Limits to Privatization

Source

• Book: Limits to Privatization: How to Avoid Too Much of a Good Thing. By Ernst U. von WeizsΣcker, Oran R. Young, Matthias Finger, Eds. Earthscan, London, 2005

From the chapter: Conclusions, by the book editors and Marianne Beisheim (Final Draft, September 03 2004)

Text

Evaluation: Limits to Privatization

So far, this book has given an overview of privatization as one of the major trends of our time, with a range of evidence for what privatization has entailed in different sectors and parts of the world, and discussion of specific issues. Let us now offer some more systematic conclusions.

Privatization produces positive results under some conditions, negative consequences under others. Our goal is to identify the determinants of success and failure rather than to argue ideologically for or against privatization.

The Bright Side: pointers for beneficial privatization

Privatization can produce positive results under the right circumstances.

Our analysis highlights the following benefits:

• Increased investments. Privatization can attract investment to the development of infrastructure. In many countries, the public sector has not been in a position to finance necessary investments in water and sanitation, telecommunications, and transportation systems. In the areas of telecommunications and transportation, there are numerous examples of successful privatization and of public-private partnerships, e.g., in the form of BOT (build-operate-transfer) schemes. Relatively few are included in this book because they are already well documented.

• Better quality of services. In the case of telecommunications, the quality of services has improved dramatically after privatization, although it remains unclear what proportion of that effect has to do with private ownership and how much stems from technological progress. Quality improvement was usually a main reason for privatization of water and sanitation. In the postal sector, to take another case, public services have been lamentable in a number of countries, and privatization has helped restore the quality of services for the customer, albeit often at a higher price. Many cases produce positive results in terms of improving quality of services, although often with equity problems.

• Saving taxpayers money. It is widely assumed that privatization increases economic efficiency. An educated guess, based on figures regarding staff employed, is that efficiency typically increases twofold (Shelley 1998). The main reason for this is that privatization usually removes earlier restrictions on staff redundancies. Of course, it is grossly simplified to assume that the remaining staff can do the same job that the larger one did.[Omit - Wiedauer piece shows that accident record was no worse after privatization] Moreover, redundancies usually cause persisting unemployment, with highly undesirable social side effects. There are a few sectors (e.g. telecommunications, air transport), on the other hand, in which employment actually increased after privatization and liberalization because the markets expanded.

• Innovation and Capacity Building. Regardless of the potential for market expansion, operators exposed to competition tend to be more innovative and creative than public operators. Due to their exposure to international competition, private actors typically have a strong incentive to turn to the most modern technologies available. This drive to innovate may turn out to be the most convincing argument for privatization, not least because it also involves capacity building, improving skills and knowledge in the broadest sense needed to make use of modern technologies and to improve competitiveness. Still, it is important not to overdo this argument. There are cases, such as the ascent of high technology in Japan, where the state acted to stimulate aggressive and commercially successful innovation. And cut-throat competition in the global markets of today has forced many firms to cut deeply into their Research and Development budgets to survive.

• Reregulation. The success stories have one thing in common: a strong state capable of defining and when necessary policing the rules of the game. As privatization has often been preceded by deregulation and liberalization of markets, it has often proved necessary to reintroduce regulations in order to protect consumers and prevent severe damage to the environment. In developing countries regulations are important also in connection with the pursuit of equity and social access. Sⁿdhoff has given some advice on guidelines for good practice in section IV. Neverthess, a recent World Bank policy research report on privatization states that ôcreating regulatory institutions that render decisions legitimate to citizens and credible to investors has proven to be the most vexing problem of every infrastructure reform programö (Kessides 2004: 16f.).

To all these factors, we would add the caveat that gains may be attributable as much to increased competition as to privatization. This implies that competition is an important factor for the success of the private provision of services.

The Dark Side: signs of damaging privatization

Yet privatization clearly has its dark side, and certain patterns show up repeatedly in cases involving undesirable outcomes.

The following conditions are commonly associated with unsatisfactory results (see also Carnegie Council/Friedrich Ebert Foundation 2003):

• Inadequate rules governing investments. Not only in developing countries, public authorities often lack the political power and the experience needed to deal effectively with powerful international corporations. In many cases, governments are unable or unwilling to secure legal certainty and administrative continuity and lack adequately formulated rules guiding the operations of private investors. Governments, under public pressure, often define unrealistic targets regarding matters of performance and prices that drive private investors away.

