The mixed joys of privatisation

As a rule, I've supported the privatisation of state-owned enterrpises - particularly underperforming ones. In many cases it has lead to more efficient provision and better financial performance than under state ownership. But there are key exceptions. The experience with privatised natural monopolies has been decidedly mixed. The key element of market competition is missing and so one has to rely on a government regulator to keep such firms honest. In Britain, for example, the performance of privatised water companies has been a disappointment, with large price hikes, growing pollution and wastage.

A more glaring concern is the growing use of private firms to finance and operate public works, such as highways or hospitals. In many cases this is done under the so-called Build, Operate and Transfer approach or some variant of it. Such a system has three major problems. First, there is an obvious moral hazard around quality. Private firms have an incentive for their work to last until it is transferred to the state - but not a day longer. That can result in cost savings through inferior materials and workmanship leading to higher maintenance costs. This poses a medium-term budget risk to governments.

Second, in most cases if the venture fails, the taxpayer ends up bailing it out. Just as central bankers are lenders of the last resort, so too governments have often had to come to the rescue. As blogger and economics professor John Quiggin has noted:

..these episodes underline the point that, for essential services, government is the provider of last resort. It can sell the assets, and forgo the associated earnings, but it can’t divest itself of the obligation to step in (and pay up) when something goes badly wrong.

A popular alternative has been for governments to agree to vary the terms of the contract to allow firms to impose higher rentals or charges - for example, for a tollway that is losing money. Of course, either outcome undermines the claim that private firms reduce public risk or deliver more efficient services.

The third, and most fundamental, problem with privately financed public works are that they invariably cost more. Not only do firms have to ensure they make a profit, but they also face a higher cost of capital. This is a point that John Quiggin has been making for many years. Meanwhile, Kelvin Hopkins writes in today's Guardian that the cost of privatisation will haunt us for years to come. He makes the point well:

The illogic of private investment being given incentives to replace public investment is compounded by the fact that the cost of government borrowing is much cheaper than servicing private capital investment. The money markets are generally enthusiastic about lending to government because such lending is secure, which is why the interest charged is low. By contrast, private-sector investment always requires a risk premium and profit-taking.

Government's natural advantage is in raising money cheaply. The private sector's is in running organisations efficiently. Public-private ventures should capitalise on these core strengths, with the government raising the money - perhaps via bonds, as Ken Livingstone has suggested - and the private sector partner running the operation. This makes economic and fiscal sense - but has the key failing of not taking government capital spending 'off the books'.

Comments

[Chris Cook]

In fact, there is a non-toxic form of PPP now possible, although you won't find either the DTI (in denial) or professionals (paid by the hour and with a vested interest in complexity and conflict) telling you about it.

And that is simply for public assets to be held by a Trustee or Custodian in perpetuity, and for that Trustee to be a member of a UK Limited Liability Partnership - the simplest and most flexible corporate form ever created.

"Capital Users" - who could be anyone: private, public, charities, individuals, whatever - simply pay a reasonable, and probably index-linked return to (pension) Investors for as long as the Capital is used. But unlike debt, the Capital NEED not be returned, so the costs of finance using this simple new form of proportional revenue share "equity" is cut dramatically.

Such "Capital Partnerships" are not borrowing, since there is no obligation to repay, although an Investor may sell them, of course, and they demonstrate empirically that the Chancellor's "Golden Rule " is baloney.

Investors? Well there are billions of petrodollars in the Gulf queuing up for Islamically sound Sterling-denominated investments in UK infrastructure revenues.

[Lafayette]

NE: "The key element of market competition is missing"

This is often the reason for having incorporated state-owned companies in the first place.

Take for instance telephony or the postal service. Had it not been run originally by the state, private companies would have cherry-picked the local markets they found the most lucrative and let the others go without? This is what train companies inevitably did.

Of course, back then, no one had the idea of "contiguity", meaning that one could not pick and chose markets, but took them as a bundle especially when distance was the predominating factor.

"large price hikes, growing pollution and wastage."

