RLIT0000197
RLITO000197
OD
National Audit Office
The Shareholder Executive and
Public Sector Businesses
REPORT BY THE COMPTROLLER AND AUDITOR GENERAL I HC 255 Session 2006-2007 I 28 February 2007
The National Audit Office scrutinises
public spending on behalf of
Parliament. The Comptroller and
Auditor General, Sir John Bourn, is
an Officer of the House of Commons.
He is the head of the National Audit
Office, which employs some 850 staff.
He, and the National Audit Office, are
totally independent of Government.
He certifies the accounts of all
Government departments and a wide
range of other public sector bodies;
and he has statutory authority to report
to Parliament on the economy,
efficiency and effectiveness with
which departments and other bodies
have used their resources. Our work
saves the taxpayer millions of pounds.
every year. At least £8 for every
£1 spent running the Office.
RLIT0000197
RLIT0000197
RLIT0000197
RLITO000197
Gi)
National Audit Office
The Shareholder Executive and
Public Sector Businesses
Ordered by the
LONDON: The Stationery Office House of Commons
£13.50 to be printed on 26 February 2007
REPORT BY THE COMPTROLLER AND AUDITOR GENERAL I HC 255 Session 2006-2007 I 28 February 2007
This report has been prepared under Section 6
of the National Audit Act 1983 for presentation
to the House of Commons in accordance with
Section 9 of the Act.
John Bourn
Comptroller and Auditor General
National Audit Office
22 February 2007
The National Audit Office
study team consisted of:
Mark Halliday, Esther Hurrell, Akhil Patel,
Peter Sharpe, Mark Shearsby and Richard Wade
under the direction of Patricia Leahy
This report can be found on the National Audit
Office web site at www.nao.org.uk
For further information about the
National Audit Office please contact:
National Audit Office
Press Office
157-197 Buckingham Palace Road
Victoria
London
SW1W 9SP
Email: enquirie
© National Audit Office 2007
RLIT0000197
RLIT0000197
CONTENTS
EXECUTIVE SUMMARY
PART ONE
The Shareholder Executive was set up to
deliver a step change in the performance
of Government as a shareholder
The creation of the Shareholder Executive
Before the Executive was set up, there was no
consistent approach to the management of
Government shareholdings
The implications of policy for commercial
objectives were often not made
sufficiently transparent
Managing public sector businesses consistently
for value represents a step-change in the
Government's approach
PART TWO.
The Shareholder Executive has made
a good start, despite operating within
a limited framework
The Executive has established a good
shareholding model through which it
discharges the shareholder function
The Executive has attracted experienced staff
with public and private sector expertise
The Executive has had early successes in
bringing about beneficial change
The Executive's structure and remit limits
its scope for realising greater benefits
Photographs courtesy of Alamy.com
PART THREE
Changes are required to keep
up momentum and to build on
early achievements
In the near future the Executive and some
businesses face strategic challenges
Resolving conflicting roles in its postal industry
responsibilities needs to be a key priority
More meaningful measures could be adopted
to provide a better assessment of the
Executive's work
The Shareholder Executive itself needs to
be seen to be managed for value
The Executive must plan to maintain the quality
of its staff and consolidate its knowledge base
APPENDICES
1 Study methodology
The Shareholder Executive's StartUp Review
Approaches to valuation
RON
International approaches to .
Government Shareholding
wa
The Executive's internal reporting
6 Previous PAC and NAO references to
shareholding issues
RLIT0000197
RLIT0000197
24
24
25
25
26
28
29
32
34
37
4l
44
RLIT0000197
'LIT0000197
EXECUTIVE SUMMARY
businesses’ in its portfolio (hereafter “target” businesses)
by £1 billion between 2004 and 2007. This report
examines the changes to the shareholding function
brought about by the Executive and whether it is on
course to achieve its objectives.
3. Where the Government is a controlling shareholder,
it can hold management to account for the performance
of businesses by using several “shareholder levers”. These
are equivalent to and can be compared with the levers
available to a private equity firm (Figure 3). These include:
selecting the Chair and Board members; approving
transparent business objectives that respect policy
constraints; monitoring and rewarding performance;
dealing with non-performing management; and agreeing
finance for investment. Responsibility for advising
Ministers on the use of most of these levers is delegated
to the Executive where it has been given responsibility for
looking after the Government's ownership interests.’
4 To date, the Executive has generally acted as an
effective and intelligent shareholder by making good use
of the shareholder levers. In particular, it has developed
a framework which allows its skilled staff to apply the
shareholder levers available to it in a consistent way.
This focus on shareholder value has resulted in some
notable successes. For example, in the 2006 sale of
Westinghouse, the Executive, as a trusted central body
within government, played a key role in the agreement to
allow Westinghouse to bid to build new nuclear power
plants in China. Selling Westinghouse with these contracts
already negotiated helped to bring in £3 billion against
initial expectations of £1 billion.
5 Important issues need to be addressed to allow
the Executive to build on its early work and have a
greater impact. The Executive has no statutory authority
to manage government interests and has to market its
services to departments in order to bring government
businesses into its portfolio. Despite its success in
achieving this, a number of omissions or inconsistencies
still exist which can lead to inefficiencies and poor
value for money. Another important issue is the range of
responsibilities that the Executive has in relation to the
postal market. It is responsible for DTI policy on the postal
market and the Post Office network, oversight of the postal
services consumer watchdog and, in some respects, the
statutory regulator while also managing the shareholding
in Royal Mail. These varied responsibilities mean that the
Executive has to advise on how to manage the conflicting
2 The six businesses are: BNFL, CDC
the financial year 2004-05
NATS, QinetiQ, Ri
al Mail and Roy
The Ministers
s contributed approximately
are the Secretaries of State who, as heads of various
onsible for the statutor
corporations, non-departmental public bodies, executive agencies
RLIT0000197
RLIT0000197
EXECUTIVE SUMMARY
pressures and priorities. There is a risk that some
judgements could be settled internally and the shareholder
value case not be made clearly or transparently, a risk that
will become more important as competition within the
postal market increases.
6 The Executive's target ~ to increase the value of
the target businesses by £1 billion - has brought greater
attention to shareholder value within public businesses.
Going forward, however, there are limitations with the
target that will need to be addressed. It is difficult to link
the achievement of the target with the Executive's own
performance in managing the shareholdings on behalf
of Government. Furthermore, the earnings of these target
businesses can potentially be volatile and the performance
of a single one can have a decisive influence on whether or
not the financial target is achieved. Continuing with a single,
portfolio-level target alone is, therefore, inappropriate.
7 The ability to access financing for investments is
critical to the success of a commercial business. As long
as a business is within the public sector, however, its
investment needs are subject to fiscal policy constraints and
compete with departmental and government-wide spending
priorities. Because of these constraints decisions on whether
or not to invest in a business are not considered on the
basis of a sound investment return alone, as is the case with
private sector businesses (some of which compete directly
with public businesses). Inevitably, the current framework
means that the scope for using this important shareholder
lever is reduced.
8 A further consequence of this is that businesses
have an incentive to build up cash reserves in case of
future need, which could otherwise be passed back to
departments in the form of dividends. The Executive has
a generic aspiration that businesses should pay dividends
but no specific business-level dividend targets.
9 This report finds that the Executive has improved
the way in which Government acts as a shareholder.
Taking this into account as well as its annual budget
of £9.9 million and the value it has already brought to
the taxpayer, for example through its role in the sale of
Westinghouse, the National Audit Office concludes that
the Shareholder Executive has provided value for money.
10 On the basis of the above conclusions, the report
recommends the following:
Mint. These businesses were selected for the target because by the beginning of
THE SHARE!
ND PUBLIC SECTOR BUSINE
EXECUTIVE SUMMARY
A) On optimising the framework
Findings
Al The Executive's early performance supports the case
for central management of the shareholder function in
Government, in line with internationally recommended
best practice (paragraphs 2.13-2.15, Appendix 4).
A2_ The Executive's current location in the DTI means
that it is responsible for, in addition to the shareholding
in Royal Mail, DTI policy on the postal market and the
Post Office network and oversight of the market regulator
and consumer watchdog. This could lead to the Executive
advising on how to balance competing pressures rather
than being able to make the shareholder case clearly and
transparently (paragraphs 2.23, 3.4).
A3__ Asa DTI body, it operates within departmental
pay and grading limits which could inhibit recruitment
of appropriately skilled staff on whom the Executive's
effectiveness depends (paragraphs 3.15-3.16).
A4 From 2008, the Executive's ring-fenced budget
will expire and there is some uncertainty about future
arrangements. This could result in either the DTI funding
activities which benefit other government departments or
vice versa (paragraph 3.11).
AS Anumber of inconsistencies and omissions to the
portfolio exist. The Executive lacks the authority to address
these (paragraphs 1.4, 2.18-2.23, 3.10).
Recommendations
Al The Executive's performance could be enhanced
if it had independent status and funding, and flexibility
to set remuneration, with attendant accountability
arrangements and greater challenge, for example
from a Board of Directors.
A2 Membership of the Stakeholder Group should
be extended to include representatives from all of the
shareholding departments.
A3_ There should be a presumption that all publicly
owned businesses should fall within the remit of the
Shareholder Executive. Departments should comply with
this presumption or explain the rationale for exceptions to
the satisfaction of the Cabinet Office and Treasury.
A4 The Executive should not have responsibility
for Royal Mail policy or oversight of PostWatch and
PostComm. This will enable it to concentrate better on the
case for enhancing shareholder value in Royal Mail.
6 THE SHAREHOLDER EXECUTIVE AND PUBI
CTOR BUSINESSES
RLIT0000197
RLIT0000197
B) On improving the availability of
finance for investment
Findings
B1_ Decisions taken by departments to invest in public
businesses are subject to fiscal policy constraints and
compete with other spending priorities. But the availability
of finance for investment can have a major impact on
the value of a business; and the ability to provide finance
would increase the Executive's effectiveness in its dealings
with businesses (paragraphs 2.24-2.26, 3.13).
B2 As businesses are not guaranteed to have access to
financing, they have an incentive not to pay dividends to
their sponsoring departments (paragraphs 2.27, 3.8).
B3 The level of dividends paid by businesses in the
portfolio has increased in total since the Executive was set
up, but — partly for investment reasons — has not increased
as a share of operational profits (paragraphs 2.28,
Figure 10).
Recommendations
B1__ Finance for investment that is supported by a robust
business case should be made available more consistently.
There are a number of ways of achieving this, including:
i Placing the Executive explicitly in the lead for the
budgetary oversight of investment in businesses on
behalf of sponsor departments. Responsibility for this
could be delegated to the Executive by departmental
Accounting Officers.
ii Ata minimum, requiring the Executive to report on
investment planning and the impact that the current
framework has on shareholder value.
B2 In these circumstances it would be reasonable to
require the businesses explicitly to pay over excess cash
except where the Shareholder Executive had given prior
approval to investment. To increase transparency around
this process, the Executive should set business-level
dividend targets.
©) On improving performance and
managing business risk
Findings
C1 Going forward, measuring its performance via
a portfolio target alone is inappropriate because the
Executive's remit does not allow it to manage its
businesses as a portfolio by, for example, disposing of
assets — the usual way to deal with poorly performing
businesses in a portfolio (paragraphs 1.14, 3.5-3.7).
C2 The Royal Mail, British Energy and BNFL face
strategic challenges over the short-term which will have
an impact on their value. Each of these businesses are of
such a size that an individual result can skew (up or down)
the overall result — as can be seen in the last two years
(paragraphs 3.2-3.3, 3.7, Figure 12).
Recommendations
Cl The Executive's target for increasing the value of
its businesses should be amended to include measures
that are based on the results of the individual businesses
alongside an aggregated portfolio-level target.
C2 The targets must take into account the challenges
facing each individual business (for example, the
investment case for Royal Mail, the restructuring of BNFL,
and decisions to be made regarding the equity option in
British Energy).
THE SHAREHOLI
RLIT0000197
RLIT0000197
EXECUTIVE SUMMARY
R EXECUTIVE AND PUBLIC SECTOR BUSINESSES 7
PART ONE
1.1 Businesses owned or part-owned by Government
still make an important contribution to the United
Kingdom economy. Their combined turnover in 2005
was well in excess of £25 billion, or over two per cent
of Gross Domestic Product, and they were responsible
for the delivery of a number of critical public services,
such as safe and efficient air traffic services over national
airspace, the clean up of nuclear waste, defence research
and the universal provision of postal services? Typically,
the businesses provide services to the public sector and
other parties to meet these public policy objectives on
a commercial basis. Any business needs to generate a
sufficient surplus (or profit) to cover its investment needs
and the commercial risks it faces. If not run well or
managed for value, businesses will not make profits, pay
dividends or reinvest any surplus in improving service
provision; and may require financial support in the form of
debt or equity to maintain operations as a going concern.
As the value of businesses in the public sector is large there
is a significant public interest in avoiding such outcomes.
1.2 Balancing public policy and shareholder value
objectives, however, is difficult. As a customer, the
Government can sometimes benefit from the delivery
of policy objectives at a price below the real cost to
the business. On the other hand, the Government,
as a shareholder and in most cases a lender’ to these
businesses, has an interest in their long-term value
and will want to ensure that they are compensated
appropriately for the public capital invested in them.
Another important consideration for Government is
ensuring that public expenditure remains consistent with
RLIT0000197
RLITO000197
The Shareholder
Executive was set up to
deliver a step change
in the performance
of Government as
a shareholder
fiscal rules and this can limit the availability of capital
for investment in businesses.’ There is a tension between
these aims and in the past government departments
struggled to balance these important responsibilities
— often with the result that long-term shareholder value
was not protected adequately. The Public Accounts
Committee and the National Audit Office have previously
highlighted concerns about this (Figure 1 and Appendix 6).
Furthermore, between 2000 and 2003 some of the major
government-owned businesses sustained large losses’
~an indication of the challenge faced by management
and departmental teams to protect shareholder value.
The creation of the
Shareholder Executive
1.3. The recognition of the difficulties inherent in
balancing public policy and ownership objectives and
thereby ultimately in preserving and enhancing the value
of public businesses led in 2003 to the creation of the
Shareholder Executive (“the Executive”). Figure 1 charts
the increasing concern during the 1990s and early 2000s
about shareholder value issues, both within the UK and
overseas. As in other countries, the Executive was set up
to centralise shareholding expertise within government, to
bring a specific focus to shareholder issues and to improve
government's performance as the owner of businesses.