• Insufficient competition and private monopolies. Supporters of privatization often claim that it will lead to more competition which will increase efficiency. But some cases of privatization û especially those accompanied by deregulation û lead to the concentration of power in the hands of a few suppliers and ultimately to the negative consequences associated with conditions of monopoly or quasi-monopoly. Consider the transfer of municipal power plants into private hands and the elimination of rules prohibiting or restricting branch banking [explain] as cases in point. This allows suppliers to capture a disproportionate share of the market, leaving consumers with few options in securing the goods and services they need. Moreover, corporations tend to raise prices once a dominant market position is established. Hence, before privatization, competition policies and antitrust laws should be in place.

An obvious problem with privatizing infrastructure occurs when there are "natural monopolies". When the service in question is a single water system or electrical grid, competition remains an illusion. Even bidding itself is typically non-competitive. In the water sector, for example, a small number of international companies dominate the market and can act like a cartel to obtain long term exclusive contracts.

• "Cherry picking" and marginalization of the poor. Public utilities can provide services to all as a matter of public policy. But it is often commercially rational for private companies, especially in developing countries, to cherry pick or, in other words, to serve the well-to-do rather than the poor, to limit their supply of services to the better-off urban areas. Rich people generally find cost-covering prices acceptable, while the poor cannot afford to pay. Privatization can divide societies into ôhavesö and ôhave-notsö with large differences in the access to or quality of the services (e.g., education, police protection, drinking water and electricity, recreation facilities) available to the two groups. In many cases after privatization the poor have to spend a much higher proportion of their income to satisfy such ôbasic needsö.

Using the example of water access, Sⁿdhoff (in section IV) demonstrates how a poverty-orientated regulatory-policy may avoid cherry picking and may even improve the poor's access to public goods. Concession contracts should include binding guidelines on supply, price, and competition. The World Development Report 2004 discusses some more innovative examples of how to increase poor clientsÆ choice and participation in service delivery. The latest World Bank policy research report on privatization revises privatizationÆs effects on distributional equity and calls for regulatory safeguards, including safety nets and tariff rebalancing schemes (Kessides 2004: 16, 23ff). Pricing policies should ôstrike a balance between economic efficiency and social equityö and new ways must be explored to increase poor people's access to services.

• Termination of cross-subsidies. Public authorities have a long tradition of using ôcross-subsidiesö in the provision of services. European cities, for instance, have routinely subsidized their public transport systems by using income from profitable electricity networks or waterworks. State telephone services have provided subsidies for postal systems. Profitable state-owned companies were often used to subsidize services involving health, education and welfare. Privatization has stopped such cross-subsidies. This often leaves the government to provide services to the poor with insufficient resources or to subsidize firms to provide affordably-priced services. But this begs the question: Why use scarce government resources to sponsor private profits? On the other hand, that may still be the cheapest solution if the state is unable to provide the necessary services on its own.

• Deficient Contracts - Shifting Risks, and Externalizing Costs. Contrary to naive expectations, privatization is seldom a one-time event that commits companies to strict standards of performance. Most cases deal with evolving relationships that change with events and circumstances and that often undergo constant renegotiation. In this process, governments û and citizens û often find themselves at a great disadvantage. They usually lack information that the experienced international companies possess. Companies often use political connections, pressure, or bribery to secure regulatory decisions to their liking. In extreme cases, they can threaten to terminate supply contracts altogether, a strategy that is tantamount to blackmail.

Privatization is meant to shift certain risks from governments to firms. In practice, it often works the other way around. Many contracts include a guaranteed rate of return. Companies entering uncertain economic environments routinely demand protection from fluctuations in currency and local demand. In the energy sector, power-purchasing agreements typically ask public utilities to buy electricity from private suppliers at fixed prices calculated in hard currency, regardless of changes in the exchange rate or in the level of demand. Such contracts have driven huge public utilities to the brink of collapse, and in some cases over the edge. The World Bank actually supports such asymmetric contracts to encourage private companies to invest in public services.

Even in advanced economies, the transfer of risks is often illusory. Politically, governments cannot afford to allow companies supplying essential public services to collapse. In many cases, there are irresistible pressures to bail out private providers, even when their problems are self-inflicted.

Contracts seldom force private operators to take external costs into account. Such costs range from the local impacts of toxic wastes to global warming and from the degradation of earlier public services (e.g., high quality public transportation) to the erosion of local cultures. In the absence of effective rules of the game, private companies are free to pull up stakes and move on when conditions in a particular location become unfavorable or to find ways to divert the harmful side effects to distant locations through measures such as the use of tall smokestacks.

