In defence of capital charges (and higher public sector discount rates)

I don’t usually see the National Business Review but a copy of the latest issue turned up at home and I flicked through it on Saturday afternoon.  On page 2, I found a very strange article, in a column called (Tim) “Hunter’s Corner”, about health funding and (in particular) the application of the “capital charge” to DHBs.  It is, we are told, a “knuckleheaded approach” and should, in Tim Hunter’s view, be abolished.

Capital charges have been around for a long time now, since 1991 in fact.  Here is one description

The charge is levied on the net worth (assets minus liabilities) of departments and some Crown entities. The assets are assessed on the basis that they are valued in financial statements and may include buildings and other fixed assets, cash appropriated for depreciation or held as working capital, inventory, or receivables. The capital charge represents the opportunity cost of money – what the government can expect to earn in alternative investments entailing similar risk. It may be thought of as an internal rate of return on the government’s investment in its own entities.

and here is one articulation of the point of the charge

The capital charge has a dual purpose: it signals that capital is not costless and should be managed as would any other cost of production, and it spurs managers to include the cost of capital in comparing the cost of outputs produced by government entities with the cost of obtaining the outputs from outside suppliers. The charge puts internal contracting on the same footing as contracting out and encourages full cost recovery of outputs sold to governmental or private users.

It has always seemed eminently sensible to me.  Don’t charge for the cost of capital and government agencies will be incentivised to use lots of it, and to do things themselves that might be more efficiently provided by private sector firms (whose owners will, reasonably enough, expect to cover the cost of capital).   Without a capital charge, any hope of limiting those tendencies requires (even) more centralised adminstrative edicts.

I couldn’t see any information on The Treasury’s website about the current rate of captial charge, so I’ll take Mr Hunter’s word for the fact that it is “typically about 6-8%”.    Eight per cent (nominal) is the standard discount rate Treasury recommends for project evaluation.

So what bothers Mr Hunter?  His article seems to imply that capital charges squeeze the funds available to deliver health services to the public.  Waive them and suddenly DHBs will have more money.  Except that, were capital charges to be scrapped, one would expect to see an entirely-commensurate drop in central government funding to DHBs.  Of course, the Crown could decide it wanted to spend more on health service delivery but logically that is a quite different decision.  One can increase health spending with or without the capital charge.  All else equal, just scrapping the capital charge would increase the overall government deficit, and it would weaken the incentives in government agencies for capital to be used wisely and abstemiously.  Crown capital costs –  and that costs fall on citizens and taxpayers.

Hunter also seems worried about incentives

“…charging 6-8% on net assers provides an incentive to sell property and lease it back where the rental cost is below the capital charge”

Indeed, and so long as the capital charge is designed reasonably well, that is a feature not a bug.  Recall that the purpose was to help efficiently allocate resources and not artifically favour in-house solutions.

Getting still more specific, he goes on to argue that

“However, the actual cost to the Crown of the capital is more like 2% (the latest bond tender achieved a weighted average yield of 1.8%) and the chances of a DHB achieving a lease cost at or below that level are zero.  This means the capital charge incentivises the DHB to increase the actual cost to the Crown.”

It has to be pretty worrying that a senior business journalist thinks an appropriate measure of the Crown’s cost of capital is the rate it can raise debt at.

Just as for any private sector entity (businesses most obviously, but the concept applies more broadly), the cost of capital is better represented by some weighted some of the cost of debt and the cost of equity.    That is what The Treasury is trying to mimic in its recommended discount rates (and, I assume, in calculating rates of capital charge).  You can see the various assumptions (including the equity risk premium and leverage) laid out at the link.

The fact that the Crown doesn’t pay dividends and isn’t listed on the stock exchange doesn’t change the fact that equity capital has a cost.   When the government takes our money – and that is how the government raises equity, coercively through the tax system –  we can’t use that money for other things.   As citizens we, presumably, expect them to use that money wisely, and at least as well (for things at least as valuable) as the alternative options we have open to us.  Opportunity cost matters.    And, of course, the Crown’s cost of issuing debt isn’t just kept modest by the actual equity the Crown has accumulated, but by the ability of the Crown to raise our taxes whenever necessary to service the debt.   Lenders know that; in fact, they count on it.   And yet in evaluating state projects that option cost (to citizens) isn’t internalised.

I wrote a post a few years ago on the question of what price we should put on government projects.  Here are a couple of key paragraphs.

The Reserve Bank of Australia recently ran an interesting and accessible Bulletin article on the required hurdle rates of return that businesses use in Australia.  They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours.   In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers.     The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.

As a citizen, it is not clear why I would want to government to use scarce capital much more profligately than private businesses might do. I use the word “profligately” advisedly – using a lower required rate of return puts less value on citizens’ capital than they do themselves in running businesses that they themselves control.  And if the disciplines of the market are imperfect for private businesses (as they are), the disciplines on public sector decision-makers to use resources wisely and effectively are far far weaker. Fletcher Challenge took some pretty bad investment decisions in the 1980s and 1990s: its shareholders and managers paid the price and the firm disappeared from the scene (along with many more reckless “investment companies”). The New Zealand government, architect of Think Big debacle, lives on – citizens were the poorer, but ministers and officials paid no price.

And here was a chart from J P Morgan that I used in a recent post

hurdle rates

I also noted

If anything, there are several reason why governments should be using higher discount rates than private citizens would do:

  • Governments raise equity (“power to tax”) coercively rather voluntarily, and effectively impose near unlimited liability on citizens.
  • Governments are subject to fewer competitive pressures and market disciplines to minimise the risk of resources being misapplied.
  • Many government investment projects exaggerate the exposure of citizens to the economic cycles (the projects go bad when the economy goes bad)

The last of those isn’t really relevant to use of capital in the health sector, but the other two certainly are.  They represent what looks like a pretty good case for requiring something well above 8 per cent to used in evaluating public sector capital projects, both when seeking new funding from the government, and when making ongoing management choices within organisations.