This report examines the changes brought about by the
Executive operating within the policy, regulatory and fiscal
constraints of central government and its performance
against its objectives.
4 This includes bodies classified as UK central and local government public corporations as well executive agencies, non-departmental public bodies and
statutory corporations involved in commercial activities.
5 Most of the major UK government-owned businesses were sold off during the 1980s and 1990s but a large number of public sector businesses are still owned
by central and local overnment.
6 Only two public businesses are listed (QinetiQ Plc and British Energy Plc) although some have private shareholders alongside the Government (e.g. NATS,
Partnerships UK and Working Links).
7 Only five businesses in the Executive's portfolio (see Figure 2) can raise third party debt: British Energy, NATS, Partnerships UK, QinetiQ and Working Links.
8 This issue is discussed more fully in paragraphs 2.24ff and 3.12-3.13.
9 In the three (financial) years prior to the creation of the Shareholder Executive 20 [of the] businesses now within the portfolio...recorded losses of.
£4.9 billion at the net income level, or £2.7 billion if losses relating to the change in BNFL’s nuclear liabilities are excluded” (Shareholder Executive
2004/05 Annual Report, p.10
8 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLITO000197
PART ONE
PAC and NAO reports are in bold (see Appendix 6 for further details)
1992 m_ PAC report on the Sale of Water Authorities notes insufficient separation of regulatory and selling teams
m_ UK Corporate Governance: Cadbury Code of Best Practice for listed companies
1993 m New Zealand sets up Crown Companies Monitoring Advisory Unit
1994
1995 — m Privatisation of British Rail Maintenance Ltd
m UK Corporate Governance: Greenbury report on directors’ remuneration, in response to ‘fat cats’ concerns
International Corporate Governance Network of companies, investors, and academics established
1996 — m Privatisation of Railtrack
@ Privatisation of British Energy
1997. m PAC report on privatisation of British Rail Maintenance Ltd notes insufficient departmental monitoring
Australia establishes dedicated Unit to advise on shareholder value and business issues
1998
PAC report on the Sale of Her Majesty's Stationery Office criticises department's over-reliance on HMSO’s Chief Executive in
advising on the sale
Sweden centralises state business ownership to Ministry of Industry, and sets up a dedicated team
UK: Combined Code, drawing together Cadbury Code and subsequent reports
PAC report on the Sale of Railfreight Distribution questions whether the sale was managed to maximise value for taxpayer
PAC report on Railtrack Flotation is critical of the handling of the sale, driven by policy rather than valve
Finland revises state ownership procedures
OECD publishes Principles of Corporate Governance
The Netherlands centralises ownership function to Ministry of Finance, late 1990's
NAO report on the Post Office’s acquisition of German Parcel recommends departments need a team with corporate finance
expertise to help appraise such acquisitions, and notes that some countries have a single department with oversight of
government businesses
Royal Mint begins making losses
Royal Mail (Consignia) begins making losses
1m Formation of Partnerships UK to provide central government advice on PPP and PFI opportunities
2001 m_ Denmark transfers ownership of 11 businesses to specialist unit in Ministry of Trade and Industry
2002 m_ Norway consolidates ownership to unit in Ministry of Trade and Industry; Sweden's State-Owned Enterprises Division
(1998) given greater powers
tm USA Corporate Governance: Sarbanes Oxley Act
2003 m Shareholder Executive established
OECD produces its Survey of Corporate Governance of State-Owned Enterprises
UK Corporate Governance: Higgs Report on non-executive directors’ role; Smith review of audit committees. Combined
Code revised to incorporate Higgs & Smith
2004 Shareholder Executive moves to DTI and merges with their shareholding teams
France sets up Agence des Participations de I’Etat
International Network of Government Ownership Agencies (INGOA) established
OECD publishes Guidelines on Corporate Governance of State-Owned Enterprises
HM Treasury publishes Corporate Governance in Central Government Departments: A Code of Good Practice
2006 m_UK Corporate Governance: Combined Code revised
Source: National Audit Office
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 9
PART ONE
1.4 Although the Executive has a separate identity, it
exists as an operational group within the Department
of Trade and Industry (“the DTI”), Itis responsible for a
number of activities, the most important of which is the
management of shareholdings in 17 government-owned
businesses either on behalf of (in an executive capacity)
or in co-operation with (in a “joint leadership” role)
the sponsoring departmental shareholding team. It also
plays an advisory role to the relevant team for a further
10 businesses. In each of these cases, the Executive or
the departmental team are responsible for advising the
relevant shareholding Ministers on decisions. These
businesses are listed in Figure 2. It is important to note
that not all bodies which have significant commercial
activity, and in which the Government has an economic
interest, fall within the Shareholder Executive's remit.
Though its mission to improve shareholder performance is
government-wide, it cannot compel departments to give
it responsibility for managing their ownership interests.
Examples of omissions from the remit are listed in Figure 9
on page 21.
1.5 Asin the private sector, a number of “shareholder
levers” exist to influence how a business is managed
so that its value is protected and increased. Figure 3
on page 12 lists these levers. As can be seen, not all of
these are available to departmental shareholding teams or,
through them, to the Executive. The implication of this is
discussed in paragraphs 2.24-2.26 and 3.12-3.13.
1.6 In terms of its reporting arrangements, the
Executive is accountable to the following in part
or in full for its activities (see Figure 4 on page 13):
m= to the DTI Permanent Secretary for its administrative
budget, covering all operational costs, and its
“programme” budget which covers the cost
of external advice on issues relating to BNFL,
British Energy and the Royal Mail. For 2006-07
the administrative and programme budgets were
£5.1 million and £4.8 million respectively;
to the Permanent Secretaries of government
departments which own businesses for the
management of shareholdings and any corporate
finance work (see below) carried out on behalf of
that department; and
Between Novem!
Secretary and the Cabinet Secretary. The Chairman was officially in the en
with the Cabinet Secretary. Althou
ber 2006 and February 2007, the Chief Executive reporte
h the current Chairman is stepping
ite depart
which there was a restructuring team in place
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLITO000197
= tothe Stakeholder Group, consisting of a senior
official from each of the major shareholding
departments (DTI, Ministry of Defence and the
Department for International Development)
and the Treasury: the Group monitors the
Executive's performance against its objectives
and its overall mission to improve shareholding
across Government.
1.7. The Chief Executive also has two to three meetings a
year with the Cabinet Secretary to review the Executive's
delivery of its government-wide mission.'” This reporting
arrangement is in place to maintain a link to the centre
of Government and because the Executive is responsible
for managing shareholdings on behalf of Government.
Indeed, between 2003 and 2004, the Executive sat within
the Cabinet Office where it had a purely advisory role. Its
move to the DTI in 2004 was a condition of it being given
the opportunity to take over executive responsibilities for
the DTI businesses.
1.8 The DTI teams were between them responsible for
British Energy, the United Kingdom Atomic Energy Agency,
BNFL, the Export Credits Guarantee Department and the
Royal Mail.'' The Royal Mail team was also responsible
for policy issues relating to the postal market and the
Post Office network and sponsored the market regulator,
PostComm and the postal services watchdog, PostWatch,
and these responsibilities were absorbed by the Executive
at the same time.
1.9. The Industrial Development Unit (IDU) carries out
corporate finance advisory work for central government.
The IDU employs staff on fixed term contracts from the
private sector with relevant professional skills (typically
banking and accountancy). It appraises and negotiates
financial assistance to non-government owned companies,
and provides financial, analytical and negotiation support
across government in its dealings with corporate bodies.
In any one year the IDU can advise on projects in excess
of £500 million. The IDU has the further goals of: (i)
mobilising quick decision making to meet commercial
timetables, and (ii) avoiding unnecessary external costs by
making more efficient use of outside advisers on specific
tasks. As it is now fully a part of the Executive, IDU staff
are interchangeable with other professionally qualified
members of the team.
id to a (part-time) executive Chairman who in turn reported to the DTI Permanent
mployment of the Cabinet Office and therefore had a line managerial relationship
wn, it is envisaged that there will continue to be a post of part-time Chairman.
rental shareholding teams within the DTI, except in the case of British Energy for
RLIT0000197
RLIT0000197
PART ONE
Role of Shareholder
Executive
(see paragraph 1.4
for definitions)
Executive Role
Joint Leadership Role
Advisory Role
Source: National Audit Office
Government Department
Department of Trade and Industry
HM Treasury
Department for International Development
Department of Work and Pensions
Department for Transport
Ministry of Defence
Home Office
Scottish Executive
Department for International Development
Department for Regional Development, NI
Department for Communities and Local Government
Department of the Environment, Food and Rural Affairs
Department of Culture, Media and Sport
The Shareholder Executive interacts with public businesses and Government departments in a range of ways.
Business
Royal Mail
British Energy
UK Atomic Energy Authority
BNFL
ECGD
Partnerships UK
Royal Mint
Actis
Working Links
NATS
UK Hydrographic Office
Met Office
Qinetiq
DsTL
DARA
ABRO
Forensic Science Service
Scottish Water
CDC
NI Water Service
QEII Centre
Fire Service College
Ordnance Survey
‘Covent Garden Market Authority
itish Waterways
Tote
‘Channel 4
Total
2005-06
turnover
£ million
9,056
2,593
361
1,417
88
16
115
48
55
687
75
170
1,052
353
166
137
158
1,019
387
4l
VW
22
118
in
191
2,208
894
21,449
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
al
PART ONE
RLIT0000197
RLITO000197
Appoint/Remove Management Team and non-Executive Directors
‘Management Team
1m Nonperformance is scrutinised robustly and if necessary new
management is appointed.
Non-Executive Directors
tm Non-Executive directors have fiduciary respon:
the interests of the Board.
ss to. act in
iw __Ensures proper scrutiny of management over such issues as audit
and remuneration.
Set the business objectives, investment policy and approve the
business plan
w__Ensures that business and financial objectives are consistent with
the shareholder's interests in long-term value.
m_ Ensures investment policy is aligned with the long-term strategic
health of the business.
tm Approves investment in assets where necessary.
Link management reward to delivery of value over three to five years
tm Provides management with incentives to act in accordance with
the shareholder's interests.
Monitor Performance
tm Shareholder can intervene before problems materialise.
Ensures that the shareholder uses the other levers in a
timely manner.
Set capital remuneration policy to extract surplus cash
im This ensures that shareholder's funds are not stored up in the
business but can be invested profitably elsewhere.
Approve financing including equity contributions and/or borrowing
Influences business strategy.
Exit the business by selling shares to another party
iw The ultimate signal to management that it is not performing in
accordance with the shareholder's interests.
Source: National Audit Office
12. THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
m__Ensures management delivers businesses and financial objectives.
Private Equity
Firm
Yes (and own staff
may act as non-
Executives}
Yes
Yes
Yes
Levers available to
Cabinet Office,
Treasury or
ital
Finance Director
No
No!
No
No
Yes?
Shareholder
Executive/
Departmental
shareholding team
Yes (after
consulting other
interested parties)
Yes?
No
No
4 I The Shareholder Executive's accountability
RLIT0000197
RLITO000197
PART ONE
for DTI businesses
For the £5.1 million admin budget
and £4.8 million consultancy budget
Permanent Secretary, Department of
Trade and Industry
The
Shareholder For advice on management of shareholdings
‘ and corporate finance issues
Executive
Permanent Secretaries of Government
Departments which own businesses or
receive corporate finance advice
and objectives
For the overall cross-government mission
Stakeholder Group: senior officials
from major business-owning
government departments
Source: National Audit Office
Before the Executive was set up, there was
no consistent approach to the management
of Government shareholdings
1.10 As soon as it was set up in 2003, the Shareholder
Executive undertook an initial assessment of the
performance of Government as a shareholder to get
a better understanding of prevailing practice, both
domestically and internationally. The review concluded
that “the overall performance of companies in Government
ownership has been poor.””? The review also found that
spending on external advice between 2000 and 2003 on
shareholding issues totalled approximately £70 million.
1.11 The findings of the review were consistent with
previous PAC and NAO conclusions outlined in Figure 1.
Two inter-related problems lay at the heart of the
government's approach to shareholding at the time: there
was a general lack of staff with relevant commercial
and financial experience; and government's approach
was fragmented because responsibility for looking
after the public shareholder interest lay with individual
departments. In the absence of a central co-ordinating
body, this arrangement inhibited the spread of existing
good practice. While there were individual pockets
of good practice, the limited effectiveness of some of
the shareholding teams led to declining confidence
in them at the Treasury and gave rise to the need for
separate checks and duplication of relationships with
executive management.
12 Appendix 2 provides further details about the review
13 Evidence to House of Com
14 Risk mar the Nuc
y ple, HC
Js “The Departn
their attention to the risks posed by British Energy's liabilities
Trade & Industry Select Committee, 18 July
264 Session 2003.
nt in discussions with other departments whose policies affecte
The implications of policy for
commercial objectives were often
not made sufficiently transparent
1.12 A further, and significant, problem lay in the inability
of many departmental teams to reconcile successfully
competing government priorities. It is common for state-
owned businesses to be required to meet a complex
array of policy objectives, in addition to the standard
shareholder objective, which is to protect and enhance
long-term shareholder value. For example, the Royal Mail
Group is required to run a network of post offices that is
significantly larger than what it believes is an optimum
commercially viable network of around 4,000 post
offices!’ in order to meet social policy objectives.
Balancing the need to increase shareholder value against
these other objectives requires transparency so that they
are assessed with full knowledge of their expected impact
on value. This enhances decision-making.
1.13 The National Audit Office has previously highlighted
the difficulties that can be faced by officials when trying
to reconcile competing policy objectives. In the report
Risk Management: The Nuclear Liabilities of British
Energy, for example, the National Audit Office referred to
the constraints felt by DTI officials in dealing with other
departments whose policies affected British Energy. The
officials did not, therefore, draw attention to the risks
that might return to the taxpayer as a result of decisions
affecting British Energy’s business.“
2004: 6 February 2004 sub-headi
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 13
PART ONE
Managing public sector businesses
consistently for value represents a step-
change in the Government's approach
1.14 Ensuring that a business is run well requires effective
use of the shareholder levers identified in Figure 3.
