Dave Grimmond wants us to think about the higher risks we face when the Crown owns commercial businesses, and whether that helps the efficiency of our economy

Dave Grimmond wants us to think about the higher risks we face when the Crown owns commercial businesses, and whether that helps the efficiency of our economy
What would the actual impact be if the Bluff smelter closed?

By Dave Grimmond*

There has been a lot written recently about the interaction between the upcoming public share offer for Mighty River Power and the blackmail tactics of Rio Tinto to use this event as a means of extracting a further subsidy from our national government.

I wish to focus here on a couple of the underlying economic issues involved here: the economic purpose of privatisation programmes and the economic impact of a closure of the Tiwai Point Smelter.

The financial impact of the proposed privatisation of government-owned power companies is simply an adjustment of the mix of assets and debt on the Crown’s balance sheet.

The potential economic benefit from this financial redeployment comes from two areas: a reduction in Crown (ie taxpayer) risk exposure and a potential gain in economic efficiency.

The ownership of commercial entities exposes the Crown to higher risks than normal public assets.

Taxpayer risks

Taxpayers underwrite public assets.

For non-commercial assets, the risk is essentially spread across the whole of the economy.

Our ability to fund public education and public health systems are underpinned by the overall performance of the economy and the ability of citizens to pay required taxes.

For commercial assets there is the added risk of commercial performance within a specific market. Financial performance depends on both the latent demand for the product or service, and on the commercial performance of the specific organisation.

Thus the return to government is influenced by factors such as the demand for electricity, coal or TV advertising, the performance of the state-owned enterprise compared to competitors, and the quality of management. 

The upside is of course higher returns on assets than is available from other public assets, but this comes at the expense of higher risk exposure.

It is the nature of risk exposure that in most years investors receive reasonable returns, but every now and then a series of circumstances leads to a catastrophic situation for the enterprise.

Most companies have a limited life, even the once mighty do not last forever (for example, Kodak).

When privately owned, business failure allows a process of “creative destruction” to take place where resources are re-deployed to better (or luckier) management teams and activities that yield higher returns for investors. 

Public ownership tends to undermine this creative destruction process.

Political considerations cloud commercial considerations, typically resulting in a taxpayer funded bail-out of the failing enterprise.

These bail-outs occur infrequently, but are typically large enough in scale to offset the apparently good returns of previous years. This risk exposure is inherent in all government funded commercial investments.

The implication is that the figment of high returns is a poor basis for government funded investments, and the sell-down of the government commercial assets will reduce their exposure to these risks.

Economic efficiency

Another argument for the sale of government owned commercial enterprises is to promote economic efficiency. By increasing private ownership, one is likely to increase the profit motivation of the organisation, thus increasing incentives for cost reductions and expansion into new product areas.

There is debate about the extent that such efficiency gains will materialise through partial sale of an enterprise, rather than its complete privatisation, but at least some efficiency gain should materialise from privatisation. Whether such potential gains justify privatisation is likely to be case specific.

It may also be the case that many of the benefits of efficiency gains could accrue to others rather than the new owners. This depends on the nature of the enterprise and competitive pressures, ie the extent that gains benefit clients (eg reductions in electricity prices) rather than owners (higher profits).

An implication is that the price received for the sale of a state owned enterprise may have little reflection on the potential economic benefit. An apparent low price may actually reflect a higher long term economic benefit as the price might reflect the extent that efficiency gains will be shared around the economy. 

In the case of the sale of electricity generation companies, the probability of a closure of the Tiwai Point Aluminium Smelter and the financial implications for the profitability of electricity generation activities needs to be factored into the price willing to be paid by potential investors.

The favourable price paid by the smelter for electricity means that this need not be a negative impact for all electricity generation companies.

However, the implicit reduction in demand for electricity should favour the generation companies with lower marginal generation costs. The implicit increase in electricity capacity should place downward pressure on the electricity price paid by electricity consumers (or at the very least less upward pressure), which will have competitive advantage benefits for New Zealand based industry as well as purchasing power benefits for retail consumers. 

The closure of Tiwai point would of course have a disproportionate impact on the Southland economy. Although, this will cause some short run discomfort for the region, the harm for medium term prospects for Southlanders is likely to be minimal.

To begin with the Southland economy is performing well. Despite falling production levels at the smelter, Infometrics estimates that Southland economic activity expanded by 5.4% in the year to March 2012 (compared with national growth of 2.3%).

There will of course be sizeable impacts for members of the Southland community. To begin with, the smelter directly employs around 800 workers (representing 1.5% of employment in Southland).

There are also a number of businesses who benefit from having the smelter in the region. However, closure would not have the 3,200 job impact intimated by smelter propaganda.

To begin with Southland has one of the best performing labour markets with an unemployment rate in December 2012 of 4.6%, compared with a national average of 6.9%. The implication is that prospects of finding alternative work are probably better in Southland than in most other places in New Zealand.

In addition the 3,200 job impact figure is based on regional multiplier analysis, which is likely to overstate the job impact of a closure.

