Vol. 7 No. 3
SUMMARY
In Victoria there is a renewed debate about privatisation, centred around the Kennett Government's proposal to privatise the SECV and the State Labor Opposition's claim that this is against the public interest.
The debate occurs against the background of recent World Bank research indicating that there have been 15,000 privatisations of state-owned enterprises worldwide (most since 1990); that most clearcut success stories come from high- or middle-income countries; and that recent evidence suggests (contrary to earlier academic theory) that there are positive benefits from private ownership as well as from establishing a competitive market structure. Further background includes the rapid changes now occurring in the structure of the electricity industry worldwide which involve increasing exposure to private sector competition; the poor performance by the Victorian electricity industry (BIE data up to 1992 show Victoria then had the worst efficiency among the States); and the fact that Federal Labor is continuing to pursue a privatisation programme.
The criticisms of the Victorian Government's privatisation programme include arguments such as that public assets are held in trust and cannot be sold; that privatisation will increase income inequality; that privatisation has not worked in the UK; that there will be "exploitation" by private monopolies; and that it would be wrong to allow foreigners to run "essential" services such as electricity. This Backgrounder shows these arguments to be wrong or based on false reasoning.
It concludes that, properly implemented, privatisation is in the public interest and that those opposing it are supporting narrow sectional interests. The test of whether privatisation will be beneficial is not whether there will be a net gain in State revenue, or even lower consumer prices, but whether goods and services are likely to be supplied at a lower cost in terms of use of resources.
BACKGROUND
Viewed in historical terms, the worldwide privatisation movement is not really something new but a return to the more normal situation where private enterprise was the main supplier of a range of what are now described as "government services". After World War 11, there was an enormous expansion in the rôle of government as most economists (and many others) argued that society would benefit if governments were to intervene more to correct for what was known as "market failure". For example, it became widely accepted in the community that lower income groups should have reasonable access to health and transport services, that the private sector would not necessarily provide this, and that the way to achieve it was for the government to become a major, if not the sole, supplier of such services. Government monopoly was also seen as better than private monopoly because it would protect the individual from "exploitation".
However, since the early 1980% there has been a growing realisation that, while "market failure" certainly occurs in the private sector, there is also a phenomenon which has come to be known as "government failure". The realisation came that the large expansion in the rôle of government in the economy had not overcome the problems perceived as justifying government intervention and that, in fact, new problems had emerged.
In the public enterprises area, their performance was not only poor in terms of financial results but also left a lot to be desired in terms of the standard of services delivered. Thus, as stated in a June 1994 comprehensive review of privatisation in The World Bank Research Observer:
Since the big expansion in state ownership in the 1960 and 1970s, the number of state-owned enterprises (SOEs) worldwide has been shrinking at an accelerating pace: more than 15,000 SOEs, at a conservative estimate, have been privatised, most of them since 1990. Years of disappointing SOE performance and a history of half-hearted and ineffectual attempts at reform have impelled many governments ... to launch privatization programs. (1)
It is relevant to the current debate in Victoria that most Asian and Latin American countries have moved in recent years towards the operation of electric power stations by private enterprises; and that the California Public Utility Commission recently announced that it is considering a similar model to that being pursued by the Victorian Government. It is not an understatement to say that the electricity industry worldwide is going through a considerable process of change involving the exposure of the industry to the pressures of private sector competition.
The World Bank review also points out that it has not simply been that public enterprises have yielded a disappointing return on the capital invested in them, but that their inefficiency has slowed the growth in the private sector too. It is worth recalling that the principal objectives of the World Bank Group are the promotion of economic development and the reduction of poverty.
In considering the case for privatisation, it is important to recognise why this failure of government intervention has occurred. Public choice theory points out that, as politicians and bureaucrats benefit from building up their own empires, their natural instinct is to expand their power and influence by responding to organised pressure groups in the community that seek to obtain concessions. For each individual in the community, the cost of granting such concessions is small and is therefore unlikely to produce organised opposition. But the cost to the community as a whole can be considerable.
