#15 - Hybrid Industries
Why we need a new way of thinking about public and private ownership
It seems Andy Burnham will become the UK’s next prime minister, uncontested, before July is out. Voters and MPs are left wondering: what will a Burnham government look like?
For the most part, your guess is as good as Left on Read’s.1 Burnham’s ideology (if you can call it that) of ‘Manchesterism’ is a loose selection of guiding principles that are rapidly being shaped but seem to encompass devolution and at least some greater government ‘control’ of services. With renationalisation of the water networks among the policies touted, this will likely reignite the UK’s obsession with the respective merits of public and private ownership.2
What this debate does not often consider, however, is that not all forms of private and public ownership are made equal: there is a great difference, say, between the way in which supermarkets and water companies can both be said to be ‘private’. Nor are public and private spheres distinct – they often blur, merge, cooperate and compete, and can end up shaping each other’s very form and being.
Nowhere is this blurring more evident than with utilities: energy and water. In much of the Anglosphere, and to a lesser extent in Europe, these services are to some extent privatised, yet widely considered by the public as a ‘right’. This uneasy combination has given rise to a particular form of highly regulated private ownership that Left on Read will call ‘hybrid industries’. And as we shall see, hybrid industries are a uniquely bad way of doing things.
To explain this concept, let’s consider three different parts of the UK energy market.
First, shippers. As a customer, you never interact with shippers. When you buy natural gas to heat your home, you buy it from a supplier. However, the supplier does not buy the gas directly from a producer, instead they buy it from a shipper. Shippers are effectively commodity traders: they buy gas at one price in one location and sell it at another somewhere else.
Government isn’t especially concerned by the activities of shippers. All government really cares about is that the amount of gas bought each day equals the amount sold – otherwise gas cannot be safely supplied to your homes. Consequently, penalties are applied for failing to ‘balance’ these trades, but otherwise shippers are fairly lightly regulated and there is a low barrier to market entry (there are hundreds of shippers operating in the UK).
Overall, the privatisation of gas shippers works fairly well. In essence, shippers act as a forecasting service: they constantly compete to improve their profit margins by more accurately predicting how much gas will be needed and when. That helps ensure the right amount of gas is bought and sold. And by having numerous shippers operating in a large, liquid and competitive market, the quality of forecasting is generally improved.
Second, suppliers. These are the companies that British people actually buy their energy from: British Gas, Octopus, E.ON, EDF etc.
As soon as consumers are involved, government immediately becomes a lot more interested. Most people in the UK see energy as a ‘right’, or at least part of the basic standard of living, and so governments of all parties believe everyone should pay broadly the same price. They also want vulnerable people to get discounts, or not be immediately disconnected if they fall into debt.
These are outcomes that would not be delivered by an unregulated market. Suppliers would, quite justifiably, charge different amounts to different customers based on the cost of supplying them. And given the mountain of energy bill debt (£5.5bn) and the extreme difficulty of recovering it, in most cases they would simply disconnect indebted customers.
As a consequence, suppliers are much more heavily regulated than shippers: government, via the regulator Ofgem, sets a limit (the ‘price cap’) on what suppliers can charge; suppliers must also administer various government schemes, such as the Warm Homes Discount or the soon-to-be-defunct Energy Company Obligation, which funds energy efficiency upgrades; and suppliers most also meet numerous requirements on disconnection, metering and billing.
So yes, energy suppliers are privately owned and can and do compete with each other to win customers. However, the terms on which they compete are quite limited due to the level of regulation (most tariffs, for instance, simply hug the price cap). This state of affairs – private ownership with significant regulation and limited competition – is a ‘hybrid industry’.
Third, networks. These are perhaps the most extreme example of hybrid industries.
Networks are the physical infrastructure (pipes and pylons) used to move gas and electricity. In the UK, almost uniquely in Europe, energy networks are all privatised. This immediately creates several issues: firstly, this infrastructure is, to put it mildly, absolutely critical to the security and wellbeing of the country; and secondly, it is naturally monopolistic: energy networks are extremely expensive to build but can handle huge volumes, meaning there is little point building another pipeline next to one that already exists. This means that, if left to themselves, infrastructure owners could exploit their monopoly position to raise prices well beyond what it costs to build a single piece of infrastructure.
The net result of all this is that, despite having privatised the networks, government is very interested in how they are managed. Consequently, if you thought suppliers were highly regulated, network owners are up to their necks (the licence authorising National Gas to run the gas transmission network in Great Britain is 579 pages long).
In countries where network infrastructure is privatised, this is usually done through a ‘Regulated Asset Base’ (RAB) – one of the tightest forms of regulation available. Under a RAB, not only is the price the network can charge users set, but costs incurred by the network owner must be approved by the regulator and contribute towards their ‘allowed revenue’. The allowed revenue is fixed by the regulator in such a way as to allow a regulated ‘rate of return’ (i.e., profit), usually around 5%, with various incentives and penalties for meeting performance targets.
A company operating a RAB, then, is manifestly not what you and I think of when we think of a ‘private business’. These companies do not control what they spend money on nor what they charge users; that is fixed by government (via the regulator). This is a ‘hybrid industry’: a public entity owned by private investors.
