Privatisation – Part 2

One of the respondents to my earlier post on NSW electricity privatisation accuses me of a possible “ideological bias against privatisation” and proceeds to make sweeping generalisation about the benefits of privatisation.. I thought I might clear the air on this issue.

I have always adopted an agnostic stance on privatisation – i.e. I do not start with a prior presumption for or against. I certainly refuse to start with a belief that it is unsound public finance for our governments to borrow or that government borrowing for infrastructure investment puts upward pressure on inflation and interest rates whereas a comparable private investment does not (an economic nonsense of the very first order).

I then ask myself the question: will the private sector prove a more efficient owner-manager of the proposed infrastructure than government? There is little doubt that the private sector is generally better than the public sector in design, construction and operation of infrastructure. But capturing these benefits does not require private ownership. Governments can and do out-source most operational matters to private companies and consultants.

On the other hand, the efficiency case for private ownership of infrastructure is based on a number of preconditions which may or may not apply in practice.

Firstly, it assumes that the equity risks of the infrastructure project are largely commercial in character. But the equity risks are often more regulatory and political in character and in such cases the private sector is likely to demand an excessive risk premium. In the case of electricity privatisation, I accept that the electricity business requires skills in trading and hedging which the private sector is likely to be better at.

Secondly, the government is not always able to effectively transfer to the private sector the ultimate risk of default. Whatever the formal contracts might say, if a privatized hospital, school, road or railway network fails to perform, the government is held responsible. This is not relevant to electircity.

Thirdly, private ownership is able to deliver benefits to users only if there is sufficient contestability in financial and service markets, thus preventing costly regulation and close monitoring. This condition will largely apply in electricity.

Fourthly, private ownership will often lead to improved managerial incentives. And this is true of electricity. But in other areas it is far from clear. While government agencies are often derided for their lack of modern management expertise, in recent years they have developed ways to auction out community service obligations to avoid opportunistic political interference while also giving managers clear goals and well-structured performance incentives.

Finally, in some cases, assigning infrastructure ownership predominantly to the private sector leads to a misallocation of capital resources. For example it may create a bias in favour of infrastructure investments with good commercial potential and against social infrastructure with high social returns (an issue I return to later). As well, in the case of new roads, privatization can distort patterns of usage (forcing motorists to take less time-saving alternatives).

In short, I have few qualms about privatisation of electricity (the non-natural-monopoly bits) but each privatisation case needs to be assessed on its merit. .

Let me stress again. As an economist, I have nothing against private financing in principle. I just want to see the decision made on grounds of cost-effectiveness not prejudice or preconceptions.

This entry was posted in Economics and public policy, Politics - national. Bookmark the permalink.
Subscribe
Notify of
guest
26 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
Ken Parish
Admin
13 years ago

Convincing arguments in favour of privatisation of electricity generation, Fred. You’ve certainly convinced me for one, and I had previously been very much undecided and frequently a sceptic on privatisation (mostly because, as you note, privatisation doesn’t make sense for natural monopolies e.g. Telstra’s landline infrastructure, railways etc) . Between you, Nicholas and Harry Clarke (who also not infrequently argues against stereotypical expectations based on his general ideological orientation), you oz econobloggers are shining examples of evidence-based rigour and the sort of sceptical objectivity to which all professionals and academics should aspire but which few achieve. It makes me feel inexplicably happy, even light-hearted to know that there’s so much more to political blogging than tunnel vision partisan stoushing. If only the benign contagion would spread more widely.

NPOV
NPOV
13 years ago

By your suggestion that “that if a privatized hospital fails to perform, that government is held responsible”, do you mean that if, say, a previously-government-run hospital goes broke within a few years, the public would demand that “the government do something”, and that “doing something” might well mean handing over funding to the owners of the hospital to keep it running?
If so, a) are there examples of this sort of thing actually happening in the real world? and b) why do think the same wouldn’t be true of a power plant?

