The pounds 11bn shocker
They were knocked out for pounds 5.2bn. Now they are worth pounds 16.8b n. Patrick Hosking explains how the Government got it wrong
Sunday 13 August 1995
It was a tense time for Wakeham. His predecessor had been Cecil Parkinson, whose efforts to privatise the electricity industry had ended in failure. Part of Wakeham's mind was not on the hideously complex business of privatisation at all, but on the upheaval in the Conservative Party. Sir Geoffrey Howe had just resigned from the cabinet. Michael Heseltine was challenging Margaret Thatcher for the throne. The vote was less than three days away, and Mrs Thatcher - it later transpired - would shortly be appointing Wakeham as her campaign manager.
But if the mood in Westminster was panicky, the tone of the meeting in Wakeham's office was confident. The quirky "Frankenstein" TV commercials had aroused widespread interest in the impending sell-off. More than 12 million small investors had registered an interest in buying shares in the regional electricity companies, or RECs. The only outstanding decision was on the price.
The stock market had been jittery, unnerved by the civil war in the Tory party and the imminent war in the Gulf. The underwriters - large institutions which, for a fee, agree to step in and buy all the shares if there are no takers elsewhere - were playing hardball, demanding a higher dividend yield for the shares and therefore a lower price.
But according to one person present at that meeting, there was little difficulty about agreeing a price. Shares in all 12 RECs would be offered at 240p. The biggest REC, Eastern Electricity, would alone fetch pounds 648m. The dozen together would raise pounds 5.2bn - in principle enough to slice 3p off income tax for a year.
It seemed a decent enough sum at the time. When the sale went ahead three weeks later, John Major, the new Prime Minister, was able to hail the privatisation in the Commons as "the most successful ever".
The shares were 10 times oversubscribed, applications were drastically scaled down, and the shares went to a premium on the first day of dealing. Unsurprisingly, there were grumbles that the industry had been sold cheaply.
But no one had any idea just what a bargain price 240p was. Four and a half years later, the scale of the misjudgment looks gigantic and the sale proceeds pitifully small. Two weeks ago, Lord Hanson - not a man with a reputation for overpaying for anything - offered pounds 2.5bn for Eastern alone, almost four times as much as the Exchequer received for it. All 12 RECs were valued at pounds 16.8bn at Friday's stock market close, as the table illustrates.
The latest round of bids for RECs and speculation about more bids underlines just how much the Government and, therefore, taxpayers were short-changed. Today Scottish Power is offering more than pounds 900m for Manweb, the REC serving Merseyside and North Wales. In 1990, the Exchequer got pounds 285m for it. The US Southern Electricity International is bidding pounds 1bn for Sweb, which fetched only pounds 295m at privatisation.
Every other REC has at least doubled in value. Most have trebled. Speculation is rife that more bids will be tabled, boosting REC prices still higher. In total, the RECS are now valued at pounds 11.6bn more than the Exchequer received for them in December 1990. The sum forgone is barely imaginable: pounds 11bn could pay for a pounds 550 tax rebate for every household in the country.
Electricity consumers have been painted as the victims of privatisation. In fact, power prices in real terms are no higher than at privatisation and are starting to fall. The big losers were not consumers, but taxpayers. With the benefit of hindsight it is clear that the "family silver", as Harold Macmillan once dubbed privatisation assets, was not so much sold as given away.
So how could the Government and its advisers have got it so spectacularly wrong? More than 50 groups advised the Department of Energy: merchant banks, stockbrokers, lawyers, and a host of property valuers and accountants. Their accumulated expertise was to cost more than pounds 200m. Yet no one saw what was to become blindingly obvious in retrospect - that the RECs were being sold for a song. How come?
The explanation has its seeds in the restructuring of the industry many months before the actual flotation. And central to the story was the role of NM Rothschild, the merchant bank which advised all 12 RECs.
From its offices in St Swithin's Lane in the heart of the Square Mile, Rothschild had been a key player in the City Establishment for almost two centuries. It helped finance the Suez Canal. Its clients included such blue-chip companies as British Airways, Hanson and Rothmans. Its links with the Government were second to none: Norman Lamont and John Redwood were both ex-Rothschilds. And of course Wakeham himself, now Lord Wakeham, is, controversially, a non-executive director there.