Note that none of this is about taking a view on the appropriate level of health services the public sector should provide, it is simply (but importantly) about helping to get closer to recognising the true costs and risks associated with the capital devoted to funding these services.

There is no perfect system for allocating capital, whether within a private multinational company, or within a government.  “Perfect” is never the relevant benchmark.  But if the capital charge regime isn’t perfect –  and that is almost inevitable –  we are materially better off with it than without it.   I hope the Minister of Health pays no attention to the siren call from Tim Hunter to scrap capital charges, at least as they apply in the health system.    There is probably a stronger case to scrap DHBs themselves, but even if that were done much the same challenges around the efficient use of capital, getting the best mix of labour and capital, would still face health system managers and those funding them.   Capital costs, and those (true) costs are quite high, especially when politicians and public officials are making the decisions, and rarely face sufficiently strong incentives to utilise capital as efficiently as possible.

9 thoughts on “In defence of capital charges (and higher public sector discount rates)

  1. In the context of the proposed ITP mega mergers…is it reasonable to ask what mechanisms and incentives will operate for the proposed entity to use capital in an effective and efficient manner?

    Like

  2. This is a very odd analysis, especially for a former public servant (have you ever worked in an organisation actually subject to market disciplines?). Particularly odd is the idea that governments raise equity coercively and have fewer market disciplines. They don’t have any because the State is not part of the market, it actually sets the rules, and therefore doesn’t ‘raise equity’ by definition.
    As an example of the charging of a rate of return by the Internal Affairs department, the effect on the National Library has been on reduced opening times over summer, and it has also curtailed some services. Which market organisation competes with the National Library and could provide those services?
    As an aside, Tim Hunter is one of the few business journalists who realised that New Zealand had a tax haven operating within, as set up by Treasury. Presumably, your former colleagues thought it was a good idea to undermine other countries tax bases, and reduce their ability to raise equity from those living overseas without wealth and expensive tax lawyers.

    Like

    • The government does set the rules and that is why I have never understood the concern over selling state assets. Build the asset with easy rules, sell the asset and toughen the rules and then subsequently buy back the decimated asset and resell, ie rinse, wash and dry again and again and again.

      Like

  3. The issue isn’t that market organisations compete with the core functions of many govt organisations, it is about incentivising the efficient use of capital (whether around land, computer system, vehicles, buildings or whatever).

    The state does implicitly “raise equity”: when it takes in taxes (“coercion” at the individual level, even if “society” collectively approves of it) more than it spends and builds a net asset position, it is raising equity – akin to “retained earnings” in the private sector. And the govt has considerably fewer disciplines around its use of that money than most private sector firms do.

    You are right that my career was in public sector organisations. Within the Bank however i oversaw for several years our active trading operations, and choices about when to take more discretionary trading risk (and what sort of returns we needed to manage to adequately cover the cost of taxpayers’ capital). I’m also trustee of a couple of superannuation schemes where risk/returrn tradeoffs, and returns to capital, are ever-present considerations for stakeholders.

    Like

  4. Fletcher Challenge took some pretty bad investment decisions in the 1980s and 1990s: its shareholders and managers paid the price and the firm disappeared from the scene (along with many more reckless “investment companies”)

    Again I point to the callous RBNZ directed interest rate engineered increases that have decimated NZ industry. Nothing to do with poor decisions by business entities but everything to do with the interference by the RBNZ with aggressive interest rate increases. The Tree God did not allow the roots to grow far and wide which meant that the tree(the NZ Economy) was not stable and branches(NZ Industry) had to be lopped off to keep the tree standing up.

    Like

  5. Heh… never underestimate the ability of a so called ‘business’ journalist in NZ to bolloix it all up and confuse debt for capital…

    The key point about the cost of capital is allocation of a given set of funds amongst competing objectives – there has to be an independent ‘measuring stick’ to assess whether a project adds value for the taxpayer (well in theory). The cost of capital methodology is far from perfect but it is the least worst of the alternatives…

    The problem with a higher cost of capital is that the organisation (applies to Govt as well as private sector) only invests in risky projects – thus a cost of capital of, say 12% implies riskier projects will be approved while perfectly adequate ones will be rejected (say a return on funds on 10%)… the higher hurdle rate can be seen as a form of adjustment for uncertainty, which may be reasonable for private companies operating in fast changing markets (technology, FMCG) but should not apply to Govt…

    An 8% discount rate for whole of Govt doesn’t seem unreasonable, although for some parts of Govt it may be too high and other parts too low…

    Like

    • His reply on Twitter was:

      Tim Hunter Retweeted Michael Reddell
      Sorry Michael, but you’re wrong.

      Those arguments didn’t convince me…..

      Agree re the adverse selection risk, altho the Treasury discount rate guidelines do appropriately distinguish between vanilla projects (eg generic buildings) and inherently more risky projects

      Like

  6. I have worked for many commercial businesses over the years including with Fletcher Challenge. The lease versus buy option is always a significant debate around board room tables. Financial feasibility maths usually means that we end up with a lease option as being mathematically more favourable.

    Personally, if you are working towards a 3 to 5 year time frame then the lease option gives you the newest equipment with no or low maintenance costs but if you are working towards a 10 to 50 year time frame eg property, then it works out much more cost effective when the debt gets paid off but of course the maintenance costs start to creep upwards. The one most significant unknown variable is of course the capital gain potential in ownership.

    Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s