Unlike shareholders in publicly-quoted businesses, the
Government does not usually have the ability to sell
shares as a signal to management that it is performing
poorly. Equally, there is little external market scrutiny of
company performance. This is often also true of private
equity companies, which generally own a majority stake
in an unlisted company. The Executive's position as
shareholder is analogous in some ways to that of a private
equity company, which provides business experience and
critical oversight of management performance.'? The latter
tends, however, to take a more active role in the oversight
of a company than departments did in the past, with the
explicit aim of increasing the value of their investment.
Ultimately private equity companies are able to “exit” the
business if they feel that it will not increase in value. This
option is not available to Government when management
is performing poorly because its businesses are not owned
solely to create value, and any question of sale is looked
at within the broader context of an asset disposal strategy
and wider policy objectives.
15 Private equity firms differ from the Executive in the sense that they manage their companies
five year horizon, beyond which they expect to sell the companies,
16 In 1997 BNFL Inc. signed a contract with the United States Depart
plutonium contaminated) waste on a fixed price basis. As are
17 This change included transformation from a public corporation into a public limited company, redefini
in the C&AGS report The Acquisition of German Parcel HC 858 (Session 19}
see paras 1.10 to 1.15
14 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
either to a third party or through a flotation on the
ent of Energy to treat, pack
tof rising costs this and other fixed price contracts proved to be loss makin;
1.15 The Government has the power to appoint,
incentivise and remove management, approve strategy
and business objectives and monitor performance. The
Government's poor record as a shareholder has been
due in part to the ineffective use of these shareholder
levers. The timeliness of the use of these levers has been
a particular problem. There have been repeated instances
of a lack of critical challenge to proposed corporate
strategy, leading to poor investment decisions - BNFL’s
investment in nuclear waste treatment activities is one
example.! During a period of change!” the Royal Mail
posted four consecutive annual “profit warnings” (i.e. that
profits would be significantly lower than management
had previously forecast) between 1998-99 and 2001-02
without immediate consequences. More timely scrutiny
of the company by the departmental shareholding team
would have resulted in a better awareness of business
prospects and the potential scale of the losses, and
earlier consideration of management changes. A loss
of confidence in the management often resulted in
departments second-guessing boards and executive
teams, leading to a blurring of proper management
accountability. In some businesses, such as trading funds,
departmental pay constraints have had an adverse impact
on the ability of the Executive to attract, retain and
incentivise experienced management teams.
ssively to ensure that they grow quick!
stock market
and ship offsite 65,000 cubic metres of transuranic
the arms length relationship with Government
2000
RLIT0000197
RLITO000197
PART TWO
2.1 Following its move to the DTI, the Executive
developed the following objectives, as part of its 2004-05
to 2006-07 Corporate Plan:
lm toensure each business delivers sustained positive
returns, and returns its cost of capital'® within the
policy parameters set by Government;
= toincrease by £1 billion the value of a portfolio of
six target businesses owned by Government, within
a framework of clearly defined policy, customer and
regulatory objectives;
m= to provide corporate finance expertise within
Government; and
m= toachieve a progressive return to dividend paying.
2.2 An important part of the Executive's attempt to bring
greater focus to shareholder value across government
was the introduction of a shareholder value enhancement
target to measure the overall change in the value of its
businesses as a result of its work. The objective for the first
reporting period was set at £1 billion and was applied
only to six target businesses. As this was the first attempt
to link performance and shareholder value, the Executive
decided to apply this objective to businesses with which
at that time they had a close working relationship.
2.3 Once the target was established, the Executive
commissioned external consultants to develop the detailed
methodological framework and advise them on the best
way of measuring the £1 billion increase in shareholder
value. Given the visibility of this target, we conducted a
RLIT0000197
RLITO000197
The Shareholder Executive
has made a good start,
despite operating within a
limited framework
thorough analysis of the way in which it was constructed.
In evaluating the target, we made reference to the
Executive's aim that the target should:
= focus attention on improving shareholder value;
= be applicable across a diverse set of government
owned businesses;
attempt to measure value enhancement rather than
absolute value; and
m= _use reported, rather than forecast, financial data.
2.4 The Executive selected an Economic Profit
methodology, which uses reported results to calculate
year on year changes in shareholder value for its diverse
range of businesses. This methodology is used widely
in the commercial sector and has the advantage that it
is relatively simple to understand and apply relative to
other methods (see ‘box’ below). Though it is applied at
the level of an individual business, the Executive reports
results aggregated across the target businesses. Measuring
value is not an exact science and Economic Profit, like
all valuation methodologies, has limitations because it
relies in part on assumptions that are based on subjective
judgement.'’ Where possible, the Executive has reduced
the measure’s reliance on assumptions to a minimum in
comparison with other approaches it could have chosen.
Overall, we conclude that the measure met the Executive's
initial aims particularly in bringing about a greater focus
on shareholder value across a range of government-owned
business. The way in which this measure is applied is
addressed in Part 3.
PART TWO.
Alternative Valuation Methodologies:
Economic profit: This is a measure of value created
in recent financial reporting periods. It uses published
financial results to calculate a shareholder's return
on investment after accounting for the risks attached
to that investment. As a backwards-looking measure,
it cannot be manipulated by future forecasts or by
altering the timing of year-end cash-flows.
Discounted Cash Flow This is a measure of value that
a business will create in the future. The analysis uses
detailed projections of a business's free cash flow (that
is, the cash available after all business costs are paid).
The cash flows are discounted, most often by using
a measure of the cost of capital adjusted for risk: the
resulting “present value” figure is a statement of the
business's worth in today’s money.
Multiples: This is a comparative estimate of current
value - a relatively ‘top down’ valuation methodology
based on published accounts and the proposition that,
in an efficient market, similar businesses should have
a similar business outlook and generate similar value
based on the net cost of their sales. Therefore, the
value calculation is based on gathering financial data
for a comparator group of similar companies.
Note: see Appendix 3 for further details
2.5 The Economic Profit methodology measures changes
in value and does not provide an absolute valuation of
the Executive's target businesses. We therefore conducted
a further exercise to ascertain an approximate aggregate
valuation of 18 businesses in the Executive's portfolio””
Subject to the caveats outlined in Appendix 3, we estimate
the enterprise value of the Executive's portfolio to be
between £17.1 billion and £20.8 billion as of
30 June 2006*'. The businesses can be grouped into
different sectors, shown in Figure 5.
Lower end
of valuation
{ million)
5,643
Upper end
of valuation
(€ million)
5,643
Business type Example
businesses
Listed
companies
British Energy
QinetiQ
Investment CDC
businesses Actis
ECGD
BNFL
Royal Mail
UK Atomic
Energy Authority
NI Water Service
Scottish Water
NATS 991
Channel 4
Ordnance Survey
Working Links
DSTL
Royal Mint
Covent Garden
Market Authority
Tote
4,722 5,209
Utilities 5,755 8,723
Service 1,209
businesses
and others
Total portfolio 7A 20,784
Source: National Audit Office
20 This exercise was carried out using a multiples-based approach and covered 18 businesses for which reasonable comparators could be found. Figures have
bilities. Appendix 3 provides further de
not been adjusted for any Ii
21 The Executive decided not to measure the absolute value of its businesses because alternative methodologies incorporate (largely subjective) forecast
financial data. In complete form, these valuations may also include legacy factors beyond the control of the current management, such as pension liabilities.
16 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLIT0000197
The Executive has established a good
shareholding model through which it
discharges the shareholder function
2.6 The shareholding model aims to implement
the Executive’s four shareholding principles (clarity,
value, transparency and professionalism) for managing
shareholdings across government. The starting point
from which the Executive puts this model in place is
a framework document which sets out the roles and
responsibilities expected of the Executive, the sponsor
department and the board of each business. This results
in a separation of policy and customer roles (which are
retained by the sponsor department) from the shareholder
function (which is taken on by the Executive).
This separation has generally been achieved for the
executive businesses, though not with the Royal Mail
(paragraph 2.23 and 3.4).
2.7 This framework document’ establishes the
governance arrangements that apply to a business and
what is required from management in terms of the
timely provision of data, and the approval of corporate
strategy, proposals for Board remuneration and so
on. In the case of departmental trading funds these
governance arrangements have been strengthened by
improving the quality of the information flow between
the Executive, the department and the business and by
increasing the role of non-Executive Directors. Non-
Executive Directors bring a range of skills to the Boards
of public businesses: they provide greater challenge to
management and raise concerns with the Executive and
departmental shareholding team when necessary. They
are also selected to bring specialist business expertise
and corporate governance skills to Boards to improve
decision-making. Such improvements in the governance
of public businesses can be seen in cases of the Treasury
and MoD trading funds. Going forward, the Executive
could consider its own staff for filling non-executive Board
positions — as is the case in Sweden.
2.8 The implementation of the shareholding model has
provided the Executive with the opportunity to ensure
that businesses are being run effectively and to hold
management to account for performance. Evidence
gathered from our case study businesses”? indicates that
the Executive has made appropriate and timely use of
22 In some cases the framework document takes the form of a letter
Executive) to the Chairman of the Board.
23 The businesses selected for closer examination were Actis, CDC, BNFL, NATS, Royal Mail and the Royal Mint
took shared exec
24 The Energy Challenge Energy
stive responsibility for QinetiQ, the subjec
This was noted in the Executive's Start-Up Review (see Appendix 2
RLIT0000197
RLITO000197
PART TWO.
the shareholder levers: this includes addressing poor
management by the removal of Directors and/or new
Board appointments.
2.9 A major part of the Executive's role is to help to
articulate the value implications of policy and other
objectives so that decisions on policy issues can be made
with the best available information about their benefits and
costs. There is some evidence of the Executive carrying
out this role in the recent Energy Review’ in relation to
British Energy and the potential sites it owns (paragrapl8.3)
although there is no formal mechanism for costing the
impact of policy proposals in relation to shareholder value.
The Executive has attracted
experienced staff with public and
private sector expertise
2.10 Bringing together good quality staff with the right
skills (especially investment management and corporate
finance skills) within Government was one of the main
drivers behind the foundation of the Executive. The role
combines commercial acumen with an understanding
of decision-making processes within Whitehall. To be
effective, therefore, the organisation needs to draw on
a mixture of public and private sector experience. In
addition, the Executive needs a relatively senior team in
order to be credible with the Boards and management
teams of its businesses.””
2.11 So far, the Executive has recruited staff with a view to
achieving this balance of public and private sector skills.
For example, of the 12 directors in post as of December
2006 two have a background in strategy, six in investment
banking or corporate finance and four largely in the civil
service. Our organisational review found that bringing
together staff from different backgrounds with a diverse
range of skills was on the whole working well, with much
sharing of knowledge and expertise.
2.12 External feedback on the Executive's staff from the
businesses and departments has mainly been positive.
Those interviewed said that the Executive's business
experience and understanding of the individual companies
have made it a credible shareholder representative. This
was notably evidenced to us in the cases of Actis, CDC,
NATS and the Royal Mint. In each case the director?” we
In addition, from early 2004, the Executive
(Cm 688
26 We spoke to the Chief Executive of the Royal Mail; the Senior Managing Partner of Actis; the Managing and Finance Directors of CDC; the non-executive
Chairman, Chief Executive and Partnership Directors of NATS; and the non-executive Chair
an of the Royal Mint.
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 17
PART TWO.
spoke to mentioned impartiality and openness as features
of the Executive's approach, and welcomed the focus
it has brought on commercial rather than policy issues.
Some of our interviewees also told us that these good
relationships with the Executive have often benefited from
staff continuity on both sides. Any tensions we identified
related to negotiations over access and remit, rather than
challenging professional competence.
The Executive has had early successes
in bringing about beneficial change
2.13 The change in approach to the way in which
Government manages its shareholdings - based on
staff with relevant skills making appropriate use of the
shareholder levers — has so far brought about a greater
focus on shareholder value. The most tangible example
of the value created by the Executive in its work to date
relates to the sale of Westinghouse. The DTI and the
business both agree that the Executive made an important
contribution by persuading government to take advantage
of favourable market conditions to increase proceeds from
the sale (see the case study opposite).
2.14 In previous work the National Audit Office has been
critical of the terms on which financial advisors have been
appointed by public bodies.”” An aim of the Executive
was to reduce dependence and increase value for money
from the use of private sector advisors. Because it is able
to provide more expertise within government and through
tighter specification of work the Executive estimates that it
achieved savings of around £7.5 million in 2003-04, rising
to a total of £12.1 million by 2007 which is approximately
17 per cent of the amount spent on advice in the
three years prior to the establishment of the Executive
(paragraph 1.10). We have examined the assumptions
behind the 2003-04 estimate and, though it is difficult to
be precise about the actual figure, we are confident that
the Executive has helped achieve savings of this order of
magnitude through a more timely appointment of advisors
and by negotiating tighter terms of engagement.
2.15 An increased focus on value may not always be
able to resolve the challenge of reconciling competing
policy and shareholder objectives successfully. Without
27 See the C&AG's report N
Use of Consultants, HC 12:
such as fixed priced and incentivised contracts instead of standard time and m
This is based on th
regate performance of all of the businesses in the por
RLIT0000197
RLITO000197
formal mechanisms to cost and recompense businesses for
delivering policy objectives (something which takes place
in some countries overseas — see Appendix 4 — but which
does not always occur under current UK arrangements) it is
difficult to predict if the improved approach to shareholding
will result in a sustained improvement in the performance
of businesses. Since the Executive was established, the
performance of the businesses in the Executive's portfolio
has generally been positive(Figures 6 and 7) although this
indicator does not imply a causal relationship. Results have
been aided by improving or stable economic conditions
which have boosted the performance of some of the larger
businesses (Figure 8 on page 20)”° British Energy’s profits
have been driven up by a large increase in wholesale
energy prices since 2002 and CDC's positive results are
helped by the performance of businesses in emerging
markets; multi-lateral agreements on debt servicing with
several major creditor countries (Brazil, Nigeria and Russia)
have also improved ECGD’s financial results”; and the
performance of NATS has improved markedly under new
management, but the company has also been helped by an
upturn in air traffic since lows following the aftermath of
11 September 2001 and the greater stability conferred by
the 2003 regulatory solution which involved contributions
from different stakeholders.