• Fraudulent practices and corruption. In some cases, the critical divide is not between public and private provision but rather between law-abiding and transparent business practices on one side and tax-evading and even criminal activities on the other. Here the state and law-abiding companies have a common interest in orderly and transparent business practices. Whenever privatization and relentless cost-cutting following privatization lead to incentives to move operations into illicit work, losses from a growing shadow economy can easily outweigh any gains from increased efficiency.

Privatization and deregulation can create conditions that allow corporations to engage in a variety of fraudulent practices. As the recent energy crisis in California makes clear, this can happen in advanced industrial societies that normally operate on the basis of respect for principles of democracy and good governance. In California, regulatory reform divided the production and distribution of electricity between separate companies and capped the prices distributors could charge consumers without capping the prices that suppliers could charge distributors. The result was a golden opportunity for producers to manipulate the system to their own advantage. As the story of ENRON shows, fraud can occur all the way up to the top of the corporate world. In developing countries and countries in transition, opportunities for fraud are greatly magnified. The exploitative actions of a small number of oligarchs in the Russian Federation who amassed huge fortunes during and after the wave of privatization of the 1990s constitute a striking case in point.

Corruption flourishes under conditions of privatization, although that state monopolies can also be open to bribery. In the case of privatization, the vulnerability to corruption seems to be highest in the process of bidding and decision making on the sale or leasing of state property. The experiences collected in this volume do not allow any conclusion on whether state or private ownership is more vulnerable and under which specific conditions. But both phenomena are widespread.

Generally, cost-efficiency is improved through redundancies without sensitive employee adjustment plans û generating the negative social side effects mentioned above. Fair and sensitive adjustment plans for redundant employees could help (cf. Savas 2000, 311). All too often, to save money, private providers hired unskilled workers and failed to train them. In the case of private prisons or schools or private policing this has tremendous negative effects for the quality of services.

• The fox in the hen house. Privatization and deregulation can create situations in which the activities of former regulators are captured by those whose actions they were intended to supervise. For example privatization of air traffic control can allow airlines to acquire substantial holdings in the air traffic control industry, leading to increased dangers of competitive advantage of one company as well as safety concerns.

• Costly competition. Counter intuitively, competition can result in higher prices for customers. In the case of compulsory fire insurance for private homes in Germany, the fees of the state-run insurance monopoly were lower than those of the new, competitive private insurers, even with the state using part of its income from fees to subsidize fire brigades and preventative measures. Private insurers, by contrast, distribute part of their income to shareholders and allocate some to advertising campaigns designed to win customers from their competitors.

• Weakened democracy and reduced participation. Historically, democracy at the local level has focused on decisions regarding the use of public (municipal) property. People tend to be well informed about who runs the local utilities and whether they have done a good job. There is a sense of common ownership among members of the electorate with regard to waterworks, power stations, public parks and public transport. The public sector is part of a broader public domain that is the domain of citizenship, a set of practices embodying values as equity or accountability (cf. Marquand 2004). In developing countries public services are being perceived as part of a process of democratic nation building. After privatization, state supervision of the performance of privately owned utilities is rather abstract and may not be conducive to high levels of democratic participation. Hence, we ask whether privatization may have the effect of discouraging democratic participation and even of alienation from government.

This concern grows stronger when the private owner is a multinational corporation, whose decision-making processes are impenetrable to the local population. Our cases involving privatization of municipal water supplies exemplify this syndrome. The typical pattern features the creation of a private utility to supply water, the subsequent takeover of that supplier by a multinational corporation which soon proceeds to raise prices beyond the means of many local residents, and in some cases ultimately to pull out again on the grounds that supplying water to the affected community is not profitable. The community is left high and dry with little capacity to supply water to itself in the aftermath of a breach of promise on the part of the distant supplier.

• Public goods. Public goods are what we all need or cherish and what we traditionally have expected the state to supply. Of course, it is possible for the state to subcontract the provision of public goods to private operators and to pay for them when they cannot be produced at a profit. If the state cannot afford to pay an appropriate price. it is then tempting for the state to encourage the contractor to collect feesfrom beneficiaries of the services. This invariably raises severe equity problems. The supply of military and police services provides a good example. If human security, one of the most central public goods, becomes dependent on the ability of recipients to pay, the very notion of a democratic state (ôone person, one voteö) is called into question. Things get worse if the private police or military forces succumb to the temptation to exercise power outside their mandate and get involved in embezzlement or other criminal activities. In failed states, private police forces may be better than nothing. But it should be a primary goal for society to re-establish the public authority and not to let ômarketsö determine who gets the benefits of security and protection.

