Why does privatisation sometimes go wrong?

The imposition of flawed privatisation models imposes economic losses far beyond the sectors concerned. Although the problems experienced in privatised industries have largely been the result of political interference and state regulation, their failure may be misused by ideological interventionists to undermine trust in markets more generally.

Both the public and opinion-formers have weak incentives to properly investigate why particular sectors have not performed well and this ignorance can be exploited. If the political culture turns against relatively free markets, the wider efficiency losses are likely to be substantial, as more and more economic activity becomes subject to high taxes and restrictive controls.

Privatisation is a political process and as such will be vulnerable to the problems afflicting political processes in general. Almost inevitably it will be influenced or even ‘captured’ by special interests. As a result, there is a risk that the outcome is not a dynamic free market, or even a lightly regulated sector. At worst, government will regulate the market to enable special interests to extract ‘rents’ from taxpayers and consumers. Such a model would protect favoured interest groups from new market entrants, competition and disruptive entrepreneurship, while participants’ profits might well rely on state subsidies.

As public choice theory would have predicted, many of the privatisations of the 1980s and 1990s did not produce anything approximating to free markets in the sectors concerned. In some industries at least, the period might more accurately be characterised as a shift from ‘state-capitalism’ Model A to ‘state-capitalism’ Model B. This raises the question whether Model B, consisting of heavily regulated markets under nominal private ownership, delivered economic benefits compared with the direct state ownership of Model A.

The answer is likely to depend both on the characteristics of a particular industry and the regulatory structure adopted post-privatisation. In an unhampered market economy, sectors characterised by major economies of scale and vast, inflexible, long-term capital investments – such as the rail industry – are likely to be dominated by large firms exhibiting high degrees of vertical integration. The ‘command economies’ within such firms will exhibit significant knowledge and incentive problems no matter what the ownership model. Thus, ceteris paribus, the benefits of privatisation are likely to be lower in such industries than in naturally more fragmented, dynamic and competitive sectors.

Nonetheless, there are particular problems associated with state ownership that are likely to apply across all sectors. These are explained in detail elsewhere, but include politicisation, producer capture, and poor incentives for entrepreneurship, innovation and cost-control. Where state regulation ensures monopolies, such pathologies may be exacerbated by an absence of competition. The poor results became apparent in the nationalised industries of 1970s Britain. Endemic misallocation of resources led to heavy taxpayer subsidies and poor quality services for customers.

However, some of the privatised sectors exhibit broadly similar problems today. The following (non-exhaustive) analysis therefore draws on theory and recent evidence to summarise some possible reasons why artificial post-privatisation markets could fail to produce efficiency gains compared with the directly state-controlled model that preceded them:

  • Politicisation – The propensity of politicians to interfere in a sector could hypothetically increase post-privatisation, resulting in increased regulation/taxation and concomitant efficiency losses. This outcome may be particularly likely in sectors with high political salience. Any change in the status quo creates risks for policymakers, providing incentives for them to intervene. The costs of such intervention are likely to be opaque and widely dispersed, leading to limited accountability.
  • Overregulation – Politicians may face fewer disincentives to impose costly regulations on a nominally privatised sector than under state ownership. In the former case, the negative effects can be blamed on private firms, whereas in the latter they are likely to be blamed directly on the government, creating higher political costs. Voters and ‘opinion formers’ have weak incentives to become well informed about such issues. Senior officials may benefit from the salary and status opportunities provided by expanded regulatory oversight, while key corporate players in the sector may welcome additional regulation if it serves their interests (for example, by raising barriers to market entry and protecting them from competition).
  • Flotation receipts – Short-term incentives to maximise flotation receipts may encourage the creation of heavily regulated ‘rigged markets’ that reduce the risks facing investors. Large, risk-averse institutional investors, such as pension funds, may prefer a model that effectively guarantees returns rather than entrepreneurial and disruptive freed markets that threaten incumbent players.
  • Transaction costs – Artificial post-privatisation markets may depart significantly from the organisational forms likely to evolve in an unhampered market economy. It is conceivable that in some instances such artificial structures increase transaction costs compared with direct state ownership, thereby reducing allocative efficiency.
  • Restructuring costs – Structural changes may weaken ‘social capital’ within a sector by disrupting working relationships, as well as losing specialist, often asset-specific knowledge and skills through the departure of long-term staff. Organisational cultures may also be weakened or destroyed. The role of such factors in efficient operations may be somewhat opaque to both policymakers and senior management.
  • Moral hazard – If sectors comprise ‘essential’ infrastructure then firms can be sure that governments will step in if they fail. Indeed, rules are typically in place that set out how this would be done. Limited liability laws and the use of special purpose vehicles also limit downside financial risks. These factors may encourage excessive risk-taking and a concomitant misallocation of resources.
  • Rent-seeking – A combination of heavy regulation and private ownership could potentially increase incentives for special interests to engage in rent-seeking activity. Profit-making businesses might have stronger incentives to lobby for regulations and subsidies that increase their profits than the less commercially minded managements of state industries. There is even a danger that ‘crony capitalism’ could emerge, as observed with privatisations in post-Soviet economies.

