Privatisation of Electricity in New South Wales

This has become a topic of absorbing interest in recent months. Unfortunately, press coverage of the debate has focussed more upon the internal conflict, within the Australian Labor Party, and external conflict, with the trade unions, to which the issue has given rise. The actual issues involved are nowhere near as exciting as a head-on stoush between Morris Iemma, Michael Costa and John Robertson's public ownership diehards at the party's recent state conference. As a result the press, always more concerned with conflict and division than rational debate, has given the issues involved little if any real attention.

Hopefully this debate may serve to rectify this deficit.

The question is of considerable importance to the State's future and long term economic well being. In September 2007 the State government released the Report of the Owen Inquiry into Electricity Supply in NSW. Chaired by Anthony D Owen, Professor of Energy Economics at Curtin University the Inquiry considered a number of issues and formulated a series of recommendations. I will be referring to this report at various points in this article.

Before I launch into the bulk of my argument, however, I thought it would be beneficial to try and "head off at the pass" at least some of the very bad arguments which are almost invariably wheeled out to oppose the privatisation of government owned industries. Since you are almost certain to hear them all tonight it is probably best to deal with them first.

The first of these is that the government's electricity business represent such enormous money spinners that the government, and hence taxpayers generally, will suffer once these lucrative profits fall into the hands of the private sector. According to an article which the NSW Greens MP, John Kaye published recently in – where else? – the Australian Socialist:

The industry is also an important revenue generator for the State… The part of the industry that is scheduled to pass out of public ownership currently returns about $1 billion a year to the state's treasury. This is money that will disappear after the sell-off, requiring matching cuts in government-funded services.

Privatisation is the magic pudding of the voodoo economics brigade…

Australian Socialist Volume 6 No. 4 2007-2008 page 4

Whatever else it does, the last sentence of this passage illustrates what must presumably be the first rule of the guide manual for opposing privatisation: never pass up an opportunity to substitute invective for rational argument.

More interesting, however, is that this argument never found its way into the submission which Mr Kaye himself placed before Owen Inquiry. One can wonder why but quite possibly it was because an experienced economist like Professor Owen would have been only too well aware of the fallacy which it involved.

What the argument neglects is that when you sell a share in a business obviously you forgo that proportion of the business profits which that share commands. Thus if a business makes $100 million per annum and you sell a 25% share in that business then you no longer get $25 million in profits. But then you get the price of that share. And how does the market calculate that price?

The short answer is that it does so by capitalising that annual profit into a lump sum. Say you want to give someone an income of $1,000 per annum in perpetuity. Do you need to give them an infinite sum of money in order for this to happen? Not at all. If the interest rate is 10% then all you need give them is $10,000. Invested at 10% this sum will yield an income of $1,000 per annum.

This basically is how the market computes the value of income yielding assets. If the profits of an industry are $1 billion per annum and the interest rate is 10% then the value of that industry is $10 billion. It is also why, when interest rates fluctuate, or threaten to fluctuate, so also does the price of the share market. Thus if the interest rate fell to 5% the value of the industry would rise to $20 billion. By the same token if the interest rate rose to 20% the value of the industry would fall to $5 billion.

Of course it is not quite as simple as that otherwise the price to earnings ratio of every share would be identical. When the market calculates the price of a share it is factoring not only the present level of profits which the business generates but also the level of future profits which the business is expected to generate. Thus if the prospects for a business are poor the share price may be lower than what the current level of profits would suggest, and vice versa.

Putting this reasoning to work if the government sells its electricity businesses then obviously it foregoes the profits which those businesses generate. But then it obtains those future profits effectively capitalised into a lump sum. And what does it do with that lump sum? The government invests it. And where does that investment take place? Almost certainly the government's own indebtedness – usually paying off a debt is the best investment. By so doing the government reduces its own interest bill, to an extent which equates roughly with the profits it expected to get from the businesses in question.

Yes, the government loses the profits but then it reduces its interest bill by roughly the same amount. The two simply cancel out. The government, and the taxpayers, are no worse off.

However, let us take Mr Kaye's fallacious argument a little further. If investing in profitable businesses was such an advantageous strategy, yielding income which could be used to offset the burden of taxes upon us all, why should the government stop short at the electricity industry? Why not invest in other businesses which return a profit? Gee, if we went sufficiently far down that path maybe we could eliminate taxes altogether.

