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Abu Dhabi, UAEMonday 25 June 2018

Economics 101: When is privatisation a good idea?

While a privatised company has every incentive to cut costs, it has no incentive to pass those savings on to consumers - as happened with the UK's British Rail break-up 

Privatisation can sometimes go awry, such as happened with the UK's British Rail. Jason Alden/Bloomberg
Privatisation can sometimes go awry, such as happened with the UK's British Rail. Jason Alden/Bloomberg

Saudi Arabia’s Vision 2030, as well as the visions of several other GCC countries, feature privatisation as a key policy instrument.

Although the diversification efforts that the Arabian Gulf countries are exerting are without global precedent, privatisation is a relatively mature policy domain, especially in the wake of former British prime minister Margaret Thatcher’s trailblazing wave of privatisation during the 1980s. What lessons should the Gulf countries keep in mind as they consider selling off state assets?

Before we explore the relevant recommendations, it is worth explaining what the Saudi government is looking to achieve by privatising state industries. There are two broad goals. First, the government wants to raise capital. The economic vision is predicated upon the need to develop new economic activities as alternatives to the well-established oil and gas sector and its downstream dependants. This requires investment both in physical and human capital, which in turn requires significant volumes of liquid assets upfront.

Borrowing is one potential source of the relevant capital but, given the uncertainty around the reforms, stemming from their unprecedented nature, lenders are understandably cautious, which increases the yield that they demand. Therefore, in a diversified capital-raising portfolio, it makes sense to combine borrowing with drawing down existing assets, including the selling of state-owned enterprises.

Second, the government wants to improve the performance of the organisations that it is seeking to privatise. The theoretical argument is straightforward. In a conventional company that is owned by private shareholders, the owners will demand that the company be run in a manner that maximises profits, which necessarily implies the elimination of wasteful managerial practices. To achieve this goal, they appoint a management team, who are then monitored by the profit-hungry investors and held accountable by them, on pain of being fired should their performance become unacceptably poor. Due to their having a direct stake in the company’s profits, shareholders are motivated to exert considerable effort in monitoring the activities of the management team.

When a company’s principal is the government, on the other hand, this motivation is largely absent because the civil servants overseeing the organisation do not benefit financially when its performance improves. Accordingly, they are unlikely to track the managers’ activities closely and are unlikely to acquire the expertise necessary to understand the technical aspects of the company’s operations, which may otherwise be exploited by managers to conceal poor performance.

While this line of thinking is essentially sound, and represents the thinking behind Thatcher’s bold privatisation policy, it omits a key link in the efficiency chain that was exposed spectacularly by some of the less successful examples of British privatisation.

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Read more:

Economics 101: how should Bahrain spend its oil windfall?

Economics 101: The coming trade war offers opportunities for Arabian Gulf countries

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In particular, while private owners are almost certainly better motivated than civil servants in weeding out inefficiencies such as over-hiring, excessive wages and overpaying suppliers; competition is usually required to ensure that private shareholders steer the company in a direction that serves the interests of consumers. Put differently, public monopolies are bad for consumers, but private monopolies might introduce alternative ways of harming consumers despite eliminating internal inefficiencies. What can go wrong?

The key risk is over-pricing as the private monopoly exploits is market position. Thus, while the company has every incentive to cut costs, it has no incentive to pass those savings on to consumers; instead, it might charge even higher prices than the public monopoly, while the shareholders laugh all the way to the bank. This is what happened following the privatisation of British Rail in the UK, the national railway provider: a series of regional monopolies were created, which correctly surmised that increasing prices was an easier way to increase profits than cutting costs.

The antidote, therefore, is to introduce competition where possible, as this forces companies to compete for customers by lowering prices and improving quality. The UK successfully did this in the telecommunications sector and today citizens of all of the Gulf countries are reaping the benefits of the UK’s experiment as Gulf telecommunications have been liberalised. Consumers can now threaten providers with switching to a competitor in the event of poor service, which motivates providers to deliver good service.

The problem with competition, however, is that you can’t always introduce it. In the case of activities that require huge amounts of investment, and where operational costs are small compared to those fixed costs, competition is inefficient because it requires duplicating investments. The best example is water: imagine the cost of having multiple water grids, and multiple sets of pipes flowing to each house. This is a key reason for the failure of British Rail’s privatisation: having multiple sets of competing railway lines is grossly inefficient.

Under these “natural monopoly” scenarios, the best practice is usually privatisation combined with a government regulator overseeing the private monopoly. Sometimes, this works well, as in the UK’s water privatisation program; others, such as the UK’s railway privatisation, still fail. Our next article will explore optimal regulation of privatised firms.

Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.