I was asked yesterday by a friend who is an accountant what I thought about the problems in water companies. This was my reply:
What most accountants, let alone non-accountants, do not really understand about the accounts of any private sector entity that they look at is that there is, implicit within them, what is called a ‘capital maintenance concept'. An accounting system is used to determine whether, over the course of the period, the relative worth of an enterprise has increased as a result of the transactions that it has undertaken, or reduced, ignoring for these purposes additional contributions received from its shareholders, and returns paid to them.
Before 2005 we used historic cost accounting in the UK. What this accounting framework emphasised was the ability of the enterprise to maintain its physical capacity intact. In other words, whether or not the entity was to be considered a going concern was determined on the basis of whether it could command the physical resources that it required to deliver the goods and services that it sought to sell to willing customers. The care emphasis was, as a consequence, upon the delivery of service and the profit and loss account was considered the primary accounting statement.
Since 2005 we have had International Financial Reporting Standards in use in the UK, and right across Europe as well as in about 80 other countries. The capital maintenance concept within this type of accounting differs from that within historic cost accounting. IFRS seeks to preserve the financial capital of the entity. As a consequence the focus is on the worth of those financial resources and the balance sheet is predominant, but not with regard to what is actually owned, or to which purpose it is put, but rather with regard to its financial worth to third parties. This is ‘mark to market' accounting. There is actually some considerable indifference within IFRS accounting as to what the organisation actually does: in principle one pound earned from bank interest is exactly the same as one pound earned from the supply of essential drugs to the NHS or, come to that, one pound earned from the illicit supply of drugs to those using them in night clubs.
The IFRS approach is supposed to maximise shareholder value, where the shareholder is only concerned about the receipt of a financial return on the share that they own. What is not explicitly stated within this framework, and which has only relatively recently been appreciated by academic accountants, is that implicit in this is the fact that what is being said is that the shareholders do not, as such, care in the slightest bit about the organisation in that case because they do not in fact own it: all that they actually own is the share that it issues, which gives them a right to a return if the company decides to pay it to them. However, because it has become commonplace in the last fifteen or so years for directors of companies to be heavily rewarded by bonuses that are usually linked to the value of company shares there is a considerable incentive upon the directors to increase the value of those shares because they personally gain as a consequence even though the company might not. There is implicit in this process a significant degree of moral hazard. Because shareholders only receive the upside of transactions with the company, with the cost of its failure being very largely imposed upon society at large, the inclination for companies to both overstate their earnings and over distribute their profits is very high. The result is that there is significant financial engineering rather than real product engineering to deliver financial rewards rather than returns that benefit society as a whole. With colleagues with whom I have worked on this issue we have described this as the process of hollowing out firms.
All this preamble is very relevant in the context of water companies. When these companies were privatised there was an implicit contract made with them that they would continue to supply essential water and sewage services to all consumers within the geographic area that they served. Again, implicit within this contract is the assumption that they will maintain the necessary infrastructure to do so. Unless they do so they cannot be a going concern. However, what is readily apparent is that the financial worth of that infrastructure is actually very low: no one can really use it for anything but the supply of water services, and given that only one company can have a contract for the supply of water in one area the likely financial value of any particular asset on the balance sheet of a water company is quite low even if that same asset is absolutely fundamental to the supply of water or sewage services in an area. The focus of emphasis within IFRS accounts is, then, wholly inappropriate in the case of water companies, but they are used nonetheless. Historic cost accounting, with its focus upon the supply of services would obviously be considerably more appropriate in this case because what it would highlight is the fact that, as is now very obviously apparent, these companies are not maintaining the physical capital that is required to supply their services into the future. It is very likely that they are financial engineering instead.
Three questions follow. The first is whether these companies can in that case be truly considered to be going concerns when it is apparent that at some point their systematic failings will cumulatively indicate a systemic failure to supply water and sewage services within this country.
Second, in that case, and given that one of the reasons why these companies have failed to maintain water and surge systems is because they have mist likely over distributed profit to their shareholders, in my opinion, would be whether those shareholders should be due any compensation if the companies in question were to be taken back into national ownership? My answer would be that they are not. I think a review into this issue now would be of public benefit.
Third, who should then pick up the cost of those essential water and sewage services on which we all rely?
My suggestion is that in the long term there may be an inevitable cost to consumers from increasing the quality of the supply made to them by water companies. However, to be offset against this are savings from the payment of dividends and the removal of the entire corporate infrastructure which currently surrounds this industry. In addition, if, as is very likely, that replacement infrastructure is considerably more efficient than the Victorian system that it will replace, including with regard to leakages, processing of sewage, and the reduction in waste, then there may be considerable savings to in fact pass on to the consumer, which no shareholder would then partake in.