 

This is an edited extract from Without Delay: Getting Britain’s Railways Moving.

The future of the railways

This debate marked the launch of my new paper on rail privatisation, Without Delay: Getting Britain’s Railways Moving. The study is heavily critical of the 1990s privatisation model, in which politicians and officials imposed a complex and fragmented structure on the industry, ignoring the lessons of both transaction cost economics and railway history.

 

Is privatisation to blame for high rail fares?

IEA Blog, December 2014

Rail fares per passenger-kilometre are on average around 30 per cent higher in Britain than in comparable Western European countries. In addition, annual regulated fare increases exceeded the Retail Prices Index, an official measure of inflation, by 1 percentage point per year from 2004 to 2013. This is widely held to be a consequence of privatisation: the necessity for private rail firms to make a profit and pay dividends to shareholders meaning that fares must be substantially higher than otherwise would be the case. It is therefore argued that the rail industry should be reformed to help tackle the cost-of-living crisis and secure a ‘better deal’ for passengers.

In May 2014 more than 30 Labour parliamentary candidates called for train operations to be taken over by the government as current franchise agreements ended – a form of gradual renationalisation. Official Labour Party policy does not go quite so far, but would allow publicly owned train operators to compete with private firms. This approach could lead to creeping renationalisation given political influence over the franchising process. There are also calls to introduce a freeze on rail fares or at very least a ‘tougher cap’ on increases.

Proposals to address the cost-of-living crisis by increasing state involvement in rail are based on a series of misconceptions. Indeed, the heavy focus on fares suggests fundamental ignorance of the economic importance of rail to the UK economy. While the average household spends approximately £64 per week on transport, only about £3.30 is spent on train and tube fares. The impact of any fare reductions on the cost of living would thus be trivial. By contrast, policies that reduced motoring costs (c. £56 per week per household), such as cuts to fuel duty and car tax, would offer substantial relief to household budgets.

Another problem for the re-nationalisers is the relatively modest profit margins of the train operating companies, estimated at around 3 per cent of turnover. This implies that the ‘savings’ from no longer paying out dividends to shareholders would simply not be large enough to fund a significant reduction in fares. This conclusion also holds when other privately owned elements of the rail industry are considered.

Additional state intervention in the rail market would also be poorly targeted if poverty alleviation were the aim. On average rail travellers are far better off than the general population. Almost 60 per cent of spending on rail fares is undertaken by the richest 20 per cent of households, who also spend a higher proportion of their incomes on rail fares than poorer groups.

