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«1 In recent years a plethora of academic studies have emerged which focus upon varying themes relating to the UK water industry since it was ...»

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The Economic Consequences of Accounting in the English and Welsh Water

Industry: A non-shareholder perspective

Magda Abou-Seada

Christine Cooper

Firoozeh Ghaffari

Richard Jones

Orthodoxia Kyriacou

Mary Simpson


In recent years a plethora of academic studies have emerged which focus upon

varying themes relating to the UK water industry since it was privatized in 1989. (For

a selection see, Shaoul, 1997a, 1997b; Ogden, 1995; Ogden and Anderson, 1999;

Letza and Smallman, 2001). Since 1989, the UK water industry has been under much scrutiny both in terms of its financial operations and structure (in particular pricing policies and investment practices), and its treatment of both the environment and its customers. Some research has suggested that the water industry has poorly managed both its operations and its social responsibility (See for example, the work of Lobina and Hall, 2001; Howarth, nd). Furthermore, there have been claims that the regulators of the industry, notably OFWAT (The Office of Water Services) and the Environment Agency themselves need to be regulated. This is due to the occurrence of a catalogue of serious disasters including compromises in water quality, which have jeopardized public safety (Lobina and Hall, 2001). Those water companies concerned, in turn have faced insignificant fines and inadequate punishment by the regulators.

Taken together, these issues cast serious doubt over the Thatcher Government’s claim that privatization would increase efficiency and thus in turn the public and all those involved in the industry would benefit (Shaoul, 1997a; 1997b). Recent studies have shown that many employed in the water industry have taken redundancies or have lost their jobs through the pursuit of increased efficiency (Hall & Lobina, 1999).

Taken together, these studies provide valuable insights into the significant problems of the water industry at various levels; structurally, regulatory and operationally.

The paper is concerned with the economic consequences of the accounting choices made by the Thatcher government with respect to the economic model of regulation.

While most research into the economic consequences takes a shareholder perspective, this paper considers the economic consequences for the consumer of those choices. We demonstrate that the accounting choices have meant that water has been significantly overpriced since privatization and that they make it more profitable for water companies to invest in new infrastructure and/or sweat existing assets, rather than repair or maintain their infrastructure.

2 Aside from the arguments surrounding the efficiency of the private sectors, it has also been argued in many quarters that the government decided to privatise water in order to provide a mechanism through which new investment could be made in the water infrastructure without financing this investment through taxation orborrowing.

There is little doubt that some of the Victorian infrastructure needed renewing. But this is only part of the story, privatisation can be seen as part of an effort by the state to disengage from investment while stimulating capital accumulation (Kerr, 1998).1 We would argue that the stimulation of capital accumulation was the more forceful driver behind water (and other) privatisation. As a consequence of this, average household water bills have increased by almost 40% in real terms in the first decade under privatisation (Smith, 2003).

Thus the purpose of the paper is to add to the growing body of literature which suggests that it would problematic to accept the claim that water privatization was primarily introduced to enhance the efficiency (what ever that may mean) of the water industry and to transfer the “risk” of investing in new infrastructure to the private sector. Instead we interrogate the history and functioning of the regulatory accounting model to demonstrate that it “stacked the cards in favour” of shareholders over consumers ad thus enhanced the capital accumulation process.

The paper is structured as follows. The next section considers the accounting literature on the economic consequences of accounting choice generally as well as the economic consequences of regulatory accounting. This section also considers the specific form that the economic regulation of privatized industries has taken and how this form is systematically biased in favour of shareholders. It then briefly moves on to outline the regulation of privatized water companies in England and Wales. The following section looks at the historical development of the regulatory accounting model which is used to determine prices. For this we go back to the Thatcher era and the birth of privatization. The following two sections then deal with the details of the pricing model and the risk/return tradeoff. Finally, we present our conclusions. It might seem surprising that the majority of private companies have eschewed current cost accounts, yet the regulators still use them. Here we explain that the use of current cost accounting in regulatory accounts is welcomed by private 1 Kerr, D., (1998), The PFI Miracle, Capital and Class, 64 (spring) pp 17 - 28

