The hopelessly oversimplified debate around our country’s water and power

The privatised, regulated utilities—gas and electricity across Britain, plus water in England and Wales—have survived in more or less their current form for over three decades. But reform is in the air and at the next general election the political parties will need to argue for their positions. The history of the ownership and control of these utilities offers salutary lessons on what works and what does not—and, with millions of people affected by the services these utilities provide, it is important to heed them.

The UK’s national infrastructure is in need of massive investment for maintenance and upgrade. In its recent five-yearly assessment, the National Infrastructure Commission calculated that the “government’s commitment to a sharp increase in public sector investment in infrastructure to around £30bn per year will need to be sustained until 2040.… Meanwhile, private sector investment will need to increase from around £30–40bn over the last decade to £40–50bn in the 2030s and 2040s.” 

But there is doubt about how this is to be paid for. Nationalisation is not going to do the trick on its own. Nor is financial engineering: at the end of the day, that amounts to borrowing—and, sooner or later, borrowing has to be repaid, with a return to the lender.  

The fundamental question is the funding: where do the resources come from? It is inescapable that if we are going to invest more over the next decades, then we are going to have to consume less for a while than we otherwise would have. Historically, one mechanism was personal saving, which meant people consumed less, squirrelled more away—and the capital markets would channel the corresponding resources into physical investment. That investment would produce a return that, in due course, would provide the resources to redeem the initial personal savings (typically, to fund retirement). But personal saving rates are unlikely to increase sufficiently to deal with the problem.

An alternative is that investments are funded out of current or future taxation—essentially compulsory saving on a society-wide level. This is what happened after the Second World War, when the nation’s infrastructure had to be rebuilt. 

The third alternative—and there are no others—is that charges to users increase. A fundamental principle underlying the current structure of the regulated utilities (except rail) was that the consumer should pay the full costs of supply, including the costs of capital investment in infrastructure and equipment. 

Funding out of charges and funding out of taxation are by no means the same thing: the burdens fall on different individuals; the incentives for both consumers and the industries are different; and the politics are different. It was a judgment about how best to balance these factors that lay behind the privatisation of the utilities in the first place.

If the general taxpayer is to make a contribution to gas, electricity and water provision, that violates the current principle that each industry should “stand on its own bottom”. On the other hand, privatisation has not been an unqualified success. So what is the best course? Changing ownership in the sector may have merit but, on its own, will not solve the underlying funding problem. However, addressing the funding problem through increasing the role of government will inevitably precipitate a need to review ownership and governance. That is the key thing to bear in mind when looking at the various arguments and the examples from history.

Costs of consumption

Sharp increases in supply costs have raised ever more doubt as to whether the consumer can be expected to continue to bear the whole cost of their utility use though higher charges, even though that might be the economically “correct” thing to do in terms of allocating incentives. We are witnessing a combination of pressures: catch-up of historical underspend on maintenance; investment to cater for the background growth in demand for water and power; recent moves to protect the environment, such as the construction of the new Thames Tideway Tunnel; all in addition to the international rise in fossil fuel prices (which may well fall again, substantially). 

The recognition of the national and global interest in reducing greenhouse gas emissions has created a new and distinct consideration. The transition away from oil and gas as a source of heat and power, as well as the move away from the internal combustion engine, towards electricity generated sustainably requires massive investment in the private home and in commercial enterprise. New equipment will also be required in the electricity generation and distribution industries. If the full cost of this new investment were reflected in the price of electricity, the consumer would have little incentive to switch into it. We want people to consume less carbon and more electricity than they would choose to at pure cost-based prices. 

The failure of recent governments to make fuel duty keep pace with general inflation illustrates the extreme difficulty of implementing direct charging for carbon (in 2000, fuel duty was 49 pence per litre and it is now 53 pence: a real-terms halving compared to general consumer prices and an even bigger fall relative to average household incomes). So it seems that, in practice, governments will be driven to the second-best alternative of subsiding substitutes for fossil fuels. The best way to deal with this is by paying cash subsidies to consumers (which is partly what the government did in the different context of the recent rapid rise in energy prices).

