ࡱ> IKHq` .bjbjqPqP *>::&%f8:V:~"$RhAAVr ځږPij$l0`.``PV #AA:::D::: 4@"b Implications of the Current Economic Crisis: 1 The Danger to Scotlands Water from Flawed Utility Pricing Jim Cuthbert Margaret Cuthbert October 2009 In September, the World Economic Forum produced a report which ranked Britain seventy-first in the world for macro-economic stability: their ranking implies that Britain is less stable than, for example, Montenegro or Peru. While we have serious reservations about the World Economic Forum, which promotes a right wing neo-liberal approach to economic policy, nevertheless, their report does graphically illustrate that something profoundly bad has happened to the UK economy. This reversal to the UKs economic fortunes invalidates one of the primary arguments traditionally put forward by Unionists. Look at the strength of the UK economy, the traditional argument goes: How could Scotland possibly afford to go it on its own? The UKs economic reversal should certainly have knocked this argument on its head. But the current economic situation also poses real threats for Scotland, as well as potential opportunities. It is important that we understand the nature of these threats so that we can, as far as possible, do something about them. And it is also important that we understand why the UK economy went so badly wrong so we can avoid making similar mistakes ourselves. We intend to explore issues surrounding these themes in what we hope will become an occasional series of contributions in DestiNation. We have taken as our topic for this first article the question of utility pricing: and, in particular, the pricing of water in Scotland. There are two reasons for this choice. First, because the current crisis in public expenditure, combined with the flawed pricing model used for water in Scotland, means that there is an imminent danger of the privatisation of water in Scotland unless immediate action is taken. Secondly, because it is in the Scottish governments power to take action which would permanently remove the threat of privatisation, if it has the will. To understand the nature of the threat, it is necessary first of all to look at how water prices are set in Scotland. Although water in Scotland is publicly owned, and is governed by a Scottish regulatory body, the pricing model used by the regulator is the same as that used by OFWAT for the privatised water industry in England. An important aspect of that model is determining how much the customer should pay to fund the provision of the capital assets used by the water company. Unfortunately, the method used for this aspect of setting water prices is flawed. The full details are set out in a paper we published in the Fraser of Allander Quarterly Economic Commentary: [1]. The reason for this error has been a misapplication of the principles of current cost accounting. Essentially, current cost accounting techniques were introduced within the old nationalised industries to make managers aware of the value of the capital resources they were using and to encourage them to use such resources efficiently. However, these techniques were then misapplied by the regulator in the quite different context of setting prices in the privatised water industry. The result is that customers are over-charged, and a privatised water company earns a windfall profit in respect of any capital expenditure it undertakes. The effect is large: a privatised water company could well earn a windfall profit of around 40% of the value of capital expenditure. The existence of this windfall profit can be seen in the otherwise irrational frenzy with which foreign investors competed to take over the privatised water companies in England. It can also be seen in the huge dividends paid out to the owners of the English water companies, relative to the amount of capital investment actually funded by equity: annual returns of 20% to 30% relative to the amount of capital actually invested have been common. The same technique is used for setting water prices in Scotland: but there are no shareholders to take out the surplus in the form of excess profits. Instead, the excess is used to fund capital investment: so that the Scottish water customer funds a substantial amount of net new capital investment direct from the charges he pays thus violating the normal principle of inter-generational equity. This does not just mean that water prices in Scotland are too high, with all the adverse social and economic effects this implies. It also means that Scotland is a tempting target for privatisation. And that is where there is a particular threat posed by the current economic crisis. It is now absolutely clear that we are moving into an era of significant real cuts in public expenditure. We do not yet know how bad these cuts are going to be: but we do know that they are going to be very severe. For example, in a statement to the Scottish Parliament on 30th April, John Swinney envisaged real cuts of 3% per annum in the Scottish governments budget as from 2011. Against