be reasonably far down on my list. You can make a defensible case that New Zealand's electricity system is one of the world's least screwed up; mucking about with it is risky. The likely equilibrium isn't a private system but rather a regulated cartel industry with more downside risk than upside. Seamus's worries aren't crazy. If I got to choose between DoC selling off half its estate at auction and full privatization of the energy companies, I'd pick the former.

Selling assets to pay for the quake

This morning's Press speculates about whether Christchurch might sell off some of the town's corporate assets to help pay for reconstruction. It isn't ruled out by earthquake recovery legislation, so the folks who like to be paranoid about privatization think there's a secret agenda.

Under what conditions is it optimal to sell off assets post quake? It depends a whole lot on whether the city is credit constrained, whether the city has better inside knowledge on the likely path of recovery, what information people might draw from asset sales about that knowledge, and whether it made sense for the city to own the facilities in the first place.

If the city is not credit constrained, then the earthquake is largely irrelevant. Recall that the best argument for Council ownership isn't whether the asset returns a positive financial return on investment but rather that difficulties in contracting for particular kinds of service delivery combined with differential incentives across private and public ownership may make public ownership sometimes optimal. It may be simpler for the Council to own the local power lines company Orion than for it to attempt rate of return or other forms of pricing regulation on the natural monopoly utility.

If the set of assets held ex ante by Council were optimally held by Council, then the main driver of post quake divestiture, absent credit constraints, is if Council's costs of ownership increased with the earthquake relative to the private sector's costs of ownership. The earthquake could plausibly have just made it a lot harder for Council to keep on top of its varying interests and so divesting itself of some assets that require more time and attention than Council's now able to give could make sense. I don't know which if any of Council's assets would fall into this category.

A second reason for divestiture would be if Council expected a faster depreciation of those assets than the private sector expects. If Council thinks land values will plummet, selling off land before that happens would make sense. But if everyone reads into a Council asset sale that Council has inside knowledge that things are worse than folks expect, and if there's uncertainty about outcomes, and if expectations about outcomes drives selection among multiple potential post-quake equilibria, then Council could do better by holding off on those sales or by making complementary investments that serve as countersignalling.

That changes where Council is credit constrained. If borrowing for the rebuilding becomes relatively expensive, selling off some assets that had ex ante been best owned by Council could make sense. The losses from a slightly less efficient ownership structure would be smaller than the increased borrowing costs otherwise incurred.

But all that's predicated on Council's holdings being ex ante efficient. Here's the list, according to the Press:

Christchurch City Holdings Ltd (CCHL) is the commercial and investment arm of the Christchurch City Council. CCHL manages the ratepayers' investment in these seven fully or partly-owned council-controlled trading organisations: Orion New Zealand Ltd – 89.3 per cent shareholding. Christchurch International Airport Ltd – 75 per cent. Lyttelton Port Company Ltd – 78.9 per cent. Christchurch City Networks Ltd (trading as Enable Networks) – 100 per cent. Red Bus Ltd – 100 per cent. City Care Ltd – 100 per cent. Selwyn Plantation Board Ltd – 39.3 per cent.

They seem to have left out VBase, which I'm pretty sure is Council owned.

There's room to argue about whether Council needs to own the bus company. As they've already facility in place for different companies to bid for routes, the efficiency gains from privatization are limited, but so too are the contracting costs for outsourcing. Seems a reasonable candidate for sale. I can't see any particular reason why Council should own the Port at Lyttelton. Facilities there had seemed on the decline prior to the earthquake; insurance-funded reconstruction could put the Port into a really good position for sale. Selling off some assets that were at best questionably owned by Council makes more sense than earthquake levies.

Update: See Roger Kerr's summary of positive privatization outcomes elsewhere in New Zealand.

Opportunities lost

Every time Don Brash steps out to say something, I weep for what could have been in 2005. Then I remember that he'd have been as much constrained as anyone else in office and outcomes wouldn't have been quite as cool as I'd have hoped. But here he is taking on Bernard Hickey's odd claim, critiqued here Saturday, that the difference between the dividend rate paid by SOEs and the government's borrowing rate is sufficient reason not to privatize:

Bernard, I see you're suggesting that it is a “line-ball” call whether it makes sense for the government to sell stakes in some of the SOEs because the government is getting a dividend yield of 7.6% on its investment in the energy companies but can borrow at 5.5%. I’m not sure I understand what you were saying, but if I do understand it, I certainly disagree with you! Leaving aside the fact that of course the government would expect to get a higher return from a risk asset than it pays on a debt instrument, you seem to be assuming that the government would sell the shareholdings for the net asset backing of the shares. Why on earth would it do that?