Ownership and control

Neither the desire to regulate nor the payment of subsidies necessarily require a change of ownership, though that is an option. In the 19th century our railways remained entirely private shareholder-owned companies but experienced government regulation of their shareholders’ rate of return on capital. 

In the 20th century, established medieval legal structures were adapted as alternatives to traditional shareholder ownership of public infrastructure. In 1908, the Port of London Authority was created as a public trust. That served as a model for the British Broadcasting Corporation and the Central Electricity Board, both in 1926. The BBC and CEB were public corporations—but with an independent board of management and a duty to achieve financial break-even after any grant. The 1933 London Passenger Transport Board took over the private bus and Underground companies and was a public trust with public interest objects. In 1939, there was the British Overseas Airways Corporation. 

These models represented a compromise between public ownership and those defending the tradition of private interest. Of the many forms of governance available, the public trust is perhaps the one most worthy of reconsideration for our utilities. There was a role for central government, but, in other respects, the intention was to keep government and other interests away from the management of the business. 

After the war, Labour’s Herbert Morrison threw his weight behind the principle of a government-owned and -controlled public corporation: 1948 saw the British Transport Commission (which owned and operated the railways, buses, London Transport and road haulage) and British Electricity Authority enter operation. Like the trusts, they had independent boards with public interest duties and a requirement to break even after grant, with their capital investment programmes subject to government approval. They were a step closer towards full-blooded government ownership and control (though Lord Justice Denning, in a definitive judgement on the legal status of public corporations, said: “in the eye of the law, the corporation is its own master”).

Political interference and crumbling of the imperative to break even removed the incentive on the utilities boards to manage the enterprises efficiently and produced a result that pleased neither the taxpayer nor the consumer. Nationalised industries came to serve their own interests and ministers came to use their influence over the projects for political ends. High-Speed 2 is a nationalised enterprise from our own time that has illustrated some of the difficulties.

Going private 

The 1980s privatisations of the nationalised industries were essentially to reinstate competition and financial discipline, both as spurs to efficiency, as well as to isolate day-to-day management from political influence. For-profit, monopoly, private shareholder infrastructure companies (managing essential facilities such as networks of pipes, wires and tracks) were created, with competition among private enterprises to supply products to end-consumers using open access to the infrastructure on fair terms. The public interest (including both the interests of end-users and the legitimate interests of investors in the industries) was represented by formal stipulations contained in legislation and in licences issued by a secretary of state and enforced by regulators who were independent (answerable to parliament and the courts, but not answerable to ministers). The regulators oversaw terms of access to the monopoly infrastructure and prices to consumers. Some broader aspects of “the public interest” could have been drafted into their duties, but were not. There were some attempts by ministers to exert pressure, but if government wanted something, it now had to get legislation through parliament: it could not insist on things on a whim, in the way that had been so damaging in the past.

In setting the charges for consumers, the regulators estimate the utility firms’ operating costs and the long-term capital costs of supply over a forthcoming “control period” (typically, five years), factoring in a fair return on the value of the capital invested by owners of the firm’s shares and bonds. Crucially, this assumes that the enterprises will act efficiently, including husbanding their borrowings prudently. Any inefficiency will not be remunerated and will fall as a cost to the shareholders. Equally, outperformance of the regulator’s efficiency assumptions will land as a benefit. This forward-looking system of price control is intended to create a for-profit incentive on management to deliver efficiency. 

A crucial step is the computation of the “value of the capital invested”, which informs a determination by the regulator of what investors are permitted to earn return on. The regulator must be satisfied that the new investment will be “used and useful”: otherwise there would be an incentive on the part of investors to promote spurious capital projects knowing that they would earn a guaranteed return. The upshot is that end-users fund all investment through the charges they pay.

Capital for the nationalised industries also has to be paid for. It increases the national debt, which ultimately has to be serviced out of taxation. While government borrowing may carry a lower rate of interest than private borrowing, the argument has been that this advantage is offset by poor cost efficiency. 