–  –  –

The economic consequences of accounting and the impact of regulators Arnold and Cheng (20002) note that accounting choices are said to have economic consequences if these choices alter the distribution of firm’s cash flows or the wealth of parties that use accounting numbers for contracting and decision making (Holthausen and Leftwich, 19833). They further note that by calling attention to the conflicts of economic interest inherent in the choice of accounting methods, the economic consequences literature has helped to dispel any myths that accounting choices are neutral or disinterested. Although some (eg Ghosh and Alvis, 2003) see accounting as neutral (and therefore helpful in making social decisions). Others (Hal,

2003) recognise that while accounting choices can be made which produce “interested” consequences they suggest that this is not a concern so long as everyone follows the rules. This fails to address the problem which this paper attempts to address which is that those who set the rules are neither disinterested Hodder et al, (20024) suggest that rules (especially accounting nor neutral.

standards) are a problem, seeing SFASs as (regulatory) risk factors.

The accounting literature is replete with studies that explore how and why firms manage their earnings (eg managerial compensation, risk aversion, debt covenants and signalling) (Hodder et al, 2002). The vast majority of economic consequences papers recognise the cash flow consequences of accounting policy choices and look at the market responses to accounting changes (Ball and Smith, 19925; Burgstahler 2 Arnold, P., and Cheng, R. H., “The economic consequences of regulatory accounting in the nuclear power plant industry: market reaction to plant abandonments”, Journal of Accounting and Public Policy, Volume 19, Issue 2, 30 June 2000, Pages 161-187 3

Holthausen, R.W. and Leftwich, R., 1983. The economic consequences of accounting choice:

implications of costly contracting and monitoring. Journal of Accounting and Economics 5 2, pp. 77– 117 4 Hodder, L., Kohlbeck, M., McAnally, M. L., “Accounting Choices and Risk Management: SFAS no 115 and US bank Holding Companies”, Contemporary Accounting Research, Summer 2002, 19, 2 pp 225 - 270 5 Ball, R.J. and Smith, C.W., 1992. The Economics of Accounting Policy Choice, McGraw-Hill, New York.

4 and Dichev, 19976; DeAngelo et al., 19947; Hand and Skantz, 19978; Healy, 19859;

Muller, 1999 and Soo, 199910). Some are self-conscious about this (eg Morana and Sawkins, 2002) while others fail to explicitly recognise that there are other stakeholders aside from market participants.

There are less papers which look at the economic consequences of regulatory accounting. Notable exceptions include Arnold and Cheng (2000), Chen et al (198711), and (Callihan, 199412). Arnold and Cheng (2000) look at the US Nuclear Power Industry. They argue that accounting methods adopted by state utility rate setting commissions determined how billions of dollars invested in cancelled nuclear projects were allocated between financial stakeholders, including utility stockholders, ratepayers and federal tax payers. While Arnold and Cheng takes a market perspective, it clearly recognises that regulatory accounting plays a large part in the distribution of wealth and costs between different groups within society. Presenting a more nuanced view of society, the paper takes extant power-relations into consideration more explicitly than earlier work which tended to see regulators as being pro-producer or pro-consumer. This view can add to our understanding of the relationship between the state, capitalism and the non-capitalist classes (or the relative autonomy of the state).

The theoretical literature relating to the effects of economic regulation derives from seminal contributions by Stigler (1971), Posner (1974), Peltzman (1976), and Kahn (1989) (Morana and Sawkins, 2002). Antoniou and Pescetto (1997) summarize the effects of regulation on the value, and thus the cost of equity, in regulated firms in 6 Burgstahler, D and Dichev, I., 1997. Earnings management to avoid earnings decreases and losses.

Journal of Accounting and Economics 24 1, pp. 99–126.