2.16 Moreover, there are other reasons to be cautious
about future financial performance: ten of the businesses
in the portfolio did not record operating profits in each
of the last three years (2003-04 to 2005-06).°° And in
the near future some major businesses (Royal Mail,
British Energy and BNFL) face difficult challenges (see
paragraphs 3.2 and 3.3) which could have a negative
impact on financial performance.
2.17 It is therefore not yet possible to say whether the
change in approach will translate into healthy financial
performance on an ongoing basis, particularly given the
paramount importance of ensuring that public policy
objectives are met. The Executive's own internal measures
back up this conclusion (see Appendix 5). They point to
an improvement in the relationships with businesses and
in the approach to managing shareholdings; but they also
point out that most of the businesses have yet to deliver
healthy financial performance on a sustainable basis.
Plc HC 1096, Session 2001-2002, Recommendation 8. See also the C&AG'S report Central Government's
7, on the use of all types of advisors, which recommended that public bodies
als” (Recommendation v
io, though a full (six-year) set of data was not available for New Covent
Garden Authority, Fire Service College, Northern Ireland Water Service and Scottish Water.
18 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
The Shareholder Executive separately monitors ECGD’s new business performance, excluding the le
30 Inthe three years prior to the Executive's creation, nine out of fifteen businesse
s made profits in each of those three years. The twelve businesses not included
RLIT0000197
RLIT0000197
PART TWO.
CASE STUDY
The Westinghouse sale achieved £2 billion more than the
initial estimate
£ mil
After obtaining ministerial approval, the Board of BNFL decided men
‘on 30 June 2005 to sell Westinghouse Electric Company 4,000
U.S-based subsidiary providing fuel, technology and services 3,500
to the commercial nuclear energy industry. The anticipated level /
of proceeds from the sale was thought to be approximately 3,000
£1 billion, Officials at the Executive recognised that the value of
the company would be much enhanced if potential buyers saw zjs00
pany po! y
that it could win lucrative contracts in overseas markets. Initially, 2,000
senior civil servants at the DTI and Treasury were unwilling to
consider Westinghouse taking on commercial risk overseas as 1,500
it had recently been involved in some unsuccessful ventures in 1,000
the USA. :
. 500
On account of its role as trusted advisor ~ a role that could not
easily have been played by an external advisor - the Executive 0
built a consensus in favour of allowing the company to negotiate 00
contracts for the provision of nuclear power plants in China prior
to the sale. The Executive was able to persuade officials that by -1,000
getting these contracts ready, the proceeds from the sale would 00-01 01-02 02.03 0304 0405 05.06
increase with little additional financial risk to the Government
as the contracts would not become effective before the sale
took place. In large measure these contracts, as evidence of SourceriNelional Avila Office
the company capturing a greater share of the buoyant global
nuclear energy market, were responsible for BNF being able
to sell Westinghouse in a competitive auction for £3 billion
against an expected £1 billion, once the sale was completed on 7
16 October 2006."
Source: National Audit Office
Year
Return on Net Assets (per cent)
14
12
10
The Executive's structure and .
remit limits its scope for realising 6
greater benefits 4
2.18 The decision to move the Executive to the DTI in 2004 2
was a pragmatic one. This contributed to the limitations of
the framework in which the Executive operates, giving rise to °
a number of practical barriers to further improvements.
2
0001 01.02 0203 0304 0405 05:06
Remit Year
2.19 Though the Executive has a government-wide Soorce:Aisiooal duttt Glee
mission “to be an effective shareholder of businesses
owned or part-owned by Government”’! it cannot compel
departments to give it responsibility for the management
of businesses or to make use of its Industrial Development
31 Source: www.shareholderexecutive.gov.uk
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 19
RLIT0000197
RLIT0000197
PART TWO.
MSCI Emerging Markets Price Index
1,000
900
800
700
600
500
400
300
200
100
0
Dec 99 Jun00 Dec 00 JunO1 DecO1 JunO2 DecO2 JunO3 DecO3 Jun04 Dec 04 JunO5 DecO5 Jun 06 Dec 06
Executive established (September 2003)
Percentage growth in number of flights per month handled by NATS
12
Executive established (September 2003)
Br T T T T T T T T T T T T T
Jan00 Jul0O JanOl JulO1 JanO2 Jul02 Jan03 Jul03 JanO4 Jul04 JanO5 JulO5 Jan06 Jul 06
UK Wholesale Power Price £/M Wh.
70
Executive established (September 2003)
60
50
40
30
20
10
°
Jan00 Jul0O JanOl JulO1 JanO02 Jul02 JanO3 Jul03 JanO4 Jul04 JanOS Jul05 Jan06 Jul 06
Source: National Audit Office
20 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLIT0000197
PART TWO.
Unit for any corporate finance advisory work (see
paragraph 1.9). This has meant that the Executive has
relied on promoting its own brand identity through
interpersonal relationships (in the absence of institutional
arrangements) to engage and work with departments and Examples of significant businesses, some newly created, outside
th it of the Shareholder Executi
businesses. The Executive has successfully negotiated a FM NE NOELLE NE
role for itself with a number of government departments. 2004-05
Even where its role has not been to manage shareholdings turnover
directly on behalf of the department, it has been able enaieted of wads wishes eo
to work out satisfactory alternative arrangements, for pa ’
example with the Ministry of Defence. 32 Nuclear Decommissioning Authority 1,211
Department for Transport
2.20 This need to negotiate a role for itself can lead to 2
hae A Trust ports >100
problems. The limited nature of the Executive's remit
slowed down the institution of framework documents (see Department of Health
paragraphs 2.6 and 2.7), with the Executive having to take NHS Professionals 272
part in a three way negotiation between the business, the D.C.I. Biologicals Inc? 40
owning department and the Executive. In some cases this haat ws
has led to some inconsistency, with the Executive only esinershlpastor Hisakt 7
advising the relevant departmental shareholding team. Department for Education and Skills
The advisory role works best where the Executive has a Partnerships for Schools® 7
irect relationship with th in is ke
direct relationship with the business, is kept up to date Devolved Regions, Greater London Authority
and is actually involved in advising ministers. In some or local authorities
cases, such as Working Links and the Forensic Science
Service, the advisory relationship has been a stepping Tronsport for London 2039
stone to the full executive role. Manchester Airports Group 374
Blackpool Airport Lid 353
2.21 In practice, however, an advisory role, or a less ‘one! Poe " -
than full executive role, can lead to a less intensive Sionel Pedwar Cymru (S4C) °
relationship. Generally the advisory relationship is one Caledonian MacBrayne Lid 7
where the Executive is not directly involved with the Forestry Commission
businesses or in advising ministers and could therefore Forest Enk 30
i ic ‘orest Enterprise
be ignored by those departments or their businesses that °
claim to be able to manage commercial and financial ‘Source: National Audit Office
risks adequately. For example, five of the businesses in
the Executive's portfolio’? were not included in its Annual
Report 2005-06 because the Executive had typically
advised on specific issues only. The advisory relationship
can also lead to duplication of effort between the
Executive and the shareholding department.
2.22 More importantly, there is no obligation on
departments to involve the Executive at all with their
shareholdings and other commercial activity. Figure 9
provides some indication of the main omissions from
the Executive's portfolio. There are cogent reasons for
some omissions, but we have not found a sensible
rationale behind all of them. For example, the Executive
has no involvement in the commercial activities of the
Department of Health and the National Audit Office has
recently criticised the Department and its Information
32 For example the Shareholder Executive has been successful in obtaining a seat on an ‘ownership council’ set up to advise relevant Ministers on MoD trading,
funds; and it seconded a member of staff to the MoD shareholding team which has responsibility for the shareholdings in the MoD trading funds
33 These are: Fire Service College, Northern Ireland Water Service, Ordnance Survey, QE2 Conference Centre and the Tote.
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 21
PART TWO.
Centre’s negotiations of a joint venture which it believed
could have benefited from the Executive's advice.“
Moreover, paragraph 2.14 of this report highlights
the Executive's work in reducing the Government's
dependence on private sector advisors: in negotiating
the deal, the Information Centre incurred advisory costs
of over £1.7 million which could potentially have been
reduced by working more closely with the Executive.
This inconsistency and lack of statutory authority to bring
businesses into its portfolio is incompatible with the
Executive's government-wide mission and highlights that
the pragmatic decision to situate it within the DTI, with its
current governance arrangements (paragraphs 1.6-1.7), has
not succeeded in enabling it to deliver its mission fully.
2.23 The Executive's current remit also departs from its
‘own principles and OECD best practice guidelines’? in
that it has multiple roles in relation to postal services. As
well as a shareholder role in relation to Royal Mail, it is
responsible for policy matters relating to it and oversees
the work of the postal services regulator and watchdog.
These conflicting roles are part of the legacy of its transfer
to the DTI in 2004. This issue is also discussed in Part 3.
Financing and dividends
2.24 Our findings above concluded that the Executive has
made use of the “shareholder levers” available to it to ensure
that government-owned businesses are managed for value.
The Executive, however, lacks the full use of an important
lever which is available to investment management bodies
in the private sector — the ability to arrange for the provision
of financing to businesses when they have a good case
for it, such as an investment that will increase the value
of the business over a medium to long period of time
(e.g. three years or more). Private equity firms carry out
similar functions to the Executive in the private sector. They
generally hold controlling shareholdings in businesses and
have significant influence over management to ensure that
the businesses are managed for value and growth. Their
involvement in financing gives them an additional means
of controlling the strategic direction of a business through
approving the investments that a company makes and
therefore the return — in the form of dividends and increased
shareholder value — that is expected from them.
34 See the C&AG's
1.45. See
5 The OECD produ
in the field.
report on Dr Foster ince: A Joint Venture bet
Iso para
that joins the portfolio has a pre-existing
accountable for delivering value under that structure. Bu
ween the Information Centre and Dr Foster LLP, HC 151, Session 2006-2007,
1d its Guidelines on Corporate Governance of State-Owned Enterprises in
uuideline in the first chapter reads “There should be a clear separation be
RLIT0000197
RLITO000197
2.25 The Executive does not have this level of influence.
Any financing that might be needed can come from the
departments themselves in the form of debt or equity, or
from the National Loans Fund: however the capital sum
comes out of Departmental Expenditure Limits or Annual
Managed Expenditure and therefore has to compete with
other capital spending requirements within the respective
departmental public spending programme and the overall
fiscal framework. There is a risk that businesses will not
be able to access adequate financing for investment,
irrespective of the impact this could have on
shareholder value.*°
2.26 Provision of financing under the current framework
is largely based on an assessment of future needs during a
three year Spending Review period, with some flexibility
within periods to invest from departmental savings. It
is often difficult, however, for a commercial business
to forecast investment needs for such a period and its
investment cycle might in any case take a new direction
during the period.
2.27 Given this risk, there is an incentive for management
to keep cash in the business against any future investment
needs (which may or may not arise) and only to pay
dividends to cover the department's annual cost of capital
charge within its Departmental Expenditure Limit. In some
cases, the Government does not to receive dividends as
part of an agreement over funding plans, debt covenants
or for policy or legal reasons.”
2.28 Dividends paid by the portfolio businesses have
increased over the last three years, but represent a
decreasing proportion of operating profits — see Figures 10
and 11. At present any dividend proceeds above the cost
of capital charge can be retained by departments and can
be used for other non-investment related expenditure.*®
While this gives the department some incentive to ensure
that a business regularly pays dividends, it does not
necessarily address the management incentive to keep
cash in the business, which could be to the detriment of
overall shareholder value.
paragraph
following a number of international policy developments
‘een the state’s ownership function and other state functions
ard to market re (our italics)
that the Executive should simply hold management
and it may not allow for essential investment to maintain or enhance the competitiveness of the business. In fact, many formerly publicly owned businesses
underwent a capital restructuring before pr
37 For example, as part of the Royal Mail’s Renewal Plan, the Government agreed not to take dividends for three years; British Energy returns cash to the
Government as part of the cash sweep arrangement; a debt covenant prevents NATS’ regulated subsidiary (NERL) paying dividends until 2008; BFL agreed
to return value to the taxpayer thrc ssets; and Channel 4 and British Waterways, both statutory corporations are required to break even
and reinvest any surplus towards their public service objectives.
38 This process does not apply in the same way to some businesses, designated as self-financing public corporations. The department may make a contribution
to the Treasury; however, this is generally substantially less than a cost of capital charge
22 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLIT0000197
PART TWO.
In 2001-02, the businesses made a cumulative operating loss and therefore the percentage valve figure is negative in this year.
£ million Dividends as percentage of operating profits
50 3
Dividends paid (£ million)
40 Dividends as percentage
of operating profits 2
30
1
20
10 0)
0
J
-10
2
-20
-30 3
2001-02 2002.03 2003-04 2004.05 2005-06
Year
Source: National Audit Office
Dividends paid over the period totalled £143.1 million.
£ million
40
35
30
25
20
UKHO DSTL —QintetiQ Met Actis DARA Working NATS FSS QE2 Ordnance Royal
Office Links Conference Survey Mint
Centre
Ss
w
Source: National Audit Office
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 23
3.1 Part 2 identified a number of issues and practical
barriers that could limit the Executive's effectiveness
as it evolves further after its good start. These relate
to the Executive's location, remit and the nature of
its responsibilities. Addressing these concerns will be
important because the Executive faces a number of
strategic challenges in the near future, as outlined in the
next section.
In the near future the Executive
and some businesses face
strategic challenges
3.2 Royal Mail has to restructure and modernise to meet
the challenges of a more open and competitive market for
postal services. This will require major investment which
current government policy requires should be sourced from
Royal Mail's resources and public funds on a commercial
basis. The Executive has limited freedom of action to
mobilise investment funding in such cases. It has, however,
engaged actively in helping to build the investment case for
modernisation. The proposal was first submitted with a view
to a decision in April 2006 and agreement was reached on
investment of £2 billion in February 2007: The documents
we reviewed support the Executive's positive influence in
two areas: first, in articulating the financial implications
of different options and second, in setting robust financial
targets to hold management to account. The injection of
capital into the company, if it takes place, will initially
decrease performance against the Economic Profit target
because it will be some time before the modernisation
view Report Department
24 THE SHAREHOLDER
JTIVE AND PUBI
OR BUSINESSES
s business
requires prior approval from the C
Electricity A
Changes are required
to keep up momentum
and to build on
early achievements
programme provides a return on the investment. Figure 12
on page 26 shows the contribution made by the Royal
Mail to the Executive's performance against its £1 billion
target. Investment by Royal Mail will, therefore, have a
large impact on the Executive's ability to meet its current
£1 billion target (or any future version of it).