The trouble is, though, that unless those shares were to be confiscated – a strategy which might recommend itself to someone like Mr Kaye, whose opinions must presumably bear some degree of affinity with those of the Australian Socialist – then the government would presumably have to find the funds necessary to make the purchase. Of what value would these profits be if they were matched by the interest bill on the necessary borrowings?

Returning to a point which I made earlier, the market, when it calculates the price of a share, factors in not only the profits which the business is generating at the moment but also the profits which the business was expected to generate. Thus if the government was not managing its electricity businesses particularly well the profits which it was realising might be substantially less than those which were achievable. However, when it sold those businesses the price would reflect the not only profits which were being earned but also the ones which could have been earned once those business were placed under better management. In other words the government gets a bonus which it would never have earned had the businesses not been sold.

This brings me to one of the other, very bad, arguments which perennially addle this debate. To be fair, it is not in truth a fallacy, because there is every prospect that those who make this point will be proved correct. However, the problem lies not in the essential correctness of the argument, which may well be sound, but in that what will almost certainly be a positive is packaged and presented as a negative.

I speak here of the assertion that privatisation of the electricity industry will lead to job losses within that industry. According to Mr Kaye – I am sorry to pick on him but if you want bad arguments his public contributions definitely seem the place to find them:

From protecting medium and long term quality jobs to securing apprenticeships and training opportunities, the cost-cutting imperatives of investor-owners will devastate employment opportunities and the ability of Australian society to develop a strong industrial base.

Australian Socialist Volume 6 No. 4 2007-2008 page 3

I remember watching, many years ago, a documentary about India. At one point the documentary showed the Indian railways, which at that time were largely hauled by steam locomotives. There was this fascinating segment where we were shown the way in which these trains were loaded up with the coal they needed to burn. Basically, a plank was led up to the fuel carriage. A succession of skinny, sunburned men, naked except for a loincloth, would then walk up that plank carrying a small tray of coal on their heads. Each would, when he got to the top of the plank, deposit the contents of the tray into the carriage and then walk back down again to fetch more.

As you can imagine, the loading process must have taken some time. It was, as one might say, labour intensive. Now in Australia we almost certainly would have done things differently. To start with, we probably would have used a diesel train, which could have been fuelled by the simple expedient of turning a tap. Even in the days when coal and steam locomotives were all the rage, it is doubtful that we would have ever used a process quite so inefficient and wasteful of labour.

Doubtless, at some point the Indian railways must have decided to modernise. I strongly suspect, however, that when they did there would have been some sub-continental equivalent of John Kaye decrying the "devastating" effect which such measures would have had upon employment within the Indian railways. What would become of the "long term quality jobs" which these measures were bound to eliminate?

The simple reason why we in Australia do not have to endure the standards of living – one uses the term loosely – which prevail in third world countries today, and which once prevailed before the advent of the Industrial Revolution, is that for the last 250 years we have been constantly finding newer and better ways to eke out the productivity of labour. That is to say, we have been finding ways to produce with ten men what once took 50, a hundred or even a thousand.

Not far up the road from where I live they are building an extension to the local nursing home. This construction requires a considerable degree of excavation before it can proceed. A century ago the task would have required anything up to several dozen men wielding shovels and pick-axes. Today three or four men driving earth moving machines are all that is needed. This is why real incomes today are five times higher than what they were in 1908.

The simple fact is that if the government's electricity businesses need only employ a fraction of the people who currently present themselves on the payroll then this is a state of affairs which represents a standing reproach to the quality of the government's business management. This inefficiency either serves to reduce those wonderful profits which these businesses are supposed to generate

Pardon the pun or represents a standing cost which must be borne by the electricity consumers of this State. If we allow labour to be used inefficiently then we suffer for it in the same way as did the inhabitants of India or our forebears a hundred years ago.

According to Mr Kaye:

The neo-liberal ideological virus [as I say never pass up an opportunity to substitute invective for rational argument] has spread to political leaders throughout the world. Without a shred of evidence [emphasis mine], it has become axiomatic that public provision is inferior to private, that cooperation is less effective than competition and that compassion is a sign of weakness while greed is strength.