How to realise money for investment for this purpose? That appears obvious to me. As I suggested on my blog recently, there is what is called a savings glut in both the UK and the world at large at present. It is estimated by the Resolution Foundation that the net worth of UK savers went up by approximately£ 900 billion during the course of the Covid crisis, for example. I'm not pretending that all this money is available for reinvestment because some is implicit in the values of houses and shares, both of which might tumble if there was significant disinvestment from them. But, there are also considerably increased cash balances saved in UK banks and building societies at present, running to hundreds of billions of pounds, most of which are earning incredibly low rates of interest. If only the government was willing to reorganise the tax reliefs that it provides on both ISA and pension accounts so that those reliefs were only provided in exchange for the use of the contributions made in socially desirable projects, leaving the market to fend for itself with regard to other activities, then some of the £70 billion a year that goes into ISA accounts and the more than £100 billion a year that goes into pension savings could undoubtedly be redirected to provide the capital required to reinvigorate our water and sewage systems.
What would the return be? There are three. The first is a secure future, with health not being at risk. That seems to me to be pretty significant. The second would, of course, be a fair rate of return to those who have lent the money. That seems fair. The third would be essential environmental protection which is necessary to save the biodiversity of the society we live in and so becomes part of the whole process of tackling the degradation of our environment.
Why should shareholders get a share of this? I really do not know. But more than that, if we took all these factors into account, and managed water and sewage in the integrated way that I suggest I suspect that we could have all these savings and in the long run water and sewage at a lower cost than we do now, providing benefits to the consumer. We do, unfortunately, have a government that does not think that way because anything but short-term electoral gain does not seem to matter to it. That is a cost that we have to live with.
I hope that this helps.
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https://corporate.dwrcymru.com/en
Just for the record, Welsh Water (Dwr Cymru) is run on a not for profit basis. They claim that every penny is put back into the business.
They borrow through the Luxembourg stock exchange…
One of Thatcher’s advisors Alan Budd no less – appears in a documentary I recommend called ‘The Divide’ and he concedes that the extra resources he hoped would be provided by the private sector in services like water were never realised.
What actually happened of course is value extraction (hollowing out as Will Hutton used to call it) – of wages, pension pots, repair budgets, investment budgets, assets etc., all called ‘efficiency savings’ of course) which were turned into income streams by the financial sector and then reported as profits. And thus the financing of the real workings of the utilities and it liabilities in delivering clean water and the proper disposal of sewage were ignored.
There were no real profits I would argue. All that happened was that money that was benefitting the many was moved around so it benefited fewer people.
Basically Budd and many others were misled by that Neoliberal lie about ‘rationality’ – that water utilities and the like would behave in their own best rational self interests and maintain standards. He and others did not factor in the financial sector yearly bonus culture which drives short term profit grabs and exerts huge pressure on directors and their boards – nor the concept of ‘greed’.
As you say, essentially this set up made managers out of people who essentially had no interest in day to day management of clean water and safe sewage disposal. All they wanted was a return, a bonus or a pension fund maintaining its value.
There is a case for taking Government to court in my view for privatising utilities so badly. I mean the incompetent the way this has been handled beggars belief.
BTW ‘Mark to market’ accounting is what is supposed to have killed the likes of Enron, where the share price was everything and promoted undeserving confidence in the corporation.
You’d think the penny would have dropped well before this latest obscenity against us and the environment.
The penny dropped before this happened – they saw a chance to loot and took it
@PSR
“Alan Budd ….. the extra resources he hoped would be provided by the private sector in services like water were never realised.”
Key word ‘hoped’. Nobody with any sense thinks investors operate as charitable donors. They seek financial return. I’m fairly sure Thatcher was stupid enough to believe Alan Budd and his ilk.
“I hope that this helps.”
I think this is one of the best forensic pieces you have written. I suddenly realised how old fashioned I am, and perhaps why I am so often baffled by the priorities of enterprise. I cannot help still looking first at a P&L Account, as if it was important; and I do not think I realised just how far ‘business’, the world of the international financial market, had departed from it as a matter of first principles. The point of the the P&L Account is that (however vulnerable) it provided a relationship with what the business is actually doing, and more important; good at doing. This slowly became distorted and difficult to follow over time (and became further distorted by the problem of inflation accounting); but if the balance sheet and market ‘worth’ of the enterprise is the sole matter of executive attention, then everybody is doing precisely the same thing: financial manipulation. What a business does is irrelevant. This tells you nothing about what anyone is actually doing; or actually doing anything at all. The whole of business, in every sector is actually operating solely as a competitive provider of financial services; there is only one “Market”: a financial one.