The skewed distribution of rail ridership towards high-income groups severely limits the potential for enhanced price controls to reduce the living costs of those on modest incomes. Indeed, for the population as a whole, more stringent fare regulation is fundamentally flawed as a cost-reducing measure, since what is saved in fares must be paid in additional taxes. Worse still, price controls reduce the efficiency of the rail network by artificially stimulating demand and increasing industry costs. Lack of price flexibility also makes it much harder to make better use of existing capacity. The resulting overcrowding creates political pressure for state spending on uneconomic new rail infrastructure, at additional expense to taxpayers.

Even if they were successful then, the proposals for additional state intervention to moderate rail fares would be ineffective at addressing cost-of-living issues, and in the case of further price controls entirely counterproductive. However, the proposed interventions would almost certainly fail to achieve even their stated objectives because they reflect a flawed analysis of the problems facing the sector.

There are several reasons for the high costs of the rail industry, but ‘privatisation’ per se is not one of them. Firstly, the effects of the history and geography of Britain’s railways should not be neglected. For example, the high share of rail travel involving trips to and from London – a vast and expensive global city – raises costs compared to other countries, even if other factors are held constant.

Secondly, it is misleading to refer to the reforms of the 1990s as ‘privatisation’ without understanding the extent to which the state continued to regulate, fund and direct the industry. Nominal ownership was indeed transferred to the private sector, but key decisions remained with the government. Opportunities for entrepreneurship, innovation and cost-cutting were heavily restricted by regulation. Unsurprisingly, major productivity gains were not forthcoming.

To make matters worse, policymakers imposed a complex, artificial structure on the industry. Contrary to evolved practices, the sector was fragmented, with separate firms managing the infrastructure, owning the rolling stock and operating the trains. These arrangements required armies of highly paid lawyers, consultants and bureaucrats, and also created numerous other inefficiencies.

Under a genuine privatisation model, there would have been strong incentives to reduce these additional costs, for example by moving back to a structure of vertical integration. However, traditional railway industry structures and full private ownership are effectively banned under European Union law. The proposals for part-renationalisation will not address the fundamental flaws in the structure of the rail industry that push up costs. EU ‘open access’ rules limit the options for more radical reform.

Renationalisation policies also risk further undermining the limited opportunities for entrepreneurship and innovation on the railways. The shortcomings of state-owned enterprises are well documented, and include poor cost control, lack of entrepreneurship, susceptibility to political interference and endemic misallocation of resources. In the longer term, these inefficiencies would tend to lower productivity on the railways, resulting in some combination of higher fares, higher subsidies or reduced quality of service. A range of new problems would be added to an already suboptimal industry structure.

Finally, the high cost of Britain’s railways to a large extent reflects wasteful investment in uneconomic new infrastructure. Since the mid-1990s it has been government policy to encourage modal shift from private road transport to public transport. This contrasts with the previous post-war emphasis on the managed decline of rail.

In this context, subsidies and other interventions have artificially inflated passenger numbers, creating a rationale for new capacity. Moreover, government funding helped create a powerful rail lobby with a strong financial interest in extracting additional resources from taxpayers.

Several large rail projects have been undertaken during the ‘privatisation’ era, including High Speed 1 (HS1), the West Coast Main Line upgrade, Thameslink and Crossrail. The cost of these five schemes alone is approximately £50 billion in 2014 prices. While taxpayers have paid the lion’s share of the bill, there has also been a significant impact on fares in some areas. For example, passengers in Kent have seen steep increases following the commencement of HS1 commuter services.

More generally, wasteful spending has contributed to concerns about the taxpayer funding such a high proportion of industry spending, strengthening the case for regulated fares to be raised above the official rate of inflation. Importantly, rail infrastructure projects have typically been heavily loss-making in commercial terms and poor value compared with road schemes. They would not have been undertaken by a genuinely private rail industry that was not reliant on state subsidy. Wasteful investment, and its impact on fares, is the direct result of government policy and should not be blamed on privatisation.