If I’ve misunderstood you, can you give an example of a case where the government has to take up some of the “risk of default”?

observa
observa
13 years ago

Keating nails the ‘obscurantists’ pretty well here
http://www.smh.com.au/news/opinion/iemma-deserved-better-than-naked-obstructionism/2008/05/05/1209839545859.html
The important part to note is that electricity is now a competitive industry, whereas the poles and wires aren’t. That’s why SA separated the two and its working fine. That’s Iemma’s tack too. It was probably a valid criticism of the privatisation of Testra that the copper/fibre network was not separated from the retail/mobile part of the business.

“If Ive misunderstood you, can you give an example of a case where the government has to take up some of the risk of default?”
The privatisation by the former Liberal Govt of the LLyell McKewin Hospital in the NE suburbs of Adelaide springs to mind NPOV. Although OK for the private winning tenderer for a while, it soon became a loss making venture and the management began to savagely cut costs to save their leaky boat. So much so that the public complaints about falling service standards became too great politically and the Rann Govt brought it back under the public purse by mutual agreement (basically the private owner handed it back for free, incurring a large capital loss on the deal) To be fair, the taxpayer enjoyed a cheap hospital for a few years and it was a fast growing area straining the facility. Really the private owner was trying to take on a hospital of last resort, rather than the tried and true private model of picking the eyes out of the most profitable clientele. No doubt that salutaery lesson is well known to all the players now.

observa
observa
13 years ago

salutary not salutaery… God I know how to spell but these clunky big fingers and pecking skills are getting to be a worry.

NPOV
NPOV
13 years ago

observa, thanks for that info. I did a bit more reading about attempted public hospital privatisations in SA and elsewhere. It does seem that once you have a culture of public hospitals established, privatisation is almost impossible to pull off successfully. Which is odd, because as I understand it, in Canada, most health services are provided by privately run clinics and hospitals quite successfully, and I had thought that Australia might benefit from moving towards such a model.

David Rubie
David Rubie
13 years ago

NPOV wrote:

I had thought that Australia might benefit from moving towards such a model.

We (sort of) have, although the presence of public hospitals mean that it’s the perfect recipe for “privatising profits, socialising losses” – our private hospitals are generally well run, pleasant places that avoid emergencies, difficult operations, research and anything that smacks of expense that isn’t covered by either insurance or government funding, leaving the public hospitals to take all the worst cases, emergencies and anything expensive or untreatable.

Now, that model can probably be made to work but only if the public hospitals started charging the private ones back for all the work they kick over the fence they don’t want. I suspect it won’t happen, as it makes hospitals into loss making enterprises.

Re: comparing the Telstra privatisation to the NSW electricity one: in hindsight it was obviously a mistake not to chop Telstra into two parts, but the previous government wanted money when they privatised it and the vast amount of it’s value was in the monopoly infrastructure, hence the botched job. Electricity is a bit different in that the value is in the power generators rather than the wires themselves.

Brendan Halfweeg
Brendan Halfweeg
13 years ago

…or that government borrowing for infrastructure investment puts upward pressure on inflation and interest rates whereas a comparable private investment does not…

Fred,

I’d suggest that there is a difference between public and private debt. The very fact that public debt is secured against tax receipts rather revenue and/or assets makes public debt attractive to banks. Obviously, all borrowing puts pressure on rates, but public debt will have a somewhat crowding out effect on private investment, and it is difficult to build in the opportunity cost of it being harder for a small business to borrow into any CBA of public borrowing.

There is also the market signals that public borrowing sends out, which can be even harder to judge.

Also, your assumption that privatised electricity won’t have the same pressure on politicians to shield the public from failure are fanciful. The state will put price regulation, quality of supply regulation, distribution of supply (ie. electricity utilities would be forced to supply unprofitable customers), foreign ownership regulation and all sorts of other regulation that will impede the market from operating efficiently. All of this government meddling, together with the client electorate, will make further government intervention more likely, not less.

Private investors that chase regulated utilities are simply hoping that they can manipulate the state to bankroll their investment and guarantee a return. They are rent seekers, just like every single one of Telstra’s shareholders were, although the T2 investors got their fingers burnt initially.