I could never understand why the water companies were privatised as public companies; they were monopolies, and could only be monopolies. Market thinking was irrelevant – except to the ideologists of neoliberal Conservatism. Fortunately, in Scotland water remains out of the hands of the utter lunacy of privatising water companies.
Now tell me, does the economics profession understand anything at all about the coneptual thinking of IFRS, the theory, practice and consequences?
Re the last – no, not at all
But that is what I am working on, at least in part
And thanks for your kind opening comment
We learnt a long time ago that privatised fire fighting services do not work.
Why would we expect privatised water services to be any different?
It seems that the IFRS is lacking the conceptual thinking to look at the broader interests of the stakeholders of companies, in the case of water and sewage every one of us. Lets hope your work to change the IFRS accounting system to deal with the modern crisis will come to fruition. Certainly, the Tory government couldn’t really give a damn about sewage effluent into rivers and sea or changing accounting systems of companies. Thank goodness enough Tory backbenchers at least threatened to rebel and that the sewage problem is not completely neglected and brushed under the carpet, don’t hold your breath but maybe your nose!
🙂
So as you explain it Richard it looks as if IFRS is part of capitalism devouring itself as predicted by Marx long ago. The moral weakness at the heart of IFRS and the advantage the FIRE sector has taken of it is part of the death process of western civilisation as the FIRE parasite kills its host. Did the academics really not appreciate the problems inherent in IFRS or were they paid to look the other way?
I sense it is more akin to the problem
Bill Cash now faces as he realises the damage to British science caused by the version of Brexit he called for to support his ideology.
I doubt if this process of decay is reversible though a Labour government could and should renationalise the water companies, without compensation as you suggest.
Like many (I suspect), when the water industry was privatised I engaged in a little gentle stagging in order to emerge with an interest in what I had owned and was being taken away from me. There has been a small flow of dividends ever since and quite a significant gain in market value, driven largely by the “mark to market” philosophy you mention. If the whole lot were taken back for nil consideration I would not consider it a loss, merely a reversion to the status quo ante.
John wrote: “Fortunately, in Scotland water remains out of the hands of the utter lunacy of privatising water companies.” This is true for domestic water supply throughout Scotland, where Scottish Water is the sole supplier, but non-domestic (i.e. all business and commercial outlets) supply is different. Scottish Water owns the entire infrastructure (domestic and non-domestic) and supplies the water used for non-domestic purposes, but the delivery of that water and waste water/sewage removal is privatised under the aegis of Scotland on Tap which licences commercial water suppliers (currently 18 of them) to effect deliveries/waste removals and bill the customers.
As I understand it, these hybrids of state and privatised delivery came about under the last Labour UK Gov before a Scottish Parliament existed. The “market” approach for non-domestic came first (Scotland on Tap still has a .gov.uk email address rather than a .gov.scot address, which rather suggests that it is ultimately controlled by Westminster, not Holyrood), but devolution came along before domestic water was dealt with and the then Scottish Gov (Labour & LibDem coalition) thankfully opted for state control. It would be interesting to know if the non-domestic sector in Scotland is encumbered with PPP/PFI costs which characterise so many of the Blair/Brown era initiatives.
If only I had time…..
Thank you for that information, I confess I was insufficiently diligent to be aware of it; and what a depressing illumination of human folly. Privatised opportunities to extract monopoly rents have spread like a contagion through our culture. Everything has to fit the paradigm, neoliberal model, whether or not it is absurd; literally, ‘no matter what’. The “model” of modern business is utterly, stupefyingly mindless.
I have checked the ‘Scotland on Tap’ website. It makes clear that “The network of water and sewerage pipes in Scotland is wholly owned by Scottish Water. It acts as the wholesaler in the market, selling water and sewerage services to the water companies, known as suppliers. Having bought their wholesale services from Scottish Water, the suppliers then bundle these services with other value-adding offerings and sell them to customers.”
This means all the heavy lifting on providing the actual service; the investment, supply and infrastructure is supplied by Scottish Water. What do suppliers do? The “bundling” of “offerings” by suppliers is usefully explained by three case studies, which as far as I can see amounts to the supplier giving advice on savings (in one case study this amounts to informing the customer they were paying for an unmetered service, although they actually had a meter!); or in another case offering a discount of some kind against the existing supplier. That’s it? This is the genius only the ‘market’ can produce?