3.3 Other strategic challenges relate to the potential
conflict between nuclear energy policy and the
Government’ interests in the nuclear power sector.
The Secretary of State for Trade and Industry (along
with Ofgem) has a statutory responsibility to protect the
interests of consumers through, wherever appropriate,
effective competition.“° He also owns BNFL and, through
the Nuclear Liabilities Fund, is the owner of an option on
part of British Energy’s equity. One potential challenge is
the plan for BNFL to break up the British Nuclear Group
(BNG) and sell the business at the same time as the
Nuclear Decommissioning Authority (NDA) is letting a
long-term contract for operating, decommissioning and
cleaning up the nuclear sites at Sellafield. These sites are
currently operated by a part of BNG. The decision to sell
BNG in parts might reduce the value obtainable but was
taken in the light of the overall nuclear decommissioning
strategy. A second challenge, following the recent energy
review,"! relates to the potential development of sites for
nuclear power generation next to those owned by British
Energy or the NDA. The Executive will need to ensure that
the debate is informed by full knowledge of shareholder
value issues and, as in the case of the first challenge,
should put forward the shareholder case clearly.
repaid by 10 million sharehold
Utilities Act 2000 anc
RLIT0000197
RLITO000197
Resolving conflicting roles in its postal
industry responsibilities needs to be a
key priority
3.4 The Executive's responsibility for policy on the
postal market and Post Office network issues and its
sponsorship of PostComm and PostWatch are part of
the legacy of the Executive's transfer to the DTI, when
it absorbed the responsibilities of the former Royal Mail
team (paragraph 1.8). As a non-ministerial Government
department, the annual budget of Postcomm is agreed by
the Treasury, without the involvement of the Executive,
reflecting the regulatory independence of Postcomm.
The Executive, however, appoints the PostComm
commissioners. The Executive is also in the lead on policy
for consumer representation in the postal services market,
it has a sponsorship role for PostWatch and and advises
Ministers on PostWatch’s budgetary proposals before
they are put forward for parliamentary approval. These
conflicting roles make it hard for the Executive to give
clear and transparent advice on Royal Mail shareholder
issues while at the same time ensuring that there is fair
and open competition within the marketplace and that
the interests of consumers of postal services are protected.
While we have found no evidence of problems so far, this
will become a larger issue as the postal market becomes
increasingly competitive. The separation of shareholder
role from the policy, customer and regulatory roles in
other departments has been one of the benefits brought
about by the Executive and is very much in line with
OECD guidance (paragraph 2.23).
More meaningful measures could be
adopted to provide a better assessment
of the Executive’s work
3.5 There are risks associated with the Executive’s
£1 billion portfolio target. It is very common for private
sector investment companies to manage investments on
a portfolio basis."? This is a standard risk management
technique which recognises that businesses may suffer
sporadic poor returns as a result of cyclical or market
conditions.The overall financial risk to the portfolio is,
This is generally true of pension fund managers rather than private equity firms, which may select a risky portfolio in an attempt to achieve
RLIT0000197
RLITO000197
PART THREE
however, reduced through careful selection of a large
number of investments that behave in different ways.
The effect of this is that no one individual business will
affect the overall portfolio return greatly. Equally, a private
sector investor can dispose of a consistently poorly
performing business.
3.6 The Executive is unable to select a balanced portfolio
in this way. First, it does not have the ability to dispose
of poor performers in its portfolio. Second, the financial
performance of a few significant businesses in the
Executive's portfolio can change its overall performance
markedly within a short space of time, either positively or
negatively. In a balanced portfolio the exposure to this
risk would be much smaller; but in the Executive's
portfolio several of the companies are of such a size that
cyclical movements and other factors affecting a single
business could jeopardise the Executive's performance
against its target.
3.7 This appears to have been the case in the first
two years (2004-05 to 2005-06) of the three year
target reporting period. In these two years, the value
of the six target businesses increased by a total of
£2.56 billion (£1.64 billion in 2004-05 and £0.92billion
in 2005-06). 47 per cent of this increase was due to
Royal Mail and 23 per cent to BNFL over these two years
(see Figure 12 overleaf). Over the next year, the investment
in Royal Mail, if approved, could erode a large portion of
the value increase achieved in these two years because
it will take a few years before the business can provide a
return on the additional capital invested in it. This would
not necessarily be an indication of poor performance
on the part of the Executive. As progress towards the
financial target might be affected in this way, alternative
targets would better reflect the Executive's performance
with respect to each of the businesses. For example, the
Executive could be required to meet an overall portfolio-
level target which could be broken into a series of
individual business-level targets. To avoid the risk outlined
above, the Executive would, over a given reporting period,
have to meet a certain proportion of these business-level
targets — suitably weighted towards the larger businesses to
avoid a loss of focus on overall value.
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 25
PART THREE
RLIT0000197
RLITO000197
But changes in the value of one large business {in this case Royal Mail) can have a massive influence over the performance of the
portfolio as a whole (all figures are in £ million)
Cumulative Economic Profit change
Total = £2,557 million
2,500 EI
=z
I 201 I 129
2,000 P23 I
1,500
Three year £1 billion target
1,000
500
0
27
500
Royal Royal BNFL cpc NATS QinetiQ QinetiQ
Mint Mail disposal
Target businesses
Source: Shareholder Executive
3.8 In paragraphs 2.25 to 2.27 we explained that
businesses could have an incentive to hold back dividends
and build up reserves of surplus cash against future
financing needs. In some cases, the Executive and the
business have an agreed rationale for holding back
dividends. For the rest of the portfolio, the Executive could
examine each case on its merits and construct a dividend
target for each business so that reserves of surplus cash do
not build up on the balance sheet. Currently the Executive
has the initial aim of “providing a progressive return to
dividend paying”. In the absence of any changes in the
Executive's ability to arrange financing for businesses (as
proposed below ~ see paragraphs 3.12-3.13) this target
would need to take account of future investment needs
so that cash was not unnecessarily extracted from the
business by the centre.
26 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
The Shareholder Executive itself needs
to be seen to be managed for value
Location and reporting arrangements
3.9 The Executive's current governance arrangements do
not fit well with its government-wide mission, as discussed
earlier (paragraphs 2.19 -2.20). The Chief Executive
retains a supportive link to the Cabinet Secretary which is
valuable as a line of communication but an institutional
link would give it greater central authority. The Executive
also reports to the Stakeholder Group which monitors the
Executive's performance against its objectives. Membership
of this Group could be extended to include, as it once
did, a Cabinet Office representative and representatives
from other shareholding departments. The Group carries
out a valuable role as “champion” of the Executive across
government but may not be in the best position to carry
out the challenge function. As representatives of the
shareholding departments they also have policy interests
in the businesses which could make it difficult for them
to take an independent view on the shareholder value
objectives. Changes to reporting arrangements - such as the
creation of a Board of Directors to reinforce management
accountability — could improve the Executive's ability
to carry out its government-wide mission and increase
its effectiveness. The New Zealand approach to public
shareholdings is one in which the equivalent body provides
advice to ministers under a statutory framework setting out
the roles and responsibilities of shareholding ministers and
separating commercial from policy aspects.
3.10 Trying to transplant one country’s system wholesale
to another can cause difficulties. Moreover, establishing
similar arrangements in the UK would be time-consuming
and costly. An alternative approach which would give
the Executive greater central authority would be that the
Cabinet Office and Treasury require departments to either
delegate full executive responsibility for the ownership
of their businesses to the Executive, or explain to the
satisfaction of the Cabinet Office and the Treasury why
that should not be the case, or why, as with the Ministry
of Defence, a joint team would be a better way for the
Executive to secure both a direct relationship with the
business and a role in advising ministers.
Funding
3.11 The current ring-fenced portion (£4.6 million)
of the Executive's annual £5.1 million administrative
budget (paragraph 1.6), which followed the move from
the Cabinet Office, is currently in place until 2008.4°
Subsequent arrangements have not been finalised and
any changes to the Executive's portfolio as a result of this
report will have implications for the Executive's current
level of funding. There are a number of possibilities
including a continuation of the current arrangement under
which the Executive does not charge other government
departments for its involvement and the Treasury makes
provision for government shareholdings within the DTI
budget." An alternative option that could be considered
would be for the Executive to begin charging departments
for its services. There is a possible risk that this would
reduce its involvement with departments to an ad hoc
advisory role (unless the Executive was required to take
on a direct role in managing shareholdings on behalf of
43 The ring-fencin
44 Theo
nly excer
which manages the Department's shareholdings in
45 Only the NHS Foundation Trusts are able to
ion to this is that the MoD paid 80 per ce
that are able to access private capital. Government-owned businesses clas:
RLIT0000197
RLITO000197
PART THREE
departments), and that the charging mechanism would
be costly to implement. A third option would be for the
Executive's budget to be set independently of the DTI’s as
in the case of Postcomm (paragraph 3.4) — although this
would necessitate a change in status.
Ability to arrange financing
12 In the countries we looked at for overseas
comparisons, most public businesses are able to borrow
from private sources of capital provided they can convince
both the shareholder body and private lenders that the
business plan is viable, and that they will be able to
service the debt and make the required return on capital.
Such countries consider that this market discipline and
increased shareholder oversight generally favours well
thought through investment plans. As a matter of policy,
UK Government Accounting excludes this approach
on value for money grounds given the lower cost of
Government borrowing."?
3.13 If the Executive had the ability to provide businesses
with access to finance, it would have an additional lever to
help it manage for value. This might be achieved in various
ways, including the following:
m= Government departments could delegate to the
Executive a budget, consisting of funds within
Departmental Expenditure Limits that were planned
for investment in businesses. This would enable
the Executive to support, within reason, well
thought through investment cases and strengthen
its ability to ensure the excess cash was paid back
to government.*° Such arrangements are possible
within the current budgetary framework. The
Accounting Officer could retain formal responsibility
for Government Accounting purposes but would
delegate authority to the Executive for investment
purposes. It follows that the Accounting Officer
could revoke this delegated authority should
changing priorities so require.
= Another option would be to give the Executive
responsibility for monitoring and reporting on
departmental investment planning for public
businesses. This would include assessing the impact
on shareholder value of the operation of the current
framework. This option would make the results
of financing decisions transparent and should,
therefore, lead over time to better decision-making.
tive for his role within the joint team
and provide a rare example of bodies classified to the public sector
ied to the private sector are able to raise third party debt.
46 Inthe case of departments where alternative arrangements exist, the Executive could chair an investment committee which advised the Accounting Officer.
ND PUBLIC SECTOR BUSINE
27
PART THREE
The Executive must plan to maintain
the quality of its staff and consolidate
its knowledge base
3.14 High calibre staff are essential to the Executive's
work. Given the range of commercial issues dealt with
by the Executive a significant proportion of its staff are
recruited from industry and the financial services sector,
currently on fixed-term contracts or on secondment.
This benefits the Executive because the steady flow of
individuals in and out of the organisation ensures that staff
have the most up-to-date knowledge and experience. There
are risks associated with this: for example crucial corporate
knowledge and experience could be lost and relationships
with key stakeholders would need to be re-built following
the departure of a particular member of staff.
3.15 The Executive will need to manage these risks
through knowledge management and robust succession
planning, as part of a broader human resources
programme tailored to attracting and retaining the mix
of public and private sector skills on which its success
depends. It has limited scope to match the remuneration
available to staff with similar skills in the private sector
because it is bound by the DTI’s pay and grading system.
The Executive need not try to compensate individuals
at the same level as the private sector because it offers
unique opportunities — for example, working to ministers
on high-profile issues. It may, however, need to have
greater flexibility than is afforded under the current pay
and grading structure to ensure that the flow in and
RLIT0000197
RLITO000197
out of the organisation is maintained under any market
conditions. For the Executive to have greater flexibility a
change in status would be required. Partnerships UK,*” for
example, also relies on recruiting experienced staff from
the private sector and, as a Companies Act company, has
greater flexibility over pay and terms and conditions.
3.16 So far, this has not caused difficulties. The first
fixed-term appointments and secondments were made at
a time when the external labour market conditions were
favourable to the Executive because the financial services
sector experienced a temporary lull in recruitment and
because the Executive was able to offer the attraction of
working on interesting public sector deals to potential
new recruits. As a number of the original appointments
and secondments at a senior level come to an end in 2007
and 2008 these conditions no longer apply if the upturn
in recruitment within the City of London continues.“ This
could also make a notable difference to the Executive's
corporate knowledge and external relationships, as six
of the current 12 directors and four of the 16 assistant
directors are due to leave within this two year period.
Figure 13 shows the staff numbers in each category (fixed-
term, permanent and secondment) for these two levels.
3.17 Another factor that could affect recruitment is
the Executive's perceived proximity to the centre of
Government. Decisions taken on the future location and
status of the Executive should, therefore, consider the
influence these will have on its ability to attract staff with
the right skills and experience.
13 I Cre int eealeyfensleymenttstoaitiner ten leavers ni200/enei20C8 cate neretets enn heanietiect(ontivel Exeot
Permanent Secondees or shortterm appointees
due to leave after the end of 2008
Directors
Assistant
Directors
Secondees or shortterm appointees
due to leave by end 2008
5 15 20
Source: Shareholder Executive
Partnerships UK (PUK) is a joint venture between HM Treasury (which owns 44.56 per cent of the company), the Scottish Ministers (which owns
4.44 per cent) and the private sector (which owns 51 per cent). HM Treasury has a substantial minority shareholding. PUK works exclusively for the public
sector to improve the delivery of Public Private Partnerships.
