Infrastructure Regulation: State Owned Enterprises Vs Investor-owned Infrastructure Operators
Economic incentives used by regulators work differently on private and public companies. Some policies will be similar, such as those related to accountability, transparency, and citizen participation. Some regulatory policies will be different, like supporting government policy to corporatize and then commercialize a SOE. Other areas require careful analysis of the impacts of different types of incentives, for example choosing between cost of service regulation and high-powered incentives based on price caps (RPI-X). This article aims to outline the discrepancies between regulating private and public companies.
The material from this article is taken from the Body of Knowledge on Infrastructure Regulation and its section on State Owned Enterprises. For a more detailed explanation of each area, please follow the link at the end of each section or visit: http://www.regulationbodyofknowledge.org/faq/
Table of Content
- Infrastructure Regulation: State Owned Enterprises Vs Investor-owned Infrastructure Operators
- Promoting Good Governance for a SOE
- How the Commercialization of SOEs can Improve Financial Performance
- Governance procedures that promote strong performance in SOEs
- Funding investments: Privatization Vs Public Ownership
- Appropriate Return on Investment for a SOE
- Strategies for Regulating State-owned Enterprises
- The Role of a Regulator in a Privatization Transaction
- References
- Related Articles
- Links
Promoting Good Governance for a SOE
Due to the mixed performance of state owned enterprises in developing countries, there is a clear need to identify and implement governance procedures that will provide strong incentives for cost containment, service quality improvements, and network maintenance and expansion.
Seek Insulation from Politics: A SOE that is driven by politics will be more responsive to short term pressures, more sensitive to protecting vulnerable groups, and will have multiple objectives.
Communicate Clear Priorities: When objectives are not prioritized citizens have no way to evaluate political leaders. Corporatization and Commercialization are two strategies for clarifying organizational objectives and improving governance.
Promote Good Governance: The OECD has identified governance principles that promote strong performance and give citizens confidence that resources are being used effectively to meet infrastructure needs.
The state should:
- Act as an informed and active owner
- Promote transparency
- Select Boards of Directors
- Adopt accounting systems
Information and Monitoring Performance: Information is central to the process, though stakeholders have different interests in revealing data. motivations of the operator and the government in using information related to aspects of utility investments and operations, will include Asset base, Financial performance, Volume of demand, Tariff Setting, Commercial efficiency, Capital expenditures, Operating expenditures, and Technical efficiency.
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How the Commercialization of SOEs can Improve Financial Performance
Commercialization of SOEs can improve access to external funds crucial for network expansion. In addition, commercialization can strengthen incentives for cost-containment in operations. Regulatory authorities should provide input into the corporatization and commercialization process, since the internal governance system adopted by the operator establishes the foundation for incentives and information provision. The public policy decision to commercialize an infrastructure SOE goes beyond initial corporatization. The fundamental goal is to reduce the role of non-transparent political considerations in the provision of infrastructure services. The process separates the government’s role as policy-maker from the role of managing operations. Another part of the reform process involves the establishment of an autonomous regulatory agency charged with implementing public policy—reducing the role of politics in the oversight of infrastructure firms. The result of corporatization and the creation of a regulatory authority is improved incentives for augmenting short and long term performance of the SOE.
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Governance procedures that promote strong performance in SOEs
The degree of centralization vs. decentralization seems to be nation and sector-specific. A single national monopoly may obtain scale economies for smaller countries, but regional operations may be more appropriate in larger nations. Telecommunications and electricity transmission tends to involve national markets, where as electricity and water distribution is often local and fragmented.
Whether the firm operates in competitive or monopoly market also affects regulatory strategies regarding corporate governance. SOEs must address internal and external issues—so, again, lessons from around the world can assist in sequencing the reform of SOEs. In addition, hard budget constraints and performance related pay can improve performance.
