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.

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.

Why are rail subsidies so high?

Taxpayer subsidies to the rail sector have reached astronomical levels. At £6 billion per year (including Crossrail), they have roughly trebled in real terms over the last twenty years. But the high rate of subsidy has not led to a reduction in fares, which recently have risen above the official rate of inflation. There are two main reasons for the large increase in taxpayer support. The first, and probably most important, is wasteful investment in loss-making new infrastructure. This is the direct result of policies that have aimed to increase public transport ridership and reduce car use.

For much of the post-war period, rail was viewed as a declining industry. Despite previous government efforts to suppress private road transport, the step change in efficiency resulting from the door-to-door transit of passengers and freight led to rapid growth in car and lorry traffic. A policy of ‘managed decline’ was therefore applied to the railways. British Rail received subsidies to keep the system going and there was some modernisation of key inter-city routes, but there was little enthusiasm to attempt to reverse the long-term trend.

This changed with the ascendancy of environmentalism within government. With their perspective grounded in radical egalitarianism, environmentalists not only objected to the pollution produced by private road transport; they also resented its social aspects – for example, the way that cars had become symbols of wealth and individual expression. The environmentalist agenda gradually captured university departments, various government bureaucracies, elements of the media and eventually national policy. In the mid-late 1990s, the road construction programme was cut back dramatically and a new strategy introduced. Private road transport would be deliberately discouraged with travellers encouraged to use buses, trams and trains instead.

For the railways this represented a sea change. The new policy meant that rail now had prospects for growth. It did not, however, change the fundamental economics. Since rail involves at least a three-stage journey, compared to the door-to-door convenience of private road transport, it remained unattractive for the vast majority of journeys.

Following privatisation, however, the policy of encouraging more rail travel appeared to be successful. Usage rose by around 50 per cent between 1997 and 2012, to levels not seen in peacetime since the 1920s. This reflected not just the impact of various deliberate policies, but also other trends such as a booming central London economy for much of the period and demographic changes that led to a huge expansion of the ‘inner city’, pushing middle-class families out into the commuter belt to avoid poor schools, anti-social behaviour and fear of crime.

A combination of increased ridership and price controls produced severe peak-time overcrowding on several routes into London. Train operating companies have been constrained in their ability to smooth the peaks using the price mechanism, since season ticket fares on most London commuter journeys are regulated by the government. With a severely limited ability to deploy the price mechanism and other means to make more efficient use of existing rail capacity, the industry has increasingly focused on supplying new infrastructure to accommodate growth. This has proved hugely expensive, however. The final cost of the ongoing Thameslink 2000 upgrade, for example, is likely to be £6 billion. And the Crossrail scheme will cost £16 billion.

Since in commercial terms such projects are loss-making and would never be undertaken in their current form by the private sector, taxpayers have been forced to fund them. Accordingly, wasteful investment in new rail infrastructure is probably the largest single factor in the growth in taxpayer support in the post-privatisation era. Such investment has not been restricted to overcrowded routes in the South-East. The government also funds improvements for blatantly political reasons, in regions where there is little passenger demand. For example, it was recently announced that branch lines in South Wales would be electrified – at taxpayers’ expense, of course. The environmentalist agenda means that rail schemes get priority even though the government’s own cost-benefit analyses show that economic returns from road improvements are far higher.

The second major reason for the increased burden on taxpayers is the artificial structure imposed by the government on the post-privatisation rail industry. Historically, railways that developed in the private sector exhibited a high degree of vertical integration. This meant in practice that the same company owned the tracks and operated the trains, thereby avoiding the transaction costs associated with complex contractual arrangements between highly interdependent separate organisations.

Partly as a result of EU policy, Britain’s privatisation model has been very different, with one firm owning and maintaining the tracks, other firms operating the trains, and another set of firms leasing out the rolling stock. On top of all this complexity, the industry has been tightly regulated by various government agencies. The resulting fragmentation, combined with layers of bureaucracy, needlessly increased costs on the network. In addition, the high levels of regulation severely hindered entrepreneurship. As a result, the productivity-boosting innovations that have cut costs in other industries did not materialise on the railways. Indeed regulation is now so restrictive that private rail firms have effectively become subcontractors for the Department for Transport.

Structural reform would therefore be one of the best ways to reduce the burden on taxpayers. The government should stop prescribing the level of vertical integration and instead free the rail industry to become more efficient. This policy should be combined with a more rational approach to rail investment. A first step is to abolish price controls to remove artificial distortions to fare levels and consumer demand. The provision of new capacity should then be left to the private sector, without taxpayer support. It would make commercial sense to build new infrastructure in high demand locations where it could be funded by fare revenues or land development. Uneconomic projects driven by political motives and special-interest lobbying would no longer get built.

The economic case for phasing out subsidies is very strong. The taxes imposed on individuals and businesses to support the railways destroy jobs and hinder wealth creation in the wider economy. In addition, large parts of the rail industry could thrive without the bureaucratic micro-management that comes with government support. It may seem counter-intuitive, but removing rail subsidies could also end up benefiting passengers, by unleashing entrepreneurship and innovation on the railways that would drive down costs.

22 January 2013, LSE

Regulation, not privatisation, to blame for inefficient railways

The recent history of Britain’s railways has undoubtedly brought the whole concept of privatisation into disrepute. But this is unfair. Rail privatisation was a pastiche of genuine privatisation – in many ways it actually increased the level of state control.

Last week’s McNulty Review estimated that costs are about 40% higher on Britain’s railways than comparable European networks. Taxpayer subsidies, adjusted for inflation, have probably more than tripled since the British Rail era – reaching around £7 billion per annum. As McNulty explained, higher costs are to a large extent the result of the fragmentation of the industry. A vertically integrated industry was split up, with different firms managing the infrastructure, running the trains and leasing the rolling stock. As a result, transaction costs mushroomed.

It is a myth, however, that fragmentation was the result of privatisation per se. The government imposed an artificial structure on the industry from above. Indeed, when train operators subsequently approached the government with a view to taking ownership of the track, they were rebuffed. Moreover, the regulations imposed on the ‘private’ rail industry made it virtually impossible to close loss-making lines, while franchise agreements with train operators effectively forced them to continue running uneconomic services.

By contrast, the structure of a rail industry under genuine private control would be determined by market forces. Historical experience suggests that vertical integration would predominate. This may be explained both by the desire to minimise transaction costs and the relatively high degree of asset specificity on the railways (for example, rolling stock is often designed for use on particular routes). Moreover, genuine private owners would be free to close uneconomic lines and cancel loss-making services. Freed from government price controls, they could set fares to address overcrowding. Expensive new capacity would be funded by fares and land development rather than taxpayers (many of whom never use the railways).

A truly private railway would be efficient, innovative, responsive to consumer preferences and would not require taxpayer support. It is time the critics (such as Will Hutton) stopped blaming privatisation for problems caused by government intervention.

24 May 2011, IEA Blog