Clearly there are strong grounds for criticising the privatisation model imposed on the rail industry. The productivity gains associated with private enterprise were largely suffocated by heavy-handed regulation; a complex and fragmented structure pushed up costs; and huge sums have been wasted on uneconomic projects. In this context, it is unsurprising that fares have not fallen. However, it is also the case that these problems are symptoms of government intervention rather than the result of privatisation per se. Indeed they would not have occurred had the railways been privatised on a fully commercial basis under a ‘light-touch’ regulatory framework which allowed the organisation of the industry to evolve according to market conditions.

 

A longer version of this article was published in Smoking out red herrings: The cost of living debate.

Why are rail subsidies so high? The lessons from transaction cost economics

Richard Wellings on The Influence of Coase on Economic Policy – The Next 50 Years from Institute of Economic Affairs on Vimeo.

West Coast Main Line row: should railways be renationalised?

In many ways the railways have been successful over the last fifteen years, with significant growth in passenger numbers and freight. Several routes have been upgraded, ageing trains have been replaced and safety has continued to improve.

Taxpayer subsidies have, however, reached unacceptable levels, at around £5 billion a year. And costs are much higher than on comparable networks abroad.

In reality, the railways were not privatised properly. Politicians and officials retained tight control. As the current West Coast debacle shows, the government decides who runs the trains. It also decides levels of service, controls prices and determines the priorities for investment.

This is not genuine privatisation. Rail firms are essentially subcontractors for the state. And the high costs of the railways flow directly from these high levels of government involvement.

In particular, the government has imposed a complex artificial structure on the industry. The railways are suffocated by unnecessary bureaucracy. Highly paid lawyers, accountants, consultants and civil servants have benefited at the expense of taxpayers and passengers.

A further shift toward nationalisation would only make this worse. Nationalised industries are hugely inefficient and quickly become a drain on the economy, as we know from bitter experience in the 1960s and 1970s. Politicians would exert even more control over the railways, squandering money to buy off special interests and wasting yet more billions on uneconomic vanity projects.

In the 19th century private firms built and operated a vast network without massive handouts from taxpayers. A similarly innovative and entrepreneurial private rail industry is the best way to improve outcomes and reduce costs. In particular, the same firms should be free to own the tracks and run the trains, as happened in the past. This is the best way of removing the political interference that is holding the industry back.

4 October 2012, BBC

The government is off track with its uneconomic transport policy

Is electrifying branch lines in Wales a top priority for transport investment? It seems unlikely. But then again the government’s plans to invest £9.4bn in rail infrastructure show scant regard for economics. Cynical political calculation seems to be the driving force.

Regional interests have long complained that London receives a disproportionate share of transport spending. Now the provinces will get their pet projects: the north of England gains more services through the much-hyped Northern Hub; the East Midlands benefit from the electrification of the Midland Main Line; and so on.

But most of these schemes are difficult to justify from an economic perspective. In commercial terms they are loss-making and require substantial taxpayer support. Indeed, it seems likely that, as the number of train services increases, additional operating subsidies will be required. Taxpayers already pay around £5bn per year towards the railways.
The government has claimed that much of the cost will be recouped from higher passenger numbers and efficiency gains. This is doubtful. There are numerous examples of rail planners forecasting passenger growth that failed to materialise. And while efficiency gains are possible, they will be difficult to deliver given the complex artificial structure imposed on the industry.

Then there is the argument that rail improvements deliver wider regeneration benefits, boosting growth. This is also questionable. There is little evidence of economic resurgence in many of the provincial towns already enjoying fast rail links, such as Doncaster, Darlington or Wigan.

Worse still, new rail projects often become magnets for expensive taxpayer-funded regeneration schemes, promoted by local political elites. The government has spent billions along the route of High Speed 1, for example. Such regeneration efforts are counterproductive. If favoured areas improve, others tend to decline, due to the redistribution of taxpayers’ money.

The railways are a classic example of a politically distorted market. There is huge variation in the level of subsidy to different parts of the network. London commuter routes generally receive little funding from government, in marked contrast to rural provincial routes that are almost entirely dependent on handouts. This system means passengers on more profitable lines (including in and around London) may end up cross-subsidising those on loss-making ones. At the same time, those choosing to drive instead of travelling by train face very high rates of taxation through the imposition of both VAT and fuel duty – a clear instance of unfair competition.