48 According to the Centre for Economics & Business Research, a consultancy which compiles figures on trends in City activities and jobs, the number o
jobs in London's finance and business services has risen strongly in the last two years. This confirms trends noted by recruitment consultants Joslin Rowe
hho reported a downturn in 2003), and Morgan McKinley, whose London Employment Monitor estimated only 2,104 new City jobs in September 2003,
pared with 5,733 two years later, and 9,639 in August 2006.
28 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
APPENDIX ONE
This section outlines the research methods used in the
course of our examination.
Interviews
We conducted in-depth interviews with staff from
the following organisations (the number of interviews
conducted with each is in parentheses). The interviews
generally lasted an hour and were largely semi-structured.
Whitehall bodies
Shareholder Executive (18)
DTI (1)
Cabinet Office (1)
Treasury (2)
Ministry of Defence (1)
Department for International Development (1)
Department for Transport (2)
Government-owned businesses
Actis (1)
British Energy (1)
BNFL (1)
CDC (1)
NATS (1)
Royal Mint (1)
Royal Mail (1)
Private Equity Firms
= 3i()
m — Apax (1)
International bodies (interviews conducted by phone)
= _ Division for State-Owned Enterprises, Ministry of
Industry, Employment and Communications, Sweden
RLIT0000197
RLITO000197
Study methodology
In addition, we corresponded by email with staff
from the bodies listed below under ‘examination of
overseas experience’.
We also attended a “live” meeting of the Stakeholder
Group (5 July 2006) and the Shareholder Executive's
internal performance monitoring meeting (12 July 2006).
These interviews provided information for all aspects
of our work, The more discrete streams of work are
highlighted below.
Documentary review and analysis
We have reviewed a range of documentary evidence
relating to the Shareholder Executive and its work, and
government owned businesses, in particular:
m= Correspondence and formal agreements, including
Chairman’s Letters, between government departments,
the businesses, and/or Shareholder Executive
m Agreements and correspondence between,
Shareholder Executive, DTI, and the Cabinet Office
= The businesses’ and the Shareholder Executive's
‘own annual reports, management information and
board minutes
= _ Information on the Executive's and the DTI’s
remuneration framework
m= The Executive's ‘Traffic Lights’ and Investment
Reviews and other documents relating to
performance monitoring and review
Organisational review
To deepen our understanding of how the Shareholder
Executive operates and how it manages its internal and
external relationships, we carried out an organisational
effectiveness review. The review used the NAO’s Efficiency
Toolkit as the basis for structuring questions to understand
these aspects of the Executive's working practices.
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 29
APPENDIX ONE
The NAO’s Efficiency Toolkit offers a framework for
assessing the various factors which influence an
organisation’s efficiency, and making recommendations
for improvements. Some of these factors are also highly
relevant to the organisation’s effectiveness, and we drew
on these aspects of the Toolkit, including its modules on
people management and internal communication. More
information on the toolkit and how it can be applied can
be found on our website, at http/www.nao.org.uk/
efficiency/toolkit/index.htm
Our organisational review work involved interviews with
eight of the Executive's directors and group interviews
with eleven members of staff below director level. In total
we spoke to over a third of the Executive's employees.
The interviews were semi-structured with independent
facilitators leading the group discussions. These covered
topics such as:
m= leadership
m= external stakeholders
= communication
= people management.
We also integrated some of these inquiries into interviews
with external stakeholders such as departments and
business representatives (see the schedule above).
We were also advised by an Expert Panel member with
specialism in organisational health and effectiveness on
the general methods [and design of the questions] for this
part of our study.
Case studies
We selected the following businesses for closer
examination as case studies on how the Executive
manages its shareholdings or equity interests:
= British Energy
= Royal Mail
= NATS
m= CDC and Actis (taken together)
= Royal Mint
m= BNFL
30 THE SHAREHOLDER EXECUTIVE AND PUBLI
TOR BUSINESSES
RLIT0000197
RLIT0000197
We also reviewed the Executive's corporate finance
advisory work via the Industrial Development Unit.
These particular examples were selected to give us
coverage of the different types of working arrangement
the Executive has with businesses (i.e. executive,
advisory, joint leadership) as we predicted that this would
determine the extent of its influence. We also wished to
cover businesses of significant value on the grounds that
scrutiny of these cases would have greater impact on
improving value for money from the portfolio as a whole.
These businesses cover approximately 71 per cent of the
portfolio by turnover (2005) and 75 per cent by value (as
of June 2006).
The case studies were designed to examine whether
or not the Executive could demonstrate early signs
of effectiveness.
Examination of overseas experience
We considered the general international context to the
Shareholder Executive's work, referring to the OECD's
2005 Corporate Governance of State-Owned Enterprises:
A survey of OECD countries. In particular, we compared
the Shareholder Executive's role with that of equivalent
bodies in New Zealand, France, Sweden, and Australia.
These particular comparators were chosen for a number
of reasons. They represent a variety in the size, nature and
relative importance of the state-owned sector. Each of the
countries has undertaken some reform and centralisation of
the state ownership function in recent years, but they have
done it in different ways. And the OECD survey highlighted
areas of interest and good practice in each one, which
provides interesting comparisons for UK experience.
This involved internet research, review of documents such
as Annual Reports, and contact with our fellow Supreme
Audit Institutions in those countries. We also conducted
detailed email and/ or telephone discussions with
representatives of the Agence Des Participations de I’Etat
in France, the Crown Company Monitoring Advisory Unit
in New Zealand, the State-Owned Enterprises Division in
Sweden, and the Government Businesses Advice Branch
in Australia.
Valuation
We assessed the Executive's application of an Economic
Profit methodology to track changes in value over time.
In particular, we examined why this particular method
was chosen and whether or not it was fit for its intended
purpose. This included building the Executive's model
from first principles and testing its sensitivity to its
assumptions. A brief description of the model and our
analysis is provided in Appendix 3.
As the Economic Profit methodology does not provide
an absolute valuation of the businesses in the Executive's
portfolio, we conducted an exercise to obtain an
approximate valuation for the businesses. We generally
used a “market multiples” approach which is also
described in Appendix 3. The valuation range obtained
can be found in paragraph 2.5.
Comparison with private equity firms’
approach to shareholding
Private Equity investment managers do not usually apply
an explicit set of methodologies in a formalised way, but
they do make full use of the shareholder levers (described
in Figure 3).
The Private Equity firms we interviewed employ differing
skill sets, for example fund managers with business
sector expertise but who are also financially astute
and well trained; or investment managers with proven
financial expertise, but who also have hands-on business
experience. Their starting objective is to buy a business at
an attractive price relative to how they view its prospects.
This could mean, for example, buying in at a low multiple
of earnings, intending to exit later when the stock market
revalues the sector at a higher multiple of earnings.
Apart from timing the purchase to avoid paying too high
an entry price, there are two main value drivers. The first
is financial engineering, mainly finding ways to increase
the level of debt that can be serviced. The second is taking
steps to grow the profits that the entity can generate.
This might be achieved by cutting costs, by re-allocating
resources or — very selectively — by new investment or an
acquisition strategy.
RLIT0000197
RLIT0000197
APPENDIX ONE
To deliver value, the controlling shareholder has to build
a common agenda with the executive management.
This is done through agreeing value targets, typically
equity related, and rewards that are likewise typically
linked to equity. Along with rewards, the methodology
also involves applying sanctions, for example dismissing
underperforming management, ruthlessly.
Analysis of businesses’ financial
performance
Using data published in the annual reports of the
businesses in the portfolio we conducted an analysis
of financial performance, looking at trends in turnover,
operating profits before tax and interest and return on
capital employed.
As part of the case studies, we touched on financial
strategy issues — in particular the significant financial
challenges faced by some of these business over the next
few years (see paragraphs 3.2 and 3.3).
Expert panel
We put together an Expert Panel to review and challenge
our work and thereby provide quality assurance. The panel
consisted of a range of experts external to the National
Audit Office. They were invited to comment on the
emerging findings as we completed our fieldwork, and on
the structure and draft of the report. Panel members were:
= DrHarry Bush, CB Board Member and
Group Director,
Econcomic Regulation,
Civil Aviation Authority
Consultant and
organisational
effectiveness specialist
Chief Executive, NESTA
m= Dr Mee-Yan Cheung-Judge
= Jonathan Kestenbaum
Research Professor
in Privatisation and
Regulation, Cranfield
School of Management
. Professor David Parker
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR
BUSINESSES 31
APPENDIX TWO
A review of Government's performance as a shareholder
was commissioned by Sir Andrew Turnbull, then Cabinet
Secretary, as part of the Shareholder Executive's initial
business plan. The aim was to assess the performance of
the Government as shareholder, and to make evidence-
based recommendations about how this performance
could be improved. The report was discussed in detail
with the main shareholding departments and incorporates
their comments. The methodology and key findings and
recommendations are summarised below.
Methodology
The Shareholder Executive was informed by a broad range
of evidence and information, including a detailed review
of a sample of seven key portfolio businesses: Royal
Mail, NATS, BNFL, QinetiQ, Met Office, Royal Mint and
CDC. The Executive conducted an extensive interview
programme to gather information. They spoke to a wide
range of stakeholders, including departmental officials;
board members of government-owned businesses;
external advisory firms; and representatives from other
relevant parties including regulatory bodies, private equity
firms, and overseas government shareholding teams. In
total some 97 individuals were interviewed. The report
also draws on a detailed review of relevant departmental
files and correspondence; company reports and business
plans; and published corporate governance guidance.
All this information was used to analyse financial
performance, and to assess governmental practice in using
shareholder levers.
32 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLITO000197
The Shareholder Executive’s
Start-Up Review
Findings and recommendations
The Review concluded that, despite some recent
progress, the overall performance of government-owned
businesses had been poor. 20 of the businesses now
within the Executive's portfolio had sustained losses of
£2.7 billion over the three years to 2003-04, excluding
losses relating to nuclear liabilities. The causes of poor
performance reflected a number of weaknesses at both the
shareholder and business levels. The report's key findings
and recommendations to improve the performance of
Government as a shareholder are summarised below.
The report's concluding chapter offers a new model for
the management of government shareholdings. It proposes
overarching principles, including clarity and transparency
of objectives, a shared vision between the Board and
the shareholder for the company, robust shareholding
involvement in exercising key shareholder levers and a
clear incentive framework for Boards to reward long-term
value performance.
RLIT0000197
RLIT0000197
APPENDIX TWO
Finding
Absence of appropriate corporate
governance arrangements
Multiple, unclear and inconsistent objectives for
government-owned businesses
Failure to ensure Boards have appropriate skills;
little systematic assessment of boards and delays in
tackling underperformance
Board remuneration and incentives were at
inappropriate levels and were not clearly aligned
to key highlevel targets
Ineffective performance monitoring by the
shareholder, coupled with sometimes excessive
and ineffective interventions
Poor financial management including a lack of equity
and debt discipline
Inconsistent approach across shareholding
departments, with teams lacking appropriate skills
and high staff turnover
Inefficient use of external advisors
Recommendation
Systematic application of corporate governance best practice,
including a formal Governance Letter setting out arrangements
Clear objectives to be set out in Chairman's Letter, with
maximisation of value within the policy and regulatory framework
‘an explicit aim and the financial impact of non-commercial
objectives made transparent
‘More systematic involvement in board appointments; regular
internal and external Board assessments; clear determination to
terminate appointments in case of poor performance
Set remuneration at a level to attract high calibre staff, and link
individuals’ incentives to a few clear targets
Clear methodology for monitoring business performance against
plan, with intervention more targeted and effective
Regular reassessment of capital structure, clear dividend policies,
borrowing from government on commercial terms
Introduce a professional and consistent approach to the
shareholder function, suitably skilled and senior staff and
good career incentives
Reduce the use of external advisors, build up in-house expertise,
improve management of advisors.
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
33
APPENDIX THREE
Introduction
Fundamentally businesses purchase assets at a cost with
the aim of creating value greater than the cost. Assets
can be either tangible such as plant and machinery or
intangible such as staff contracts or intellectual property.
The historic cost of an asset is usually straightforward to
measure and is often a matter of fact. Measuring value is
more difficult. An identical asset will be worth more if it is
better managed. Valuation methodologies seek to quantify
the worth of better management. Any valuation method is
a process tool, which makes it subject to the vulnerability
of “garbage in, garbage out”. This Appendix gives a
brief outline of the methodologies used in the course of
‘our study.
Valuation methodologies
During the course of our study we have referred to
three methodologies:
Economic profit: The methodology selected by the
Shareholder Executive using historic data. On this basis
Economic Profit is the after-tax operating profit less a
cost of capital charge for the operating assets. It is based
on past performance and so cannot be manipulated by
future forecasts or by altering the timing of year end cash-
flows. Economic Profit has the benefit of incorporating
profitability, size of capital base, return on capital and the
cost of capital into a single measure;
Discounted cash flow: Discounted cash flow analysis
generally uses future free cash flow projections, that is
the cash available after all business costs are paid. The
cash flows are discounted, most often using the weighted
average cost of capital as the discount factor. The resulting
present value is a statement of the business’s value in
today’s money;
34 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLITO000197
Approaches to valuation
Multiples: A valuation theory based on the proposition
that, in an efficient market, similar assets sell at similar
prices. Therefore a ratio comparing value to some business
specific variable (operating margins, earnings, etc.) will be
the same across similar firms.
The National Audit Office commissioned Accenture to
develop a valuation range for the Executive's businesses
using a multiples method. The results are set out on
page 36.
Economic profit
The Economic Profit Model's prime purpose is to analyse
the impact of change to the in year Economic Profit.
An analysis of the accuracy of the Economic Profit
Model, based on its assumptions has been conducted to
understand the impact of varying these assumptions on
the model's output. This shows that the Economic Profit
Model, in common with other methodologies, is sensitive
to the underlying inputs into the model. Where possible,
the Executive has reduced the measure’s reliance on
volatile assumptions to a minimum in comparison with
other approaches it could have chosen, by holding stated
assumptions constant over the three year period.
Components of the methodology
Weighted Average Cost of Capital (WACC): This is the
return owners and lenders expect for investing in an asset.
It is the sum of the cost of debt and the cost of equity, each
weighted by their share of the overall value of the asset.
Increasing the cost of capital usually leads to a decline in
change in value of enterprise. However, the sensitivity of
value change for each business is different.
