Hungary’s Investment Environment. Run or Play? Part 1

The idea that people and even companies are locally dependent, and not mobile assets, is now a long established academic debate. This may be at odds with some of the earlier ‘globalization literature’ which classified multinational companies as highly mobile and which seek out the cheapest labor and locations.

Hungary, and more specifically the new Fidesz Government,  is now putting this theory to the test. Interestingly, they are applying it to economic sectors that are less mobile than manufacturing. Utilities, retail chains, banks, telecoms, all sectors that require huge amounts of investment over a long period of time and that can not easily dispose of these assets – particularly in the current economic climate.

What I would like to do in this multi-part blog post is to attempt to understand the impact on the utility and energy sector that Hungary’s two extraordinary taxes (extension of the Robin Hood tax and special sectoral tax) will have on the companies and the country in the medium and long-term. And how this affects Hungary as a country that potential investors will invest in.

In this first post, my intent is to just lay down the basics of how the utility sector works with the political/regulatory sphere. This will allow a means to assesses recent changes in Hungary and the medium and long-term impact of tax changes.

Competitiveness of location

The energy, and more specifically the utility industry, is marked by embedded assets. They are stuck to their geographic location. Therefore, it is incumbent upon them to make the place they are located in, a competitive and attractive place to do business.

The role that utilities play in the US, since they are consigned by decades of regulatory oversight, is to act as economic development agencies. They help companies find suitable locations for investments and can act as go-betweens, for interested companies and local governments. They are essential players in the economic development of US states.

Utilities in Europe, while they may not play this essential go-between role (particularly in more liberalized markets, even less-so), they do play an important role as economic development agents by ensuring reliable infrastructure and acting as indicators themselves, for other investors. The utility industries close proximity to political and regulatory decisions can make it a litmus test for the broader economic environment in a country. Utilities are sensitive to the predictability of regulations and long term investment signals governments convey. In addition, utilities and other energy companies, are the economic backbone of a country – and essential for economic development, particularly for manufacturing.

There is a political and economic balance that politicians and regulators take with utilities. There is a margin of profit allowed to monopolistic utilities (and even those operating in a semi-competitive environment) in exchange for good service quality and competitive prices. When the prices become uncompetitive or perceived as too high, it can be shown, that political and regulatory efforts will be taken to reduce the profit levels. This may take the form of altering the market structure (movement from monopolistic to competitive market), imposing special taxes (a Robin Hood tax), or altering specific regulations that impact the profit levels.

These different steps can have long-term and short-term effects on how companies operate. What is essential is that investments continue in order to maintain the competitiveness of the location (upgrading lines and investments into generation and fuel supplies) and to allow a long-term predictable regulatory environment. Disruption of this path, will set back past efforts of providing sectoral stability. This can be seen in how privatizations were conducted and initial conditions agreed to. For example, if respect for these earlier agreements are not honored or acceptable alterations are not reached, then even the reason for privatization (modernization of infrastructure at a lower cost and economic growth) is lost. High market risks are reintroduced and investment decisions are delayed.

Therefore, it is essential that historical commitments are honored, or altered with mutual consent, by politicians and regulators with input from utilities. If continuity of investments is maintained in a stable regulatory environment then this sends a signal to other industries and over the long-term reduces the risk level for a country; with the knock-on effect being lower financing costs and lower prices for household and industrial consumers.

With these basic parameters laid out, in this first part, I’ll apply these to the situation in Hungary. This is particularly important as Hungary was the first country in Eastern Europe, where utilities were privatized and bought by foreign investors. Just a few years ago, a CEO of one of the largest utilities told me, the risk level his company gives for Hungary was no different than for a Western European country. However, a regional banker recently told me energy companies now see Eastern Europe as a high risk investment location with low returns. Making it an undesirable location for business.

These views will be examined in the second part. The recent imposition of extraordinary crisis taxes in Hungary may affect  investment plans and the countries investment environment – including assigned risk levels. In the next post, these new taxes will be reviewed and the impact these may have on the utility companies. The final post on this topic will address the medium and long-term impact this has on the country and other industrial sectors.