Yes, privatisation has costs that were once hidden by profligate state budgets. The price of clarity, even in water distribution, is that price hikes will occur, where justified if it is a question of a utility.

As for wastage, that has been there for ages, literally. It depends upon how old your distribution system is, be it water or electricity. Like some businesses, these services involve complex distribution structures that require constantly a maintenance budget to repair and rebuild.

In the past, state companies can be blamed for having forgone maintenance to pay people decent wages, all the while keeping the price down. It is difficult to juggle these three factors as a state service beholden to voter sentiments, particularly when voters think instinctively that because it rains, water should be nearly free. After all, it is not something one “produces” but simply collects and distributes.

That charade is now behind us and an open market is extracting the price necessary to maintain a water supply and to have people understand that just because it rains does not mean that water is necessarily low cost. How best to do that? With a price stiff enough to make people aware of water's scarcity.

Utilities are a special market and do not subscribe to the usual dynamics of market forces. They should be considered, measured and judged by a separate set of particular rules. One of which might be capping profits of such companies at nominal rates - for instance 10 to 12%?

[jon livesey]

"take for instance telephony or the postal service. Had it not been run originally by the state, private companies would have cherry-picked the local markets they found the most lucrative and let the others go without? This is what train companies inevitably did."

Instead, we suffered under decades of state-dictated restrictive practices. Want to attach anything but a state-mandated telephone? Sorry. Want your own telephone rather than a "party line"? Sorry. Want private delivery at a time of your own choosing? Sorry. Want guaranteed privacy? Sorry. Want a way to get around civil servie strikes? Sorry.

I appreciate Lafayette helping me spend my own money, but if supermarkets are free to set up shop in the most profitable markets, I can't see why phone companies shouldn't do the same. If the state wants to subsidize outlying areas, it can do what it does with bus services - subsidize private operators, which ia a lot cheaper than the state setting up its own infrastructure.

I'd like someone to answer a simple question. If state monopolies are so obviously to our benefit, why do they have to be imposed by legislation.

[Lafayette]

"but if supermarkets are free to set up shop in the most profitable markets, I can't see why phone companies shouldn't do the same."

The nature of "utilities" is to provide a universal service that should be available to all consumers, even those in rural communities.

If state monopolies in Europe were formed to do that, it is because the governments at the time felt that was the best way to bring the services to a maximum percentage of the population. In America, Bell Telephone was given a national concession for telephony and, though regulated, became a successful blue-chip company.

I agree that there are now better ways of achieving the same objective using private enterprise and avoiding monopoly costs. But that does not change the hypotheses by which utility services must reach most of the households. If not regulated, companies will simply content themselves with the lucrative urban and suburban customers.

When it is necessary to interfere with market parameters, then that market become distorted. It is therefore best to offer a concession to the operating company, which is renewable and where prices are subject to state approval.

Not all consumer markets have the same characteristics of accessibility and utility markets in particular do not. Telephony, because of technology, has transformed itself into a commodity, but largely because the existing network has been developed and amortized over many, many decades.

[jaim klein]

Excellent note. The key feature is keeping the expense out of the books, that is the budgeting political process. BOT allows bureaucrats to spend money with no political supervision. When I was a bureaucrat, it was a fine tool, now I see it as irresponsible spending.

[Valuethinker]

The UK Water Industry was *not* privatised on efficiency grounds, primarily.

What had happened was that in the 'stop go' economy of the late 60s, the economic crises of the 70s, and the budgetary restraint of the early Thatcher Years, the industry had been on a yearly capital budgeting scheme, decided by HM Treasury.

You can't run a big infrastructure industry on that basis. There were huge capital expenditures required to meet EU standards legislation and to repair decaying infrastructure.

The industry was privatised with a market capitalisation of $5bn, and capex plans for £30bn. That is almost unprecedented: that would be like privatising a company called British Telecom that had 1 million subscribers, and a mandate to connect up 30 million homes over the next years.