Capital structure: The percentage of debt impacts
the value change in a business as capital structure is
an important component in ascertaining the WACC.
Generally, because lenders accept less risk, debt tends
to be cheaper than equity and hence highly indebted
businesses tend to have lower WACC.*”
Taxes: Increasing tax has a negative impact on valuation
as lower profits are received by equity holders and hence
valuation tends to decline.
Growth rate: Growth rates, being predictions of the future,
can have dramatic effects on a valuation. The Shareholder
Executive model uses a zero growth rate and hence it
has no impact on the value change. This intentionally
means that the Executive's valuations are not presented as
complete valuations of the businesses it supervises.
Generally speaking, adjusting the individual assumptions
seems to have a mild impact on the change in value,
which reflects the stability of the model. For example, in
the case of three businesses (Royal Mail, Royal Mint and
NATS) a one per cent increase in WACC (eg 7.80 per cent
to 7.87 per cent) leads to decline in change in enterprise
value by one per cent. For the other three target businesses
this one per cent increase in WACC would reduce
enterprise value by two per cent. There is a larger degree
of sensitivity to changes in net operating profit, with a one
per cent increase typically increasing value by between
two per cent and six per cent.
RLIT0000197
RLIT0000197
APPENDIX THREE
The Weighted Average Cost of Capital is one of the key
assumptions that is held constant in the model. This
allows the Executive to assess business performance
on a constant basis and excludes the possibility of
manipulation. The market assessment of risk, however,
changes from year to year and would be relevant to a
valuation of the business undertaken for other purposes.
Below is a comparison of the WACC assumptions of the
Economic Profit model vs. WACC rates that emerge by
inputting a different beta value into the model” — beta
is one of the key metrics used to derive the WACC rates.
From the table below one can see that dynamic modelling
of individual sub assumptions such as beta leads to
change in some of the key inputs, which in turn impacts
the accuracy of calculation of the change in value.
Discounted Cash Flow
If conducted on the same basis Discounted Cash Flow
should produce an equivalent result to Economic Profit
methodology.”!
The advantages of using Discounted Cash Flow are:
= _ it calculates value of business as the expected
cash flow discounted at a rate that reflects the risks
inherent to the cash flow. Modelling individual
components of the cashflow for different risk
characteristics may be advantageous;
Dynamic modelling of individual sub assumptions such as beta leads to change in some of the key assumptions, which in turn impacts the
accuracy of calculation of the change in Valve.
BNFL pc NATS Qinetiq Royal Mail Royal Mint
Original Equity Beta [Fixed over time] 0.958 0.980 1.167 1.195 1.214 1.050
Accenture Equity Beta 2005 0.403 1.114 0.682 0.598 0.857 1.096
Accenture Equity Beta 2006 0.612 1.308 1.308 1.333 0.856 1.159
Original Posttax nominal WACC (per cent) 7.059 9.512 7.762 8.572 8.634 7.997
[Fixed over time]
Accenture Post-tax nominal WACC (per cent) 5.261 10.237 6.193 6.315 7.283 8.171
from beta change 2005
Accenture Posttax nominal WACC (per cent) 5.939 11.285 7.515 9.094 9.084 8.409
from change in beta 2006
Source: National Audit Office
49 The Executive measures Economic Profit at the entity valu which excludes financing effects. Th impact of capital structure comes through
the WACC figure. In addition, there is no straight line correlation between WACC and capital structure: if gearing goes beyond a certain point the WACC
increases because of a risk that the business cannot service the debt
50 The beta is a measure of market risk, based on whether the past observed correlation of a given stock with the stock market is greater than or less than
parity. A stock that is considered defensive will have a correlation of less than one — falling (or rising) in value by less than the market movement. Any price
movement that differs from the beta is the result of stock specific risk.
51 For a mathematical proof of equivalence see Appendix B of "Valuation: Measuring and Managing the Value of Companies”, McKinsey & Company, 2005
44th edition)
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 35,
APPENDIX THREE
= _ itis the theoretically strongest approach to
estimating the intrinsic value of a company, which
enables a detailed bottom up analysis by each cost
driver and business segment to be created;
= itis ideal for valuing specific changes to a business
or building a range of scenarios, which shows the
impact on value of different views of the company’s
future; and
= itexplicitly measures change in cash flows from
capital investments.
The two key disadvantages of Discounted Cash Flow are that:
= _ itis time consuming to get right, which includes
selecting an appropriate discount rate; and
m= it includes a wide range of forward looking forecast
assumptions, the accuracy of which significantly
affect the ultimate valuation of a company.
Multiples
Generally speaking, multiples are considered an
inferior method of valuation unless there are very good
comparators. The principal reasons are:
m__ they are too affected by one-time events;
= __ itis difficult to account for future events; and
= _ itis difficult to account for risk differences
between businesses.
The use of multiples has advantages. It incorporates
a variety of information in a simple way. It implicitly
includes market consensus about comparable businesses
discount rate and growth. It is in effect a free ride on
the available market information. Business multiples
are most often used to value privately held companies
where market pricing and valuations do not exist. This
is an analogous situation to that of government owned
businesses. A second common use is to validate the
results produced by other methods. A careful review of a
company’s multiples against those of its competitors can
help verify those alternative valuations.
The principle underlying the method is to search the
equity markets for businesses most comparable to
the target business. Important characteristics include:
operating margin, company size, products, customer
segmentation, growth rate, cash flow, location of
operations, etc. Once this is done an average multiple is
calculated. There are a number of ways of calculating the
multiple. The most common method is to use Enterprise
Value divided by Earnings Before Interest Tax Depreciation
and Amortisation. This multiple is then applied to the
Earnings Before Interest Tax Depreciation and Amortisation
of the target business to arrive at an Enterprise Value.
36 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLITO000197
In carrying out the valuation exercise, Accenture identified
a number of close comparators for seven of the businesses
covered by the Shareholder Executive. Accenture found
moderate comparators for a further nine businesses.
Two businesses have stock exchange listings, providing
market valuations. Finally nine companies did not have
appropriate listed comparators and were therefore
not considered. The results cover 18 businesses in the
portfolio for which a market value or close and moderate
comparators could be found.
The valuation exercise generated two separate ranges.
The higher valuation range was between £17.1 billion
and £20.8 billion as of 30 June 2006.
This can be broken down by segment as shown in
Figure 15.
The valuation range for businesses in the
Shareholder Executive's portfolio, by type
Segment Valuation range’
{£ million)
Lower end
Upper end
Listed businesses British Energy 5,643 5,643
QinetiQ
CDC
Actis
ECGD
4,722 5,209
Investment
businesses
Utilities BNFL
Royal Mail
UKAEA
NI Water Service
Scottish Water
5,755 8,723
NATS. 991
Channel 4
Service 1,209
businesses
and others OrdnancalSurvey
Working Links
DsTL
Royal Mint
Covent Garden
Market Authority
Tote
Total 17,111 20,784
Source: National Audit Office
NOTE
1 ones ‘excludes liabilities that Accenture considered
8, such os pension liabilities ond significant
pes ss he poole tr one cry aly
by 's teported financial information. Taking
(dk acai loge ie anes ke 1
between £4.97 billion and £8.84 billion.
APPENDIX FOUR
As part of our investigation, we considered the
Shareholder Executive's role within the broader
international context, and with particular reference
to experiences in Sweden, New Zealand, France and
Australia. The methodology is explained in Appendix 1.
The findings of this work are summarised here.
The International Context: the
government shareholding function
in OECD countries”
In spite of a wave of privatisations during the 1980's and
1990's, the role of state ownership in OECD economies
remains significant, described by the OECD as ‘remarkable
for its size [and] economic impact’ (p. 21). The UK's
government-owned businesses had a turnover well in
excess of £25 billion in 2005, or well over two per cent
of GDP; by comparison, state-owned enterprise turnover
is over five per cent of GDP in New Zealand and over
10 per cent of GDP in Italy, Sweden and France.
International approaches to
Government Shareholding
Although individual circumstances within each country
may vary, there are common issues faced by state-owned
businesses internationally. Foremost among these is a lack
of exposure to market disciplines: the threat of takeover
or bankruptcy is largely absent. Most of the OECD
government businesses are fully or majority owned by the
state; only a minority are listed. Secondly, there is also
often no clear owner of the business, but instead a range
of competing stakeholders with differing objectives: civil
servants, different Ministers, parliament and the general
public. This can cause difficulties in the articulation of
clear business objectives, and in the relative prioritisation
of commercial, policy and regulatory interests.
The OECD survey examines how the ownership
function is organised in different countries, categorising
models into three basic types, termed Sector, Dual and
Centralised. Figure 16 defines each model, and gives
advantages and disadvantages of each one.
RLIT0000197
RLITO000197
Type of ownership
Sector (Decentralised): state-owned enterprises are
under the responsibility of relevant sector ministries
Centralised: ownership is concentrated in one
Ministry, usually Finance or Industry
Dual: ownership shared between sectoral Ministry,
and a central one, usually Finance
Source: OECD and National Audit Office
Advantages and disadvantages
Industry expertise concentrated in one area, but harder to separate policy or
regulation from shareholding issues, as all lodged together.
Clear separation of shareholder function from policy and regulation and
consistency in ownership approach. Centralisation of expertise; possibly resultant
greater flexibility in remunerating necessary private sector skills. Risk of too
strong a commercial focus.
Scope for clear separation of roles, but also for businesses to become too
powerful if neither Ministry exercises control effectively. This model has generally
evolved as a result of Finance Ministry power, rather than through design.
52 The OECD published Corporate Governance of State-Owned Enterprises: A survey of OECD countries in 2005, following a trend of reforms in the way
member countries organise their shareholding functions. This section is based on their work.
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 37
APPENDIX FOUR
Trends in ownership of the government
shareholding function
There has been a trend in recent years towards
centralisation of ownership itself (see Figure 17), or
at least towards creation of a co-ordinating body to
provide consistency in ownership policy. As with the
state businesses, common issues internationally are also
faced by the state ownership bodies. They may require a
degree of autonomy in order to bring sufficient focus on
ownership and value interests. They also generally need
to be able to recruit people with specialist private sector
skills. Greater autonomy may make a body better able to
attract such skills, and allow greater flexibility in setting
remuneration outside the usual constraints on public
sector organisations.
RLIT0000197
RLITO000197
Case Example: New Zealand
New Zealand's Crown Company Monitoring Advisory Unit
(CCMAU), set up in 1993, is one of the longest-established
international equivalents of the Shareholder Executive.
The New Zealand model of state ownership offers a clear
separation of shareholder value from policy and regulatory
interests, with certain ministers given a specific remit to
focus on commercial priorities. Primarily this remit rests
with the Minister of State-Owned Enterprises, who is
responsible for shareholder value in the 18 state-owned
enterprises. The Minister for Crown Research Institutes
has similar responsibilities for the nine Crown Research
Institutes. Other Ministers have responsibility for the
shareholding in individual companies, as can be seen
in Figure 18. In each case the Minister of Finance has
50 per cent ownership, with the other relevant Minister
owning the remaining 50 per cent. CCMAU has an
advisory and monitoring role for all such businesses.”
Crown Companies Monitoring Advisory Unit established to advise the Ministers responsible for
Commonwealth Shareholder Advisory Unit (now Government Businesses Advice Branch) established
to provide commercially focused advice to the Minister of Finance and Administration. The
Commonwealth's ownership interest is generally represented by the Minister for Finance and
Ownership of the majority of government businesses centralised to Ministry of Industry, Employment &
Communications, to be overseen by a dedicated Division for State-Owned Enterprises (SOEs)
Revision of ownership procedures, but ownership still sectoral, with a Unit in the Ministry of Trade and
Ownership responsibility for 11 SOEs transferred to @ special unit within Ministry of Finance.
Supervision of a number of SOEs transferred and consolidated in a special unit of Ministry of Trade
Division for State-Owned Enterprises given greater responsibility (for board nominations and
Ownership centralised and the Agence des Participations de I’Etat (APE) created to oversee
Date OECD country Nature of centralising reform
1993 New Zealand
shareholder value in government businesses.
1997 Australia
Administration and the relevant portfolio Minister.
1998 Sweden
1999 Finland
Industry playing a co-ordinating role.
Netherlands Ownership function centralised to the Ministry of Finance, late 1990's.
2001 Denmark
2002 Norway
and Industry.
Sweden
ownership policy).
2003 UK Shareholder Executive established.
2004 France
the function
Source: OECD
53 There is one exception, Air New Zealand, where the Crown's majority ownership interest is overseen directly by the Treasury.
38 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLIT0000197
APPENDIX FOUR
18] Dual but centralised ownership of New Zealand government businesses
50% 18 State-Owned 50% Minister for State-
Enterprises Owned Enterprises
90 _
50% dasenich 50% Minister for Crown
Research Institutes
Institutes
Minister of Finance
has 50% of government's 7
ownership in all state 50% 9 Other business pry Sectoral Ministers:
businesses entities Agriculture,
Education, Transport,
Broadcasting,
Monitoring Research, Science &
Technology, Internal
Affairs, Economic
Development
Crown Company Monitoring vr
Advisory Agency vice
Source: Crown Companies Monitor \dvisory Unit, New Zealand
For the State owned enterprises, policy is kept separate
from commercial priorities not only through this ownership
structure, but also through a requirement of the State-
Owned Enterprises Act, that activities required for policy
rather than commercial reasons are carried out through
arms’ length contracts which make their cost explicit.
CCMAU exists to advise the Minister for State-Owned
Enterprises on business performance, and strategic
ownership issues. It is a centre of expertise on governance
and appointments, and also provides other ministerial
support. It plays an active monitoring role, receiving
and analysing quarterly reports from the businesses.
Whilst it does not set value targets for the businesses,
it does encourage the use of Economic Value Added
reporting, similar to the Shareholder Executive's Economic
Profit measure.
Although housed within Treasury for administrative reasons,
CCMAU is independent. It has about 21employees,
organised into four teams, three of which are sectoral and
one specialising in governance and appointments. As a
small public sector organisation requiring specialist skills,
it faces similar staffing and corporate knowledge risks to
the Shareholder Executive (see paragraphs 3.14 - 3.17),
managing these by ensuring more than one advisor works
on each business at any given time, and by careful rotation
of advisors between businesses.
