Council Debt for Dividends

My colleague Professor Glenn Boyle provided a few rather insightful comments on what's going on with Council-owned assets in Christchurch. I've hoisted them up from the comments section:

The first question to ask is: what are these increased dividends going to be used for? There are two possibilities - greater council spending or lower rates. It's hard to believe it couldn't be anything but the former.

That being the case, what really matters is the quality of the intended spending, i.e., is it covering its cost of capital? (which is more than just the cost of the borrowing used to finance the spending) Since we don't know what the increased spending is going to be on, it's impossible to say anything definite about this. But the quality of council spending over recent years, and the quality of the 'analysis' underpinning it (e.g., the $70m cycleway), means the most plausible assumption is to place 0% probability on these borrowed funds being spent wisely.

There are other interesting undercurrents in all this though. First, by getting CCHL to do the borrowing, the council is avoiding the need to reveal it on its own books, i.e., it's cunningly 'hiding' the extent of its indebtedness. Second, and more importantly, the council is effectively saying it can invest new capital more productively than CCHL. This is intriguing, given that we're repeatedly told what great investments the CCHL assets are, that they return 15% per annum, and how rates would be so much higher if we didn't have them. If all this were true, then the best strategy available to the council would be to reinvest the borrowed funds in the CCHL assets to provide for further growth. By implicitly saying it could do better than this, the council clearly doesn't believe its own spin.

This is hardly surprising. The arguments trotted out to justify the 'keep-the-CCHL-assets' line are so transparently flawed that the only plausible explanation for the council's behaviour is good old fashioned empire building (something that those of us who work at the University of Canterbury are familiar with).

But now the chickens are coming home to roost. As well as the disturbing announcement identified by Eric, this week we've also learnt that (i) Red Bus earned basically zero profit in the last financial year and will pay no dividend, and (ii) the council has sold one asset (Jet Engine Facility - what on earth was it doing owning it in the first place?) in order to prop up another loss-making subsidiary (VBase).

It's like living in an episode of Mad Men (without the fun parts).

Glenn is entirely right. Council drawing funds out of the Council-held firms is inconsistent with Council's repeated assertions that the rate of return on Council-held firms is very high.

Council should be in the business of providing decent roading infrastructure, working and reliable sewers and waterworks, and a few consumption amenities. They are not the best owners of things like ports. The temptation to tunnel assets out by deferring maintenance and loading the companies up with debt ... well, some perils are just too perilous.

Debt for Dividends

Christchurch City Council refuses to sell Council-owned assets to help pay for the earthquake rebuild. They should sell some of those assets, so long as it's to pay for roads and sewers rather than for stadiums. But, a lot of folks just hate the idea of selling off the assets, and so it isn't happening.

Instead, Council-owned companies look like they'll be taking on debt to pay a higher dividend to Council.

The Christchurch City Council's investment arm may have to borrow to meet higher dividend commitments of $140 million over three years to the council.

Christchurch City Holdings (CCHL), which oversees the council's trading companies such as Orion and Christchurch Airport, promised to step up dividends after the earthquakes.

Its new statement of intent for the next three years from July 1 this year to June 30, 2016, forecasts dividends of $46m, $46m and $48m to the council.

It is a significantly higher level of ordinary dividends than before the quakes, when dividends ranged from about $30m to $35m each year.

CCHL's profits for the three years are forecast to be $33.1 m, $37.6m and $43.1m. CCHL will need to borrow $26.2m to meet its commitment to the council, unless it receives more dividends from the council's seven trading companies, increasing its profits.

CCHL chairman Bruce Irvine confirmed CCHL would borrow to meet the gap between its forecast profits and the dividends if needed.

I'm not a corporate finance guy, but it seems a bit odd to be borrowing to pay dividends to current shareholders. It's not something I'd expect would typically be recommended. Borrowing money to finance projects that yield a longer term rate of return in excess of the borrowing costs - that tends to be recommended. If firm shareholders have short term financial issues that mean they've a strong preference for having cash now, sensible Boards, I'd have thought, would have reminded those shareholders that they could divest themselves of a few shares if they needed a short-term cash hit.