Australia has had a long history of such concessions. For many years, parts of the rural and manufacturing sectors were recipients, to the considerable cost of the rest of the community. But particularly in Victoria, we have also had much experience of over-manning and inefficiency in the public sector, mainly as a result of the protection which that sector has had against competition and of the capacity of the powerful trade union movement to extract concessions from governments of all political persuasions.
Just as the free trade movement fought "McEwenism" in the rural and manufacturing sectors in the interests of the community as a whole, the privatisation movement can be seen as doing the same thing -- but this time the force of conservatism resides with those vested trade union interests which are so dependent for their power and influence on retaining a strong public enterprise sector. It is relevant that well over 60 per cent of the public sector is still unionised compared with less than 30 per cent of the private sector.
IMPROVED P.T.E. PERFORMANCE
It must be acknowledged that in Australia there has been a significant improvement in recent years in the performance of public trading enterprises (PTEs). Productivity and profitability have picked up considerably, though analyses show that most PTEs are still performing below international best practice. The latest Bureau of Industry Economics analysis of the electricity industry, for example, shows that the total factor productivity gap between the Australian and US industries in 1992 was still around 27 per cent, with Victoria the worst performer among the Australian States. (2)
The improvement reflects the fact that the trade union movement was forced to accept that the internationalisation of the Australian economy required large cutbacks in staffing in order to reduce the costs of services provided by public enterprises. There is also no doubt that the threat of privatisation played an important, indeed vital, part here and, in a limited number of cases, actual privatisations have occurred. (3) The Federal Labor Government has even been "brave" enough to pursue a privatisation programme, though union opposition has been a major inhibiting factor in the full privatisation of such enterprises as the Commonwealth Bank, Qantas and the Australian National Line, not to mention Telecom (which is not scheduled even for what I call a Clayton's privatisation -- that is, a partial sale but with the government still in control).
THE CORPORATISATION ALTERNATIVE
These improvements in the performance of PTEs, which include significant improvements in the performance of Victorian PTEs, raise the question of whether, rather than proceeding with their privatisation, PTEs can be "reformed from within" by a process of corporatisation. Such a process gives the enterprise a greater degree of independence from political interference and, in essence, replicates a private sector business in most respects except that it remains government-owned. In short, can the perceived deficiencies of PTEs be remedied without changing ownership?
Some analysts have concluded that competition and regulation are more important than ownership in determining economic performance. This view is reflected to some extent in the Hilmer Report, which, while not opposing privatisation per se, emphasises "reforming the structure of public monopolies to facilitate competition" rather than changes in ownership per se. According to media reports, the (leaked) draft report of the Industry Commission analysing the effects of implementing the Hilmer proposals suggests that they would produce considerably cheaper food, housing and electricity prices. Electricity charges would fall by 26 per cent by the year 2000 for big business users and by 11 per cent for households. Such a conclusion would apply to an even greater extent to a properly implemented privatisation programme.
There is, indeed, a major unanswered question here: namely, if Hilmer and others agree that PTEs should be restructured to operate in the same way as private sector businesses, what justification is there for continuing to operate those enterprises in the public sector? Is it not better to privatise and keep the sticky hands of government away from such businesses?
OWNERSHIP IS IMPORTANT
The World Bank researchers had little doubt about the answer. Their conclusion was that
[M]uch experience of the past two decades shows that, in practice, markets and public ownership are linked in ways that can reduce competition, even without a significant market failure ... state ownership, created to overcome or correct market failure, can sometimes aggravate or perpetuate it.
An earlier World Bank review was even more specific, viz.:
First, private ownership itself makes a difference. Some state-owned enterprises have been efficient and well-managed for some periods, but government ownership seldom permits sustained good performance over more than a few years. There is a higher probability of efficient performance in private enterprise, and that needs to be considered in choosing whether to invest public funds in SOEs -- or in health, education, and other social programs.
Second, the process of privatization, though not simple, can and has worked; this is true for a variety of enterprises in a variety of settings, including in poor countries. (4)
In short, it may not simply be a matter of, for example, breaking up a State monopoly, such as the SECV or Melbourne Water, into corporate units which engage in some form of competition against one another. Ownership does matter, and private ownership is most likely to succeed.