Closure would reduce the demand for services from Southland firms, and this might touch many workers, but this does not mean that the impact will be sufficient for so many to lose their jobs or mean that those impacted are unable to find alternative employment.

--------------------------------------------------------------------------------------------

David Grimmond is a senior economist at Infometrics. You can contact him here »

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

21 Comments

Comment Filter

Highlight new comments in the last hr(s).

its not just commercial/non-commercial.
This is utilities. The asset life is 50 + years, and concessions often longer. These are the platforms upon which residential and commercial life/activity are based....
The brand and creative disruption thoughts don't apply the same.
And market theory does not apply to areas of market failure, that we have because of size and location.
Plus when these type of assets fall in private hands they do the opposite of what you say:
Monopoly pricing
Regulator price gaming
Crowding out alternative/rival investment.
Political leverage (pretty much the tactics employed by RIO right now) bringing in the asset owners of all other generation/distribution assets over the threat of lower wholesale pricing - refer below>
 
For example, can you show ANY where in the world, where following power assets transfer to private ownership, that pricing/or tariffs have gone down?
Hint - answer is similar to: erewhon....
 
http://en.wikipedia.org/wiki/Tiwai_Point The third P69 Line was built in the early 1980s as part of Muldoon government's "Think Big" projects.
 

Well replied....I was going to answer this clap trap and then saw you'd done it...
;]
Its not so much about efficiency as a utility but resiliance, the power has to be there 100% of the time, ppl, lives and business relies on that.
regards
 

Standard Econ101 mantra.
 
We are dealing with energy here - without which NOTHING happens.
 
That's lifeblood territory.
 
Physics doesn't take much notice of an appraisal via an artificial proxy-based system, Dave. The 'Southland economy' is nothing more than a representation of a growing global population, and dwindling resources. There may be more deckchairs passing your point of observation, but if that is due to the deck sloping more, the increase is not something to celebrate.
 
Tiwai only existed while the electricity price was subsidised to the point where it more than offset the shipping from Weipa, and back to wherever. Undervalued energy, nothing more, nothing less. Useful for more than smelting a bulk, non-local resource.
 
 

"corrections". Which is why I  see a 75% and Nicole Foss thinks a 90% correction is possible.
All the debt and money in the banks cant buy what energy is left.....ergo that debt and money has to be removed/destroyed.
regards
 

'Tain't a closed system.  The Earth receives a massive delivery of energy from an outside source every second of every day.

So right MdM. Not only open, but infinitely large, and infinitely small with equal wonders and benefits in both directions. 
 
Turtles all the way down, turtles all the way up.

I dont know what you are smoking but I reckon you should be sharing
;]
regards

No I do not believe you are correct in terms of thermodynamics or engineering,
"In thermodynamics, a closed system can exchange energy (as heat or work) but not matter, with its surroundings."
We also have a time component and the sun's supply while effectively lasting billions of years is actually limited for our use. 
In engineering
"In an engineering context, a closed system is a bound system, i.e. defined, in which every input is known and every resultant is known (or can be known) within a specific time."
For open,
"Open systems have a number of consequences. A closed system contains limited energies. The definition of an open system assumes that there are supplies of energy that cannot be depleted"
The key is time and depletion really.
So the planet is really finite and limited, hence I agree with mistnz, a closed system IMHO.
regards

What limits the sun's supply for our use?  Do you really think depletion is a relevant concept in the case of solar energy?

Does Infometrics receive most of its funding and projects from the government, and would that be at risk if it did not parrot the government line? This paper seems a very naive simplistic throwback to the 80s and Rogernomics, where at least the government had the excuse that it didn't know any better, and government entities under Muldoon had been appallingly managed
 When privately owned, business failure allows a process of “creative destruction” to take place where resources are re-deployed to better (or luckier) management teams and activities that yield higher returns for investors. 
That certainly happened when Air NZ, and KiwiRail failed under private ownership. Having invested in a basket case (Ansett) or been stripped of huge amounts of cash, (Kiwirail) the taxpayers had to bail both companies out because they are essential services. Providing electricity is an essential service. 
Another argument for the sale of government owned commercial enterprises is to promote economic efficiency. By increasing private ownership, one is likely to increase the profit motivation of the organisation, thus increasing incentives for cost reductions and expansion into new product areas.
The SOE model is supposed to promote economic efficiency, and if the Board are not doing so, they should be sacked. That the incumbent Board and CEO are staying on with huge pay increases shows that they are immediately becoming less efficient by that measure. Certainly the profit motivation may well be increased (The crown's interest should be for all citizens, not just itself as shareholder), but in electricity's case the easiest option by far is to gouge consumers. Complete faith in the Fair Trading Act to stop this is supremely naive. Expansion into new areas is far less clear under either ownership. MRP has already I believe lost considerable amounts on overseas ventures. If true, was that management oversight or not? Being government owned did not stop the ventures. Is there clear evidence of real efficiency gains in the private sector? There is certainly evidence of a loss of economies of scale; and a vulnerability that can be taken advantage of.
If Tiwai Point should close (as it happens I will remain very surprised if it is), do not hold your breath for power price decreases.
Am not sure who came up with this nonsense that governments are incapable of running anything first, Infometrics and like minded "economists" or the National government (or Roger Douglas). I accept it can be self fulfilling, as in the Nats (and Infometrics, apparently):
Governments are useless at running anything,
We are the government
Therefore we are useless.
As with say Singapore, in New Zealand's small economy, there are a number of essential industries where both the government's economy of scale, and their implied guarantee, might well be the only way to establish businesses of scale. Selling off the ones we do have, that have both essential services, and irreplaceable assets (like river access and dams) built over a century, is depressingly short sighted.
Given the fiat position of the NZ government, the dividend streams to be lost, and the risk it is now puitting its citizens as taxpayers and consumers under, the case for selling is purely ideological and has nothing at all to do with schools or hospitals.
 