Finding finance

Beginning in the 1990s, the UK saw a new phase in the financing of these sectors. The Private Finance Initiative and the Public Private Partnerships were attempts to leave the state responsible for providing goods and services in the public sector and provide a firm commitment to long-term public finance, while securing private sector efficiencies through commercial contracts to supply. Although some of these worked well enough, many did not because of the difficulty of drafting and enforcing large contracts with 30-year terms. The PPP for the London Underground, 2003–2010, was particularly disastrous. 

There was general confusion between financing and funding by these schemes. One consequence was that the public were led to believe, for instance, that private investors were paying for new hospitals. But they were dismayed years later to discover that debt repayments and interest were consuming large portions of the NHS budget.

This experience has led many to conclude that, for complex infrastructure, a long-term PFI or PPP contract with a private provider— and attendant legalistic inflexibilities—is much less likely to succeed than independent regulation of an enterprise through a licence which defines the rules of operation. The licence can be amended from time to time. 

Ownership or incentives? 

Ultimately, the history of ownership and control of UK public enterprises is mixed, with at least as many failures as successes. It is reasonable to conclude that ownership is not as important as the structure of governance and that, where it can be sensibly preserved, competition is an effective spur to efficiency. 

Whoever owns the enterprise, if the statutory powers and duties are unclear, or if the objectives of management are confused, or if the commercial and personal incentives they face are not consistent with those objectives, then the enterprise is likely to fail. 

The privatisation of the railways involved direct subsidy from the start, and this special feature offers useful experience and evidence on the importance of getting incentives right. When the government came to restructure the nationalised railway in 1993 it recognised that, to avoid a reduction in service levels, it would have to keep the existing subsidy in place. The solution was to create Railtrack as a financially self-contained, shareholder-owned infrastructure company and to pay subsidy to the train operating companies who were Railtrack’s “customers”. That way, Railtrack received no direct subsidies and earned all its income through its charges, thus preserving the normal commercial incentive structure. 

Later, ministers intervened and undermined this structure in several ways. The company came to anticipate that it would be bailed out from the consequences of imprudent risks—notably, the unwise “Passenger Upgrade 2” contract with train companies for the West Coast Mainline. And the government ultimately found it convenient to start paying a direct “network grant” to Railtrack’s successor, Network Rail, a company limited by guarantee without shareholders. 

The government also granted Network Rail the benefit of an unlimited guarantee on its debt (“the government credit card”). This enabled the company to borrow its way out of trouble, thereby materially weakening incentives to manage efficiently and within budgets. In response, the government introduced a valuable legal requirement to agree a “High-level Output Specification and Statement of Funds Available” every five years, to be scrutinised by the independent regulator (and similarly for the National Highways). In this way, the government was effectively driven to revert to treating Network Rail as though it were a nationalised industry, with detailed Treasury control of capital expenditure. 

The lessons

In thinking about reform of the utilities, what matters is not so much ownership as clarity on objectives, powers and duties, and consistent incentives on management and competitive forces. Day-to-day interference with an established structure by government (whether the enterprise is in the public or private sector) has almost always produced a poor outcome.

A clear financial bottom line, together with consequences if it is breached, is one of the more important incentives. Therefore, if subsidy is to be paid, there must be transparency ex ante about how much it is going to be—and clarity that management will be held to account for it. Otherwise, management failures and damaging short-term political interference may be hidden. The retrospective making-good of financial deficits when projects were supposed to have broken even is no way to conduct business. Accountability is lost. Inefficiency and uncontrolled subsidy will be the consequence.

Various parties on the producer/supplier side appeal for subsidies to support their particular interests—especially in electricity supply and in respect of the railways. But it is hard, in practice, to create a structure through which government can pay subsidy direct to producers/suppliers without creating distortions or perverse incentives. It is better to seek ways of giving support to consumers (“user-side subsidy”).

Privatisation may not have worked perfectly, but nor did nationalisation. The big challenge for any government is finding a realistic, coherent and long-lasting plan for funding the infrastructure we need. Suitable ownership and governance reforms will then need to follow.