WHY PRIVATE OWNERSHIP IS BETTER
This is not to deny that, by restructuring public enterprises and requiring them to operate as if they were in the private sector, considerable improvements can be obtained in efficiency, quality of service and profitability. Nevertheless, the gains are likely to be limited by the continued operation of the enterprises within the public sector. There is an inevitable and on-going conflict between operating on a fully commercial basis and either taking unjustified advantage of government ownership or being subjected to political pressures not to make commercial decisions. For the Government, there are also considerable accountability problems.
The retention of an enterprise within the government sector in a corporatised form gives that enterprise the appearance and form of being a body that is outside political control and influence. At the same time the Government, and some Minister within the Government, has to accept final responsibility for its outcomes. In these circumstances, a situation can be created that offers the worst of all possible worlds -- a body that has the potential to exploit its privileged position as a government body and its arm's-length position from the Minister to take unjustifiable risks, to squash potential private sector competitors, or generally to pursue policies that are not in the interests of the community, and a Minister who is told that he should not interfere. In the end, however, the Minister is accountable and has no alternative to taking action to stop the pursuit of what are judged to be politically inappropriate policies, thus destroying the image of independence and recognising the reality that the Government has ultimate responsibility.
The reality is that it is difficult for the Government and the Minister to avoid having a significant direct and indirect influence on the key policies to be pursued by corporatised public enterprises. The Board has to be appointed by the Government/Minister, as generally is the Managing Director, and Board Members rely on the Minister for re-appointment. There is also a tendency to choose Board appointees from among those who are sympathetic to the Government of the day, and/or who are representative of interest groups which have particular barrows to push. This is not likely to produce the most satisfactory commercial outcomes. Beyond that, the Government can exploit the monopoly position of a corporation by using it as a vehicle for collecting additional tax revenue through the guise of "dividend" policy, which is usually determined by the Minister or the Treasurer.
Apart from this, the Board and management of the enterprise may operate policies that are inconsistent with the underlying commercial interests of an enterprise simply because they judge it "impolitic" to change policies. They may judge that any such change will result in the Minister directing that it not be made, or failing to reappoint them.
THE MAIN PURPOSE OF PRIVATISATION
It is important to recognise the point that the main purpose of privatisation is to improve the efficient functioning of the economy. There is a close parallel between the privatisation of PTEs and the elimination of protection against imports, which is now accepted by all major political parties. Both are designed to expose the respective sectors of the economy to greater competition and, through that, to allow that good or service to be supplied at a lower cost in terms of the use of resources.
That process is now almost universally accepted in the economics profession as leading to an improvement in average living standards in the community, even though the initial effects may include a reduction in employment. The dynamic effects flowing from the encouragement to private investment, because of the lower costs which businesses face, are likely to provide additional jobs in due course.
THE EFFECT ON GOVERNMENT REVENUES
It follows from this that the test of whether a privatisation will be beneficial is not whether the State Government will have a short-term gain in revenue in net terms. (5) While such a gain is likely in many instances, though not necessarily in the case of the much-discussed SEC, whether or not such a gain occurs is relatively unimportant in the overall scheme of things. If the privatisation is done in a way that allows scope for improvements in efficiency, there are likely to be benefits to the Victorian community. In the case of the SEC, for example, the unbundling of the distribution and generation arms into a number of distinct units, and the creation of a framework within which competition can occur, offer the potential for resources to be freed for other purposes and for investment to be encouraged by lower costs and improved service.
EXPERIENCE WITH PRIVATISATION
In considering the potential for benefits from privatisation in Australia and Victoria, it is relevant to examine what has happened with privatisations in other countries. The World Bank Research review points out that, until very recently, studies undertaken of industrial economies largely attributed superior efficiency in private over public firms to market structure rather than to ownership. The review also states, however, that
[M]ore recent evidence, which compares SOE performance before and after privatisation, shows considerable economic benefits resulting from properly structured privatisation, even when the privatised firms were monopolies. (page 251)
It also makes the points that
Most clearcut success stories come from high or middle-income countries ...
and that
the privatisation process is harder to launch in least developed countries, and the chances of failure are greater. (page 252)
SOME CRITICISMS OF PRIVATISATION
Criticisms made about privatisation include the following:
Loss of Value
One accounting analyst sponsored by the union movement has suggested that the value of a public asset is reduced when it is sold because a private sector purchaser faces a higher cost of capital and is liable to pay company tax. Most accounting analysts consider this to have no validity and a moment's thought would suggest that there has to be something wrong with an analysis that implies that values of assets can be increased by moving private sector assets into the public sector! (6) Why don't BHP shareholders offer the company to the Government and take "the Paris option"? Why hasn't anyone involved in the 15,000 privatisations that have occurred realised the "loss" that occurs?