7 DeAngelo, H., DeAngelo, L. and Skinner, D.J., 1994. Accounting choice in troubled companies.

Journal of Accounting Economics 17 1/2, pp. 113–143 8 Hand, J.R.M. and Skantz, T.R., 1997. The economic determinants of accounting choices: the unique case of equity carve-outs under SAB 51. Journal of Accounting and Economics 24 2, pp. 175–204.

9 Healy, P., 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics 7 1–3, pp. 85–107 10 Muller, K.A., 1999. An examination of the voluntary recognition of acquired brand names in the United Kingdom. Journal of Accounting and Economics 26 1-3, pp. 179 - 191 11 Chen, C., Fanara, P. and Gorman, R., 1987. Abandonment decisions and the market value of the firm: the case of nuclear power project abandonment. Journal of Accounting and Public Policy 6 4, pp.

285–297 12 Callihan, D., 1994. Corporate effective tax rates: a synthesis of the literature. Journal of Accounting Literature 13, pp. 1–43 5 three ways. First, consumer protection theories, in which regulators protect consumers by bearing down on monopolists, lowering prices and controlling for the externalities, which drive a wedge between private and social costs and benefits. In this case regulation has a negative effect on company value by increasing the cost of equity capital. Second, producer protection theories, in which regulators are "captured" by incumbents. Potential entrants are effectively excluded leading to decreases in the cost of equity capital implying a positive effect on share prices.

Finally, regulatory utility maximization theories, in which regulators seek to protect their own position at the expense of consumers and producers. The effect of this on equity returns is unpredictable. It is interesting that none of these seems to be able to see the synergistic relationship between the state (and the regulators) and the private utility companies. There are substantial debates surrounding the relative autonomy of the state from capital (see Cooper et al, 2004)13. It is too simplistic simply to show a crude correspondence between the activities of the state as simply serving the needs of the ruling or capitalist class. What is required is an explanation of how the very form of the activity is inscribed with the traces and priorities of the capitalist system, with the result that it is so distorted and limited, and so systematically biased in its working, that it is inadequate as a means of creating a truly liberated human social order.

Clearly, regulators impose some kind of “cost” to regulated companies, not least since regulators impose on companies the additional burden of producing regulatory accounts. However, in the case of the English and Welsh water companies, the regulator is specifically concerned to ensure that the water companies earn a decent rate of return. Thus as a guarantor of profits, it would also be possible to characterise the water regulator as bringing significant benefits to water companies which arguably outweigh the costs. This explains how the regulatory system is inscribed with the traces and priorities of the capitalist system.

The economic regulatory model that was used in one of the first privatisations (BT) in the UK was designed to ensure that the rate of return earned would be enough to guarantee a high initial share price. As we shall see later the UK govenment 13 Capitalism, States and Ac-counting, (with L Catchpowle and A Wright), Critical Perspectives on Accounting, Volume 15, Issue 8, November 2004, Pages 1037-1058 6 specifically decided not to follow the then dominant US economic model for utility regulation which set a limit on the rate of returns earned by utility companies.

Instead, the preferred model in the UK was a cap on prices. On the surface it may appear that a price cap regulatory model is more socially progressive, as we will see later in the paper, the regulatory model adopted in the UK water industry in fact meant that water prices were excessively high.

Although it is clear that in both countries, the regulator has large control over the distribution of wealth between consumers and shareholders. With respect to the US nuclear power industry, Arnold and Cheng (2000) write that “because utility rates are set by state commissions, the nuclear power industry represents a sector of the US economy where distributions of economic wealth depend extensively on state actions and institutions, as well as market forces.” Another similarity between the US and the UK is that in both countries the technical complexity of the rate setting process allows for deviations between stated policies and practical consequences. In the US although rate setting commissions often adopted the policy objective of allocating costs equitably between ratepayers, taxpayers, and utility owners, slight variations in elected accounting methods could skew the distributions of cash flows in favour of one group or another. Later we will explain how in the UK, the regulatory accounting choices have ensured significant returns to the private water companies at the expense of customers.

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