Tuesday, May 16, 2023

Public ownership or regulatory reforms

I started doing research on the ownership and regulation of network utilities in the early 1990s. Then in 1995 I went to the European University Institute to do my PhD and in 2000 I defended my thesis on “Privatized Utilities: Regulatory Reform and Corporate Control,” which you can read here if you are interested. After that, I spent two years and a half in the Regulation Initiative of the London Business School.

I see that the debate around these issues has not lost interest, although today there are new issues like climate change. A key topic today, like then, is whether the nature of ownership (public or private) is crucial to obtain good social results, or these can be achieved with regulation, one that can coexist with several ownership models.

Since the XIXth century until today, there has been a lot of diversity in the ownership structure of network utilities over the world. Public intervention in these industries, given the presence of naturally monopolistic segments, is widely accepted. Several authors in the economics literature have addressed the comparative advantages and disadvantages of private regulated network utilities vs publicly owned ones. The debate is about how best to correct or alleviate a market failure (natural monopoly) or achieve other social objetives (such as universal access), while at the same time securing necessary investments and providing incentives for efficient operation.

Laffont & Tirole (in their classic 1993 book on regulation, ch. 17) criticized the conventional wisdom at the time about the advantages and disadvantages of public vs private regulated ownership. They argued that the disadvantages of i) absence of capital market monitoring, ii) soft budget constraints, iii) risk of expropriation of investments, iv) lack of precise objectives and v) presence of lobbying,  are not universal in, or exclusive of, full public ownership. Similarly, the advantages of i) consideration of social welfare objectives and ii) centralized control, can be attained with appropriate contracts or regulation keeping private ownership.

Instead, they proposed to focus the discussion in one particular trade-off that arises from asymmetric information and incomplete contracts. Namely, on the one hand private regulated firms suffer from the conflict of interest between shareholders and regulators. For instance, each principal fails to internalize the effect of contracting on the other principal and provides socially too few incentives for the firm’s insiders. On the other hand, the managers of a private regulated firm invest more in noncontractible investments because they are more likely to benefit from such investments. Public Enterprise managers are concerned that they will be forced to redeploy their investments to serve social goals such as containing unemployment, limiting exports, or promoting regional development. The authors concluded that “taken together, these two insights have ambiguous implications for the relative cost efficiency of the public and private sectors; theory alone is thus unlikely to be conclusive in this respect.”

David Newbery (1999), in another important book, surveyed the history of network utilities in several regions of the world, and concluded that there is not much difference in terms of performance between a publicly owned monopolistic utility and a privately owned regulated monopolistic utility. 

Similarly to Laffont and Tirole (1993), Newbery (1999) pointed out that both private and public sector owners delegate operations in a board and a managerial team, which enjoy a degree of discretion. Government intervention is generally less costly under public ownership, but a promise not to intervene may be more credible under private production and may have positive incentive effects. But achieving this credibility is not straightforward: “The real case for privatization  must be that it is easier to sustain eficient pricing under private ownership in the face of political and populist pressures, and that privatization will generate additional efficiency gains.”

The differences in performance may come more from changes in the industrial structure, especially when some segments of the value chain can be opened up to competition: “Privatizing public utilities is primarily about ownership rather than control, since utilities can face remarkabky similar regulation under public or private ownership. Liberalization, in contrast, subjects utilities to market forces; it can induce more dramatic changes in performance than privatization alone.”

Tirole (2016) in his post-Nobel prize book on “The Economics of the Common Good” goes beyond his statements in Laffont and Tirole (1993) to argue that ”the conception of the State has changed,” from one of Producer of goods and services through public corporations, to a modern one focused on fixing the rules of the game and correcting market failures. Modern public finance textbooks reflect this evolution. Early editions of these textbooks or handbooks had chapters on “pricing in public enterprises,” which have now become chapters on natural monopoly pricing, admitting that regulated firms may be owned by private investors. 

Private firms in regulated sectors may deliver positive social outcomes, but only if some conditions are in place, mainly regarding adequate regulation. But beyond the objective empirical evidence, there has been a “backlash” in the public opinion of many countries. The late historian Tony Judt, in his celebrated last book “Ill Fares the Land” captures the discontent with privatization also in Britain when he criticizes the business oriented mentality of the new operating companies. Although countries like Chile, the UK or Spain were among the ones that privatized more firms in the 1990s, three decades later the controversy about the ownership of network utilities, and of water operating companies especially, has not disappeared. In an article in the Financial Times just yesterday, the prestigious columnist Martin Wolf echoed this controversy, and mentioned the interesting proposals made by an important expert, Dieter Helm, who has suggested radical regulatory reforms that are not mainly based on a focus on ownership.

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