When companies instead are borrowing to make their big shareholder happy about the current dividend flows, I start worrying about a whole pile of other ugliness that could be going on. Like, whether the company is making adequate investments in the maintenance of its physical assets or whether it's deferring maintenance to make the dividend payments. But again, I'm not an accountant or a corporate finance guy, and I've certainly not cracked open the CCHL books. It just smells a bit off. When a company is taking the dividend as a constraint against which to optimise instead of as the residual of what's left over after they've paid the bills, I wonder whether they really ought to have different owners.

But maybe a finance type who reads the blog can set my mind at ease here. Or maybe this is just standard practice when the government owns NZ companies. I remember something about something involving Solid Energy doing something like this.

Update:

• Apple has borrowed to cover dividends and share buyback. Borrowing for a share buyback is different: the firm gets to own more of itself. And Apple had tax reasons to borrow rather than to bring its overseas cash back to the US.
• Weird stuff can happen such that companies can't make a scheduled dividend payment while all is fine, or where a profitable company hits a liquidity constraint and so has to borrow despite profits in excess of the dividend payment. But here CCHL deliberately lifted the dividend payment to transfer more money to Council post quake. If they're doing that, why not just sell some shares in it instead?

More thoughts on the Christchurch plan

Eric has covered this off well, but here are a few additional thoughts:

1. There is a multiple equilibrium story under which it makes sense to spend money on civic projects that would otherwise not pass a cost-benefit test. The idea here is that there are two potential futures for Christchurch, one in which there is confidence in its future as a strong vibrant city, and the other in which it is much reduced in size and importance. Moving to the second equilibrium rather than the first would potentially imply as large a reduction in the value of the Christchurch's fixed capital as has already occurred from the earthquake, and so there might be some value in putting in a large injection of public capital as a way of signalling the liklihood of the better equilibrium. That story works for a national injection of public funds. I'm not sure it works as a policy if associated with the new bright shining white elephants is a legacy of high rates to pay for them.

2. The stadium: The economics of this are not quite as bad as a comparison with Dunedin would suggest. First, if it is accepted that there will be a stadium, the decision on whether to put on a roof has to compare the cost of the roof versus the additional ticket revenue that a roof would bring. A roof probably fails that test, and as Sam Richardson points out, you have to also look at the spillover cost on the competing CBS arena, but the economics are not as bad as comparing the full cost of a roofed stadium to none at all. In Dunedin, the full cost was marginal. In Christchurch, we are starting from a point of Lancaster Park having been replaced by insurance money. Again, this is predicated on the idea that there will be a stadium of some sort. My problem with the stadium idea is more with their choosing to start afresh rather than look to extend the current temporary facility which is still close to the city centre in a way that preserves, but doesn't commit to, the option of a roof.

3. The convention centre: Eric has written on this, but I can't resist adding my voice. This is why the stadium doesn't upset me so much. The stupidity pales into insignificance compared to the silliness of building a purpose built facility from scracth that is able to host up to three conferences simultaneously. (Aside: from my limited experience with organising conferences, if you have choice over location and date, you choose somewhere where you will be the only conference operating at the time.) The conference centre should be small close to hotels and the performing arts centre so that larger affairs could spill out to those areas.

4. The choice of sites: Great cities evolve as a series of second-best decisions on where to locate things based on where suitable sites are available. There is a limited role for governemnt intervention through eminent domain, but mostly cities evolve through private investment, with investors required to take into account the existing value on the sites they develop via the price required to purchase those sites. The impression one gets from reading the city plan is that locations have been chosen as if were were starting from a blank slate, rather than asking how best to use the existing value.

5. The library: Why change the site from the current location, which was close to the centre anyway. And shouldn't we be waiting a few years before investing in a library to see how the move to electronic delivery of reading material affects the nature of a public library?

6. Future planning: No-one is going to agree on every aspect of any plan, and the main thing is to get some certainty around the environment and allow investment to proceed. So this statement from the plan (as reported on Stuff) particularly frightened me:

To ensure the city has high aesthetic appeal, a new design panel made up of representatives from the Christchurch City Council, the Canterbury Earthquake Recovery Authority and Ngai Tahu will consider every building consent application.

