Privatization: What is the role of a regulator (if any) in a privatization transaction?

[Response by Sanford Berg, May 2009]

In a privatization transaction, all the parties will be disappointed if assumptions made by the various stakeholders are inconsistent or the rules under which the privatized entity will operate are ambiguous. The regulator can provide a reality check on the numbers that the Finance Ministry is assuming and the numbers that the “winning” bidder is using. Stakeholders are entitled to their own views, but not to their own “facts”. Since the value of an asset is the present value of the future cash flows generated by the asset, the price, quantity, collections, technical and commercial losses all affect the value of the asset to potential investors. Different bidders may have different business models (and cost-containment capabilities). The greater the uncertainty regarding the nature of future regulatory and public policies, the higher the cost of capital is to compensate investors for the risks they are taking on. Thus, the regulatory rules, such as the price adjustment process (cost of service vs. price cap regulation), affect the discount rates used by potential investors as well as the expected cash flows from operations.

Policy Implementation: The decision to privatize involves public policy which is developed in a political context. The regulatory agency implements policy. As noted above, the value of a state-owned asset to an investor is determined by the expected net cash-flows. Those expected cash flows depend on a number of factors, many of which depend the nature of the regulatory process (citizen participation, keeping on schedule, etc.) and on how regulatory methodologies are applied (like the choice among price caps, rate of return regulation, or some hybrid). The following list identifies factors determining net cash flows:

1. Price (in fact, the entire rate structure for each customer class, including hook-up fees)
2. Number of customers in various customer classes;
3. Quantity demanded at that price;
4. Quantity actually delivered, so capacity to meet demand is important, as are line losses due to technical losses and theft);
5. Quality of service (since low reliability will be perceived as less valuable—affecting willingness to pay);
6. Percentage of customers paying their bills in each customer class (since some customers are politically powerful and others, like the Ministry of Education or Defense, may not have paid for service in the past);
7. Investment targets (since these represent obligations to make further investments which further raises the required cash flows and possibly the cost of capital if cost recovery seems problematic);

Citizen Expectations and Managerial Options: Citizens will have a diverse set of expectations. The current service price serves as an anchor for citizens who are now receiving service. Unless there is a strong political consensus that the SOE is grossly under-performing (and an awareness that the state cannot continue subsidizing service or deferring capacity investments), citizens are likely balk at any price increases. Customers are likely to view any price increases as stemming from the new owner needing to earn a return on their investment. Un-served citizens may be hopeful, but they, too, have some idea of the current price. If the government was unwilling to raise the service price so that so that gross revenues at least cover (true) operating costs, then potential investors in the SOE will be skeptical of the government’s (and the regulator’s) willingness to allow a price that will cover costs. Furthermore, if it is impossible to reduce the work force, then it will be difficult to cut costs as a technique for increasing net cash flows; excessive workers per customer or per unit sold characterizes many (but not all) SOEs. Thus, the new operator is in a bind if there are high network expansion targets, and few changes that can be made to reduce production costs or improve collections.

Objectives and Procedures of the Privatization: If the goal is to maximize revenues from the privatization, then promising investors that they will own an unregulated monopoly will maximize the bid for the franchise. Bidders would pay high amounts for a franchise monopoly with a long exclusivity period. Of course, the political sustainability of such an arrangement is likely to be low—resulting in higher risk to the investor (due to the uncertain duration of unregulated monopoly producing goods and services imbued with social importance). That risk would tend to reduce the bid, as the bidders apply higher discount rates (and shorter time horizons) to their estimates of future cash flows. Furthermore, maximizing the bid is not a reasonable objective. Other objectives have priority: network expansion and movement towards universal access would seem to be more appropriate objectives. That being the case, applying the funds raised through privatization to meeting social objectives would take pressure off the operator and increase public acceptance of the initiative. An alternative to accepting the maximum bid (with well understood regulatory rules) would be to seek the minimum price (and some price trajectory for a period) so the investors are focusing on cost containment. Of course, quality of service standards would need to be maintained. Furthermore, the possibility that there will be an excessively low bid arises. In all the above, the regulatory rules in place and procedures used to determine prices affect the bids. So the regulator is a government advisor with expertise that can be brought to bear when establishing objectives and evaluating bids. The agency also affects the perceived risks facing investors. Macroeconomic disruptions and improved information on operating conditions have led to renegotiation of contracts—an issue examined in a number of studies.

Resources

Regulating Publicly-owned water and sanitation utilities in developing countries: A report for the World Bank
June 2006.
NERA

Some Options for Improving the Governance of State-Owned Electricity Utilities
The World Bank, Discussion Paper No. 11, February 2004.
Irwin, T. and C. Yamamoto