Australian Socialist Volume 6 No. 4 2007-2008 page 3

By his use of such buzzwords as "compassion" Mr Kaye evidently seems to think that featherbedding is in some way the more humane approach. But there is in reality nothing compassionate about inefficiency. What if every business enterprise in the State tried to run itself in such a way that it employed many more people than were needed to do the job? By so doing they would generate deadweight costs which in turn could only be passed on, in a most regressive way, to the State's consumers.

If, as Mr Kaye seems to accept, our State's electricity businesses are overmanned, then ending this situation will be one of the major benefits which privatisation can be expected to achieve. There need not be any hardship to those who can be expected to lose their jobs. Much of the staff reductions can be achieved by simple attrition. Where forced redundancies prove unavoidable the government can readily insist, as part of the privatisation deal, that generous separation packages be offered. This need not impact much on the sale price of the business assets: ipso facto the packages would, after all, allow the new owners at the same time to reduce their labour costs.

This brings us to what in fact is the central issue in the privatisation debate: will the State's electricity businesses be run better by placing them into private hands or allowing them to remain in government ownership? Contrary to what Mr Kaye would have us believe there is a good deal more than just a shred of evidence to suggest that the former is the case. And in this behalf we need do no more than look at the somewhat lamentable history of government electricity provision in New South Wales.

Let us roll back the clocks and calendars more than three decades to the year 1976. That was the year the Australian Labor Party came to power in this State after a lengthy spell in opposition. It had promised a series of ambitious spending programmes and a novel way to find the money for them. It intended, as the then Premier, Neville Wran, so aptly put it, to raid "the hollow logs". These were funds which the various statutory authorities had set aside from business revenues to fund their future capital expenditure. One of those authorities was, of course, the State's Electricity Commission, which was then responsible for the provision of electrical power.

Of course the policy worked like a treat, all manner of government largesse was distributed, and votes effectively purchased. The political dividend of all this was realised when the government, which had only won power with the slenderest of margins, was returned with a thumping majority in the general election of 1978. This was the first of the so-called Wranslides.

But chickens have the regrettable habit of coming home to roost. Money which could have been expended constructing the next generation of the State's electricity assets was instead frittered away on programmes of little or no long term value. And in the winter of 1981 there came the reckoning.

I remember it well. I was in my last year at University. I had gotten out of bed that morning and was huddling before the radiator in the family room when all of a sudden the radio went silent and the radiator ceased to produce any of its comforting heat. My mother then opined that this must be one of the blackouts about which they had been speaking on the news only a short time previously.

Basically, the State's underinvestment in generating capacity had by that time become critical. The new Eraring power plant was by then still several years away from completion. Demand for electricity was falling little short of the State's ability to produce it. The government had been running every generator it could find at full bore and hoping that it would squeak through the winter.

The trouble is that one can only get away with this for so long. The state's generating equipment was simply not designed to run at full capacity for extended periods. Reliability degradation set in as the boiler tubes were subjected to unprecedented rates of wear and tear. In the end several generators at the Liddell plant simply packed it in and broke down requiring an extended period of inactivity and repair. Now the system could no longer meet demand and its operators were driven to shed the load, ie: subject the State to periodic blackouts.

And that was how we got through the winter of 1981. You never knew exactly when the lights would go out and the house would grow cold. You counted yourself lucky if you happened to be on the same circuit as a major public hospital – for obvious the reasons the power supply to these was never going to be interrupted. The problems persisted well into the following year – the government tried the somewhat desperate expedient of extending daylight saving well into the shortening days of autumn in the hope that this would reduce the consumption of electricity.

None of this speaks well for government ownership. In order to pursue short term electoral gain the Labor government had simply decided to squander funds which were vitally necessary for re-investment in the state's system of electricity generation and reticulation.

According to the ideologues of government ownership – you know, those people who say that only their opponents are ideologically driven – the great superiority of their preferred system is that "the people" retain control over the system. It is the voters who will decide how and in what way the system will be run.

Well, this crisis in the State's power supply illustrates precisely how effective that public control in practice proves to be. Not long after these events, in the spring of that year, the government faced the voters in another general election and… was returned with its massive parliamentary majority almost completely intact. So much for the electoral discipline which government owned businesses are supposed to face. As one can see, the leaden propensity of this State's voters to blithely re-elect abysmally incompetent Labor Party governments goes back an awful long way.