Maximum Thrust
13 years ago

If parliaments could bilaterally support privatisation then, if the private operations were to fail, neither political party would mislead the public by claiming that government should intervene.

Marks
Marks
13 years ago

Fred,

You said “This is not relevant to electircity” in relation to Governments being held responsible.

Perhaps this might be the case if the power went out for a day or so…but a week, or a month? No water for many, no sewerage services, no light, no food needing refrigeration?

I suggest that long before that stage was reached, there would be so much pressure on Governments to ‘do something’ that they would.

There are several precedents in Australia in the power industry for this.

I am convinced that failure by the private sector power industry in the early third/half of the nineteen hundreds was the reason for the creation of the SECV and ETSA in Victoria and South Australia…and, although I am not a historian, I suggest that the massive amounts of investment required in infrastructure and losses in production and efficiency before those catch up power infrastructure investments were undertaken must have had a major impact.

Those governments had no choice – they either waited round for the Electricity Supply Company of Victoria and the Adelaide Electric Supply Company to progressively get worse and worse, or intervene.

Just saying.

Ken Parish
Admin
13 years ago

I suggest the reason why Fred said it didn’t apply to electricity is that there would be multiple providers/generators, and the failure of one of them isn’t going to have catastrophic consequences in any event. OTO a natural monopoly privatised railway or regional cute care hospital would indeed have such consequences.

And I wonder when finishing a comment/post with the extraordinarily irritating and pointless affectation “just saying” is going to go out of fashion …

Fred Argy
Fred Argy
13 years ago

Thanks Ken. That is my very point. If one provider ran into financial difficulty, it is most unlikely it would want to stop earning revenue but even it closed shop, other providers (including from other states) would temporarily fill the gap until the market sorted things out the usual way – with a takeover occurring at discount prices (no cost to revenue). Anyhow, the sale of the government asset could have provision for interim government intervention in a case of force majeure.

Brendan, you argue that an infrastructure financed by private borrowing would have less of an impact on interest rates than one financed by government borrowing. I have not fully understood your point but this is my take on the issue.

It is important to distinguish between interest rate pressures stemming from capacity constraints (real crowding out) and those stemming from financial market reactions (financial crowding out). If Australias productive capacity is fully stretched and the central bank is adopting a non-accommodating monetary policy, any new government infrastructure investment financed out of borrowings will, if other policies remain unchanged, add to inflationary and interest rate pressures at least in the short term until the investment starts to pay off.

In such circumstances, transferring financing responsibilities to the private sector will not help significantly to ease interest rate pressures since the short term effect on aggregate demand will be broadly the same. Indeed,if the government was doing the investing, the fiscal authorities are more likely to want to minimize the risk of real crowding out by either taking action to discourage or defer other types of national spending or simply by timing well its infrastructure investment program over the business cycle.

What of financial crowding out the risk that global financial markets will require an extra interest rate “loading” for country and sovereign risk? This can happen in two ways. The first is by impacting on global capital markets; but this can be ruled out as Australia is a price-taker in these markets. The second is through effects on inflationary expectations and market credit ratings. This has been a problem in the past because credit rating agencies tended to get skittish when a major new program of infrastructure investments was financed by public sector borrowing (rather than by private interests), fearing that the lack of commercial and market disciplines in decision-making might create useless white elephants and make the additional debt hard to service. But, with public debt levels now at historically very low levels, and assuming new infrastructure decisions are made on the basis of sound cost-benefit evaluations, rating agencies and financial markets can be expected to take a more sensible and relaxed view of both public sector and external deficits .

NPOV
NPOV
13 years ago

Ken, that would then suggest a case for regulation preventing any one company from owning too much of the generation capacity. Were that company to go broke, the government would essentially be forced to step in and bail it out.
But surely the same would apply to, say, a major supermarket chain? Were Coles to become insolvent, and couldn’t find a buyer, and were forced to start closing down all their stores, I’d wager the government would step in (our State member is even trying to “step in” to discourage a nearby Safeway from converting a single store to a Dan Murphy’s – despite there being another one 200 metres down the road). We’ve already seen how that rule applies to big banks.