this kind of background, it could well prove an irresistibly tempting target for a Scottish government, of any political persuasion, to privatise Scottish water. It is important to remember that, under the current regulator, who is a keen advocate of greater private sector involvement, we are already a good way down the road to privatisation. A lot of design and commissioning work has already been outsourced to the private companies in Scottish Water Solutions, together with the expertise and skills involved in this work, and the associated research and development capacity. There has been substantial use of PFI in the water industry in Scotland: and large projects have been given to private sector companies who have limited Scottish presence witness the problems this caused in the Leith sewage works failure, when we had to wait for spare parts coming from outside the country. Further, steps have also been taken to introduce competition into the business market for water. So although we still have a water industry which is nominally publicly owned, the ground is in fact well prepared for full privatisation. It is unclear why the present Scottish government has been so inert in the face of the regulators activity to date: and why it has not given him much better articulated long term goals consistent with what the Scottish people expect from their water industry. Moving to full privatisation would be disastrous. For one thing, it would lock in permanently the current over-charging for water in Scotland. In water we have a vital natural resource which will become increasingly scarce on the world scale and which, if properly priced, should give Scottish industry a well-needed competitive advantage. If we privatise water now we will throw away permanently the opportunity to capitalise on this advantage. But there would be further adverse effects. Given experience with the English water companies, ownership of a privatised Scottish Water would almost certainly rest outside Scotland, with key skills, research and development, and head office functions, lost to the Scottish economy: and there would be a significant drain on the Scottish economy as dividends and profits were expropriated in amounts disproportionate to any capital injection made. Is there an alternative? Yes there is. In a further paper in the Fraser of Allander Commentary, [2], in February 2009, we pointed out that capital expenditure financed directly from customer charges in Scotland could be regarded as a notional loan from customers as a whole to Scottish Water: customers would then earn interest on this loan, which would be paid in the form of a general rebate on water charges. This would put water charges in Scotland on a descending path to a level significantly below the current level. But, as we showed, this approach would be eminently affordable within current levels of public expenditure provision. And since Scottish water would no longer be a cash cow, it would no longer be a tempting target for privatisation. We eagerly await a response from the Scottish Government on our proposal, following a briefing we delivered on this matter. There is a real need for those who support public ownership of water in Scotland, and those who want lower water charges, with all of the economic benefits this would entail, to press for action on this issue. Finally, we should point out that while water is the immediate priority, and is also the area where we have full regulatory control in Scotland, the same problems with utility pricing extend to other network utilities like electricity transmission and distribution, the gas network, the rail network, and even major airports. It is common to see TV and press reports pointing out how utility prices are higher here than they tend to be in, for example, our Continental neighbours. What is never pointed out is that this relates, in significant part, to the basic flaw in the utility pricing model used in the UK. This is a scandal which needs to be exposed and remedied. And we have every opportunity to make water charges in Scotland the starting point in this process. Reference 1: Cuthbert, J.R., Cuthbert, M.: "Fundamental Flaws in the Current Cost Regulatory Capital Value Method of Utility Pricing": Fraser of Allander Institute Quarterly Economic Commentary, Vol 31, No.3: (2007). Reference 2: Cuthbert, J.R., Cuthbert, M.: "A Recommendation on How the Method of Setting Water Charges in Scotland Should be Changed: Customer Financed Capital as a Notional Loan to the Utility": Fraser of Allander Economic Commentary, Vol. 32, No.3, February, 2009. (Copies of these papers can be found on our website, at  HYPERLINK "http://www.cuthbert1.pwp.blueyonder.co.uk" www.cuthbert1.pwp.blueyonder.co.uk )     PAGE  PAGE 1 /j" $ x u v t u 89:3589JL| !J![!!!j"m""""######Y$$$$$$$$ư̰̰骶̞ hOCJ hyA}CJ hGCJ hfyCJ h]CJh,xh,xCJH* h~HCJ hRCJ h;CJhkh;hpf{hpf{CJ h,xCJ hICJ h,x5CJh,x>/jkxv w qrsKL!!$$a$$a$gdpf{$a$gdI$a$..$$$$''((++,,--|.}.~.......... 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