Is a “not for profit” just the ticket for Welsh railways?

Nigel Annett says assumptions shouldn’t be made that a “not for profit’ model can work for every sector.

The success of the Glas Cymru “not for profit” model is in many ways tied to the fundamental nature of the water industry – capital intensive, very long asset lives, cashflow negative and continually having to raise additional funds from the capital markets for investment, stable regulatory regime, predictable revenues, measurable with industry league tables which allow performance to judged, a large and growing investor demand for safe long term bond returns, and perhaps most importantly, an essential public service for which customers have little or no choice but to rely on and trust Welsh Water.  In other words, the “not for profit” model has worked well because it chimes with the most important features of the water industry in Wales.

That is not to say that “not for profit” will not work in other sectors.  But it is always worth asking why “not for profit” is the best model for the outcomes we want to achieve.  What can “not for profit” do that “for profit” cannot do as well?   This has to be a judgement based on hard facts, not wishful thinking.

It should be informed by the particular characteristics of the sector in question.  For instance, if the sector is capital intensive or cashflow negative, or if cashflows are volatile, what risks lie with fixed interest investors?  Can these be mitigated by shifting the risk over to customers, as is the case with subsidies and “contracts for differences” in the energy sector?  What risks are left with fixed interest investors, and what premium will investors require for taking these risks?  Under a “not for profit” model where there is no access for risk-bearing equity capital what risks remain with the company and can these be managed?  The mutual building society sector for instance has built up reserves over many years which are higher than in the equivalent shareholder owned financial institutions, reflecting both their lower risk appetite but also to provide a loss absorbing buffer in the event of a severe stress, such as the financial crisis of 2008.

Away from financing and the fundamental features of the sector in question, do the corporate governance arrangements have teeth to ensure that performance is as good as it would have been under a “for profit” or any other ownership model?  The disciplines that come with shareholder ownership – where risk-bearing equity capital is put at risk – or from real market competition, or from real benchmark competition, cannot be underestimated.  These sorts of disciplines are important – indeed necessary – for driving performance and really have to be replicated in a “not for profit” world if we want to see results that are at least as good.   “Not for profit” needs to be as objective and hard-nosed as any other approach to owning and running important enterprises, perhaps more so when we are asking “not for profit” to be responsible for an important public service.  Any warm feeling that might come from being “not for profit” will not last long if performance falls short.

Nigel Annett is the former managing director of Welsh Water and one of the founder directors of Glas Cymru. He is a non-executive director of the Principality Building Society.

8 thoughts on “Is a “not for profit” just the ticket for Welsh railways?

  1. This is the level at which we need to be discussing public utility ownership. Nigel’s fluency in this subject only shows up my level of financial illiteracy. There is one term that I’m unclear about, namely ‘cashflow negative’. My understanding of this term is that it means what is spent is greater than what is earned. Clearly this is not sustainable beyond the short-term. I wonder if Nigel would be so good as to expand a little on this characteristic of the water industry.

  2. Nigel is right to warn us not to assume that a not for profit transport company would perform better than a commercial company.GlasCymru shows what can be done but it is very different to Andrew`s proposal.
    I would like to hear how this organisation is going to be funded and managed.

  3. Always a pleasure to see Nigel’s ideas here. I have happy memories of a decade as a Glas ‘member’.

    I think the crucial difference when it comes to mapping out the longer term risk is that water and sewerage are natural monopolies and that means planning to 2040 and beyond can be done to a fairly tight tolerance. The assets are pretty fixed as well. That allows 20-50 year bonds to be issued at an attractive coupon, which has been a strong area for Glas. A railway service cannot be a natural monopoly as it competes with other transport offerings. Rolling stock does not compare with pipes and treatment works. Long term finance would therefore have a quite different yield profile.

  4. Thanks Nigel for a much-needed reality check.

    @Rhobat “cashflow negative” means a business has a funding requirement. That’s unsustainable in perpetuity; but if cash is being invested by a business to build infrastructure or other capability which will generate positive cashflow in the long term, it can raise funding. The mobile industry is another example – their business models would be cashflow negative for up to 10 years as they built out a network which would then generate the revenues and ebitda required to service debt / pay dividends.

    What Nigel allludes to – and is often absent in post-hoc analyses of privatisation – is the fundamental issue of how risk is priced at the time the deal is done. In a low risk environment – i.e. where the business case is predictable – a Glas Cymru / debt-financed model is viable. In a high risk environment such as a startup the only game in town is equity. Between those two extremes there is a spectrum of equity, mezzanine and debt.

    Pricing of risk is sophisticated in the private sector, particularly on traded markets. It is much less understood within Government. Hence populist slogans about “not for profit” models can gain credence; or privatisation can be criticised after the fact. Or Gordon Brown’s sell-off of gold bullion can be seen as a disastrous waste of taxpayer assets.

