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Is privatising power a real turn-off?

By Carolyn Currie - posted Wednesday, 3 September 2008


In Sandra Jobson’s On Line Opinion article on a history of electricity in Sydney ("Power for the People: A history of electricity in Sydney", August 25, 2004), Sandra paints a most fascinating picture of an industry with mixed leaps between private and public provision.

All the traditional reasons for privatising leave unanswered many questions, one of the most important being "Is any price regulator proposed similar to that instituted when telecommunications was privatised? If we recall, the price regulator used to ensure competition in a two-horse industry with one new entrant, Optus, and one monopolistic public supplier, Telstra, was a total regulatory failure in preventing collusive practices and non-sharing  of telecommunications lines.

The first question has been amply considered by the World Bank and can be summarised in four themes:

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  • private ownership is linked to greater efficiencies as the agency costs provide for managers with adequate incentives to achieve production efficiency;
  • privatisation can produce gains due to a shift from monopoly to competitive markets;
  • privatisation is considered more efficient because it subjects the firm to the scrutiny of capital markets; and
  • privatisation leads to the removal of public sector constraints on efficient behaviour

Apart from these reasons, there are other rationale for reducing the reliance on government, such as achieving of a stated political mission:, for instance, helping finance certain sectors of the economy.

Another rationale may be to reduce political intervention in state owned or controlled business ventures, which prevents the true commercial operations of those entities. This has been particularly obvious in state owned banks (Currie, 2001). Such political interference can extend to the appointment of top managers; financing of government activities; offering higher than market interest rates for deposits in order to engender popularity for the government; over staffing; and the extension of loans to those individuals and companies who have close associations with the government in power. This can result often in non-payment of those loans and hence diminishing capital.

Privatisation is not the only means of reducing state ownership and control of enterprises. Economists have also touted public private partnerships and private finance initiatives as a means of promoting economic and social development. However, regulators are still debating whether privatisation and other ownership structures, which are not totally dependent on state ownership and control, achieve such goals or in fact cause deterioration in welfare levels from those existing under a command economy.

Academics and other advisers have refuted the trenchant criticism of development strategies, which rely largely on changing ownership structures, claiming success for such policies in China and Poland (Dabrowski, Gomulka and Rostowski, 2001). Dabrowski et al point out that critics ignore the principal reasons for failure of these policies in Russia, and fail to distinguish why these policies succeeded elsewhere.

The arguments of these authors illustrate some important flaws in contemporary thinking regarding the measurement and assessment of development yardsticks, which have implications for advocacy of an “optimal” model for reforming and restructuring an economy. They advocate policies to achieve success in reform by concentrating on improving the institutional, legal, and economic conditions for rapid and sustainable growth. Hence success should be measured by the increase in output deriving from the private sector from the start of recovery, (Dabrowski et al, 2001, p.297), and not by the overall growth of GNP of the whole economy as this indicator can be affected during transition by pre-reform crisis conditions.

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Dabrowski et al advocate a principle where loss making State Owned Enterprises (SOEs) should be shutdown and not privatised, and the rapid expansion of a new private sector encouraged instead. The welfare costs associated with discontinuing and not privatising SOEs can be regarded as an investment “needed to achieve permanent welfare gains from the better allocation of labour and other resources in the future”.

First, protection of the existing organisational capital of SOEs is not essential for success, as it is unsuited to the private sector.

Second, privatising to insiders is not effective unless mechanisms for accountability exist through an electoral system.

Third, the rapid growth of a new private enterprise sector rather than privatising SOEs best achieves economic reform.

Fourth, if a large state owned and control sector exists, it is essential to encourage movement of assets out of SOEs before they are privatised. This can be done through a program of fiscal constraints, and liberalisation of barriers to entry, price controls, and trade. It is the sequencing order which matters, and Dabrowski et al (2001, p.318) conclude that fast privatisation of SOEs will not produce output gains unless a completely new private sector is created.

Constructing a scale of reducing state involvement in the ownership and control of the means of production, we could put in the first stage of evolution away from a state controlled economy to full market driven one, public private partnerships (PPPs). Private finance initiatives (PFIs) could be considered as a half way house in the middle. The final stage of evolution would be privatisations.

The reason for starting with PPPs is that they have been described as a “third-way economics” (Montanheiro, 2002). This is because if the degree of government ownership rather than control is taken as a criterion, PPPs are a halfway house between full state ownership and control, and loosening the reins through PFIs and privatisations. There is yet to be an economy where there has been zero state involvement, so an economy characterised by large-scale privatisations can be taken as the far end of the spectrum.

PPPs have been defined as, collaboration between public and private parties to realise for both a surplus value (Braekeleer and Sprundel, 2002). Collaboration can take the form of a concession, joint venture corporation, or trust, set up specifically for a concrete and well-defined project with a clear public sector character. It creates surplus value in terms of better price to quality ratios, either socially or financially.

PFI projects were first trialed in the UK in the early 1990s, with a total value of US$1.65 billion undertaken in the period 1992-8 (Montanheiro, 2001). Arguments for PFIs devolve around efficiency, value for money, better relationships with users/consumers, greater service accountability but at times appear a way of reducing government deficits.

One advantage is the expertise, which the private sector, whether foreign or domestic, can contribute and which the public sector may lack.