In practice government policy makers are a bit like generals – always geared up, equipped and fully prepared to fight the last war. Having discovered the hard way that underinvestment in generating capacity was not really a very good idea they then lurched, like a drunken windscreen wiper, to the very opposite end of the preparedness spectrum.

For the next decade or more they proceeded to massively over invest in electricity generation, with the result that the State built up a significant degree of surplus capacity. From the politicians' point of view this did not represent any great problem because it avoided any suggestion that they might be responsible for power outages. But it was nevertheless an expensive luxury whose cost was borne by the inhabitants of this State. As the Owen report observes:

The affect of government decision making can be seen in the effects of generation investment decisions prior to the creation of the… [National Electricity Market] in 1989-90. The Industry Commission estimated that the excess generation that New South Wales had built had an opportunity cost of $443 million, or $77 per person in New South Wales at that time. In today's dollars this would equate to each NSW citizen paying $130 in either additional taxes or electricity charges to fund this excess capacity.

Report of the Owen Inquiry into Electricity Supply in NSW Chapter 6 p13.

Not exactly a ringing endorsement of government owned electricity generation, one would have thought. Basically, the government has made a consistent botch of it for the better part of the last three decades.

And now the windscreen wiper is now beginning to swing dangerously the other way. The events of the early 1980's are now largely forgotten – indeed, it is doubtful that anyone born much after 1970 will possess any recollection of them. And, as the philosopher George Santayana once so astutely observed, those who will not remember the past are condemned to repeat it. The surplus capacity of the 1980's and 1990's is starting to dwindle at an alarming rate. Depending upon how does the necessary forecasts, additional baseload capacity could be required as early as 2012, although possibly as late as 2015 or even 2016.

( Report of the Owen Inquiry into Electricity Supply in NSW Chapter 2 p20.)

However lead times for the construction of new plant are typically about this sort of time frame. As the Owen report observes:

Based on recent power station developments in Australia, it can typically take up to six years from the initiation of site selection and feasibility studies to reach financial close for a new power station. Securing a suitable site, and undertaking necessary feasibility studies can take up to two years whilst the preparation of an Environmental Assessment and securing Development Approval under the [sic] Part 3A of the Environmental Planning and Assessment 1979 can take up to a further two years. Detailed design, letting of construction contracts and achieving financial close can take one to two years.

Report of the Owen Inquiry into Electricity Supply in NSW Chapter 3 p30.

Why, though, is this seen as a solution to the problem? Well, as the sorry history of electricity supply in this State amply suggests government management of the resource has not exactly been something to crow about. To those who might ask: "would private enterprise do it any better?" I would respond: "could they possibly do it any worse"?

However, there are other arguments as well. The additional generating capacity which this State needs will not come cheaply. The Owen Report estimates that an investment of something on the order of $7 to $8 billion will be required.

( Report of the Owen Inquiry into Electricity Supply in NSW Chapter 6 p18, see also Appendix 6. )

The State's existing power plants are looking tired and rusty. Moreover, they too may need a serious makeover if they are to be fitted with emerging carbon reduction technologies. In addition:

… the Inquiry also factored in the cost of investment in the [government's] retail businesses that would be necessary for them to become successful businesses in the… [National Electricity Market] where they remain government owned. Essentially, Government participation in the competitive segments of the electricity industry – retail and generation requires them to adopt business strategies similar to their private sector competitors.

Report of the Owen Inquiry into Electricity Supply in NSW Chapter 6 p18.

Report of the Owen Inquiry into Electricity Supply in NSW Chapter 6 p18.

There is only one place where the government can soak up this sort of money and that this is the nation's capital markets. One can only speculate about what this additional borrowing pressure will do to interest rates. If power generation were in private hands, of course, much of this finance could be raised on the stock market. However, equity investment in government owned businesses is a contradiction in terms. The government has no alternative but to borrow the money.

Of course this creates its own particular set of issues. Those who lend money have the unfortunate habit of expecting that they will be repaid with interest. Not so with shares: you pays your money and you takes your chances, as they say. Contrary to what many may think investing in electricity generation is not exactly a lay down misere when it comes to making money. In reality it can be very much a gamble. As the inquiry observes:

Credit rating agencies consider electricity generation as 'the riskiest of the electricity utility industry because of the complex operating risks and the increasingly competitive nature of the business.'