The risky asset bit is what I'd focused on because I go after low-hanging fruit.

You say that you are not for or against privatisation in principle. I’m unambiguously in favour of it. I can see absolutely no reason for government to own commercial operations except perhaps where there are overwhelming policy arguments – Transpower, as the ultimate natural monopoly, is a good example of a company I would not privatise, and Radio New Zealand is another (important for cultural reasons having nothing to do with economics).

I see John Key’s announcement has a step in the right direction, but a very timid one. Why on earth would government want to own a majority share in three competing power generators? Government doesn’t produce the food we eat, or the clothes we wear, or (most of) the houses we live in. Why should they own three of the five generators? The New Zealand government is now one of the very few which seems to believe that they should continue to own trading operations. The NSW Labor Government has just privatised its power companies, and the Queensland Labour Government has just sold its rail system.

By the way, when the 2025 Taskforce argued for privatizing the SOEs in its latest report, we quite explicitly said that reducing debt should not be the primary driver (as it had been, arguably, with the privatisations of the late eighties) given that current debt levels, though rising strongly, are not yet at a critical level. We argued in favour of privatisation on the grounds that that was important in order to expose some of the largest corporates in the country to the opportunities and disciplines in the private sector. (Note the reference to Nokia above.) We just couldn’t see any reasons whatsoever for retaining them in government ownership.

Hit the whole thread for his back and forth with Hickey. It's towards the end of the comments thread; best just to search on "Brash".

I think Hickey's wrong on this one, but N is high enough for bloggers that the occasional foul tip oughtn't be too damning (Crampton says in fear of the next time he screws something up!)

State versus Private Ownership

John Key's proposed running in 2011 on partial privatization of state owned assets.

The response from both sides has been pretty disappointing.

On the one side, besides the usual knee-jerk opposition to any kind of privatization and fearmongering about that foreigners might buy shares, there's the claim that we lose money by selling an asset that currently pays the government a dividend higher than the government's net borrowing costs. So if some SOE pays a 7% dividend to the government and the government's cost of borrowing is 5%, they reckon it makes more sense to keep the asset and to borrow money to cover shortfalls.

Forget SOEs for the moment. If any firm is providing a rate of return that seems to consistently be beating the market, we'd expect the stock price to rise until the rate of return falls into line with market norms, right? And if that doesn't happen, it's probably because there's something a bit nasty hiding in the risk profile. Now think about the SOEs. If they're earning a high return, it's either because their valuation is out of whack or because there's some risk. In the former case, the government can do well through an IPO - they'll get more for it than they thought it was worth. If instead it's just that the assets are risky, looking at the gap between funding costs and rate of return misses something a bit important.

Now, a reasonable counterargument is that the stock market rate of return is higher than the government's borrowing costs in general, so the asset price won't be bid up sufficiently to make the difference. But note two big problems. Sovereign debt from reasonable countries is safer than most stock market investments: the market index has to pay investors for the additional risk they take on. So selling a very safe asset (a bond) at a low interest rate while buying a riskier one (keeping an SOE) isn't a "Hey! Free Money!" deal. If it were, we'd also have proven that the government should borrow heavily on the international markets and buy up shares on the NZX. Most of us don't think that would work. So why do we think there's anything particularly special about the government's current set of asset holdings? If the argument for keeping Solid Energy in government hands is that the government's rate of return on coal investments is higher than its borrowing charges, then the government should also buy up any other firm providing a high enough expected return.

On the other side, folks largely overestimate the benefits of partial privatization. Sure, having shares trade on NZX is nice, but the government maintains a 51% share. There's no potential for an external shareholder to force changes in management if things are run inefficiently. We get some extra discipline from constant daily signals of what the market is saying about the firm's performance via the stock price, and if the share price plummeted, the Minister might want to have a chat with the CEO.