Another lesson about the supply of public goods emerges from the case of railway privatization. The results have differed dramatically in Britain in contrast to Japan. In Britain, the privatization of rail tracks produced outcomes so lamentable that the government finally had to re-nationalize them. Japan applied much more caution in the first place. It kept the infrastructure in public hands and even paid subsidies to private coach operators for maintaining services to remote places. The system worked to the full satisfaction of customers. Thus, well-maintained rail tracks can be seen as public goods and the supply of service to thinly populated areas as a non-profitable public task

Our preliminary conclusion is that certain types of public goods and associated infrastructure will not be suitable for privatization so long as the state is unable (as in many developing countries) or unwilling (as in Britain around 1990) to pay for the corresponding services.

• Weak position of indebted states. Public indebtedness has emerged in recent times as a major driver of privatization. Global competition for ever lower levels of taxation has reduced the financial capacity of states worldwide. In this situation, the temptation is strong for budget ministers to deal with their yearly struggles to balance budgets by selling off what is left of valuable state assets. And it is tempting also to givethe ôpublic goodö of a balanced budget priority over the public good of social fairness in access to education, water, energy, mobility, security and other vital services. Our book reports only a few of the many known cases where privatization took place not to achieve greater efficiency or better results but simply to produce income to balance public budgets.

The privatization in Lebanon of telecommunications, electricity and air traffic control with unsatisfactory results illustrates this syndrome. The Latin American cases involving the privatization of telecommunications services show good results in Mexico, poor results in Argentina, and good results as a consequence of avoiding privatization in Uruguay. In Mexico and Uruguay, the state maintained a strong position. In Argentina, the state was weak, and private operators were allowed to establish regional monopolies. This experience suggests the need for a strong state setting the rules for private business and monitoring compliance with the rules.

The situation is particularly worrisome in developing countries that suffer from the highest ratio of foreign debt to GDP. As Sheshinski and Lopez-Calva (1999) have shown, the dynamics of privatization are strongest in developing countries anyway. The authority of the state tends to be weak in these countries. These countries might need technical and financial assistance to strengthen their regulatory capacity and to set up appropriate bodies. It has been suggested, for example, to set up learning and networking initiatives to enhance the transfer of skills and exchanges of experience or to prepare model clauses so that future contracts can avoid the pitfalls of past ones (UNDP 2003: 121). Otherwise, the result, all too often, is a weak negotiating position on part of the state followed by weak supervision by the state. Rumors to the effect that the International Financial Institutions are demanding an acceptance of more privatization on the part of indebted developing countries are disquieting in this context. On the other side, investors may hesitate because of weak enabling environments (e.g. slow process, lack of information), uncertainty and security concerns (e.g. lack of political stability and ownership protection).

A Third Way?

Drawing a sharp distinction between the private and the public makes life easy for the analyst. It has indeed provided a convenient structure for much of the dsicussion in this book..But as Shanin and von WeizsΣcker observe in section IV, it is dangerous to focus exclusively on binary relationships. There are many hybrid arrangements that do not belong unambiguously either to the public sector or to the private sector. We may face not a simple either-or choice between public or private, but a variety of options in institutional forms and modes of ownership, control, and finance (see also Starr 1987). There are historical precedents for this: think about the Dutch East India Company founded in 1602 or the Russian-American Fur Company founded in 1799. Or consider the Charter of Pennsylvania (1681) that granted ownership of a large territory to a single individual but with the expectation that he would use it to establish a colony governed as a part of the British Empire.

Today, we have public corporations (e.g. the Tennessee Valley Authority or TVA in the U.S.); mixed public/private corporations (e.g. Intelsat); social service provision by non-governmental organizations (e.g. primary schools run by the Bangladesh Rural Advancement Committee); complex leasing arrangements allowing private actors to use public lands on a long-term basis (e.g. grazing lands in a number of countries), and arrangements under which governments build infrastructure to be used by private interests (e.g. dams used in generating electricity and controlling floods).