Long before flotation, each REC submitted detailed 10-year forecasts of its expected costs, revenues and profits. According to one industry expert, Richard Turner of the consultants London Economics, "The REC managements were superb at bamboozling the Government's advisers with figures. They had all the facts at their fingertips, the Government had none. They forecast their costs were going to be higher than they turned out; they said there weren't many efficiency gains to be made. They'd say, we're in the middle of a very difficult cycle."
It was this gloomy view of the prospects for the entire industry that persuaded the Government to treat them gen- erously. First of all, they were sold off saddled with much less debt than had originally been envisaged. Secondly, the pricing regime was set laxly - so that each could increase its prices at least in line with inflation.
According to one source close to these early discussions: "The Government was outwitted." And it was Rothschild's role, getting all 12 RECs to sing from the same hymnbook, that persuaded the Government the future for the industry was so gloomy. If there had been any inconsistencies, the Government would have been suspicious.
Guided by the Rothschild team, headed by Anthony Fry, the RECs all projected high capital spending programmes and rising costs. "Basically the RECs went through every with Rothschild and put in the most pessimistic case," said the source. "They threw the kitchen sink into their capital spending projections." This view is echoed by Mr Turner, who recalls how one REC budgeted for pounds 100m of capital expenditure a yea r and actually ended up spending only pounds 50m. According to the source, the Rothschild team outmanoeuvred the Government's main advisers, Kleinwort Benson. Many of the KB team were relatively new to the sector, drafted in late in the day. The initial KB team was comparatively small because of a disag reement over fees. Meanwhile, as the flotation loomed, Evelyn de Rothschild, chairman of Rothschild, is understood to have written to the Governor of the Bank of England, then Robin Leigh-Pemberton, warning him that there would be difficulties in underwriting the issue. Th is added to the pressure for a lower price. By the time Wakeham called the price-setting meeting in November, a blanket of caution lay over the privatisation. It was, from the viewpoint of Rothschild and the RECs, a brilliant success. As the share prices have continued to rise since, there have been any number of alternative explanations. None of them stack up - at least not to a height of anywhere near pounds 11bn. Defenders of the sale argue that it was creating a new stock market sector, which investors neither knew nor understood. With the markets nervous as well, the RECs had to be cheap simply to ensure buyers for the shares - to "get the issue away", in stock broker parlance. Moreover, they argue, the privatisation succeeded in other ways, achieving the Government's aim of widening share ownership. More than 1.5 million first-time shareholders were created, by one estimate. Others argue that the pounds 11bn figure exaggerates the loss, because the capital value of the RECs could have been expected to grow anyway over the period since privatisation. This argument holds little water. The RECs were marketed to the public as "yield stocks" - dull but safe shares offering reliable and generous dividends but little in the way of capital growth. Yet while they have achieved 200 per cent-plus growth, the 1 00 largest quoted companies in Britain - those tracked in the FT-SE 100 index - managed less than 20 per cent. Nor can the apologists claim efficiency improvements to explain the enormous growth. Philip Burns, at the Centre for the Study of Regulated Industries, found last year that average productivity across the industry had not improved since privatisation. Nor does the pricing regime in the electricity industry offer any explanation. The inflation-plus-X per cent formula imposed on each of the RECs was known before privatisation. The regulator, Stephen Littlechild, later tightened the formula. Withouthis intervention one can only surmise that the RECs would now be worth even more, and the Exchequer would be looking even more hard done by. In 1992, the National Audit Office concluded that the novelty of the industry and the uncertain market conditions made it particularly difficult for the Department to price the issue. Some analysts have dismissed that as a whitewash - a view increasingly hard to dispute as the prices of REC shares continued to rocket in the following three years. The impact of the mushrooming share price has led to a related scandal - the huge pay packages given to the REC bosses. It was the fact that the sale price was so low that made the directors' share option packages so immensely profitable. The sale had some positive effects. Privatisations since then have eschewed primary underwriting. More important, the Government has become much more wary of wholesale sell-offs - where 100 per cent of the shares are sold. Six months after the sale of th e RECs, when the Government sold the two power generators, it retained substantial holdings in each, and benefited from their subsequent rocketing share prices. The beneficiaries, of course, were the millions of investors who bought REC shares. Mean- while, the scale of the fiscal disaster continues to leave observers breathless. Dan Corry,at the Institute for Public Policy Research, has the last word: "The whole thing is incredible. You can understand the first few privatisations might be sold cheaply. There was all the uncertainty. But by the time they got to electricity -one of the last things to be privatised - it really is quite extraordinary."
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