Wednesday, June 30, 2004

The Ten Objectives of Privatization

By Dr Madsen Pirie (President, Adam Smith Institute), in Privatización in the Nineties. Edited by Dr Eamonn Butler. Adam Smith Institute. London 1992.

Lowering costs
Depoliticizing decisions
Better service quality
Better management
Labour relations
Wider share ownership
Restoring profitability
Replacing capital
Competition and choice
Keener prices

With the benefit of many years' experience available to us now, it is instructive to attempt a verdict on privatization by asking what governments round the world have sought to do seek to do through privatization, and how successfully it achieves those objectives. A survey of ten principal objectives will help us fill in this picture.

Lowering costs

When governments are motivated to privatize, it is very often because they are pressured by anxious taxpayers to reduce the cost burden of the public sector. So the first objective that one might cite is that of lowering government costs.

State industries cost money to run. They very frequently -- perhaps usually -- lose money and have to be supported with subsidies from taxpayers. In consequence, many governments who turn to privatization do not do so from rational conviction but from desperation. They are seeking some way to cut spending.

Fortunately, there are two ways in which governments do cut spending as a result of privatization. First, the private industries need no more subsidies, and so the annual amount being paid out from the Treasury can cease; and secondly, the proceeds of the sale go into the Treasury, That money can be spent on now capital projects, or even to reduce taxes and so generate growth.

The evidence is clear that privatization works on both counts, with governments saving money in both ways. The loss-makers are taken off the hands of the state, and are no more a public liability. If the privatization has been done properly they will normally make profits; but even if they do not, the loss is no longer the responsibility of the goverrunent and the taxpayers.

Because the sums involved can be quite large -- in the UK sales have generated more than jC35 billion for the Treasury since the programme started - every privatizing goverrunent worries how it can be sure to get the right price for its state concerns. But while you have a duty to taxpayers in this respect, you must also be conscious of the limitations of any such attempt.

In most circumstances, nobody knows what a state enterprise is worth. Few of them have ever kept proper audited accounts; most are so loaded with political and social obligations that nobody has the slightest idea what their real trading position is. So if you think you are going to be able to sell an enterprise for the 'right' price, resign yourself to probable failure. It is going to be a guess.

But at least you can take advice. And in the UK we are fortunate in having the best pi of essional advice the w orld has to of f e-r. Our mei chant banks, stockbrokers, and management accounting firms buy and sell companies every day, and we know that their guess will be a better one than that of any politician or goverrunent official. So we have privatized, so to speak, the process of privatization itself.

And you can always test the water by selling just over half the company in the first instance. Then the market will reveal what people really think the company is worth. If you have guessed the price too low, you can make it back again when you dispose of the residual shares at the market price some time later.

Thus, when we sold British Telecom, we put only 51.2% of the stock on sale. More recently, we have been selling off the rerinainder in tranches of around 20% - and have been getting more money from those than we did from the original sale, because the value of the company has gone up in the meantime. Now everyone can see its real worth more clearly than they could when it was in the public sector. So remember that you can always recover some of the value on the sale of residual holdings.

Depoliticizing decisions

Another aim of privatization is to make industries commercial instead of political: to take them out of the control of goverrunent and into independent management.

This means that they have to raise their capital on the market, based on their long-term commercial prospects -- rather than on the basis of how hard-pressed finance ministers are able to juggle the many competing political claims upon government resources.

That in turn makes the enterprise much easier to manage. A corporation in the state sector, when it decides to expand, may well pick the most commercially viable site. But it will then have every politician in the land telling it that the new factory should go in his or her constituency instead. There will be delays and horse-trading: and eventually it will be those who can exert most influence on the government leaders who will decide the result. But once the corporation is privatized, this politicization fades away. Decisions can be made more quickly, and on a straightforward commercial basis.

The key recommendation here is that government must be prepared to let go. You would be astonished how many countries try to privatize an industry and yet keep a residual control over it, so they have some influence over its appointments, over its expansion decisions, over its commercial activities. That is not a real private company. If you want to gain all of the benefits of privatization, including commercially sound management, you must be prepared to let go.

Better service quality

A third aim of privatization is to achieve an improved quality of service. A company in the private sector will have to respond to its customers. It will have to become more efficient. It will have to keep its product attractive. Its customers will no longer be the captive taxpayers supplied en bloc by the state; instead they will be people who have choices, who might be attracted to other products, who have alternative ways of spending their money, and must be attracted to spend it on the company. If it faces the threat of competition, it will have to keep ahead of other suppliers or it will risk commercial failure.

In less competitive areas, this improved quality can be achieved by regulators who are specifically charged to ensure that the quality of service is improved. But regulation is very much a second-best: competition is the best regulator.

