So who takes the risks, and who gets paid to take them?
By Leonard Hyman and Bill Tilles:
In the UK, the government puts its various rail franchises up for public bidding periodically. Rather sophisticated corporate bidders calculate projections for rail traffic, expenses, ticket prices and the like. And based on their financial assessment offer a series of payments to the government in return for the train franchise.
This week, the two operators of the London-Newcastle-Edinburgh train line, Virgin Group and Stagecoach, announced the line was likely to be operating at a loss in the next two years. Revenues and, far more importantly, profits were not remotely going to meet expectations.
These two operators of the East Coast line effectively went to the government’s Transportation Secretary Chris Grayling and said, “Here, you can have your franchise back. Oh and we won’t pay you the £3 billion we said we would two years ago. We messed up in our sums.”
And of course the Tory government — rigid disciples of Thatcher and F. A. Hayek replied, “Bust a deal, face the wheel.” Or the stern British ministerial equivalent thereof.
Not really. What they received was not even a half-hearted, meek reminder that corporations with stockholders should realize they assume certain business risks in return for what they expected to be adequate levels of recompense. And the fact that these anticipated profits have now proven illusory does not make this the government’s problem until the franchise agreement expiry in 2022.
Or, standing on the strength of their contract agreement the government’s ministers might’ve politely reminded the unhappy rail franchisees that in the harsh language of the elementary school playground, “Sorry, no backsies.” Which is merely an eight year old’s way of saying, “See you in court.”
But what happens when rosy business scenarios fail to materialize for large, politically well-connected privately owned corporations? Nowadays in the UK, the transport secretary lets you off the hook. Risk and reward apparently means, shareholders take the rewards, government takes the risk.
Or to borrow again from the playground, being a privately owned corporation in today’s UK means getting lots of “Do overs” from a lenient government bureaucracy.
Another government approved multi-billion dollar mess takes us to South Carolina and the SCANA-Santee Cooper nuclear fiasco. Starting around 2007, SCANA embarked on an ambitious two-unit nuclear construction project. As we’ve seen since the plant’s July cancellation, completion of this project was apparently beyond SCANA’s (and Santee Cooper’s) financial and managerial capabilities.
The project failed due to relentless cost over-runs which ultimately led to the bankruptcy of the builder, Westinghouse. SCANA’s stock fell in response. But Virginia-based Dominion Energy just offered to buy SCANA in a move that would, if little else, mitigate a considerable portion of shareholder pain. Let’s look at the deal.
SCANA has already written off a part of the project. In that respect, one might argue that shareholders have already taken a hit. Except that was on the books, not in reality. Dominion is offering SCANA’s shareholders an amount equal to what their stock was worth before the cancellation of the nuclear project. SCANA shareholders may emerge from this nuclear construction debacle almost unscathed. Bondholders will collect interest and principal on schedule too.
Borrowing a concept from physics, we believe that capital, like matter, is at times almost impossible to destroy. There are infinite ways to reallocate it. But destroying it is another matter. But that’s what South Carolina’s Governor and some legislators are insisting on – that none of the cancelled nuclear plant costs will be borne by customers. They promise to free the electricity consumers from the economic burdens associated with their recently cancelled nuclear plant.
These financial burdens come in two bundles. The equity, or shares of stock, SCANA’s management sold publicly to finance nuclear construction and the bonds they sold to fixed income investors for the same purpose. It is the obligation to bondholders that concerns us here. That obligation under the proposed merger transaction is merely transferred from SCANA to Dominion.
Under this proposal, South Carolina’s electricity users continue to pay an additional $20 per month for 20 years. Dominion Resources has proposed to take those funds and retire the debt (i.e. bonds) that was originally incurred to finance the now cancelled nukes. In other words, South Carolina’s electricity consumers ultimately (even if unwittingly) incurred a portion of the financial risks and they are being asked to continue to pay for past mistakes. For which investment of course they will receive no electricity.
We are not arguing that it is good policy to let public service enterprises mismanage themselves into insolvency. Nor are we suggesting completion of the VC Summer nuclear units would have been the preferred course. The public loses as well as shareholders and creditors. But despite whatever capitalist or free market trappings are on display, the US federal government does on occasion bail out private institutions like banks, aerospace, automotive companies, and the old days even a railroad like Penn Central.
When this occurs, the government and ultimately the public effectively becomes the financial risk taker albeit implicitly. But in finance theory that is what shareholders are supposed to do. And the public frequently receives a far smaller return than shareholders for what turns out to be the equivalent financial risk.
Let’s go one step further. We can segment the electricity business by risk: the high risk commodity power suppliers and the low risk distribution or wires business. Maybe consumers would not want to directly take on the risks of the power producers, but what about the supposedly safe wires?
If the government will bail out any wires company (because we want to make sure that the company continues to provide a vital service), then do those companies need stockholders? Could a government-owned utility accomplish the same task at a substantially lower cost of capital? Darwinism may lead to good decision making, but not when the predator is leashed. By Leonard Hyman and Bill Tilles.
The Fed is in search of the elusive soft landing, but it might not find it. Read… Markets Still Blow Off the Fed, Dudley Gets Nervous, Fires Warning Shot
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