Case example: Sweden
Sweden centralised the ownership of most of its
government shareholdings to a new dedicated division
within the Ministry of Industry, Employment and
Communications in 1998. The State-Owned Enterprises
Division is currently responsible for some 36 out of
the Swedish government's 57 wholly or partly-owned
companies. The businesses which remain with the relevant
sectoral ministries are there because they are considered
to have special societal objectives which may outweigh
commercial concerns.
There are parallels with the Shareholder Executive, in
that the Division sits within a department which has
policy responsibilities relevant to some of the businesses;
and also in not having full responsibility for all
government businesses.
Sweden addresses the first of these issues with a thorough
‘Chinese walls’ division between the shareholding division
and any relevant policy teams within the department. As
regards the businesses owned by other departments, the
State-Owned Enterprises Division still has a significant
role in their oversight, being responsible for the overall
state ownership policy, for the board nominations process,
and for quarterly and annual reporting of consolidated
summary accounts showing turnover, profits, gross
cashflow, and balance sheet figures.
ND PUBLIC SEC
THE SHAREHOLDER EXECUTI
DR BUSINESSES 39
APPENDIX FOUR
RLIT0000197
RLITO000197
Country and Role in Board
Ownership unit appointments:
New Zealand
‘CCMAU, independent No seat on Board, but
team of 22 located CCMAU manages the
in Treasury process for identifying and
appointing new directors;
with the final decision
resting on Ministers.
Senior Division staff have
within Ministry ‘seats on Boards. The Unit
of Industry is also responsible for
the nomination process
for external candidates,
ultimate decision being
the Minister's.
France
APE, Agency of APE will have a seat on
Finance Ministry, the Board, but minor
c. 60 staff role in other board
‘appointments.
Australia
Australia Advice to Minister
for Finance and
Government
Administration on board
composition and potential
candidates where relevant.
Businesses Advice
Branch (GBAB)
Source: National Audit Office
Business objectives
CCMAU reviews and
advises the Minister for
‘SOEs on the financial
targets set by Boards
in their Statements
of Corporate Intent.
State-Owned Enterprise
legislation requires
commercial profitability.
The Division sets
businesses targets on
profitability, dividend
payment, and financial
structure. Key role in
strategy due to seat
‘on board.
Businesses have
profitability and debt
sustainability targets.
Principal objective for
all Government Business
Enterprises (GBEs) is to
add to shareholder value.
Dividends and finance
Dividend policy required
‘as part of Statement
of Corporate Intent,
approved by Minister
for SOEs.
SOEs are able to borrow
privately; the government
explicitly does not
guarantee the loans.
Sets dividend requirement
for each company, as a
percentage of profits.
State owned companies
normally borrow in
private markets and are
not allowed to borrow
from the state except in
exceptional cases.
Companies are financed
through private borrowing,
with no state guarantee.
Estimated dividend
levels agreed annually
between Directors and
shareholding Ministers,
who prefer dividends over
capital growth.
Government Businesses
usually borrow from
private markets.
Valuations of businesses
CCMAU does not value
the businesses.
Annual valuations
obtained from external
experts, but results not all
made public.
No explicit value targets.
No explicit value targets.
GBAB does not value the
business unless examining
the future ownership
options of the entity.
40 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
APPENDIX FIVE
As illustrated by Figures 20 to 22, the “traffic lights”
evaluation takes the form of a quarterly assessment against
six key categories: implementation of the shareholder
model; the shareholder relationship; balance sheet and
risk; future strategy; the management team and financial
performance. Each test is broken down into several
different criteria, some of which are objective (in the form
“yes/no” factual answers) while others are more subjective
(such as an assessment of quality of management). A
positive score against most of the criteria will lead to a
a} Implementation of Shareholder model
Number of businesses
RLIT0000197
RLITO000197
The Executive's
internal reporting
business being given a green mark within a test, an amber
colour where there is a mixture of positive and negatives,
and a red colour where several, or particularly critical,
scores are negative.
Figures 20 to 22 provide a summary of the number of
red, amber and green traffic lights achieved against each
of the six key categories since the Executive first started
conducting these reviews in March 2005.
Main criteria:
Date of review
Source: Shareholder Executive
18 m There is a Governance letter, Chairman's
16 letter, Statement of Government Objectives
14 for the business.
le There is a clear separation of business
. management from policy.
‘ There are appropriate shareholder
A monitoring and remuneration frameworks
3 and timely financial information is available
; on a regular basis.
Mar05 — Jun05— SepO05.-— “Dec 05. Mar 06 Jun 06
Date of review
b) Shareholder Relationship
Number of businesses Main criteria:
18 = Stoff in the company have regular and
16 informative contact with Executive
- In There Is 6 “no surprises” polley between the
6 company and the shareholder.
8
6
4
2
0
Mar05 — Jun05 ss SepO05-— Dec 05. Mar 06 = Jun 06
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES 41
APPENDIX FIVE
The principal benefits brought by the Executive's
new approach mean that the monitoring of strategy
and performance is now more active, systematic and
consistent for those businesses within the Shareholder
Executive's remit. Another aim of quarterly ‘traffic light’
a) Balance Sheet and Risk
Number of businesses
16
14
12
10
8
6
4
2
0
Mar 05 Jun OS Sep 05 Dec 05
Date of review
b) Strategy
Number of businesses
14
12
10
onan Oo
Mar 05 Jun OS Sep 05 Dec 05
Date of review
Source: Shareholder Executive
Mar 06
Mar 06
RLIT0000197
RLIT0000197
reviews is to provide early warning of potential problems.
Compared to the rapid progress shown in Figure 20,
Figure 21 shows that, as one might expect, it takes longer
to tackle the issues around strategy, balance sheet and risk.
Main criteria:
There is an agreed balance sheet strategy;
«@ capital structure in place (which provides
adequate funding for the business in the
medium term), and dividend policy (if
dividends are able to be paid).
There is no major pension deficit or any
major issues with liabilities and the balance
sheet is solvent.
Jun 06
Main criteria
tm The Board and the Shareholder
have a shared understanding of the
strategic agenda.
The strategic plan has been svitably
scrutinised, is credible, is likely to
create/enhance value; and do the right
things for the business.
Jun 06
42 THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
The Executive has also taken steps to ensure that
management teams and Boards are sufficiently
strong (Figure 22a), showing some progress although
18 months is a relatively short period to implement
planned improvements. Taking all the right steps would
be expected to stabilise and then improve financial
performance — the final chart (Figure 22b) shows that
still early days in this regard:
) Management Team and Board
Number of businesses
14
12
10
8
6
4
2
0
RLIT0000197
RLIT0000197
APPENDIX FIVE
This traffic lights model is used only an internal
monitoring tool and the Shareholder Executive does not
make public the appraisal status of an individual business.
Main criteria:
The right board dynamics are present with a
strong non-executive director team; and a
succession plan for senior management,
The Board is compliant with the Combined
Code and has reviewed its own
performance recently
Mar 05 Jun 05S
b) Financial performance
Number of businesses
12
10
Sep05 Dec 05
Date of review
Mar 06
8
6
4
2
°
Jun 06
Main criteria:
The company produces positive economic
profit; and the business is performing in line
with or ahead of budget.
The company is maintaining or improving
financial performance over the foreseeable
future and the business is free form any
substantial accounting anomalies
Mar 05 Jun 05
Source: Shareholder Executive
Sep05 Dec 05
Date of review
Jun 06
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
43
APPENDIX SIX
Previous PAC and
NAO references to
shareholding issues
RLIT0000197
RLITO000197
Report
NAO report: Financial Support for
Post Offices, HC 287 (2004-05)
Publication Date: 24/02/2005
NAO report: Risk Management:
The Nuclear Liabilities of British Energy ple
HC 264 (2003-04)
Publication Date: 06/02/2004
PAC report: Risk Management:
The Nuclear Liabilities of British Energy ple
PAC 37th Report (2003-04)
Publication Date: 09/09/2004
PAC report: The Acquisition of German Parcel
PAC 10th report, HC 422, 2001.02
Publication Date: 11/01/2002
NAO report: The Acquisition of
German Parcel, HC 858 (1999-00)
Publication Date: 24/08/2000
PAC report: The Flotation of Railtrack
HC 256 (1998.99)
Publication Date: 14/07/1999
Conclusions and recommendations on improving value for government
as shareholder
The Department, as shareholder of Royal Mail Holdings, has put in place sound
arrangements for monitoring the company’s performance. The Department, through its
Shareholder Executive, should ensure that it has in place similar arrangements for other
companies in which the Government has a majority shareholding.
The Shareholder Executive, established within the Cabinet Office in 2003, should, as
planned, be fully consulted in future privatisations and, where appropriate, should give
advice on ongoing monitoring arrangements where the taxpayer is exposed to risk.
The Department failed to establish a credible overview of British Energy's deteriorating
financial position, and did little more than gather information. Its inaction was
compounded by split responsibilities for monitoring British Energy and the design of the
New Electricity Trading Arrangements. In designing and coordinating energy policy it
failed to consider the taxpayer's potential exposure. The Department should establish
effective oversight of British Energy's financial position.
British Energy’s management did not respond effectively to the changes in the electricity
market and the Department did not challenge the company’s strategic direction.
The Department should ideally have had agreed overall financial targets for the Post
Office's business, taking into account the proposed acquisition strategy, before they
agreed to the acquisition of German Parcel. They should for the future set clear financial
targets and milestones for both an acquisition and the overall business in advance of an
acquisition and monitor them rigorously.
One of the ‘points of good practice’ departments could follow to protect the interest of
the taxpayer when handling major acquisitions:
@ formation of a departmental team with corporate finance experience and sectoral
knowledge, supplemented by external advisers, to oversee the acquisition being
kept fully informed on all aspects including negotiations and due diligence.
[On policy-driven timing of the sale and implications for value] The Department claimed
that the timing of the sale was influenced by the need to maintain the momentum of the
rail privatisation programme...Given their view that the timing of the sale was likely to
have an adverse impact on proceeds we are concerned that the Department did not do
more to identify the potential of the business and more to maximise its value.
[On not phasing the sale to maximise value] We note that the Department decided to
opt for a 100 per cent sale on the basis of their judgement that it would not have been
possible to phase the sale of shares over a period of years. This decision had important
implications for the potential value to be secured from the sale....we are not convinced
that they gave this option the thorough investigation that it merited.
44
THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
RLIT0000197
RLIT0000197
APPENDIX SIX
Report (continued)
PAC Report on The Sale of
Railfreight Distribution, HC 601 (1999)
Publication Date: 10/11/1999
NAO report: The Flotation of Railtrack
HC 25 (1998-99)
Publication Date: 16/12/1998
PAC report: The Sale of the Stationery Office
HC 599 (1998)
Publication Date: 15/06/1998
PAC report on British Rail Maintenance Ltd:
Sale of Maintenance Depots
HC 168 (1996-97)
Publication Date: 03/04/1997
PAC report: The Sale of the Water Authorities
in England and Wales
HC 140 (1992)
Publication Date: 13/07/1992
Conclusions and recommendations on improving value for government
as shareholder (continued)
This marked difference [between projected and actual freight volumes] leads us to
question whether the minimum usage charges [guaranteed until November 2006]
were set to get the best possible result for British Rail or, rather, set at a level to support
Eurotunnel, leaving Railfreight Distribution to bear the financial consequences.
The volume of freight carried was...of key importance to the success of the business
and its valve in the long term. Yet the Department did not think creatively about how to
encourage growth in rail freight... We urge departments to think creatively about how
to extract the maximum value from their assets.
The Department managed to attract only two bidders. We are not convinced that
the challenging timetable they set for the sale did not discourage other bids....[To
‘encourage strong competition in bidding] we recommend that in future sales
departments set timetables which give bidders adequate time to consider their bidding
strategy, including the options for forming consortia with other interested parties.
In future flotations, we recommend that departments should:
tm _Begin the privatisation process with the presumption that better value for money will
be obtained by selling shares in stages, with a view to disposing of the remaining
shares through a subsequent sale, or series of sales, once the company has
established a track record in the private sector.
im Ensure that the company is floated with the most favourable capital structure to
maximise the sale proceeds using the optimum mixture of debt of equity.
The Office of Public Service took a hands-off approach to the business...and chose to
limit their role to providing advice to Ministers only if requested. In the light of HMSO’s
increasing commercial problems, we consider that the Office of Public Service should
have taken an active interest in the business and should have taken the initiative, in
defence of the taxpayer's interest, to advise Ministers about the need for action to help
performance. Not doing so contributed to a loss of value in the sale.
We do not accept the Office of Public Service's view that the provision of advice to
Ministers about the decision to sell was the responsibility of the Chief Executive of
HMSO because he was the Accounting Officer. It is contrary to good practice to leave
it to the management of a business which is to be sold to take the lead in advi ona
decision to sell.
HMSO had provision for up to three non-executive directors, but positions were allowed
to remain vacant after July 1995. Individuals with commercial experience to draw
upon could have seen how badly HMSO was being run and could have alerted the
management and the Office of Public Service to the risks.
We are not convinced that the Office of Public Service obtained full value for money
from their financial advisers, Coopers & Lybrand.
The Committee note that the Department agreed objectives for the sale with British
Rail. We are concerned that they did not then monitor British Rail’s handling of the sales
more closely to assure themselves that agreed procedures were being properly applied
in all key respects.
We regret that the Department did not ensure that comprehensive valuations of
the maintenance depots were carried out...Experience suggests that the process of
considering how a business should be valued enhances the vendor's understanding of
the enterprise, and its underlying assets. It should also give the vendor an insight into
the appeal that they may have fo various potential purchasers.
We are surprised and regret that the Deparment did not inform themselves about the
expected financial performance of the businesses to be sold.
We therefore recommend that consideration should be given in future cases for
responsibilities for regulatory decisions and for selling to be located separately. This
would enable the Departments concerned to demonstrate clearly to Parliament that both
had received full attention.
Printed in the UK for the Stationery Office Limited
on behalf of the Controller of Her Majesty's Stationery Office
5526180 02/07 65536
‘THE SHAREHOLDER EXECUTIVE AND PUBLIC SECTOR BUSINESSES
45