Report of the Owen Inquiry into Electricity Supply in NSW Chapter 6 p 25, see also Standard and Poor's International Utility Ratings and Ratios, October 2002, p. 60.

( Report of the Owen Inquiry into Electricity Supply in NSW Chapter 2 p 21. )

But we have to take a guess in the next year or two if the necessary equipment is to be built in time. Want to take a punt as to exactly where it will fall? Get it right and you will make a million. Get it wrong and you will lose your shirt. I don't know what you think but I don't want the government taking that sort of flutter with borrowed money – especially when I am one of the several million taxpayers whom it will almost certainly sock to find the necessary funds.

The other problem, which the Owen report correctly notes, is that borrowings on the order of 12 to 15 billion dollars do not exactly perform wonders for the State's balance sheet. The more deeply indebted the government becomes the more risky it is seen as an investment. At the moment the State's credit rating is AAA. However, plunging the State into this sort of additional debt is not likely to see that rating preserved.

According to Mr Kaye this is nothing of any real concern. In his opinion:

Secondly, there is no reputable economic theory that opposes borrowing to build economic infrastructure. [No one suggests that there is] If there were, the home loan market would not exist. The Iemma government has allowed itself to be bullied into an obsession with protecting its AAA credit rating despite ample evidence that it has little or no relevance to the health of the state's economy.

Australian Socialist Volume 6 No. 4 2007-2008 page 3.

The other point is that, despite what Mr Kaye asserts, the rating does impact upon the overall level of the State's economic health. As the Inquiry observes:

"However, the importance of maintaining a AAA credit rating goes beyond the financial implications from securing the lowest borrowing costs. Confidence in the financial health of New South Wales would deteriorate as a result of a credit rating downgrade. This would negatively impact on business confidence, reducing the attractiveness of the State as a destination for investment, with resultant effects on the economy. This indirect cost far outweighs the initial budgetary cost, as the Victorian experience of the early 1990's demonstrated."

Report of the Owen Inquiry into Electricity Supply in NSW Appendix 6 p 11.

Confronted by these sorts of grim reality the government's choices are limited. It can either surrender that AAA rating and face the consequences or decide to borrow less for some of the government's other functions – you know, those sorts of useless and expensive things like schools, hospitals, roads, the railway system, the police etc. As the premier, Morris Iemma, recently declared:

"It is not my preference, or the preference of this Government to use public funds to build new power stations with such funding better used elsewhere such as hospitals and schools."

News release issued by the Premier of New South Wales, the Honourable Morris Iemma, 9 May 2007.

One possible solution is to let private enterprise construct the additional capacity while the existing parts of the system remain in government ownership. However, one might well ask what virtue or advantage there would be in such a hybrid. And as was argued earlier, the government must not only build additional capacity but also refurbish the capacity which already exists. The government does not escape responsibility merely by adopting the simple expedient of dumping responsibility for the former on to the private sector.

There is also the additional problem that while significant parts of state's generating capacity remain in government hands private enterprise will be reluctant to invest in the rest. It must be remembered that any such private investors will be effectively acting in competition with one another. If in New South Wales I own generator A and the government owns generator B we are both trying to sell electricity to the same market. The problem from the private enterprise point of view is that governments operate to political and not market imperatives. Most businesses do not like the idea of finding themselves up against a competitor who will not shrink from any self-destructive folly so long as it will keep them in office. It is all too likely that they will suffer collateral damage as well. Moreover, governments can subsidise their business operations from general revenue. Private businesses enjoy no such advantage.

The proof of this particular pudding lies in the eating. Despite the fact that ever since the commencement of the National Electricity Market it has been perfectly possible for private enterprise to invest in this State's generating capacity the overwhelming majority of that capacity, ie: more than 95%, remains in government hands.

( Report of the Owen Inquiry into Electricity Supply in NSW chapter 6 p 5. )

All of this strongly suggests that the best course is for the government to offload its generating and marketing assets. It should be noted, however, that the transmission assets will remain in government ownership indefinitely on the grounds that they represent a natural monopoly.

Those who oppose privatisation simply have not made their case.