Impact of Politics: Being explicit about targets and monitoring performance data can get a politician into trouble with voters. Thus, the issue of transparency arises. Benchmarking can overcome some information asymmetries, but that requires that management collect and regulators have access to information. Decision-makers can only manage what they measure, so lack of data can be taken as evidence of inefficiency. One source of inefficiency can be the lack of a hard budget constraint. Furthermore, the political economy of government suggests that when the benefits of a policy are garnered by a few and the costs dispersed across many, that the policy will adopted even when the costs outweigh the benefits or when the benefits disproportionately accrue to the rich and the powerful. That is not to say that the state does not or cannot act on behalf of the poor, only that many programs (including pricing infrastructure services below cost) tend to benefit today’s middle and upper classes in developing nations. If funds are not provided by the state for maintenance, future generations inherit production capacity that is dysfunctional.
Hard Budget Constraints: One of the key elements of incentive-based regulation is ensuring that the regulated company faces a hard budgetary constraint. This requires detailed scrutiny of the level of service and investment outputs that are actually delivered, as well as a limit on the resources that are available to deliver that level of service. A hard budget constraint will tend to force the service provider to be more aggressive in collecting receivables. In addition, such constraints tend to link investment more closely to profitability and shift objectives from simply meeting output targets to making a profit as well. Ultimately, proper financial discipline is critical to ensuring that the service provider meets and out-performs the regulatory obligations.
Internal Incentives: If there are no consequences when realistic targets are not met, then there is minimal pressure to perform at high levels. Identifying reasonable performance targets requires information about actual and potential performance. The first requires that the SOE provide appropriate data and the latter requires data from comparable infrastructure firms.
Performance–related pay (PRP) ties managerial pay to company performance. PRP is an important component for ensuring that the service provider delivers on the regulatory contract, especially in the public sector context. The interests of management need to be aligned with the required levels of performance.
Transparency: A single national SOE can be required to report data for different geographic divisions. Such information is required if the CEO is to identify high and low performing managers and to spot trouble areas—for reliability, customer satisfaction, uncollected bills, technical losses (like water leakage), commercial losses (theft), and worker productivity.
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Funding investments: Privatization Vs Public Ownership
Privatization has not been a panacea for promoting capacity expansion. In fact, obtaining the political backing and general citizen support for private participation has proved to be difficult in many regions of the world. Citizen perceptions differ widely regarding the desirability of private ownership. The sale of assets provided funds to the national Treasuries which sometimes led to increased government funding for rural infrastructure projects. Greenfield projects in energy brought new production capacity into many countries.
Privatization has been associated with the following:
- substantial employment reductions—freeing up resources for investment;
- mixed impacts on prices (depending on initial conditions);
- quality improvements in many instances;
- access and service coverage improvements;
- mixed impacts on returns to investors (relative to the cost of capital);
- reduced national subsidies to infrastructure;
- increased flows to national treasuries (from the sale of SOE assets);
- productivity improvements; and
- mixed impacts on consumers—new customers gained (with network expansion) while existing customers tended to pay more (but received higher quality service)
Just as privatization has had mixed results, the success or failure of public ownership in expanding network infrastructure is situation-specific. Some countries have used public funds to invest in capacity additions, improving service coverage and quality. Of course, such funds represent cash flows over and above those obtained through sales of the service. Thus, if price is far below cost, it is likely that public funds will go to covering operating costs rather than to network expansion. Utilizing scarce public funds to provide infrastructure services takes funds away from other services, including education and health.
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Appropriate Return on Investment for a SOE
The cost of capital for SOEs is a complex topic. First, we need to know how the Return on Investment (ROI) is to be used for decision-making. Is it an accounting item, with the funds going to pre-determined projects? Or is it a hurdle rate used to screen projects based on net present value criteria?
Funds as a Subsidy: If the ROI is only a financial technique used to account for funds provided the SOE, then the number might be viewed as somewhat arbitrary. The State provides funds for network investment or to cover operating costs. Some bookkeeping liability is entered in the SOE’s balance sheet, but this might be written off later on if future cash flows are unable to provide regular interest payments.
