To have or to hold? Auckland Council's pesky airport shares 🍋

Why do councils own debt-funded financial assets?

Auckland City Council decided earlier this year to reduce its holdings of shares in Auckland International Airport (AIA) from 18% to 10.1%.

Tim Hazeldine, writing in the New Zealand Herald, invoked the endowment effect to explain the reluctance of many Auckland City councillors to sell the council’s shares in Auckland International Airport. The endowment effect is where people value something they own more highly than they would if they had to purchase it anew.¹

He asked if those who were dead set against selling down some of the Council’s 18% stake in the airport would be equally dead set to increase that stake. If not, he said, the endowment effect is biasing their decision making.

Whangaehu valley, Tongariro National Park. Dave Heatley

Looking for consistency in the cases made for (and against) public decisions can be frustrating, as no doubt Tim knows. In this case I have more than a little sympathy for councillors, even if I think much of their stated reasoning draws on unhelpful and misleading analogies.

Public-benefit entity accounting is confusing

Assets and liabilities have very specific meanings in the accounting world. Those meanings grew out of the need to calculate the net value of firms in a reproducible and fair way, and to draw comparisons between different firms. But things are a bit different for public-benefit entities, whose primary objective is to provide goods or services for community or social benefit. This is especially so when the entities are long lived, have a monopoly on service provision, and have no practical way to shirk their service provision responsibilities — as in the case of councils.²

Let’s take the example of a 40-year old pipe providing water to a suburb, with a life expectancy of a further 10 years. Such a pipe would be an asset for a firm — the pipe has 10 years of revenue-producing potential. And its existence creates an entry cost for putative competitors, so an alternative valuation method is the cost of duplication by another firm. For a firm, the pipe is an asset, with a positive value that gets smaller as the pipe ages towards its replacement date.

The story’s different for a council owner. Nobody is looking to buy the council’s business, nor to compete with it. Their customers are not going away.³ Seen this way, the pipe should be a liability on the council’s books, which gets larger as the pipe ages. It would be best valued at the discounted present cost of replacement.

Confusingly, the council’s assets and liabilities are determined using the terminology and rules that apply to firms. Councillors have my sympathies. But that doesn’t excuse them from not thinking through, and clearly stating, the reasons behind the public positions they take.

Does it make sense to borrow money to hold shares?

Councils need a whole bunch of physical assets to service their ratepayers. As well as physical assets, councils need sufficient financial assets for liquidity — to cover differences in timing between receiving and making payments.

It makes sense to use debt to fund long-lived physical assets, to spread their cost across all those who benefit, i.e., current and future ratepayers.

Debt for other purposes is, for the most part, a intergenerational transfer from future ratepayers to current ones. This is why it can be popular with voters in council elections.

NZ councils, such as Auckland, typically hold financial assets (such as shares in firms), whose total market value is less than the council’s total outstanding debt. The opportunity cost of holding such assets, relative to selling them and retiring debt, is the interest servicing cost of a debt of equivalent value.

Does it make sense to hold such assets, as opposed to retiring debt? Or, to use Tim Hazeldine’s equivalence, would it make sense to borrow more money to buy additional shares?

From a purely financial point of view, borrowing to fund financial investments only makes sense if the total expected return from those investments exceeds the corresponding interest payments.⁴ That decision depends crucially on interest rates, the market value of the shares, and expected future dividends. Interest rates have risen significantly of late, making debt less attractive, all else equal.

So, this is an appropriate time for councils to reconsider their financial investments. The “hold shares vs. pay down debt” equation looks different now compared to two years ago.

But first, does the evidence support the idea that councils choose investments that maximise their expected return? Not really…

Financial diversification is one of the few free lunches in economics

Rule number 1 of investing is diversification. And rule number 2 is, well, see rule number 1. Diversify across companies, market sectors, geographies and countries. Diversification leads to a significant reduction in financial risk, without reducing average financial returns. Indeed, it can contribute to increased average financial returns.⁵ A free lunch indeed!

… but NZ councils concentrate their financial risk

Christchurch City Council, for example, owns many infrastructure assets, including Christchurch’s port, airport, and electricity and fibre networks. These are all geographically concentrated in Christchurch. They were all damaged by the September 2010 and February 2011 quakes, coinciding with the damage to much of the city’s roads, pipes, buildings, etc. With the benefit of hindsight, the city and its people would have been better off with financial investments in other places, and across a wider variety of sectors.

Auckland Council is also over-exposed financially to local geographic risk. As is Wellington City Council, likewise Dunedin. You’d think they might have learnt from Christchurch …

All else equal, Auckland Council would be better off investing in Christchurch Airport. And even better off investing in a mixed portfolio of (e.g., South Island) firms.