    As taxpayers, we need to be represented by people who will make well-informed judgements about the pricing of risk, including the potentially un-priced consequences of failure or the costs of decommissioning. People who also understand the time value of money and the relative costs of capital in the private and public sectors. I’m not at all convinced in Wales we have enough such people..

  5. The challenge with public transport and whether one adopts a “not for profit” model or not, is accommodating the reality, that apart form some exceptions, public transport and especially Heavy Rail, requires a substantial operating subsidy; and this is more especially true in Wales. In particular, as regards the Wales and Borders franchise, there is no profit in rail operations without a hefty public subsidy (>£160M pa). The current franchising model was/is supposed to enable innovation and efficiency in service delivery; in return for the revenue risk taken, the franchisees would be able to create shareholder value by developing and implementing more efficient operations. However over the last 15 years the rail industry has become mired in process and bureaucracy with performance measure and penalties that quiet often obscure the core objective of delivery an effective service to passengers. Furthermore the current W&B franchise was specified in 2003 on the basis of no growth!

    When one adds, that apart form London, the deregulated nature of bus networks/operations makes true transport integration almost impossible it is easy to understand calls for a different model. Perhaps first we should consider how we develop/deliver an affordable & integrated transport service access all modes – heavy rail, light rail and bus – that delivers what the passenger/customer wants: better connectivity, reliability, frequency, integration, etc and in a way that enhances the potential for economic growth and development. Whether the operation(s) is “not for profit” or not should be subordinate to these requirements?

  6. First we need a single transport authority which can franchise suppliers but in doing so can specify and insist that they work in an integrated way. London transport, with its Oyster cards used on tubes and buses, which are run by private concerns Is a model. Devolution of rail and bus regulation would allow Welsh government to set up such a authority on a regional basis which could plan and run the Cardiff region metro using different transport modes. With such a public authority in place the capital structure of transport suppliers becomes a secondary matter. If a not-for-profit company made a better, credible bid for the rail franchise than for-profit companies, well and good. But if not, then not. The considerations raised by Nigel Annett apply. One of the problems with Arriva is that a lousy franchise deal was negotiated with no growth allowance specified. A savvy public transport authority would avoid such errors. Welsh government needs to set up the authority and hire experts to run it. They will look expensive but if well chosen will repay the expense many times over.

  7. @ gwyn roberts

    Many thanks for the clarification on cashflow negative.

    I would make one comment regarding public sector skills. With the continued devolution of powers to Cardiff Bay, new opportunities arise from such powers but there is a time lag in terms of the supply of specialists who can handle the responsibility. It is possible, presumably, to buy in expertise from the private sector to plug the gap until the education sector has caught up with the training necessary to meet and sustain local demand.

    The “not-for-profit” model is, of course, non-existent and consequently misleading. The proper term is, as used by the Economy Minister, “not for dividend”. The idea that a company could only raise just enough to cover its expenditure every year is nonsensical and undermines the principle on which it is supposed to be founded. The point is that any company would seek to make a surplus which, in a commercial context, is known as a profit. The purpose of the “not for dividend” model is that the profits made are not distributed to shareholders. Thus the profits can be a source of investment funding. So it follows that funding that would not be available to the new franchise is equity. But would it not be possible to devise other forms of long-term funding through the Development Bank for Wales, should it ever come about? I remember hearing in a Financial Services Law Lecture a few years ago now that the German economy does not rely on equity funding to the same extent as the UK economy and that long-term relationships between banks and the economic sector is the basis for their funding model. I know that’s a gross over-simplification but railways have proved themselves to be a durable and popular form of transport with demand forecast to rise for a considerable time to come. It is rich in land assets, though its rolling stock is a wasting asset and there is the issue of requiring government support in the form of operating subsidies and infrastructure investment. I’ve got to the point now where I need to quote figures from Arriva Trains Wales and Network Rail’s Wales Route to begin looking at appropriate financial modelling for the rail industry in Wales that do not require private equity. Can anyone point me in the right direction?

  8. Rhobat, If the Welsh government gives the franchisee a fixed subsidy it transfers risk to the franchisee. If revenues plus subsidy do not over costs – for whatever reason – the franchisee loses money. He therefore needs equity capital as a buffer to manage that risk. If he has no equity he must accumulate substantial reserves to manage his risk, as Welsh Water had to do. Water though is a much less risky business than railways since there is no competition at all and technical change is slower. So reserve accumulation could require higher prices than a PLC need charge. Of course the Welsh government could underwrite the risks by providing a cost-based subsidy. But then there is little incentive for the franchisee to be efficient, whether PLC or mutual. Most important is decent price regulation and well-constructed contracts. They are the first essentials. The capital structure of the franchisee, whether mutual or PLC can look after itself. Not interesting except to co-op romantics.

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