Companies typically spend 1 to 1.5 times their depreciation expense on capital expenditure. In the case of the post privatisation water industry, this ratio was more like 5 times.

Water privatisation was a success because it got over £30bn of capital spending in the next 5 years off the Public Sector Borrowing Requirement. Instead of raising taxes to finance this, water rates were raised dramatically (doubling roughly every 10 years since then).

Electricity by contrast was privatised so the power unions (which had struck in 1972, in sympathy with the coal miners, and helped bring down the last Tory government, in which Thatcher was a Cabinet Minister) could not, again, stop the country and bring down the government.

It so happened the power industry was heavily overinvested, a legacy of a number of factors:

- the management boards (the Regional Electricity Boards that became the Regional Electricity Companies) had gotten good at 'gold plating' their investment schemes, so that when the Treasury cut back their spending, they still had lots left 'in the pocket'

- as a result of investment in the late 50s through late 60s, Britain had an electricity infrastructure which was more than adequate to meet growth (electricity demand had been growing at 6-8% pa and the transmission and distribution infrastructure had been built to accomodate that: when electricity demand collapsed during the troubled 70s, the spare capacity was already there)

- a similar pattern had happened in generation and was allowed to continue. From the day Thatcher took power in 1979, the industry was on alert to prepare for another coal miner's strike. For 6 years, oil fired and nuclear fired stations which had been planned in the early 70s, were completed and brought into production. Coal and nuclear fuel was stockpiled.

When the coal miner's strike came in 1985 (summer), Thatcher was ready. (they had been tipped off accidentally by a union negotiator, who had expressed concern for the health of a CEGB negotiator, who had a heart condition).

When electricity privatisation was achieved, the whole industry had so much spare capacity in terms of men, generation and distribution capacity that it could be ruthlessly stripped down, without loss of reliability.

Water never had that 'slack'. In fact in the case of some utilities (South West Water in particular) the cost of meeting the European Beaches directive and Wastewater Directives ran to the billions of pounds.

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[Suvi]

"The key element of market competition is missing and so one has to rely on a government regulator to keep such firms honest"

If government regulators are more honest and/or more competent than private companies, why did the government privatise in the first place and sell to less honest and less competent people?

Or is it just a revenue-raising and responsibility-evading exercise?

[Lafayette]

"If government regulators are more honest and/or more competent than private companies, why did the government privatise in the first place and sell to less honest and less competent people?"

Nobody is keeping anybody "honest".

In the utility business a concession is given against a set of quality of service guidelines that the concessionaire must constantly meet.

The concession can always go to another bidder to operate the works, since the infrastructure typically remains either state-owned or by a semi-public entity.

That element of competition is necessary to keep everyone honest AND assure a market price. If the concessionaire thinks the regulatory body is unfair, it takes out a law suit and a court decides.

All aspects of the concessionary contract are in the public view. True enough, the regulatory body can be corrupted by cronyism - but that is nothing new under the sun. And, it is a criminal offense, if proven.

[Laurent GUERBY]

Most of the current privatization wave occurs just because of the focus put on government debt levels and the corresponding lack of focus put on private debt levels (households and business). Obviously for a big part of these investments the three types of debt are substitutes and who holds the debt is a political choice.

Of course that tendency to look only at government debt causes a great risk of using the wrong kind of debt (inefficient and expensive) and looking at the wrong data set when setting policy (bubbles...).

In the USA, government debt is only 25% of the total debt but who knows this figure? I wrote an article on it (in french):

http://guerby.org/blog/index.php/2006/11/02/123-les-dettes

Also on your first point: "As a rule, I've supported the privatisation of state-owned enterrpises - particularly underperforming ones. In many cases it has lead to more efficient provision and better financial performance than under state ownership."

I've asked on many economists blogs if there were any recent data and publication on this meme, without any answer. Any taker?