There is an initial opportunity cost to providing the SOE with funds, but political priorities resulted in some funds being allocated to the SOE at various points of time. If past investments do not yield cash flows sufficient for interest payments, the funds still may have resulted in positive benefits to the economy via improved citizen health or through economic linkages that stimulated economic growth. Thus, ROI as a monetary measure could be modified to include non-cash returns that benefitted society.
Financial Sustainability: On the other hand, if the SOE is corporatized, it is expected to be financially sustainable. Interest payments on bonds issued by the SOE need to be paid to those investing in those bonds; otherwise, investors are not going to continue to be willing to own the bonds. Zero cash-flows to investors imply zero value. Similarly, if dividends are to be paid to the Ministry of Finance, then the mix of debt and equity determines the weights assigned to each source of financial capital. The interest cost is fairly straightforward—at a minimum, it would be the cost to the nation of raising funds in international capital markets through issuing debt. The cost of equity would have to include the added risk associated with the particular types of projects associated with the sector. Of course, nations with poor credit ratings may not be in a position to raise debt or equity capital from international financial markets.
ROI as a Hurdle Rate: When it is used for decision-making, the ROI becomes a hurdle rate. High risk projects should face high hurdle rates. Then managers can compare alternative projects that relate to the service or geographic area on a common basis; in the case of mutually exclusive projects, the use of the required ROI results in cost-effective use of scarce funds. Managers select the project with the higher net present value (calculated using the appropriate ROI).
A closely related issue is whether existing rate structures and implicit cross-subsidies mainly benefit those who are well-off. Since cash flows determine ROI, under-pricing the infrastructure service results in lower realized returns. If social objectives are met, then the lower financial ROI may not be a problem: achieving greater network coverage and serving low income households have social value. In addition, other national objectives might be met such as projects supporting regional development. So the Social ROI may be acceptable. However, there is evidence in developing countries that pricing below cost leads to inadequate maintenance. In addition, the operator will lack the funds to expand service coverage, so those without service remain unserved, where the substitutes (such as water tanker service) are very expensive.
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Strategies for Regulating State-owned Enterprises
Regulatory agencies often have limited tools to deal with powerful SOEs. Information issues associated with SOE governance also apply to regulatory strategies. Information asymmetries characterize regulation, but when the firm reports to a powerful Ministry as well as to a new regulatory commission, the difficulties can increase. In the case of a privately owned infrastructure firm, the license conditions may require that the firm provide information to the regulator. Unless such information requirements are made clear, the regulator is at a significant disadvantage. Benchmarking is one way to document relative performance, so that stakeholders are fully aware of historical trends, current patterns, and reasonable targets.
Responses to Incentives:
Privately-owned and Publicly-owned utilities respond differently to the same regulatory incentives. Research has identified two key elements:
- Price Regulation with Targeted Line Losses
- Mark-up Regulation for Distribution that limited allowed profit in a highly discretionary manner – providing an incentive to increase operating expenses relative to capital outlays.
The empirical results found that SOEs did not respond as effectively as private ones to incentives associated with reducing technical and commercial losses. Managers may not have been willing to confront the political pressures associated with dealing with non-payment and theft. It seemed that SOE were less motivated to increase cash flows due to lack of managerial motivation. On the other hand, SOEs did not respond in the same way as private firms to the incentives to inflate costs. Private distribution companies tended to inflate costs that could be passed through to consumers via (nearly annual) tariff increases.
Performance Targets (PTs) represent one of the most common tools used to incentivize performance. Some authors view benchmarking via PTs as the only tool that regulators have when regulating state-owned utilities. In the case of Trinidad & Tobago’s Regulated Industries Commission, in the review of rates for the electricity transmission and distribution utility special attention was paid to the establishment of specific targets in a variety of key operational areas. In the case of the water sector in Trinidad and Tobago, key areas of concern are likely to be the reduction of Non-Revenue or Unaccounted for Water, increasing the number of metered customers, and increasing the number of areas receiving a twenty-four hour supply.
