Governance: What governance procedures promote strong performance in SOEs?

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[Response by Carol Balkaran, Sanford Berg and Maria Vagliasindi, May 2009]

The degree of centralization vs. decentralization seems to be nation and sector-specific. A single national monopoly may obtain scale economies for smaller countries, but regional (and municipal operations) may be more appropriate in larger nations. Telecommunications tends to involve national markets, electricity transmission is generally national, and electricity and water distribution is often local (and fragmented). Water, in particular, is typically decentralized. Whether the firm operates in competitive or monopoly market also affects regulatory strategies regarding corporate governance. SOEs must address internal and external issues—so, again, lessons from around the world can assist in sequencing the reform of SOEs. In addition, hard budget constraints and performance related pay can improve performance.

Vagliasindi (2008) identifies governance arrangements that can improve SOE Performance. The Abstract to her recent Report summarizes the main conclusions:

The aim of this paper is to shed new light on key challenges in governance arrangements for state owned enterprises in infrastructure sectors. The paper provides guidelines on how to classify the fuzzy and sometimes conflicting development goals of infrastructure and the governance arrangements needed to reach such goals. Three policy recommendations emerge. First, some of the structures implied by internationally adopted principles of corporate governance for state owned enterprises favoring a centralized ownership function versus a decentralized or dual structure have not yet been sufficiently tested in practice and may not suit all developing countries. Second, general corporate governance guidelines (and policy recommendations) need to be carefully adapted to infrastructure sectors, particularly in the natural monopoly segments. Because the market structure and regulatory arrangements in which state owned enterprises operate matters, governments may want to distinguish the state owned enterprises operating in potentially competitive sectors from the ones under a natural monopoly structure. Competition provides not only formidable benefits, but also unique opportunities for benchmarking, increasing transparency and accountability. Third, governments may want to avoid partial fixes, by tackling both the internal and external governance factors. Focusing only on one of the governance dimensions is unlikely to improve SOE performance in a sustainable way.

Impact of Politics: Political leaders do not want to disappoint citizens. They tend to want to be re-elected, which requires support from voters and from campaign contributors. That means that being explicit about targets and monitoring performance data can get a politician into trouble with voters. Thus, the issue of transparency arises. Benchmarking can overcome some information asymmetries, but that requires that management collect and regulators have access to information. Decision-makers can only manage what they measure, so lack of data can be taken as evidence of inefficiency. One source of inefficiency can be the lack of a hard budget constraint. Furthermore, the political economy of government suggests that when the benefits of a policy are garnered by a few and the costs dispersed across many, that the policy will adopted even when the costs outweigh the benefits or when the benefits disproportionately accrue to the rich and the powerful. That is not to say that the state does not or cannot act on behalf of the poor, only that many programs (including pricing infrastructure services below cost) tend to benefit today’s middle and upper classes in developing nations. If funds are not provided by the state for maintenance, future generations inherit production capacity that it dysfunctional.

Hard Budget Constraints: One of the key elements of incentive-based regulation is ensuring that the regulated company faces a hard budgetary constraint. This requires detailed scrutiny of the level of service and investment outputs that are actually delivered, as well as a limit on the resources that are available to deliver that level of service.

  • Regulators set price or revenue caps to create such constraints.
  • For a publicly-owned and operated utility, a hard budget constraint would mean that if the service provider were to spend the financial resources made available in a price determination without achieving the required outputs, then it should not be allowed to increase its borrowing to meet this shortfall (Byatt 2007).
  • The government (as shareholder) would be liable to meet the costs of remedying this through the public purse. Customers should not pay twice through rates for a promised benefit.

A hard budget constraint will tend to force the service provider to be more aggressive in collecting receivables (although disconnection may be delayed on public safety or income distributional grounds). In addtion, such constraints tend to link investment more closely to profitability and shift objectives from simply meeting output targets to making a profit as well. Ultimately, proper financial discipline is critical to ensuring that the service provider meets and out-performs the regulatory obligations. (Balkaran, 2008).