Ken Parish
Admin
13 years ago

NPOV

Yes I agree. There should be rules preventing excessive concentration of ownership.

Patrick
Patrick
13 years ago

NPOV, that argument applies to hospitals, maybe, but expressed as you have it applies to anything considered vaguely important.

Were Coles to become insolvent, and couldnt find a buyer,

If this happened, the banks would appoint a receiver, or convince the management to go into voluntary administration, and the company would be either sold or revived under new management. Quite possibly the existing shareholders would lose a lot or all of their investments. A good example was the Eurotunnel, whose original investors lost their shirts, but whose present (post-insolvency) investors are making a neat return. To quote Fred:

If one provider ran into financial difficulty, it is most unlikely it would want to stop earning revenue but even it closed shop, other providers (including from other states) would temporarily fill the gap until the market sorted things out the usual way – with a takeover occurring at discount prices (no cost to revenue)

If the worse came to worse, there would be a firesale and Coles would shut down, and the queues at Woolies, IGA, etc would be longer. But I might suggest that if things came to that the Government would probably have both a) no money to do anything and b) bigger problems.

The reason the argument might apply to hospitals is mainly social expectations. There are, however, only so many beds available, and the consequences of having to drive around to one or more other hospitals in order to find a place could be more dire than having to drive around from one supermarket to another, or even than a few brown-outs.

observa
observa
13 years ago

“It does seem that once you have a culture of public hospitals established, privatisation is almost impossible to pull off successfully.”
NPOV, I reckon you nailed the ‘culture’ problem right there, because as I recall there was a lot of staff resistance to change, frustrating the new owners somewhat. As well the timing might have been bad given the shortages of nurses and doctors developing rapidly and the ready lure of other public hospitals if they didn’t agree with the change of culture. In that respect it might be an all or none proposition now. There is also the problem that their consumers often come with limited/regulated dollars for their services, irrespective of true costs.

David is right in some respects that currently private hospitals can cherry pick the most profitable services and needn’t engage in the expensive training part of the equation. However, like private schools, they also have the ability to extract more dollars from those consumers with the wherewithal to pay more and that they do fairly effectively. That has spinoffs for public provision and service standards. An example was my son breaking his jaw at footy 4 yrs ago and by the time I realised all was noy wel around 7pm on a Sat evening, it was a quick trip to Asford private emergency. That was $100(now $200 I believe) to get past the pleasant receptionist, with no bullet proof glass, Chubb security staff outnumbering the medical staff and fairly prompt attention. X-ray, up to the ward and an op first thing Mon morning and home Tues to recuperate, all on extra private health cover. When my pensioner father had to be admitted to the RAH specifically, a couple of years later, you couldn’t help noticing the difference. He was still stuck on a barouche in the emergency area in a walkway alongside the medico station the next morning. Eventually in a ward I couldn’t help noticing the lino tiles, on the floor and up the walls in the ward were the same as when I was there with a broken leg at 18. They made commercial lino tiles tough in those days, albeit they’d shrunk a bit on the walls over the years. Don’t ask me what lurks in the cracks though nowadays.

Patrick
Patrick
13 years ago

Sorry, NPOV, I forgot to mention the ACCC’s continued existence is a given.

NPOV
NPOV
13 years ago

Sure, so if Coles were forced to shut down, Woolworths would have an almost monopoly status, which the ACCC would obviously have a problem with.

As for the government having no money, the amount of capital the government would need to borrow to temporarily nationalise a supermarket chain surely wouldn’t be a major deal, seeing as govenrments always have the option of raising taxes to pay for things.