Another advantage is the ability to access the capital markets with a captive customer - the government.

Disadvantages are the need to ensure the total contract delivers benefits for the taxpayer and the investor, without costly time and transaction delays. Although a disadvantage may be a mark down in country risk borrowing lines, or reduced support from an international agency, the same cost can apply to PPP projects.

PFI projects can be taken to mean, “build, operate, and transfer” (BOT) whereby the private sector invests in a project, which they maintain and operate. The government can lease essential infrastructure to the private investors, or guarantee a certain usage and revenue in return for the transfer of risk.

If ownership of all assets, not just the assets provided by the private sector, passes out of government hands to the private investors, then effectively the utility, service, industry has been privatised. This is called “build, own, operate” or BOO; or “build, operate, own and transfer”, or BOOT, whereby the private sector totally supplants the government in the provision of services and infrastructure. This is to be distinguished from asset sales, as the private sector adds value by building and operating with BOT, BOO or BOOT structures.

Private finance initiatives, where the ownership remains in public hands but the private sector takes the risk, is attractive in advanced nations as opposed to emerging nations. This is because a high sovereign credit rating may be required in the case of a take or pay guarantees, which may be part of PFI structures, or to dispel fears of nationalisation of the operation of the asset.

Privatisations involve transferring ownership and control of assets, resources, means of production and services, from the state to the private sector. Methods, timing, and valuation are critical.

Privatisations can involve full public floats, issuance of shares at a discount to customers, suppliers, managers, and/or an employee share ownership trusts, issuance to the general public using vouchers, sale to private sector groups domestic or foreign using a tender system, subsidisation of sale with assisted loans and so on.

There are a myriad of methods of privatisation, which should be linked theoretically to the stage of economic and social development of an economy. The issue of valuation often influences the method but this in turn is influenced by two factors. These are: government goals as to proprietorship and property rights; and the stage of development of human capital. The latter refers to human capital both within the institutions subject to change in ownership, which affects its efficiency, and externally in the larger financial system, in terms of analytical capacity.

Valuation techniques

Privatisation can give rise to two difficult problems - allocation of property rights and the skills necessary to conduct a valuation. The former involves political value judgments, so only the latter is considered here. In an advanced economy the usual method of valuation of government corporations operating commercially, is to offer shares in a public float where the price is predetermined for retail shareholders within a range of bidding set by institutional shareholders.

In Australia, this was the valuation method used to assess the Commonwealth Bank of Australia, Telstra, and Qantas in the 90s. This open bidding system, although backed by a pre-bid valuation phase by the government as vendor, ensures that the final valuation is a true market value as rival bidders set the final price. However, the method relies on companies being profitable at the time of the float as the result of efficiency audits conducted during a corporatisation phase.

If an organisation is a loss-making venture, despite being corporatised, privatisation may result in a sale, which eventually transfers wealth to the private sector with zero compensation to the government. This occurred in the case of an Australian state owned bank where a government guarantee of 70 per cent of the loan portfolio and a low valuation resulted in the government not receiving any of the final sale proceeds of A$9 billion (Currie, 2001).

Several methods of valuation are used. The Discounted Cash flow (DCF) method calculates the value of the firm as the present value of after-tax net cash flow. In this case, value depends on three variables - an estimate of the net cash flow over the useful life of the firm (as an asset), an estimated discount rate, which is normally the weighted average cost of capital, and an estimate of the residual value of the firm at the end of the period. Although the method is ideal theoretically, some commentators consider that its built-in problems limit its usefulness for the purpose of privatisation (Abdel-Magid, 1999, p.8).

These problems are the subjectivity inherent in making estimates of future net cash flows and in estimating the weighted average cost of capital. In addition, the question of how to account for future inflation and high uncertainty, and incorporation of management expectations in the resulting present value, can result in over or under pricing, or inability to price individual assets.

Other valuation problems are the capitalisation of earnings using rates implicit in the price/earnings ratios for the industry. This method is difficult to apply to entities where no comparable publicly listed institutions exist.

Another approach is to use modern management techniques to forecast the future income of the enterprise, and replacement cost and value engineering to value the assets. This approach provides an opportunity for introducing market-oriented, modern management techniques to the SOE. It uses techniques such as target pricing; value engineering and activity based costing in order to generate information for decisions crucial to the technical problems associated with privatisations. Examples of such decisions are the redesign of products, the evaluation of future service potential of existing assets, retooling of factories, generating information about future capital outlays, and rationalising the downsizing and retraining of the existing labor force (Haggis, 1997, pp. 14 -15).

The claimed advantages of new ownership structures involve four dimensions, which can isolate reasons for success and failure of reform policies dependent on such changes. These dimensions are political, economic and financial, legal and managerial/organisational structure and process (Culpin, 1999, pp. 10-12).

This framework not only provides a basis for choice of ownership structure, timing and valuation, but how to judge success. At times ownership structures have been chosen to maximise returns to the government as the vendor. At other times the reason was to remove an economic burden by the creation of a privately owned entity that allocates resources in a more efficient and productive manner.

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About the Author

Dr Carolyn Currie is the Managing Director of Public Private Sector Partnerships Pty Ltd.

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Creative Commons LicenseThis work is licensed under a Creative Commons License.

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