Mitigating and managing the Council’s risks
Part Three - The challenges facing councils who want to set up and run their own enterprises
Alan Sitkin, Senior Lecturer, Regents University London
The previous blog spoke to the work done to muster political support for the heat-from-waste company that was founded during my term of office at London Borough of Enfield. One factor in my fellow councillors' response to the initiative was a concern about the risks associated with a Council-owned green business like Energetik. This blog speaks to how we tried to mitigate and manage such risks.
There is always risk with any business, but this often a reflection of other issues. The first is competency. There can be a significant disconnect between what a local authority wants to do and what it can do using its internal resources. This is relevant in places like the London Borough of Haringey whose new administration is handcuffed in its bid to shut out developers as it is not itself a developer and therefore requires external parties to do the job.
Generally, the more technical an area of activity, the more it must be run by hired hands able to enact business transformations which politicians may not be comfortable with. There was no question when we launched Energetik about bringing in outside expertise. This isn’t for any want of competence among in-house staff but about the wholly different scale of – in this case – a district heating system serving thousands of households. By their very nature specialists are in high demand and command high wages.
The second risk of state entrepreneurship is substantial upfront preparation costs, which can be difficult to explain politically. I previously spoke about local authorities paying private consultancies huge sums to develop business plans that may or may not be adopted. These studies regularly cost as much as £100,000. For Energetik we had an early business plan giving an early green light - only to have our new CEO determine that houses built according to higher standards would achieve higher performance - affecting the energy demand projections underlying the initial business plan.
I was relieved to hear this critique from the CEO because it showed she was serious about doing things right. It is very possible for a Council, especially in highly technical areas, to hire a supposed genius who is pulling the wool over everyone’s eyes. That is the third risk of state entrepreneurship…
Once our CEO had revised the business plan and we had decided to incorporate, the next risk was aligning Enfield’s oversight function, as the 100% shareholder, with Energetik’s corporate governance. This meant delegating responsibilities so that specific Council officers (operating as holding company board members or in the name of the operating company) could take certain decisions about the future of a venture that was growing but not yet fully staffed.
Above all, the greatest risk was managing potential conflicts between Energetik’s requirement to be viable and Enfield’s other objectives. Shareholders are always interested in investment returns, which are dictated by their company’s profitability. Yet our fuel poverty agenda pushed in the direction of Energetik offering cheap energy – which would hit its profits. Cheap energy would also encourage greater energy consumption, undermining our goal of sustainability.
The conundrum at the heart of this - like many green businesses - is the impossibility of achieving all objectives at once. Some stakeholders, like myself, prioritised the company’s viability, reasoning that it was only once Energetik’s future was assured that we could discount energy. This reflected my business background and understanding that companies must walk before they can run. Others took another view. The varying viewpoints of politicians running a state-owned enterprise like this over time is itself another source of risk.
Then there were financial risks associated with an industrial project involving several tranches of expensive investment. A district heating company of this kind is designed to last 80 years. This has major implications, first being that our industrial apparatus had to use top-quality durable materials. Commercially and ecologically, this was obvious. But it also meant greater upfront investment than if we had made the same mistake as past UK district heating initiatives which had adopted cheaper equipment. Cheap is always bad over the long run, with systems breaking down more often and requiring costly repairs. We wanted to turn infrastructure quality into a strong sales argument and set new standards for the UK district heating industry.
Mechanically, however, our emphasis on quality implied a longer payback period for the full project investment – £58m in 2017 when the Council agreed Energetik’s first-stage. In our eyes the cost was justified by Energetik’s low risk profile. The technology was low risk, having been tried and tested in Europe. The demand was low risk, given residential growth at Meridian Water right next to the future Enfield energy centre, plus existing and future demand elsewhere in London. Energetik was conceptualised from the outset to operate London-wide – a catchment area with a huge commercial potential. So, at that level too, the initiative made sense: low return but low risk and little volatility.
Further to this, the state’s lower cost of capital means state-owned enterprise can be viable despite lengthier payback periods. Our target internal rate of return didn’t have to be as high as the minimum 12% private business demands for this activity. It sufficed that we exceed our adjusted cost of capital, which we did. Of course, there were UK and European state aid provisions affecting these calculations – but they are entirely manageable and were successfully managed.
The final and biggest risk was philosophical. Energetik is an instance of elected members committing to investments whose pay-out far exceeds their time in politics. This depends in part on how project advocates view their role in history – and the extent to which they feel their project will benefit from external support if that becomes necessary in the future. The next blog in this series speaks to this conundrum.