Anyway, I agree it’s highly unlikely to ever get to that point, but in the real world, governments will always step in to protect or salvage companies whose collapse would have dramatic effects on large sections of the population, essentially meaning that for such companies, part of the their risk is socialised to a degree. Implying of course that it’s only reasonable that part of their profits be socialised too :-)

Patrick
Patrick
13 years ago

I meant that in a situation where no-one besides woolies could be found to buy coles at even distressed prices the government would also have to be up shit creek since that is only really conceivable in a depression, and even then unlikely. In a situation where Coles simply went slowly out of business the ACCC might try and block Woolworths from buying individual stores or, in an extreme case (I don’t think this has ever been done in a case of natural growth) force them to break up.

Implying of course that its only reasonable that part of their profits be socialised too :-)

Don’t worry, they are. Somewhat over 30 per cent of them last time I checked.

NPOV
NPOV
13 years ago

Sure, but OTOH, if supermarkets had to pay themselves for everything that governments provided out of taxpayer funds, I wonder if they’d be profitable at all.

Patrick
Patrick
13 years ago

?

Marks
Marks
13 years ago

Hmmm,

You don’t seem to think that a generator who takes over an asset that traditionally works on the basis of a safety margin will not wish to make that asset work harder?

If the generator works that asset harder, the return on assets goes up.

However, as long as the generator just uses that safety margin to sell into the spot market, the generator’s financial risk does not go up, since if the generator has an outage, they can still just not sell into the spot market when their spare capacity goes down.

As demand grows, more and more base load goes into the spot market, and as long as the generator does not commit the nominal load, they do not bear extra risk.

However, when that happens and somebody goes down, unless everybody else has excess capacity, down goes part of the system initially, and then as the margin gets even smaller, system instability is such that the whole lot may fail. Where are the economic signals that would pull extra generation into the system BEFORE the system starts to fail? Under Govt ownership, this is just planned and built in time to meet new peaks.

While people give lip service to AGW, I don’t see any evidence of them voting that way with their switch fingers, if energy consumption figures are anything to go by.

Increases in system outage frequencies and duration will certainly test people’s sincerity on that matter.

NPOV
NPOV
13 years ago

You don’t think company taxes go towards paying for infrastructure (roads etc.) that supermarkets depend on for profitability, Patrick?

WaterDragon
13 years ago

Really enjoyed Argy and this comment thread – but I still don’t want my electricity retailer privatised.
But then, living in regional Australia I have seen the laughable benefits from after the half-***ed Telstra privatisation and increased telecommunications ‘competition’.

Patrick
Patrick
13 years ago

Marks

Under Govt ownership, this is just planned and built in time to meet new peaks.

You really are having a lend, aren’t you?

NPOV, I really don’t get where this is going. They pay taxes, part of which goes to roads, etc, but so what? I don’t see how that means that a part of their profit is not due to government investment and that a part is socialised?

Presumably, since the government runs a lot of surpluses lately, the government is making a tidy fist of this ‘I tell you how much you owe me’ game. Unsurprisingly, perhaps.

NPOV
NPOV
13 years ago

Patrick, I’m just pointing out that socialising 30% of their profits is not unreasonable, given how much of the investment and potentially the risk is socialised.

I don’t doubt there do exist businesses that don’t get very good value out of the taxes they have to pay, but supermarkets surely do.

Marks
Marks
13 years ago

Under Govt ownership, this is just planned and built in time to meet new peaks.

You really are having a lend, arent you?

Nope. But of course you have the capacity figures to prove me wrong I guess?

And of course this is one of the reasons Iemma is wanting to privatise, since the Govt would have to come up with the money for that capacity augmentation. It’s in the Owen report. I recommend it for a read for those wanting in on the debate in any serious way.

The point I am making and made was that private generators can eat into their spinning reserve. If it looks like they are at capacity, they don’t have to increase that capacity unless they take on more contracts. If they don’t and there is a shortfall, how exactly do you see someone coming in and building a power station in the time frame the Owen Report reckons should happen? If a generator is running along with high utilisation (and therefore maxing out on roi), where is the economic signal to build another station that initially will be overcapacity until load growth catches up.

Utility planning 101.