Public Assets are Held in Trust
The argument here is that certain public assets are so "strategically" important that they must be regarded as being held in trust in perpetuity by the public sector.
It is difficult to understand the basis of this argument. BHP is strategically important to the economy and the welfare of the Australian people but nobody suggests it should be in the public sector. There is certainly no legal or historical basis for the "trust" claim. An analogy could be drawn with public assets that are held in trust as part of the national heritage, but such an analogy scarcely seems applicable to a PTE! The reality is that it is open to the Government of the day to sell or purchase assets and, provided such action is consistent with its enunciated policies (as was the case for the Kennett Government prior to its election), it should be entitled to do so.
It may be that, behind this argument, there is a concern in the minds of some people that privatisation will lead to a loss of some service or a disadvantage to some group. However, if that is the case, and if the loss or disadvantage is regarded as justifying compensation or offsetting action of some sort, it is open to the Government to take such action. In the case of job losses arising from privatisation, for example, there now appears to be an accepted policy of redundancy payments at the taxpayers' expense even though the equity of such arrangements is dubious (given that the jobs should in most cases never have existed in the first place).
There is also widespread acceptance that, where justified, community service obligations (CSOs) should continue to be met for low-income and disadvantaged groups. Indeed, an advantage of privatisation is that these CSOs are brought more into the open and exposed to public debate as to their justification, instead of being hidden in the accounts of PTEs.
Income Inequality Will Increase
The argument that privatisation will lead to an increase in income inequality appears to be based to a large extent on the alleged increase in income inequality in the UK under Conservative Governments since 1979. However, income inequality as normally measured has also increased significantly in Australia since the early 1980s, and we have had relatively few privatisations compared with the UK. The US experience has been similar to Australia's, but a recent analysis by McKinsey's reports that a smaller proportion of individuals in the US is below the poverty line than is the case in major European countries. (7)
Analyses suggesting increased income inequality over a particular period also need to be treated with caution. In particular, if the "income" received from free or subsidised government services or from home ownership is included, that can change the picture considerably. Also, as most people start their working lives in lower income groups and move up as they become more experienced, many of those in the lowest income group at the start of the 1980s would not still be there today.
The fact is that there is no evidence to suggest that privatisation increases income inequality, except in so far as there is an increase in executive salaries in new enterprises. Within limits, such increases are an example of an increase in inequality that is justified. The new enterprises have to compete in the market for corporate executives, and the fact that PTEs were previously run by executives on lower salaries is scarcely a good recommendation for continuing such a practice, given their generally poorer performance than comparable overseas bodies, not to mention private sector companies.
Privatisation Did Not Work in the UK
Critics of privatisation have argued that privatisation has failed in the UK and that this "proves" that it does not work. This "line" chooses to ignore the success of privatisation in just about every other country and to overlook the fact that, as the UK was the first in the field, others have been able to learn from UK experience. Even Victoria might do so!
A major criticism of the UK privatisation process is that it was far too cautious in exposing former PTEs to competition, and this has limited the improvements in efficiency. A further criticism is that, in order to widen the distribution of share ownership in the UK and to gain support for privatisation from PTE employees, many of the PTEs were sold at less than market value. But these approaches do not have to be followed in Australia.
In any event, it is far from clear that privatisation has not been successful in the UK, if account is taken of improvements in efficiency and in both consumer and taxpayer welfare. As to direct benefits to consumers, there is little doubt that, even with the lower level of competition, the UK consumer has benefited from lower prices and from improved standards of service since privatisation. There has, for example, been a large real fall in gas prices to industrial consumers and also in the main telephone prices.
