Wednesday, December 23, 2009

What is meant by obscene profits?

There is a tendency to describe New Zealand's hydro systems as 'rorts' and mechanisms to make obscene profits due to their costs being largely sunk and spent a long time ago. Such arguments might be valid if the supply of money was infinite (of course money would then also be worthless). But, money isn't infinite. Fundamentally governments (and individuals) must decide how they are going to allocate their finite capital and they cannot do everything that would be considered 'good'.

This need to ration capital leads to what economists describe as the opportunity cost of capital. Now this discussion can quickly move to the arcane discussion of asset and equity betas, risk free rates, market risk premiums, debt margins, debt:equity ratios and the weighted average cost of capital, but all these mechanisms are trying to do is come up with an objective method of comparing assets and businesses for the purpose of allocating capital.

Governments must do the same thing. Ultimately governments should decide what the minimum return is that the government should make to act in the public interest. This is an important point. Unless the government is achieving a sufficient level of public good then it shouldn't take money from the public. Only if the government can do more valuable things with the money through forced cooperation than people can achieve by themselves should the government use the money. This requires a more thorough analysis than just the opportunity cost of capital but whether the government should spend the money at all is the first decision in capital rationing in the public good.

In this context there is the frequent argument that electricity is a public good, with the implication that therefore it must be government guaranteed. However, just because something is of high public value doens't mean that it is a public good (in the sense that the government must provide). The sole purpose of government is to force cooperation to achieve benefits (greater than the commensurate costs) that would otherwise be unachievable. This is the fundamental question of whether a good or service should be fully or partially taxpayer funded against fully commercially funded.

This is where many people argue that the requirement for electricity to be commercially funded leads to higher prices. Yes, that is the point. If it isn't fully commercially funded then it is, at least, partially tax payer funded. Those that argue for less than commercial rates for electricity are arguing (at least implicitly) for electricity to be partially paid for from the general tax base (ie a redistribution of wealth). If you don't think this is true then lets explore the opportunity cost of capital in this case.

Let's consider an example where someone has a Faberge egg (for lack of a better example), an appreciating asset. Let's say that person paid $10,000 for the egg in 1900. In 2009, let's say that someone would be willing to buy the egg for $10,000,000. Should the person who owns the egg (who wants to sell) sell the egg for the original cost of $10,000 or for $10,000,000. The point of this example is that an asset has a current commercial value that can be completely disconnected from the original cost. If the seller in this example sells the egg for less than $10,000,000 then the seller is subsidising the buyer.

This, so far, probably isn't that controversial. The response to this might be that we shouldn't sell the 'strategic assets' then. But what is the opportunity cost? If we swap the mythical Faberge egg above for a mythical power station and make the seller the government then the options (for the government) are to hold on to an asset only making small returns on historical costs, sell the assets to access $10,000,000 or to require the asset to make a commercial return (also releasing, over a longer time, the $10,000,000). The decision for the government becomes should it provide cheap power, should it return the $10,000,000 to the people (through reduced taxes) or should it use the $10,000,000 to provide more valuable services (such as education, health, law and order, etc - which then reduces the tax take required to provide these services). Not requiring the commercial asset to make a commercial return (either through a sale or an explicit requirement) is a cost to the taxpayer. It is not an obscene profit.

The fundamental debate for the electricity system is whether New Zealand society is better served by increased forced cooperation (or central coordination) at a cost to the tax payer, or is it best served by a more commercial system at a cost to the electricity consumer. The 'obscene profit' discussion is a vexatious sideshow.

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