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The Role of a Regulator in a Privatization Transaction
In a privatization transaction, all the parties will be disappointed if assumptions made by the various stakeholders are inconsistent. The regulator can provide a check on the numbers that the Finance Ministry is assuming and the numbers that the “winning” bidder is using. Stakeholders are entitled to their own views, but not to their own “facts”. Since the value of an asset is the present value of the future cash flows generated by the asset, the price, quantity, collections, technical and commercial losses all affect the value of the asset to potential investors. Different bidders may have different business models The greater the uncertainty regarding the nature of future regulatory and public policies, the higher the cost of capital is to compensate investors for the risks they are taking on. Thus, the regulatory rules, such as the price adjustment process, affect the discount rates used by potential investors as well as the expected cash flows from operations.
Policy Implementation: The decision to privatize involves public policy which is developed in a political context. The regulatory agency implements policy. As noted above, the value of a state-owned asset to an investor is determined by the expected net cash-flows. Those expected cash flows depend on a number of factors:
- Price
- Number of customers in various customer classes;
- Quantity demanded at that price;
- Quantity actually delivered,
- Quality of service
- Percentage of customers paying their bills in each customer class
- Investment targets
Citizen Expectations and Managerial Options: Citizens will have a diverse set of expectations. The current service price serves as an anchor for citizens who are now receiving service. Unless there is a strong political consensus that the SOE is grossly under-performing citizens will likely balk at any price increases. Customers are likely to view any price increases as stemming from the new owner needing to earn a return on their investment. Un-served citizens may be hopeful, but they, too, have some idea of the current price. If the government was unwilling to raise the service price so that gross revenues at least cover operating costs, then potential investors in the SOE will be sceptical of the government’s willingness to allow a price that will cover costs. Furthermore, if it is impossible to reduce the work force, then it will be difficult to cut costs as a technique for increasing net cash flows; excessive workers per customer or per unit sold characterizes many SOEs. Thus, the new operator is in a bind if there are high network expansion targets, and few changes that can be made to reduce production costs or improve collections.
Objectives and Procedures of the Privatization: If the goal is to maximize revenues from the privatization, then promising investors that they will own an unregulated monopoly will maximize the bid for the franchise. Bidders would pay high amounts for a franchise monopoly with a long exclusivity period. Of course, the political sustainability of such an arrangement is likely to be low—resulting in higher risk to the investor. That risk would tend to reduce the bid, as the bidders apply higher discount rates to their estimates of future cash flows. Furthermore, maximizing the bid is not a reasonable objective. Other objectives have priority: network expansion and movement towards universal access would seem to be more appropriate objectives. That being the case, applying the funds raised through privatization to meeting social objectives would take pressure off the operator and increase public acceptance of the initiative. An alternative to accepting the maximum bid would be to seek the minimum price so the investors are focusing on cost containment. Of course, quality of service standards would need to be maintained. Furthermore, the possibility that there will be an excessively low bid arises. In all the above, the regulatory rules in place and procedures used to determine prices affect the bids.
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References
The material from this article is taken from the Body of Knowledge on Infrastructure Regulation and its section on State Owned Enterprises. Please visit: http://www.regulationbodyofknowledge.org/faq/
The issues in this article are also covered in the recently published book, Water Utility Benchmarking, by Sanford Berg. The book provides an overview of the strengths and limitations of different methodologies for making performance comparisons over time and across water utilities (metric benchmarking)
Related Articles
Links
Body of Knowledge on Infrastructure Regulation: http://www.regulationbodyofknowledge.org/faq/
Body Of Knowledge on Infrastructure Regulation Wiki Profile Page
Public Utility Research Center Wiki Profile Page
Sanford Berg, Water Utility Benchmarking, IWA Publishing, ISBN: 9781843392729