If there are continuing disputes about the quality of service that is being achieved, you can consider introducing more competition later on. Perhaps the best example from the UK was from our telephone boxes; after privatization, there were still complaints that large numbers of these payphones were out of action and had not been repaired. The regulator told British Telecom to get them
working. But he also licensed Mercury, the competitor, to enter the payphone business; and from that moment, all of the British Telecom boxes were working again. It really is true: competition is the best regulator.

Overall, the clear conclusion is that privatization has been a huge success in terms of quality standards. Privatized firms are generally more attentive to customers, and have better quality control. In too many cases, they could hardlyfail to be an improvement on what the state sector has delivered previously.

Better management

A fourth objecfive of privatization is to have industries better managed. It implies no insult to any civil servants to say that their profession, on the whole, does not make ideal managers of private industry. It is constructed on a different basis, and its rewards derive from different achievement standards.

For example, in the civil service, it is typical for seniority to count much more than in private business. And rewards usually reflect the size of your staff -- that is, the greater your office, the more that it spends, then the more important you are and the larger your salary will be. In the private sector, by contrast, ambitious young managers can be promoted because they have been able to cut down departments and save on expenditure. There is a wide cultural divide, and the best managers in the one system do not necessarily make the best managers in the other.

Fortunately, we found in the UK that privatization itself does help close the gap. The same people who behaved one way as civil servants can be transformed when they are exposed to different pressures. Once they are in the private sector, they begin behaving like private sector managers. Once they acquire the freedom to manage, we see their standards of efficiency rising, more responsiveness to customers, decades of state attitudes slipping from their minds.

There was never any question that management was better in the private sector; but now we know that privatization itself produces this effect. You do not need, ill other words, to find all of the ideal managers for your state industry before it enters the private sector. But you do need to get the right person at the top. Get the right person in charge, ahead of privatization, and the rest will sort themselves out. Working in the private sector will rapidly show the value of ambitious and effective managers. The fime-servers from the old regime will be quietly shuffled into high-sounding but lowpower positions.

Labour relations

The fifth objective of privatization is better labour relations. The public sector in every country in the world is notorious for strikes. This is because it is very much easier for public sector employees to get governments to give in by putting pressure on the general public. The withdrawal of essential services, or the threat of it, makes governments nervous for their popularity and much more ready to concede than a private sector firm would be. The private sector firm risks going broke, so costly strikes are obviously self-defeating. Governments do not, for the most part, go bankrupt. There are fewer strikes after privatization.

Good employee relations are helped by worker co-ownership: by the allocation of part of the value of the company to the workers. Workers receiving dividends and watching the capital appreciation of their own shareholdings are reluctant to strike against themselves. But there is also the fact that a private sector firm tends to consult its workforce more, and to listen to their real objectives. Also, when we move from a state industry to the private sector, new incentive bonus structures can be introduced, so that ambitious and capable employees are able to get ahead and to earn higher rewards than they would be under civil-service payscales. All this leads to better labour relations.

Accordingly it is wise to set aside 8'Yo-10% of the value of the firm for the workers. In the case of British Gas, we introduced the principle that the longer you had served with the firm, the more shares you were allowed to buy. This broadly corresponded with the workforce's own view of fairness. But remember that taking 8%-10% of the shares and letting the workers have them at half price or less costs you absolutely nothing at all, because any company in which workers own some of the shares is worth more than a company where they do not. It will have fewer strikes and will be more productive: so the shares wl-dch you do sell to the public will then be worth more, and the difference will be more than what it has cost you.

Wider share ownership

Another aim of privatization is wider share ownership, diffusing property ownership more widely in society. TWs'popular capitalism'is of course aided by popular share issues. In the UK we have taken it further by allowing the general public to buy on
credit (so that they do not have to subscribe the whole price of their shares at the outset but pay only one-third now and the rest in later years), by special shareholder benefit schemes, and by massive advertising campaigns. The result has been that we now have over three times as many shareholders as we did before the privatization movement.

But not every privatization issue is right for every investor. You may happily encourage small savers to bring their money out from the tin box under the bed in order to buy utilities or blue-chip companies. But you would not want people putting their life savings into the oil industry or the aerospace industry, for example. So when we are selling companies in high risk sectors, typically we arrange the sale in a way which appeals only to professional investors. You might have to buy a minimum of 1,000 shares, or they might be sold by the method of tender rather than by fixed price sales.

Restoring profitability

The seventh aim of privatization is to turn losses into profits. Some governments try to sell an industry and impose so many conditions upon the private operator -- that he or she shall employ exactly the same number of workers under exactly the same conditions of employment and so on -- that it is not really a private sector operation at all. It is effectively being run by proxy on behalf of the government. This is a mistake: one should never forget the remarkable power of the private sector to turn losses into profits by finding its own way to do the job better.

When we privatized our National Freight Corporation, the profits came on the first day. Every employee of that company knew well what was wrong with it before, so from the day it became a worker-owned privatized firm, the old habits ceased immediately. They earned their reward when NFC was floated on the stock market seven years after they bought it; each one gained 100 times what they had paid for their initial shares. Overwhelmingly, privatization has turned such loss-making state industries into profitable private sector ones.