In the UK electricity industry, contrary to some misinformation put around in Victoria, comprehensive information supplied to me by the UK Treasury shows that, since privatisation in 1989, there has been a substantial real fall in average prices for industrial consumers and a modest real fall in average prices for household consumers. The real fall in average prices overall during this period is probably greater than the real fall in average electricity prices in Victoria of about 5 per cent since 1979! Other benefits in the case of UK electricity privatisation include:
- Enormous improvements in productivity as a result of the elimination of excess staffing and improved work practices (employees in generation have been reduced from 47,000 to 26,000 and in distribution by 20 per cent).
- The average lost supply-time per customer has been reduced by more than half.
- Disconnections of customers for non-payment of electricity have fallen to a fraction of the level which previously existed, mainly due to the introduction of more flexible payment schemes.
- There has been a significant fall in the number of complaints received by the Regulator (OFFER).
Ironically, possibly the biggest "mistake" made by the UK Government in electricity was grossly underestimating the efficiencies that would be achieved following privatisation. As a result, shareholders in the new companies received large gains, and consumers did not realise the potential for large price reductions. This is not a criticism of privatisation per se but of the process of undertaking it. The Victorian Government approach, of using the threat of privatisation to try to make the companies as efficient as possible before they are sold, should provide a better balance between shareholder and consumer gains in the future.
The main exception to the consumer benefits story in the UK is in respect of water, where prices were considerably increased. However, this reflected the factthat, before privatisation, consumers were not paying a sufficient price to allow adequate provisions for the depreciation of capital and to meet desired quality standards. The increase in prices post-privatisation thus largely reflected the prior inefficiency of the public sector in operating the water supply system.
This example illustrates, incidentally, the point that the benefits of privatisation are not to be measured simply by reference to whether prices for consumers are reduced. In the case of British water, the benefits have come from ensuring the future provision of an improved quality of supply.
Another benefit from UK privatisation has been the elimination in the cost to taxpayers -- who, after all, are also consumers -- of the operating losses of nationalised industries. In 1979, losses of nationalised industries were costing UK taxpayers 50 million pounds per week; today those industries are paying 60 million pounds in taxes on the profits they earn as private sector companies.
The Dangers of Private Monopolies
Opponents of privatisation highlight the potential problem that it could lead to the establishment of private monopolies. However, there have been some important changes in the economy since public enterprises were first established to run various government services, and there is now a reduced risk of private sector monopolies developing in such areas. For one thing, technological change has increased the scope for competitive units to be established. This is particularly true in telecommunications. Improvements in information technology have been important in creating scope for greater competition in the electricity industry, by allowing the creation of a regulated market -- such as is envisaged by the Victorian Power Exchange. Developments in economic theory since the public monopolies were established also suggest that, where there is the threat of entry from another competitor, this can impose an effective discipline and prevent, or at least inhibit, the development of monopolistic practices.
Also, even where the likelihood is that privatisation will lead to the establishment of private monopolies, there is now a much greater capacity and experience on the part of governments in controlling and limiting attempts by private sector companies to levy monopoly profits. The model of an independent regulator who keeps monopolistic practices at bay, but which allows the benefits of private ownership to be obtained, appears to be a considerable success.
It can now reasonably be argued that it is in fact better to have a private-sector monopoly than a public-sector monopoly. A private sector monopoly faces the test of the capital market whenever it needs to raise capital, and it is subject to the threat of take-over if its performance slips. This operates as an important discipline on management, a discipline which does not exist in the public sector. The fear of domination by large monopolies might be somewhat diminished if it were realised that large firms often have fairly short lives. Of the 100 firms heading Fortune magazine's list of US's largest firms in 1956, only 29 were still there in 1992. This is a reflection of a dynamic business sector, not a failure of large businesses per se because they may have been replaced by new and often larger businesses.
Of course, as the Hilmer Report effectively proposes, it is desirable wherever possible to avoid simply transferring a public monopoly into a private monopoly. That goes almost without saying and it justifies the pursuit of structural changes before privatisation. Further, if a private-sector monopoly cannot be avoided, it is important to establish an appropriate regulatory system. But privatisation should not be avoided simply because of the possibility of monopoly.