Yes, there needs to be a consent process, but it should be based on as objective as possible interpretation of well-defined requirements specified in advance, not an open-ended subjective judgement. This is not the way to encourage investors to sink costs into designs.

7. Asset Sales: What is it about asset sales that brings out nonsense from all parties? As Eric has repeatedly pointed out, it makes sense to constantly ask whether assets would be better held privately or publicly, and a time of massive change suggests that the optimal mix might change. It is silly for the city council to take an emotional view of its holdings of the Lyttleton Port Company or the Christchurch Airport, but it is even sillier of Gerry Brownlie to suggest that asset sales will enable the financing of the planned white elephants.

More on asset sales

I'm quoted in the Press's story on potential asset sales. Spot the minor transcription error from the email I'd sent! First comment to catch it wins the chocolate fish. Two letters are missing... somewhere.

There is a strong case for selling some Christchurch City Council assets, a Canterbury University economist says.

Dr Eric Crampton, a senior lecturer in finance and economics, said that if the council was not prepared to cut its expenditure on large capital projects such as the planned sports stadium and convention centre, it should look at selling assets that were more valuable when owned by the private sector.

''Lyttelton Port and Red Bus very plausibly fall into that kind of category,'' he  said.

''We oughtn't forget that only a few years ago the council thought that a private management company would be best placed to run Lyttelton Port.

''Bus routes in Christchurch are allocated between council-owned Red Bus and other operators, like Leopard, by competitive tender. It's pretty clear that we really need to have the council owning one of the companies.''

For other assets where the council might not want to give up control, like Orion, partial private ownership could help bring in external expertise while bringing in revenue.

''For other assets where efficiency gains from privatisation are limited, there's no strong case to be made between debt and asset sales. Both reduce the city's net asset base and constrain future ability to raise debt in case of seriously damaging future aftershocks,'' Crampton said.

Ultimately, whether the council or the private sector should control an asset depended on which was best placed to operate it.

Finding the two missing letters above is left as an exercise for the reader. [Update: Philip catches it. I'd said "unclear" rather than "clear" in the sentence: "It's pretty [un]clear that we really need to have the council owning one of the companies."] I'd also sent this paragraph, which didn't make the cut:

“It’s a bit of a shame that so much of the discourse around asset sales has focused on differences between dividend rates and the interest rate on Council borrowing. First, it’s harder to put a fair value on assets held by government because they’re not traded on the open market; the recent rather large reduction in the book value of KiwiRail points to some of these difficulties. Where we are less certain of the asset’s value, we have less confidence around the actual dividend rates. Further, where reported dividend payments include a lot of booked capital gain rather than actual cash payments, it’s not entirely a fair comparison with bond payments. But more fundamentally, ownership of assets comes both with risk and with ongoing maintenance liabilities; gaps between dividends paid by Council enterprises and interest on Council debt is largely explained by that the former is riskier.”

There is little point in keeping the "family silver" as a hedge against bad times if you're not willing to sell it when bad times hit. Still, cutting back on planned expenditures on a new stadium in excess of the insurance payout makes an awful lot more sense than either debt or asset sales.

More on Council asset sales

Christchurch's "Mainland Press" emailed me for comment on whether Council should sell off some of its holdings to pay for quake-related costs. I sent them a few paragraphs they could quote to add to whatever story they were writing; they decided to run them together as an article. I think it reads surprisingly well given that I hadn't really expected that this would be an op-ed piece rather than quotes used in a longer story.

Anyway, here it is.

Open publication - Free publishing - More chch

In unrelated media-grubbing, I was on NewsTalk ZB Tuesday morning talking about how smokers are a net boon to the government rather than a drain on the system.

BERL and asset sales

The Greens commissioned BERL to look at the government's planned set of asset sales.

Recall that I've previously argued that the "but the bond financing cost is lower than the flow of dividends" argument is nonsense because it says the government should borrow to invest in the stock market where stock returns are higher than what the government pays in interest; it ignores that stocks are riskier assets than New Zealand government bonds.