Thanks in advance

Laurent

[jaim klein]

Laurent, I dont know is Israel is in your universe, but we have many successful privatizations: Bezeq, the telecom company, the service is cheaper and much improved. Kvish 6, a toll road, excellent service to no expense to the State; El Al, the airline, is not subsidized anymore, and so on. Water and wastewater privatization failed here, the business is very profitable and the State did not want to release it, and as said, the ultimate guarantor of the service is the State and cannot free itself from the responsability. I mean, water supply cannot be cut even in case of years of non payment, the wastewater service even less for public health reasons. Desalination projects are being carried out by the BOT system, based on a 25 years fixed price contract. The
State of Israel has access to very cheap financement (American guarantees) but prefers to use private financing its projects for the reason mentioned in the note: to avoid inflating public debt. Also they wish to bring in foreign capital. "It didnt cost us a cent" - they say extatically.

[Lafayette]

"In the USA, government debt is only 25% of the total debt but who knows this figure? I wrote an article on it (in french)"

Then you surely know that the French debt level is around 44% of GDP. What is your comment about that? Isn't that a heavy drag on the French economy?

Also, don't forget that in the US the debt level is lower because there has been no privatization since there were no state companies. So, the low debt level should surprise no one.

Even with the Iraq war, debt levels will hover around 25%. Still, the question is who owns this debt and will they keep it. The Chinese own a great deal of it. They buy T-notes in order to provide enough liquidity for US consumers to continue buying their goods.

But, should they ever decide, say, to hold Euros as a reserve currency, then there will be hell to pay. In fact, the recent rise in the Euro is probably do to the fact that people are tired of holding dollar reserves.

[jaim klein]

A side question:

"the recent rise in the Euro is probably do to the fact that people are tired of holding dollar reserves."

What do you mean by "tired"? Bored?

[Laurent GUERBY]

Lafayette, I'm not talking to levels relative to GDP, but levels relative to household+governement+business debt.

For 2Q 2006, USA household + government + business total debt of 208.1% of GDP:

- 92.9% of GDP for households
- 64.8% of GDP for governement
- 50.3% of GDP for business
source: Fed Z1 http://www.federalreserve.gov/releases/z1/Current/z1.pdf

For France same date, total 167.6% of GDP:

- 44.7% of GDP for households
- 68.2% of GDP for governement
- 54.7% of GDP for business

For example I did study in a top engineering school but paid next to nothing, so no debt for me (household) but potential debt for the state (government paying equipment and teachers).

All this "public debt only" focus is simply stupid, and economists do nothing to correct this to my knowledge.

[brad setser]

Excellent post; I would also note that in many emerging market privatizations (Argnetina's privatization of the utilities) the government essentially guaranteed a positive return in dollars (usually in excess of what was offered on dollar denominated government bonds with even modestly competent management) by allowing utilities to index their prices to the dollar. Argentina notoriously indexed its utility prices to US inflation, which meant that they were rising even as prices elsewhere in argentina were falling during the deflation. The result: the utilities were enormously profitable in the 99-01 period ($ peg) when nothing else was profitable -- and the utilities got clobbered when the peg broke, since the government effecively defaulted on its promise to allow dollar indexed pricing when it defaulted on its dollar debt. And since then the utilities (usually private and usually owned by foreigners) have been on the losing end of the political process.

My point: government's often set terms for utility privatization that removes currency risk from the utilities (helps get a higher price from foreign investors initially) by shifting the risk to the government (taxpayers) or to consumers -- with disastrous results (default on contract, big increase in prices, big costs to taxpayers) if the exchange rate really moves.

[Arthur Eckart]

Laurent, when assets increase (e.g. the U.S. homeownership rate rising to the highest level in history after a 10-year housing boom), then liabilities will also increase. Also, falling prices (e.g. cheap imports, which also lower prices for many domestic goods) and low interest rates have induced U.S. demand, which makes it more rational to spend than to save. Given U.S. debt levels are high and the U.S. saving rate is low, Americans may work longer than expected (e.g. postpone retirement), which should contribute to stronger U.S. growth. Overproduction of many export-led countries exceed underproduction in the U.S. There's nothing to correct on the U.S. side, because U.S. living standards are rising faster than its major trading partners.