AntiDismal and Roger Kerr pointed out the limitations of partial privatization. Kerr worries that political incentives continue to be given too strong of weight in a partially privatized firm. Imagine for the moment that some town owned most of the local port company through a holdings company and that lots of retirees had put their money into this safe utility. At the margin, Council might prefer that money be paid as dividends to help keep local body rates down and to keep local retirees happy. Both make Council more likely to be re-elected. Problems stemming from deferred maintenance - those don't show up 'till somebody else is the mayor, and might be covered by insurance if there's a handy earthquake. Some folks arguing for partial privatization have pushed for restrictions on international share purchasing: the greater the requirements for local ownership, the more SOEs start looking like the stories about this hypothetical port and town.

I worry too that partial government ownership makes bailouts or other government support more likely. Socialisation of downside risk and privatisation of returns isn't a particularly good model, but incentives under partial privatisation lean that way at the margin.

Partial privatization seems unlikely to be worse than the status quo - it just seems insufficiently better to be worth the hassle. If Key's going to take flack for any use of the P-word, it would have been nice if he'd have gone just a bit farther with it. Here's a model I think could have worked well. Issue just over eight million shares in, say, Solid Energy. Just under half get sold via a float on the NZX. The rest are distributed, one each, to the just over four million New Zealanders. The SOEs get the benefits of full privatization. If "we" own the SOEs through the government, why not just hand us each a share and stop having the government as intermediary? The only plausible argument is that certain social goals are better advanced through state ownership than regulation. That's potentially plausible in regulation of natural monopolies, but we'd still need that the losses on the social side outweigh the usual benefits of private over state ownership. And while you could make that argument for the lines companies, you'd have a harder time doing it for a coal company

Andrei Shleifer noted the conditions under which we prefer state to private ownership. It makes little sense that we're privatizing our prisons before things like property valuation, red meat inspection services, or a coal mining company.

Private Prisons

I'm a fan of privatisation. But prisons would be low on my "Things to privatize tomorrow" list.

Andrei Shleifer's brilliant "State versus Private Ownership" argues that we want state ownership in the following kind of case (quoting from the paper):

1. opportunities for cost reductions that lead to non-contractible deterioration of quality are significant;
2. innovation is relatively unimportant;
3. competition is weak and consumer choice is ineffective; and,
4. reputational mechanisms are also weak.

What about prisons? A lot of the current worries in New Zealand about private-public partnerships on prisons focus on that the private prison might pay low wages and achieve poorer results, but that's not really a problem in the Shleifer world. Why? Quality of guards, or at least their pay, is contractible. If the government wants to make sure a private prison hires high quality guards, they can write that into the terms of the PPP contract. More importantly, the government can contract for outcomes as well as outputs: write into the contract that the prison is paid a bonus for every prisoner who does not reoffend for some period after release. Make the bonus large enough, and prisons will have a strong incentive to innovate in prisoner rehabilitation. It's damned hard to think of any of the standard critiques about private prisons that can't be solved through reasonable contracting, and it's easy to imagine lots of innovative upsides through creative contracting.

But they can't solve this one. The League of Ordinary Gentlemen (HT Wilkinson) points to NPR reporting on the corrupt interaction of the private prison lobby with legislators to throw more people into prison. It turns out that private prison lobbying was behind Arizona's rather nasty policy towards illegal immigrants.

Last year, two men showed up in Benson, Ariz., a small desert town 60 miles from the Mexico border, offering a deal.

Glenn Nichols, the Benson city manager, remembers the pitch.

"The gentleman that's the main thrust of this thing has a huge turquoise ring on his finger," Nichols said. "He's a great big huge guy and I equated him to a car salesman."

What he was selling was a prison for women and children who were illegal immigrants.

"They talk [about] how positive this was going to be for the community," Nichols said, "the amount of money that we would realize from each prisoner on a daily rate."

But Nichols wasn't buying. He asked them how would they possibly keep a prison full for years — decades even — with illegal immigrants?

"They talked like they didn't have any doubt they could fill it," Nichols said.

That's because prison companies like this one had a plan — a new business model to lock up illegal immigrants. And the plan became Arizona's immigration law.

Public prisons have slacker incentives on this margin: the prison manager can consume perquisites proportionate to discretionary budget, but can't easily translate that into income.

I don't expect PPP arrangements for prisons in New Zealand to lead to prison lobbying for draconian legislation. It's too easy to monitor that kind of thing in a small country. And the upsides if the contracting is innovative are really large. But it's still enough to put prisons close to last on my "to privatize" list. At the margin, it helps push for putting more people in prison and against liberalizing laws against victimless crimes.