What really matters is whether an asset is better managed publicly or privately. If the assets are more efficiently held publicly, the "loss of flow of dividends" critique can make sense: in that case, a private owner is willing to pay less for the shares than the flow of dividends is worth to the government. Otherwise, a high dividend flow just means the asset's selling price is bid up. If the private owner expects efficiency gains, competitive IPO markets push the asset's selling price to being higher than the discounted value of the current revenue stream.

So, how does BERL approach the problem? They assume that revenues from asset sales are used to build other assets that yield dividends equal to the returns on the sold assets but that time-to-build means a few years' delay in getting the flow of assets from the alternative stream. It's then not particularly surprising that they find that asset sales are a dumb idea. It would be hard to find anything other than "privatization is a dumb idea" given that starting point. They also assume that borrowing costs are lower than dividend yields and conclude that it makes more sense to borrow than to sell off assets. They do some year by year projections going forward on the basis of the assumptions, but all that time path depends on the question-begging at the outset; I'm not going to get into whether they got the time series right.

BERL also seems pretty worried about effects on the country's net external debt position. So they set up scenarios comparing asset sales, where buyers may be foreign or domestic, with a bond issue, where bonds are assumed to be bought only by domestic investors. On this basis, they find that the asset sales will hurt net foreign liabilities. Perhaps their conclusion would have changed if they considered that foreign investors do sometimes also buy our government's debt, or that domestic investors can on-sell government bonds to foreigners.

Further, when BERL makes the case for debt over asset sales based on the difference between the government's cost of borrowing and the dividend yield from state owned enterprises, they don't seem to adjust for that dividend yields tend to be higher because asset owners need a risk-based return. If it doesn't make sense to take out a mortgage on your house at 5% because you can buy stock in a company that usually pays 6% dividends, it probably doesn't make sense for the government to do it either.

As a fun robustness check, they compare their results against a scenario where the new investments yield lower dividends than the new investments. Unsurprisingly, they find that privatization is then even worse!

I'll agree with BERL that some of the benefits of partial privatization seem overwrought. I've been critical of partial privatization, and especially of starting with the energy companies. But if this is the best case against partial privatization that the Greens can come up with, it sure isn't convincing.

Previously:

• Perils of partial asset sales
• Partial Privatisation: Hazledine (vs?) Crampton edition.
• Selling assets to pay for the quake
• Optimal quake financing
• Don't sell the lines company, sell the Port.
• Sell it already
• Seamus: Justification for partial asset sales
• Seamus: Should Meridian be Privatised
• Me in response to Seamus: Voter Preferences and Electricity

A Justification for Partial Asset Sales

Like most economists, I think, I have been critical of National’s policy to sell off non-controlling stakes in some SOEs. The argument, which I would adhere to in most circumstances, is that either there is a justification for public ownership or there is not—partial sales that allows some private ownership but without injecting the discipline of a threat of take-over would achieve nothing.
In the case of the three state-owned electricity companies, however, there might be a case. The argument is as follows: Vertical integration between the wholesale and retail sides of the electricity market essentially nullifies the market power that in principle would exist in the wholesale market with only four major generators. The close-to-balanced positions that have emerged in New Zealand, with the major gentailers each having roughly the same market share on the demand side as the supply side of the wholesale market removes the incentive for suppliers to restrict supply to inflate the wholesale-market price.

At the same time, however, vertical integration makes the retail market less contestable. If competition between retailers is not as intense as we would like, it is difficult for a new entrant to come into the market, as it would be highly exposed being a buyer and not a seller on the wholesale market, particularly in periods when low rainfall or transmission constraints gave a seller some temporary monopoly power.

Now imagine, however, that a new entrant in the retail market could simultaneously buy shares in the company that was the dominant generator in the region the entrant wanted to sell in. This would be a risk management strategy that would enable it to price to the retail market based on normal wholesale prices, knowing that losses in the event of a high wholesale price would be offset by the return on its shareholdings. Now further imagine that there are strong political reasons why the government would want to retain a controlling stake in the main electricity gentailers. In this case, these two arguments together suggest that maybe sale of a non-controlling stake is the optimal policy.

I’m not sure what I think about this, but I can’t reject the argument out of hand.