We need to talk about risk


Economies thrive on the individual pursuit of personal profit and purpose in return for taking risk. Risk as entrepreneurs mortgage the family home. Risk by leaving a secure, salaried job. Risk by investing in unproven technology. There is something noble about risk capitalism compared to rentier capitalism. And yet somewhere along the line risk has got itself a bad name. How has this happened? How has a growing aversion to risk been allowed to stifle the source of so much economic progress?

I am acutely aware by working in financial services that my own industry must shoulder much of that blame. Risk is only a noble pursuit if downside risk and upside risk are both in play. The Global Financial Crisis (GFC) revealed a financial services industry where too much of the upside was trousered by individuals, and the downside spread amongst the wider economy. That event almost sixteen years ago continues to cast a long shadow.

The GFC, and less totemic examples from other sectors, has meant that risk appetite has steadily decoupled from its natural bedfellow: reward. A vibrant economy has a rich mix of both. Risk and reward in tandem generate a healthy incentive to innovate, disrupt and become more efficient. A lack of risk generates sluggish rent-seeking behaviour. Nowhere is this more apparent than in residential property which has become a sink for British savings. The value of UK property is four times higher than our domestic stock market. In the US these sectors are roughly the same size. Whilst UK planning restrictions are a key element of this ratio, it is also symptomatic of investors looking at the constraints faced by the largest UK firms from taking risks and generating rewards.
This aversion to risk is starkly illustrated in the rollout of secure new sources of energy. Investors have been scared off by windfall taxes and extraordinary levels of planning delays. They are rarely prepared to put risk capital to work without a taxpayer-backed guarantee. This inhibits innovation, stifles productivity, and in the long run makes us all poorer.

In a fascinating study into the costs of Europe’s largest infrastructure project – the new nuclear reactor at Hinkley in Somerset – Sam Dumitriu has found that a staggering aversion to risk has led to the project becoming the most expensive nuclear power station in the world. Some of the data points are jaw-dropping.
Hinkley Point C – set to provide around 7% of the UK’s energy when complete – is on track to be four times more expensive per unit of energy than the average nuclear plant built in South Korea. The Office for Nuclear Regulation has insisted on 7,000 design modifications to identical projects delivering nuclear energy in France. This has resulted in 25% greater use of concrete, and 35% more steel. More than 31,000 pages of environmental impact assessment have resulted in millions of pounds being spent protecting a tiny number of fish in the Bristol Channel. Similar anecdotes are available from the contractors delivering High Speed Two and planning the Lower Thames Crossing.

The common theme of these projects – and within the wider economy – is that attempts to eliminate risk have often superseded a rational, data-driven trade-off between risk and reward. The rewards of lower energy costs, affordable housing and cheaper travel are sacrificed at alter of trying to eliminate a long tail of small risks. A tangential argument continues to rage around decisions taken during the COVID-19 pandemic – but you will forgive me if I don’t open that nest of vipers.

So how does the textbook of cost benefit analysis related to taking risk get superseded by acute risk aversion on the ground? The major driver is a failure by regulators, policymakers, and the legal system to consider the macroeconomic impact of many micro-decisions. Any cost benefit analysis conducted in a narrow sense may judge that eliminating risk is beneficial. But such misspecification may fail to capture wider, albeit less obvious costs.

An example may help illustrate how political toxicity contributes to this outcome. Take the area of benefit fraud. There are undeniably bad actors embedded in the welfare system. So any Department for Work and Pensions minister keen to talk (and act) tough on public sector efficiency is incentivised to layer on hoops for claimants to jump through in an attempt to minimise the risk of fraud. Rather hidden is the resource taken to construct and monitor these hoops. Even more hidden is the time taken and stress incurred by genuine welfare claimants to access support they desperately need. Good luck the Minister sitting down in a TV studio and making the case for making access to welfare easier on productivity and value for money grounds! Clearly restrictions on access to welfare are necessary, but on a risk-adjusted basis adding ever incrementally to these may well be the counterintuitive path to a more productive state, and a faster-growing economy. A more regular argument is often made for the tax system where layer upon layer of tax code stifles entrepreneurialism and often means the most successful firms are the ones with the best accountants, rather than the best products.
Data released last Friday revealed, staggeringly, that UK public sector productivity is lower today than in 1997. Let that sink in for a moment. Despite all the technological advances of the last quarter of a century the public sector is delivering less with more. That is a damning indictment of the appetite for risk and innovation in the state sector. It has increasingly permeated private enterprise too with UK private sector productivity down by two thirds since the Global Financial Crisis.

So what can be done? Well there are pockets of appetite for a different way to approach risk with recent reforms to Solvency Two and the government’s Mansion House reforms signalling intent to allocate investment to riskier projects. However policymakers also need to recognise that resisting compensation for risk “gone wrong” and avoiding taxing risk “gone right” is part of re-establishing a healthy balance of risk and reward. Policymakers should also encourage – through their own messaging – risk to be spoken about in more equal-handed terms. Only then do we have a chance of breaking out of the UK’s sluggish productivity performance. Affording a well-funded state sector depends on it.

Published on The Times: 06/05/2024

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