What lessons do these hybrids offer for the concerns of this book? It seems clear that there are good hybrids and bad hybrids, just as there are good and bad forms of privatization. Some cases have mixed results. The Russian-American Fur Company, for instance, produced marketable products and revenue for the czar but at a staggering cost in terms of the lives of Native peoples in Alaska. The Tennessee Valley Authority is often described as a success; it carried out a regional development plan beyond the capacity of private actors and at a time (the 1930s) when such actions were desperately needed. But the TVA has a poor record on environmental impacts; some even doubt its usefulness in producing hydroelectricity under current conditions. Our point is not to condemn these hybrid arrangements. Still, there is no basis for assuming that they constitute a third way that can always provide a general solution to the problem of balancing the private and the public that we have taken as the central theme of this book. So why discuss them here?? We should rather end with some positive statement, should we not?Like: Although there is no basis for assuming that they constitute a third way that can always provide a general solution to the problem of balancing the private and the public, we still find them promising and suggest to devote more research to such institutional arrangements.

Conclusion: Beware of Extremes!

We return finally to our starting point. We hope readers of this book will be convinced by our primary message: beware of extremes.

Privatization is not an end in itself. Privatization should be treated as a means of increasing efficiency and not as a way to reduce or undermine the role of the state. Privatization may be the best option in some cases, but reforming the public sector instead may be the better choice in other cases. We advocate a healthy awareness of the limits to privatization rather than unconditional approval or rejection. To achieve the best of both worlds, we need strong private enterprises and capable public agencies working together as partners.

Before taking any decisions on whether and how to privatize, all involved should consider the diverse contexts and specific local factors for the case at hand. Experience shows the importance of involvement by all relevant stakeholders at early stages of the process. Regulatory capacity should be built up before privatization. The state should define reasonable and responsible targets to be met by the private contractor. Regulatory procedures should be accountable and transparent, and their design and content must fit local conditions. They should give incentives to improve services, involve stakeholders, and be adaptable to changing circumstances and newly emerging problems.

All initiatives involving privatization should be accompanied by strong and sophisticated procedures for anticipating the kinds of problems identified above, and intervening promptly and effectively to deal with them.

We conclude with a table, which we hope encapsulates the key lessons: a checklist for public actors embarking on privatization.

We hope these, and the whole book, will help privatizations in future deliver their very real and important potential benefits, while avoiding their equally real and important potential harm.

• Public actors are responsible to the society as a whole and should insist on this mandate when negotiating with their private sector partners. To this end they should:

• Maintain or set up a reliable regulatory framework well defining the objectives or targets to be met by the private operators;

• Ensure fair and meaningful competition, securing a competitive, transparent, and accountable bidding process

• Monitor and control the performance in a way that convinces the citizens or the respective state, province or municipality;

• Impose penalties if necessary;

• Involve civil society and make use of local knowledge, look at external costs and try to create an incentive structure inducing private operators to avoid externalities;

• Protect the weak and deal with (transitional) social costs;

• Apply "cross-subsidies" if that is the best way of maintaining unprofitable but essential parts of public service that are necessary on social equity grounds;

• Protect public goods/the commons e.g. by preventing incentive structures that invite private actors to overuse, let alone destroy public goods;

• Prevent natural monopolies from turning into commercial monopolies;

• Secure a sufficient financial basis to pay private operators for necessary services (such as access to water, education, energy, communication and transport) whenever customers are not in a position to pay cost-covering prices. This implies that states should join hands in fending off harmful international tax competition!

References

Carnegie Council on Ethics and International Affairs/Friedrich Ebert Foundation 2003: Privatization and GATS: A Threat to Development? New York.

Kessides, Ioannis N. 2004: Reforming Infrastructure. Privatization, Regulation, and Competition. Washington, D.C./New York: World Bank and Oxford University Press.

Marquand, David 2004: Decline of the Public. The Hollowing-out of Citizenship. Cambridge: Polity.

Savas, E.S. 2000: Privatization and Public-Private Partnerships. New York, London: Chatham House Publ./Seven Bridges Press.

Shelley, Thornton 1998: Reforming Public Enterprises-Case Studies: United Kingdom. Paris: OECD.

Sheshinski, E. and L.F. Lopez-Calva 1999: Privatization and Its Benefits: Theory and Evidence. Cambridge, MA: Harvard Institute for International Development.

Shleifer, Andrei 1998: State versus Private Ownership. The Journal of Economic Perspectives, Vol. 12, No. 4, 133-150.

Starr, Paul 1987: The Limits of Privatization. Washington, D.C.: Economic Policy Institute

UNDP 2003: Human Development Report 2003. Millennium Development Goals: A Compact Among Nations to End Human Poverty. New York: Oxford University Press.

World Bank 2003: World Development Report 2004: Making Services Work for Poor People. Washington, D.C.: World Bank, Office of the Publisher.