Many of these distortions are deliberate. New Labour pursued policies to force people out of their cars and on to the trains. A combination of strict planning policies and regeneration subsidies was used to push economic activity into congested city centres and around public transport hubs. At the same time, measures were introduced that artificially raised the costs of commuting by car and road investment was slashed. As peak-time trains became more and more crowded, the pressure increased for investment in new capacity, even though demand had been artificially inflated by various government interventions.

In this context, the government should be extremely cautious about investing in rail. Rather than risking billions of pounds of taxpayers’ money, it should focus on creating a level playing field in transport so that investment can be based on genuine patterns of demand.

Phasing out taxpayer subsidies to uneconomic lines should be a key priority. Another important step would be to introduce more flexibility for train operators to tackle overcrowding without the need for expensive new track infrastructure, for example by providing more frequent services and extra rolling stock. Further action is also needed on planning controls. Businesses should be free to operate in uncongested, out-of-town locations, even if this means fewer people using public transport.

A radically different policy on investment is needed. Ideally it should be left to the private sector, which would only undertake rail schemes that were commercially viable. However, in the absence of a larger role for private investors, the government should take a far more rigorous economic approach to new infrastructure.

17 July 2012, City AM

We should not renationalise the railways

Privatisation is often blamed for the shortcomings of Britain’s railways. This is unfair. Genuine privatisation never happened. Nominal ownership may have been transferred to the private sector, but the government remains firmly in control.

Renationalisation would only exacerbate this problem. Politicians and bureaucrats would still make the key decisions on rail – such as today’s announcement that £9.4 billion is to be invested in various loss-making projects. But there would be even less attention given to commercial considerations and even fewer opportunities for entrepreneurship and innovation in the industry.

A far better option would be to move towards proper privatisation. Taxpayer subsidies could be phased out; loss-making lines could be closed; and investment could be restricted to those projects that were profitable. And perhaps most importantly, full privatisation would allow the merger of track and train, ending the disastrous fragmentation of the railways.

Fragmentation is not a market outcome – politicians and officials imposed an artificial structure on the industry. Historically, railways have nearly always been vertically integrated. But the government, influenced by EU policies on open access, has largely ignored this lesson. Different firms now manage the infrastructure, run the trains and own the rolling stock. There is also a complex system of regulatory oversight. This complexity has contributed to an explosion of costs. Following privatisation, subsidies from taxpayers have tripled to about £5 billion a year.

A complex structure is not the only problem facing the sector. The government also makes it extremely difficult for private companies to deliver efficiency gains. It actually became harder to close loss-making lines after privatisation, while service levels are largely determined politically, through the franchising system, rather than on commercial grounds.

The government also maintains price controls, including on key London commuter routes. Private firms are therefore severely limited in their ability to tackle congestion through more flexible fare levels. But they still get blamed for the resulting overcrowding. Worse still, the congestion creates pressure for investment in new capacity – placing a still greater burden on taxpayers.

While private involvement has brought some improvements, for example to marketing, the scope for entrepreneurship remains extremely limited. Indeed, when firms have tried to develop new privately-funded rail infrastructure, they have faced obstacle after obstacle from transport bureaucracies unwilling to cede control.

Rail investment is currently determined in a process not too dissimilar to Soviet central planning, and directed largely to meet political objectives rather than economic ones. As we see today, huge sums are spent on loss-making projects that make no commercial sense, with costs loaded on to taxpayers.

Perhaps the fundamental problem is the strength of the rail lobby, bolstered in some areas by the disproportionate political influence of wealthy rail commuters. Concentrated special interests have been able to extract huge amounts from taxpayers by capturing policy. Renationalisation is unlikely to break the cosy relationship between the rail lobby and policymakers; it will simply lead to more of the same.

16 July 2012, Huffington Post UK