It is important to recognise that hybrid industries are not a product of over-zealous regulation or private greed, but simply an inevitable consequence of government’s desire to place into private ownership an activity that is widely considered a ‘public good’. An unregulated market does as an unregulated market does, and in these cases that means delivering outcomes that government (and the electorate) deem unacceptable. If government wants to prevent these outcomes, but insists on private ownership, extensive regulation is the only answer.
As a result, hybrid industries give you the worst features of both private and public ownership: profit derives to private investors, not the public, yet there is no real competition. Furthermore, hybrid industries actively create new forms of government and private capital that are degrading to both.
Let me explain. These categories – ‘public’ and ‘private’ – are not fixed: over history, new forms of private capital (joint stock companies, stock exchanges, private equity) and government (the civil service, parliament, central banks) are constantly being created. In the case of private capital, hybrid industries offer investors a highly stable, relatively low rate of return (c. 5%). As such, they provide an expanded market for a type of investment entity that seeks these returns: companies like Macquarie (National Gas, Cadent) or CK Infrastructure Holdings (Wales and West Utilities, Northern Gas Networks), and (directly or indirectly) pension funds like the Ontario Teachers’ Pension Plan (SGN) or the Australian Retirement Trust (National Gas).
These kinds of investor are fundamentally uninterested in innovation or competition, because they are not aiming for a high-risk, high-reward investment, but instead for a highly predictable, stable return. Their business model is based on buying assets (ideally from governments at a cut price), maintaining them within the regulations, and skimming off their allowed profit. This is a genuine form of ‘rentier capitalism’: profit-making based on asset ownership rather than production.
Having too many of these entities is bad for capitalism, since it pulls capital away from more innovative, productive industries. It is also bad for the state, which is leaking capability while becoming highly dependent on these investors.
Investors in hybrid industries desire long-term policy stability above all, since potential policy changes threaten their safe returns. They will therefore only invest in countries which can guarantee this stability – pushing government away from innovation and locking in existing policies, even where undesirable. As an example, the UK government recently considered introducing ‘zonal pricing’: a regional electricity market system that would lower average bill costs but increase uncertainty for investors in renewables. The opposition of these investors, who are critical to the government’s Clean Power mission, was a key factor in the policy being rejected.
Moreover, investors in hybrid industries actually like regulation: the more regulated an industry is, the more secure their return. They do not trust government, which is prone to democratic changes of direction, so will only deal with arms-length bodies (such as Ofgem) whose functions are tightly prescribed through legislation. This means that if government wants to change something in the energy sector – introduce smart meters, say – it must bring new legislation which compels Ofgem to in turn compel the energy companies to deliver that policy. This is incredibly time-consuming, legalistic and resource-intensive, since each piece of work must be done three times by government, Ofgem and the company. Multiply this across government and you begin to understand why government sometimes moves so slowly.
Why do governments put up with this? Partly because the ideology of privatisation is deeply ingrained, and partly because these investors have so much leverage. Most developed countries are currently deeply indebted, meaning they pay high interest rates. As such, their finance ministries are keen to minimise the debt burden (or the appearance of a debt burden) as far as possible. Investors in hybrid industries offer them a very useful service: by raising private debt, backed by billpayers (not taxpayers), they allow government to move the cost of investing in infrastructure off the government’s balance sheet. The fact this debt pays higher interest rates than government borrowing, and accrues to the general public, is of little concern to the Exchequer.
So, what should be done?
Left on Read contends that we need to be a lot clearer about the respective purposes of public and private ownership. If there is an outcome that government considers essential and which requires such a high degree of regulation under private ownership that there ceases to be any meaningful competition, government should nationalise. This includes, at a minimum, water and energy networks, though trains (recently renationalised in the UK) are another good example. Alternatively, where there are large, liquid, competitive markets from which we can accept divergent outcomes, government should resist the temptation to intervene unnecessarily. A degree of regulation in these markets will of course still be needed, but not as an alternative to actual government policy.
Let me illustrate this last point. Government wants ‘vulnerable’ energy consumers to be protected, so it develops requirements on energy suppliers to protect them. Recently, government has even pressured supermarkets to introduce price caps on basic foodstuffs. The standard UK government framework for these policies is that government should ‘intervene’ to ‘correct market failings’. But an energy company wanting to disconnect indebted customers is not a ‘market failing’, it’s the market doing exactly what it should do: generate private returns.
Government in fact already has many levers for protecting vulnerable people and addressing social ills: taxation, legislation, public services, welfare. Why then are we asking private companies to fix social problems – a role for which they are manifestly unsuited – when government could make use of these tools instead?
Markets should be markets, and government should secure public goods.
Yours, dreaming of a regulated rate of return,
LoR
As a Labour joke goes: ‘A Blairite, a Brownite and a Corbynite walk into the bar. The barman says: “What do you want, Andy?”’
If you are interested to know why the distinction between private and public ownership became such a political lightning rod in the UK and elsewhere, I highly recommend the BBC podcast, ‘Invisible Hands’, which explores the rise of free-market ideals in the British right in the post-war era: https://www.bbc.co.uk/programmes/m00298t2.