[Lafayette]

LG: "All this "public debt only" focus is simply stupid, and economists do nothing to correct this to my knowledge."

Public debt, if you mean government indebtedness, has to be serviced. This means that governments must spend money servicing the debt.

Which means that taxes must be collected, which means that consumers have less discretionary income. Which means that servicing public debt must be offset by foregone consumer expenditure and therefore lower GDP and less employment.

The best public debt is no public debt, with a balanced budget. Why don't we have that, either in France or the US? Because politicians think, and quite possibly their electorates as well, that they must spend money for the greater public good.

Each country must decide what it wants to do with government taxes and the level of public expenditure for social services. But, it must be ready to assume the consequences of the levels sustained.

In France, to my opinion, those expenditures (for social entitlements) have been far too excessive for far too long. They are the major reason why unemployment has stagnated at between 8 and 10% for the last quarter of a century. People simply are not motivated to work when the dole pays so well.

Globalization has opened Europe to the winds of competition, which cannot help solve the problem. It simply worsens the pain, because the taxes (necessary to pay for the entitlements) come from salaries that have been rendered no longer competitive - which is why light-manufacturing employment has been leaving Europe in droves.

But, frankly, I think education SHOULD BE free up to university and that basic health care SHOULD BE universal. Why should people go into debt for an education and basic health care?

Seems like contradictory argumentation? Well, it isn't.

[jaim klein]

Returning to privatization: Large public infrastructure project should be undertaken by the State, because long term financing accounts for up to 50% of the project cost. A difference of 2 or 3 points in the interest the State pays makes for a great advantage for State financing as compared to BOT or other privatization systems. The question is how much more efficient is private erection and maintenance and operation compared to State erection+maintenance+operation. When State bureaucracy is honest and efficient like presumably it is in France, it makes sense for the State to act as entrepreneur. Where the State is corrupt, like Argentina, nothing makes sense except to keep away.

[Lafayette]

jk: "Large public infrastructure project should be undertaken by the State, because long term financing accounts for up to 50% of the project cost."

This is NOT a convincing argument, especially for any private enterprise with a good credit rating that can borrow money by floating a bond. Of course, if there is no private company willing to undertake the project, then, yes, maybe the state has to do it. It depends upon the nature of the project.

If it is for the purposes of infrastructure, then users have to pay. If, for instance, it’s an auto route, then the concession allocated to private enterprise can exact tolls. If its public housing, then low cost (state subsidized) mortgages can be transacted with owners - but it is imperative that the residents "own" the property and learn to build their personal equity through that ownership.

Let the state do what it does best - and running mega-infrastructure projects is decidedly not one them. These can be financial "black holes" where money is thrown in and never seen again.

[jaim klein]

"Of course, if there is no private company willing to undertake the project, then, yes, maybe the state has to do it."

Basically, we agree. Since no private company is willing to undertake large projects in unstable Third World countries, they are condemned to some kind of socialism. The State has to act as entrepreneur. The State is inefficient by definition, thus they are hopeless.

[Lafayette]

JK: "Since no private company is willing to undertake large projects in unstable Third World countries, they are condemned to some kind of socialism."

Well, maybe.

But, the World Bank, if called in by the UN, could arrange a consortium to finance the project and assure its funding.

The state need not necessarily be the lender of last resort. And, in many gargantuan projects, it should not undertake a management task. It does not have the talent to do so, and to find that talent, it would have to snatch it from private industry. Why not leave the talent where it is and simply sub-contract it?

Private enterprise is beholden to only one principal: To obtain a reasonable profit. The state does not serve that master, nor should it. So, private enterprise will work towards achieving a task at its least cost, according to a proper specification.

The only factor that trouble such a precept is corruption- which means that a proper specification is not observed or it is violated. Now, that is where the state has an ethical role to play, particularly its judicial authorities.

[goyalbb]

experience of privatisation has remain good in india. people are getting better facilities, bettter options at cheaper rates.

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