Internal Incentives: If there are no consequences when realistic targets are not met, then there is minimal pressure to perform at high levels. Identifying reasonable performance targets requires information about actual and potential performance. The first requires that the SOE provide appropriate data and the latter requires data from comparable infrastructure firms. In some cases, cross-country comparisons can be utilized to benchmark companies. Of course, the imposition of unrealistic targets reduces the credibility of the regulatory system and exposes the supplier to arbitrary enforcement activity.

Performance–related pay (PRP) ties managerial pay to company performance. PRP is an important component for ensuring that the service provider delivers on the regulatory contract, especially in the public sector context. The interests of management need to be aligned with the required levels of performance.

  • PRP ties managerial pay to company performance. In private organizations (for-profit), equity-based pay/stock options link remuneration to the company’s profitability. However, management pay can also be easily linked to quality, safety, service delivery or other aspects of the company’s financial performance.
  • To be effective, the financial incentives need to be both well aligned with the objectives set for an organization and of sufficient value to provide a real incentive to management.
  • In the UK, companies like Network Rail and Glas Cymru, which are subject to incentive regulation but do not have shareholders, have implemented PRP schemes to provide incentives to their managers to improve performanceThe schemes firmly tie the remuneration of managers to the performance of the respective companies. [Details in Balkaran, 2008].

Transparency: A single national SOE can be required to report data for different geographic divisions. Such information is required if the CEO is to identify high and low performing managers and to spot trouble areas—for reliability, customer satisfaction, uncollected bills, technical losses (like water leakage or electrical line losses), commercial losses (theft), and worker productivity. Uganda’s National Water and Sewerage Company publishes such data on its regional distribution companies on a monthly basis—providing information for yardstick comparisons. That information is also utilized in setting targets and providing bonuses for high performance.

Sir Ian Byatt (2007) underscores the importance of transparency and objective information for those regulating SOEs requires. The key words for him are competition, information, outcomes and incentives. He makes an important distinction between dimensions of performance:

Outcomes: “high level objectives delivered to customers, such as clean beaches, effective removal and disposal of sewage, and the provision of safe drinking water”,

Outputs: “the means of delivering these outcomes, involving the provision and operation of effective—and cost-effective—systems of pipes and treatment works”;

Inputs: resources utilized in the production of outputs. “The management of inputs is best left to the suppliers of the service. They need to be free to assemble the resources that they need to do the job, not to be constrained by restrictions on what they can pay their work force, or how, or how much, they can borrow for capital investment.”

Objectives: Citizens have two types of objectives—“as customers, and those of . . . guardians of the wider public interest. . . . In an open society, outcomes are the concerns of citizens as well as politicians.” Prioritizing objectives is one task of the political process—aggregating and translating citizen preferences for achieving particular outcomes. Strengthening accountability is seen as crucial if citizens are to be able to evaluate how well the political system is delivering on promises made by elected officials.

Accountability can be strengthened though performance monitoring system that incorporates a system of an independent “reporters”. OFWAT utilizes the services of “a reporter”, that is a consulting engineer to examine and scrutinize the information that is being submitted by a company. Publication of performance against targets should be an integral aspect of the monitoring system. It can be considered a “reputational mechanism” aimed at strengthening non-financial incentives on management.

 

Resources

Governance for State Owned Enterprise
World Bank Policy Research Working Paper 4542, 2008.
Vagliasindi, Maria

OECD Principles: summarized in Annex 2 of Vagliasindi (2008)
Regulating Publicly Owned Utilities: Outputs, Owners, and Incentives
Centre for the Study of Regulated Industries Occasional Lecture 20, 2007.
Byatt, Ian

Incentivizing a State Owned and Run Utility to Improve Performance—Possible Tools for Use by a Regulator
Working Paper, Regulated Industries Commission (RIC), Trinidad and Tobago, 2008.
Balkaran, Carol