There are two recommendations relevant here. One is to do any slimming down ahead of the sale; that is, there should be a preparation period in which those who will be the new management are put in charge and in which restructuring can proceed, ahead of the actual privatization. This enables the company to get ready for life in the private sector, with morale high, and greater chance of making a success of things than if they had to spend the first two or three years in bruising internal confrontations.

The second point is to be prepared to write off debt. Naturally, governments who have 'invested'millions in state industries over the years want some of it back. But governments don't invest, they spend. They like to say they are investing, but really they are spending on political priorities. Most of the money'invested'in prestigious but unviable job-creation projects is in fact lost forever: you cannot get it back because it has been spent, and is gone. The moment governments realize that they are generally unlikely to get back their past investment, the easier it is to turn the enterprise into a properly corporatized potential profit-maker.

Replacing capital

The eighth motive for privatization is to recapitalize run-down state industries. As we have seen, there are always other important claims upon goverrunent resources. It is always easier for governments to give in to the very visible demands of public employees, pensioners or welfare claimants, even if this means postponing essential projects in state corporations. Capital spending is not as urgent politically, and state corporations can always be told to make do with their existing capital stock a little longer. That is why the buildings and equipment of the public sector all over the world tend to be run-down and out-of-date.

There are two ways of recapitalizing. One we call asset enrichment -- in which, when the government corporatizes, it deliberately endows the operation with assets that it can exploit in order to re-equip. Thus the British Ports Authority, privatized in the early 1980s, was sold with land assets that could generate enough money to recapitalize the docks with the modern equipment necessary to make them viable. It worked superbly and they have been profitable ever since.

More recently, we have imposed upon some privatized companies a requirement to recapitalize, and have built into the price structure the means to do it. For example, our water and electricity industries were reckoned to be very seriously undercapitalized at the time they were sold. We have to replace the mains and sewers for the water services and we have to replace the old and dirty power stations which burn sulphurous coal rather inefficiently. So we placed an obligation upon these companies to recapitalize, and included in their price structure a factor which allows them to raise the necessary money from their
customers.

In this way it is possible to recapitalize even badly run-down public sector industries, though it does need to be given enough time to work. You may have to build into the privatization measure a ten-year programme of recapitalization.

Competition and choice

Privatization can introduce more competition. The more experience of privatization that you have, the more confident everyone is about the process, the more choice and competition you can introduce. It can be a difficult process, involving the break-up of monopolistic state corporations. In the UK we privatized our gas industry in one piece and perhaps regretted it afterwards; but later we broke up the electricity industry so as to produce at least some competition into power generation right from the start.

Often we introduce the competition first and then privatize afterwards. We did this with our National Bus Company. We allowed private operators to compete; National Bus responded to the challenge by raising its own standards and improving its own services; and then it was very easy to privatize the business afterwards. That is also the course that we have chosen to follow with the railways and with the Royal Mail.

Even if you privatize an industry with much of its monopoly power intact, however, you can always introduce competition at a later stage. When you privatize, you can specify that a thorough review will be made a few years later on, in order to see whether further competition may be justified. Thus at the end of our seven-year review period on British Telecom, the government decided to license an additional six competitors to be added to the two, Mercury and Telecom, already in the field.

Keener prices

The tenth aim of privatization is keener prices. The state sector is notoriously bad at containing its costs: passing them on to customers is just too easy when customers are captive.

If privatization is used to introduce competition, that in itself will put a downward pressure on prices. A competitive industry has to root out inefficiencies and keep costs down, or its customers will desert it.

Even if the privatized corporation is left with a degree of monopoly, it is still possible to give some protection to customers through price-capping. In the UK we use a formula based on the cost of living index, called RPI-X. Our regulated utilities are obliged by law to reduce prices every year, under that formula, by a certain percentage below the rate of inflation. It can be reviewed regularly: in Brifish Telecom the price-cap started at 3% below inflation, then it went on to 4.5%, then 6.25%, and now the limit is 7% below inflation.

Conclusion

These are ten key objectives of privatization; and the score in the United Kingdom has been ten out of ten. We did better on some points than on others, and did better in the later years of the programme, as we gradually learned more about how to achieve our objectives. Privatization does achieve all of those objectives listed, but you have to work at it. It is not always easy, but it does work and the process can be learned.

In the UK we have, I think, probably the best concentration of privatization expertise in the world. We hope that other countries will learn from our experience, and the experience of other nations which have privatized, too. There is no need to make yesterday's mistakes over again today. The best teacher is experience, and those who try privatization have learned a great deal about how to do it well, in a variety of different circumstances.

It is a joy to see privatization done well, because it can bring so many benefits to so many people. This is why privatization has undoubtedly earned and thoroughly merited its place in the economic history of our time.


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