Descending French Ridge, Mt Aspiring National Park. Dave Heatley

If councils aren’t choosing their financial assets to maximise returns, and their choices tend to increase rather than reduce risk, then what is going on? I’m not privy to discussions between councillors, but can infer possible reasons from the publicly stated positions of councillors and other advocates. First off, such investments are often referred to as “strategic assets”.

Strategic asset is a hollow term without an actual strategy in play

‘Strategy’ is a concept most closely associated with the military, games and business. In these spheres the meaning of ‘strategic asset’ is straightforward: an asset is strategic if control over that asset is essential to achieving a particular and well-defined objective … This makes the relevant asset a ‘must have’ rather than just ‘nice to have’. Control may mean a variety of things. But the important considerations in its meaning are the right to use the asset – and the right to exclude opponents from using it, which thus limits their strategy choices.⁶

Neither the right to use the Auckland airport, nor the ability to exclude opponents, seem relevant here. The airport’s existence does not rely on the council’s shareholding.

Further, is it unclear what is the “well-defined outcome” that the council might be seeking through its ownership of 18% of AIA shares. Desirable environmental and planning outcomes can presumably be achieved through the council’s regulatory powers. Share ownership complicates the exercise of those powers by creating potential conflicts of interest, real or perceived. Desirable economic, commercial and aviation outcomes are the responsibility of central government, through its regulatory agencies including the Commerce Commission and Civil Aviation Authority.

The Local Government Act 2002 defines a strategic asset as something that a council needs “to achieve or promote any outcome the council has determines to be important”. But, bewilderingly, the Act then declares airport company shares to be strategic assets, whether they meet that definition or not.

strategic asset, in relation to the assets held by a local authority, means an asset or group of assets that the local authority needs to retain if the local authority is to maintain the local authority’s capacity to achieve or promote any outcome that the local authority determines to be important to the current or future well-being of the community; and includes—

… (c) any equity securities held by the local authority in—

… (ii) an airport company …

More grounds for confusion!

“Don’t sell the family silver”

This soundbite is often rolled out as a reason not to sell a publicly owned asset. But I don’t think it makes a very convincing analogy. Family silver might have been expensive and valuable in the past. But in the modern era, it typically sits unused in the bottom of a cupboard. So, the discounted present value of its future use is pretty much zero. And, if there are no circumstances under which you can contemplate selling “the silver”, it has no sales value. That leaves only sentimental value, which might be significant, but a weak case for retaining assets that could be sold for hundreds of millions of dollars.

“Don’t raid the rainy day fund”

A rainy day fund seems like a great idea — some spare resources to draw on when it does rain. But, if the widespread catastrophic floods experienced by Auckland in early 2023 does not meet the criteria for a rainy day, then what would?

Debt-funded liquid assets are not the only way to reserve spare resources for a rainy day. For example, a debt facility that is not maxed out can be drawn down to cover rainy day expenses. So, a council that sold financial assets to retire debt has a rainy day fund of the same size as one that did not.

If strategic assets, family silver and rainy day funds are unhelpful and misleading analogies, then what else might explain the propensity of councils to hold both debt and financial assets? Hazeldine’s endowment effect — valuing something more highly simply because you own it — is one reason. But I think there is a further, perhaps more plausible, explanation.

Maxing out on debt ties the hands of councils

Councillors want to be re-elected, and often see spending on public projects as furthering that aim. Wellington Council’s 2022/23 annual plan, for example, drew the description “an orgy of spending”.

A council that can draw down on debt can fund such excesses, with little recourse available to ratepayers. But a council up against its borrowing limits can only spend beyond its means if it raises rates or sells financial assets. Both actions are highly visible, and offer ratepayers an opportunity to raise their objections.

It is in the interests of many ratepayers (and of financially prudent councillors) for councils to live within their means. Holding financial assets funded by borrowing can be seen as a device to limit overspending. This device only works, of course, if there is significant pushback against proposals to sell such assets. That pushback fulfils its function whether or not it is sensible or coherent. So, we shouldn’t expect it to be so.

By Dave Heatley

1. Tim Hazeldine Auckland Council’s airport shares - the big question that wasn’t asked ($). New Zealand Herald, 14 June 2023.

2. The Treasury publishes specific rules for public benefit entity accounting in NZ, but these fail, in my view, to deal with the issues outlined here.

3. Well, maybe council customers for drinking water are going way in 2026, transferred to new water services entities as a result of the 3 waters reforms. But the same arguments would apply if you substitute “bridge on a local road” for “pipe”

4. Further, as funds are not unlimited, the expected return from the investments chosen should exceed the expected returns of alternative uses for the same funds.

5. Diversification increases average financial returns to the extent it reduces the likelihood of a forced sale of temporarily distressed assets.

6. David Heatley & Bronwyn Howell (2010). "Strategopoly: playing with the nation's assets," Competition & Regulation Times 373104, New Zealand Institute for the Study of Competition and Regulation.