Simply awful nonsense. unbelievable in 2013 to find an economist writing this sort of stuff. Maybe we should should go line by line. It seems that essential every single sentence is created out of misguided rambling thoughts.
Although I loved the Kodak comparrison. So transparent, so irrelevant and yet so brilliant.
Then there was the tossing about of  'creative destruction'. Outstanding stuff. I personally am in favour of some creative destruction funny how no one else is. Creative destruction is only fun if you are not the one being destroyed of course.
I guess the standout is 'economic efficiency' a more unknowable thing probably does not exist in the universe than 'economic efficiency'. It is a phrase that sounds like it means something, and people will explain it but only from one viewpoint- and there is of course the rub, Economic efficiency is unknowable. It is used to justify almost anything except, free markets and competition. ( It is always possible to argue that freemarkets and competition are not efficient).
Economic Efficiency is something the soviets tried to plan for. In the real world it is never so simple. So let us agree to ingore anyone who believes in the mantra of 'economic efficiency'.
 
 
 

Very good analysis PlanB.
A lot of dogmatic characters out there still believe in the Efficient Market Hypothesis.
It's all faith based, just as religion is. 
HGW

Film and other technologies come and go
Electricity demand is permanent
So it does not need to be creatively destroyed to the joy of fund managers and speculators and need to be resuscitated with taxpayer bailouts

You are correct, but like film example we still take pictures but not the chemical type, more the digital.
So it may be with electricity. One day in the future there could be a fuelcell type device in every house and factory. Doing away with wasteful power lines and thereby doing away with big power generators. But we will still use electricity.

The "problem" is diversity and efficiency.  So say we have 100 factories, each has to have a big enough fuel cell for its peak load and expected growth, that means the expensive generation is grossly under-utilised.  So the alternative is have 100 factories with say 1/2 sized plant interconnected, or maybe just 10 largish centralised plants inter-connected that gives a bigger efficiency on plant cost so the TCO is lower.
regards

Interesting pseudonim. Kiwicha is a very nutritious cereal grown in my country of birth, in the Andes. Any link...?
Cheers,
HGW

Electricity demand is permanent - Maybe; or possibly not, as others have set out. 
 
But there are better and worse ways of generating electricity, transmitting it across distances, supplying it to people's homes, to farms and to factories and getting them to pay for it.   I would therefore propose that we want a system which encourages participants to develop and deploy the better ways, and get rid of the worse ways.
 
In theory, a competitive market (for any good or service, not just electricity) would do that - customers would take their custom to the better providers, and away from the worse providers, so the better providers would expand and the worse would have to either up their game or go out of business. 
 
In practice, it's not worked out as proponents might have hoped in the case of the electricity market, largely apparently because many retail consumers haven't been willing to use their options to their own benefit, despite extensive encouragement. 
 
This raises two questions, for me at least:  1) how much obligation does the State have to help people who aren't willing to help themselves and 2) what other means are available to encourage good practice and drive out bad?  Because Government management and/or regulation hasn't done that great a job either.

Industrial use of electricity can only be fed by a power grid with large generators attached to it. Renewable energy sources are great for household power, say 3 to 5kW. 
We will never loose the grid, which is a pity when you consider the eye sore it creates (akin to farm fences in New Zealand).
HGW

I will try again since we seem to be losing posts.
While I agree on the grid, I dont agree on there having to be large generators...Germany is currently seeing the peak power profits from the generators removed by the household solar plants feeding in....lots of these 3 to 5 kw units being effective.
What this does mean however is we need to make sure we have a resiliant system to cope with failures...which means idle plant..which means it isnt as efficient.
 
regards

dp

Another argument for the sale of government owned commercial enterprises is to promote economic efficiency. By increasing private ownership, one is likely to increase the profit motivation of the organisation, thus increasing incentives for cost reductions and expansion into new product areas.
 
Hmm.  I found the conclusion of that to be a little different to the evidence I've seen over the past 30 years or so. I would have written it as..
 
Another argument for the sale of government owned commercial enterprises is to promote economic efficiency. By increasing private ownership, one is likely to increase the profit motivation of the organisation, thus increasing the price paid by the end consumer as private organisations love being able to wring as much money out of captive customers as possible.