Tuesday, 16 January 2018

The Legacy of George Osborne

The collapse of Carillion has been heralded as a watershed moment for privatisation. I doubt that's true. The deficiencies of public sector outsourcing and PFI deals have been known for decades, while the prospect of a major change in public sector management is probably only going to occur with a change of government, which may not happen before 2022. The refusal to bail out the business, even though it means more write-offs for state-owned RBS, suggests that the government is keen to avoid the distraction of both a specific inquest into the company and a general debate about public services and infrastructure investment. The desire to protect taxpayers' money is incidental. Given the competing demands of Brexit, that is hardly surprising. While John McDonnell's robust insistence on a public inquiry has been predictable (imagine how this would have been handled by Ed Balls), the failure of George Osborne to make his now habitual dig at Theresa May was less so.

The former Chancellor's editorial in yesterday's Evening Standard, which relegated the topic behind the scourge of plastic waste, suggested the root cause was a combination of the excessive size of Carillion and the tendency of civil servants to prefer the devil they know: "The failure to use a variety of smaller, mid-size companies undermines innovation and leaves services hostage when things go wrong". What is missing from this timid analysis is political accountability. The push for government contracts to go to more and smaller firms was a cosmetic gesture during Osborne's tenure at the Treasury that has resulted in minimal change for pretty obvious structural reasons. It has little to do with civil servants' aversion to novelty. His claim also obscures that the material change in circumstances in 2010 was the imposition of austerity. This led to Whitehall putting the screws on suppliers to reduce contract costs, which was one of the contributory factors to Carillion's eventual demise. This was a death long foretold. As the old Ernest Hemingway joke has it, "How did you go bankrupt? Two ways. Gradually, then suddenly".

Osborne, not for the first time, is being disingenuous. Dealing with a single big supplier is easier for the client, particularly when cuts erode the public sector's capacity for effective supplier management, while big companies with extensive portfolios of public revenues are more likely to secure the financing necessary to initiate large contracts without the need for the state to make formal guarantees that would appear on the national accounts. This tendency towards the big also encourages suppliers to operate essentially as intermediaries (hence the way they morph into empty brands with meaningless names), willing to facilitate any new service required by the client regardless of their actual competence or history, if only to maintain the relationship and the advantages of incumbency. The result is the consolidation of companies handling government contracts, not a flowering of supplier variety, and an ever more desperate search for low-cost sub-contractors and cuttable corners rather than a commitment to innovative service delivery.

What was being outsourced to Carillion was financial and project management, not innovation or risk. For this reason it is pointless to talk of nationalising the company, or to wonder why it is being liquidated rather than being put into administration. It isn't a going concern and it has little in the way of tangible assets. There aren't any means of production to put into public ownership and the company's institutional capital centres on the ability to win public sector contracts, which would be redundant if it were nationalised. Of the 4.43bn total assets it reported in 2016, only 144m were fixed assets (property, plant, equipment etc). Cash, receivables, inventory and investments made up 2.4bn and goodwill (representing the intangible cost of historic acquisitions) a further 1.6bn. In other words, its tangible assets were largely money or near-money, most of which appears to have been haemorrhaged over the last year. The warning that creditors may receive only a few pennies in the pound tells you not only that the cash has gone but that the contracts represented by the receivables aren't sufficient to meet the liabilities, confirming that the proximate cause of collapse was evaporating margins and an inability to secure further financing.

Both of these will have been evident for months, if not years, which is why it is entirely legitimate to demand scrutiny of the apparent under-estimation of the risk of collapse by both Carillion's board and government ministers. But we shouldn't lose sight of the fundamental issue here, namely that the outsourcing sector and PFI contracts have both been pushed by structural forces towards financial arbitrage rather than competitive service delivery, a situation exacerbated for almost a decade by the contingent demands of austerity, which have reduced both the number of contracts and profit margins. The result is a "market" made up of fragile suppliers who are obliged to grow or die; or at least win new contracts, no matter how small the profit, in order to to keep the life-support machine turned on. When even the FT describes Carillion as "a lawful sort of Ponzi scheme - using new or expected revenues to cover more pressing demands for payment", then the cat is well and truly out of the bag. This was an unsustainable model and plenty of people must have known that for a long time.

Carillion's executive remuneration was geared to winning contracts and growing, which meant that there would always be a reluctance to retrench, even when the warning signs started to flash, such as in 2014 when hedge funds began short-selling the company's shares. Other obvious signs of distress were the growing deficit in the pension fund and the imposition of abusive supplier payment terms, which were increased to 120 days in 2013 (another example of financial arbitrage - client terms remained at 30 days in most cases). This was evidence in the public domain. The apparent failure to raise any of these issues at board level points to the uselessness of non-executive directors who share the same cultural values (growth at all costs, the primacy of shareholder value, the need for superior executive rewards etc). This failure also extends to ministers, who in respect of the governance of public sector outsourcing and PFI deals have a de facto non-executive role. Their inability to read the signs, and the suggestion that they may have deliberately ignored some in order to cut the business more slack, points to a similar cultural weakness.

The centrist debate on outsourcing revolves around the concept of "drawing the line", which is a mixture of Coasian theory and liberal propriety. This suggests that getting it right is a matter of refinement and judgement. As Simon Jenkins harrumphs, "How to find the ideal mix of public sector loyalty and private sector incentive has bedevilled state procurement since the dawn of time. But there should be clear rules, as with monopoly regulation, such as limits on market dominance, debt and remuneration". The suggestion that we lack clear rules on all these matters is absurd. Public procurement is highly regulated and rule-bound, not just because of political sensitivity but because suppliers themselves appreciate the advantages that accrue to incumbents through high barriers to entry. The flaw in this abstract thinking is that in the real world public sector loyalty and private sector incentive constitute a volatile mix. There is no stable combination; no clear line. This is not necessarily a problem if one is dominant. The problem arises when a dynamic like austerity erodes loyalty and incentives simultaneously. As the public sector struggles to recruit and retain staff, and as outsourcers collapse, the government is waking up to the legacy of George Osborne.

1 comment:

  1. Mirroring some of what you say above with respect to the affect Austerity has had and continues to have on the procurement process can be found in this article -

    "Finally, for now, we might also be controversial and ask whether big buyers are getting “too good” at procurement? Is the competitive process driving firms into under-bidding on major contracts? That seems to be one of the core problems here, with Carillion actually losing large amounts of money on certain contracts. Or maybe it was sheer managerial incompetence; while external events in the Middle East may be one part of the problem here, something pretty endemic has gone wrong internally for the firm to get into this sorry state"