There appear to be eighteen suppliers in the ‘Scotland on Tap’ offer list. I am puzzled to understand why the bundled services could not be more cheaply operated by Scottish Water direct to user, as a vertically integrated operator, with a service advisory operation able to negotiate with commercial businesses (and supervised by a regulator to protect users); after all, the major determinant in the whole service is the built and maintained infrastructure, and the efficiency of the supply; both, as far as I can see, are wholly dependent on Scottish Water.
That website asserts that “Competition in the Scottish Water Industry … *can* result in:
* Lower water and sewage prices
* Improved services
* Greater water efficiency
* More innovation in the industry”.
*Can*. Emphasis added. Perhaps it *can*, but does it?
Can anyone given given examples of any of these since 2008.
* Are prices lower? Is that even desirable, if it starves the businesses of the funding they need to maintain and improve their infrastructure?
* Do lower prices lead to greater efficiency? Surely greater prices encourage more efficient use of a resource, if that is what you want (is Scotland running short of water?).
* What kind of “improved services” are being delivered? Tap water is tap water, isn’t it, whatever branding it is given?
* What “innovation” has there been in the delivery of tap water?
Notice that ‘Scotland on Tap’ describes Scottish Water as a “wholesaler”, and the seller of the service to the business consumer, as the “supplier”. I find the terminology a highly unsatisfactory description of the nature of the relationships; because it is Scottish Water that actually provides both the water service and the infrastructure that delivers it, to the business consumer; and the “supplier” is simply a seller of the product Scottish Water offers.
As far as I can see the seller (“supplier”) is merely a middle-man, inserted as an intermediary between the water provider (Scottish Water), and the final business consumer. The services offered appear to consist of selling, pricing and some advice services. The seller will require to make a margin on the wholesale price and the price offered to the business consumer, to survive.
Scottish Water could supply these services direct to the business consumer, provide the advice and negotiate the price; it is reasoanble to hypothesise, cheaper than the seller, because currently Scottish Water requires to fund its service provision, and sell to the “supplier” at a wholesale price, to which the seller must add a margin for costs and profit in setting a price for the final business consumer.
That seller’s margin, gratuitously interpolated into a simple transaction between the service supplier and consumer, offers an opportunity for the final buiness consumers and the provider (Scottish Water); overall, to share that sellers margin between them in a higher price for Scottish Water than it receives from the wholesale price, and a lower price for the final consumer than the seller (“supplier”) can possibly offer. There is no substantive difference being offered in the final product the seller offers – the water. All that is needed to make that process work cheaper is a rigorous regulator to ensure fair negotiations take place, with an appeal and arbitration mechanism. At least that is how it appears to me.
These comments are already attracting political interest in Scotland….
Re the post by John S Warren at 3:08pm today: I agree it’s hugely unlikely that the insertion of Scotland on Tap as a middleman between the provider of the water, its delivery infrastructure and the removal of waste water (Scottish Water) and the end customers will ever result in lower prices for the latter than they might get by dealing directly with Scottish Water. This, therefore, begs the questions: who thought this up and why, who approved it (presumably thinking it made some kind of economic/business sense) and why does it still persist when the end users are effectively paying extra for their share of SoT’s capital, payroll, overhead etc costs and any profit margin SoT makes. It strikes me that SoT is a parasite feeding off the output of SW and the needs of the end users – in other words it’s a classic rentier.
I’ll see if I can find out more about the history of SoT – how it came about, who runs it and who actually controls it etc.
Meanwhile Andrew (at 11:12am) can rest assured that Scotland is not running short of water: as I write this the River Clyde is about to burst its banks where I live.
Ken
There is political interest in this issue….
Richard
I would hazard that it is the product of the Conservative neoliberal ideology of privatisation, no matter what, to prove that markets are the only solution to every problem, even where there is no justification for it. Water, railways (so obviously bad the business model is actually collapsing); anything that moves. The purpose is not even to show that it actually works well, but rather to demonstrate that markets are the only solution, and of universal application; whether real or fake, functioning or botched. If they could find a way to reduce the air we breathe to a market, it would happen; and an IPO would soon follow.
Walter Wink (liberation theologian) came to a similar sort of conclusion. In ‘ The Powers that Be’, he said that organisations that did not serve their primary purpose (in this case water supply and sewage disposal) but served some other hidden purpose (in this case handouts to senior managers and shareholders) were ‘demonic’. Nice to see good accounting and theology coming to similar conclusions!