Foreigners Will Run Our Essential Services
Concern has been expressed in some quarters that privatisation will lead to foreigners running "essential" services, particularly those (such as electricity) which require large lumps of capital. It is not clear why such concern should exist, provided there is a competitive situation or one which is subject to an independent regulator. Under the existing foreign investment policy of the Federal Labor Government, new foreign investment in the public enterprise sector is treated as "non-sensitive" and welcome, and is subject only to a "contrary-to-the-national-interest" test. The precedent of the Gladstone Power Station and Loy-Yang B take-overs by foreign investors implies that a foreign "take-over" of publicly owned electricity enterprises in Victoria would not be rejected by the Federal Government as contrary to the national interest (which is the test that would be applied). (8) Indeed, it will be recalled that the present Federal Labor Treasurer, Ralph Willis, "launched" the Loy-Yang B "take-over" by Mission Energy. The State Labor Government's decision to sell Loy-Yang B, incidentally, was partly motivated by the desire to do something to reduce the entrenched position of the union movement.
One aspect of the alleged monopoly "problem" from privatisation that is often overlooked is the potential for foreign investors to reduce the scope for monopolistic practices after privatisations. As a general rule Australians should not be concerned if foreigners take over former public monopolies or units of former monopolies, provided that the result is not simply to establish a private monopoly that is protected from the threat of take-over.
CONCLUSION
Overseas evidence suggests that privatisation is to be preferred to corporatisation. There is a high probability that privatisation will benefit both efficiency and consumers, and it is not correct to suggest that a private monopoly is as bad as a public monopoly.
Those who oppose privatisation are acting contrary to the public interest and in support of narrow sectional interests. Much of the opposition to privatisation in Australia is, in fact, a reflection of outdated ideological hang-ups and a desire to hold on to entrenched positions of power and influence, than a concern for improving living standards, jobs and national efficiency. In particular, the very strong opposition to privatisation by the Australian trade union movement reflects the fact that the PTEs are the power base of the union movement and that unions are resisting any undermining of that power base.
The need now is for Commonwealth and State Governments to recognise the likely benefits from privatisation and to restructure their PTEs as quickly as possible so that they can be privatised. Australia has been dragging the privatisation chain and we need to catch up with most of the rest of the world in this important area of the economy.
ENDNOTES
1. Sunita Kikeri, John Nellis and Mary Shirley, "Privatization: Lessons From Market Economies". The World Bank Research Observer, Vol. 9, No. 2, July 1994, pages 241-72.
2. "International Performance Indicators. Electricity Update 1994". Research Report 54, Bureau of Industry Economics, page 42.
3. These include the State Banks of NSW and Victoria ($576m and $1.6 bn respectively), the Government Insurance Office in NSW ($1.2 bn), the Gladstone Power Station ($753m), the TAB in Victoria ($609m), and Aussat.
4. "Privatization: The Lessons of Experience", Country Economics Department, The World Bank 1992.
5. Media reports suggest that the Industry Commission has concluded that the reform of the pubic enterprise sector along lines recommended by Hilmer would produce longer term gains in net revenue from the effects of faster growth on indirect tax revenues. Such a conclusion would also apply to the privatisation of such enterprises.
6. The true "social opportunity cost" of capital employed by the public sector is the additional wealth such funds could have earned in the private sector. The same opportunity forgone drives the cost of capital to the private sector. Thus, the cost of capital to both private and public sectors is the same when the projects being compared are of equivalent risk and are operated with the same degree of efficiency. The fact that the public sector can borrow funds at lower rates of interest than private borrowers is not relevant because the real cost of capital to the public sector is more than the cost of debt.
If the investor is tax exempt then so must be the alternative investments; therefore discount rates and net cash flows must be before taxes. The converse is true for the taxed investor; both net cash flows and the discount should be after taxes. The net result is that there will be no difference between what a taxed investor and a non-taxed investor will be prepared to pay for assets, assuming no budget constraints and no other comparative advantage/disadvantage of one investment relative to another from the investor's viewpoint.
7. William W. Lewis, "Where the Jobs Are -- And Aren't", Wall Street Journal, 7 December 1994.
8. While the sale of a State-owned asset is not subject to the foreign take-overs legislation, in most cases it would involve the establishment of a new business and would thus be subject to foreign investment policy
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