Impact of Privatisation on the Poorest in Society

Topic: Discuss the view that ‘privatisation is bad for the poorest in society’ – refer to specific developing country examples, and explain the role of regulation.

Introduction

Since the early 1980s, Privatisation has been pursued by many developing countries. This pursuit was often the result of Privatisation being a condition for granting of much needed aid funds. However, there were instances in which governments simply could not afford to keep subsidizing State Owned Enterprises (SOE), and were unable to find the capital needed for expansion. Hence, Privatisation gained favour as a means to reduce subsidies, utilize private sector capital to fund expansion, and even benefit from revenues raised by divesting assets, and in the longer term from tax revenues from the now private enterprises. These cost savings and revenue additions may then be used by governments to fund social spending to society’s benefit, moreso the poorest. Notwithstanding, Privatisation can also have a negative impact on the wider society, especially the poorest, contingent on how it is gone about. For instance, it may leads to retrenchment and unemployment, or worsening of distribution if the process is undermined by corruption, and state assets gifted to small band of actors.

Hence, it is important to examine the effect of Privatisation on developing societies’ poorest. The timely establishment of an effective regulatory environment can contribute significantly to how successful Privatisation is, both in terms of equity, and post-Privatisation firm performance. In this essay, theoretical arguments on the merits and demerits of Privatisation are first examined, after which three country cases are investigated, in the context of regulation’s impact on overall outcomes in Privatisation. Recommendations and Conclusions complete the exercise. Privatisation of public utility and infrastructure enterprises is the primary focus herein.

Literature Review

Privatisation became the caveat of most international lending institutions, after the World Bank voiced dissatisfaction with the performance of public sector enterprises, especially those of Africa. Privatisation became seen as a way to sustain the gains from public sector reform programs, because of how difficult it is to reverse. (Bayliss, 2002).

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The World Bank (2000, p. 144) also assert that the provision of utilities such as power, water, and telecommunications requires immense investment. Privatisation provides a means for much of this funding to come from the private sector. Additionally, private sector development should lead to increased revenues accruing to the state, through taxation and the sale of assets, as well as through the reduction of the obligation to invest in utilities provision.

Bayliss (2002) posits that private sector development indeed aids economic growth, which is a prerequisite for poverty alleviation, but claims there is no guarantee that Privatisation would lead to private sector development.

Nonetheless, Bayliss (2002) posits that Privatisation can yet significantly impact poverty, because of it usually being a condition tied to aid funding release.

International financial institutions such as the World Bank and the IMF (International Monetary Fund) have historically ignored poverty impacts of Privatisation. This poverty impacts slight is noteworthy, given the prominence of Privatisation in the structural adjustment programs these institutions once championed; programs aimed at alleviating the economic burdens of poor and heavily indebted countries.

However, around the dawn of the 21^st century, there was a shift to greater emphasis, at least nominally, on the effects of Privatisation on poverty. This shift is evident in the World Bank’s move from structural adjustment to poverty reduction strategies, and the IMF’s replacement of Enhanced Structural Adjustment Facilities (ESAFs) with Poverty Reduction and Growth Facilities (PRGFs), in 1999. (Bayliss, 2002)

Notwithstanding, Bayliss (2002) argues that the policies of these international financial agencies remain staunchly neo-liberal in their orientation, prioritizing a market-oriented economic approach. The characteristics of the new poverty-centric programs remained strikingly similar to the previous structural adjustment ones. The motivation behind these neo-liberal policies was the belief that the pursuit of macroeconomic efficiency goals will see a concomitant reduction in poverty.

Cook and Uchida (2001) Argue that, contrary to the international lending agencies’ belief, the impact of Privatisation on poverty is yet to be established empirically.

Birdsall and Nellis (2003) also challenge the rationale of international development financing institutions, and opine that the overarching goal of Privatisation is to secure efficiency gains. Any consideration of the distributional and poverty impacts of said Privatisation are addressed only in the context of making Privatisation more politically palatable. They argue that distributional and poverty issues are addressed specifically through fiscal actions of government, such as spending and taxation, as well as regulation.

In Privatisation, distributional effects pertain to the welfare impacts on different income groups or households. These groups would be affected through the price levels they face, access to services, and their income streams, all variables affected by Privatisation.

Birdsall and Nellis (2003) employ a framework that juxtaposes the divergent pursuits of distribution and equity, through an efficiency-equity trade-off. The framework posits that a perfectly competitive economy operating at its production frontier, can only efficiently redistribute resources through lump sum transfers which do not affect incentives, prices, and other economic considerations. Ceteris Paribus, a movement along the frontier in the direction of greater efficiency will necessarily result in reduced equity and vice versa. (See Figure 1 in Appendix). However, the economies of most developing and transitioning countries do not operate as efficiently as the more industrialized developed nations; they do not ordinarily operate very close to their production frontier.

Hence, the dual goals of increased economic efficiency and increased equity may be simultaneously pursued (See Figure 2 in Appendix). This implies that in developing countries, Privatisation can be a win-win for private interests and society’s poorest.

The distributional impacts of Privatisation depend on the nature of the enterprises being privatized. If the privatizing enterprise provides a utility service, then there are potentially great impacts on the quality of lives the poor lead, since access to these services would be controlled by private hands, whose primary motivation is profit maximization. Hence, examination of Privatisation’s distributional impact is essential to determining whether Privatisation helps alleviate, or exacerbate poverty (Bayliss, 2002).

Birdsall and Nellis (2003) identify three determinants of the distributional impact of Privatisation; the initial conditions, the sale event, and the post-Privatisation political and economic environment. They also caution that the distributional impact of Privatisation may be determined by the juncture at which the impact was measured. Hence, generalizations about the distributional effects of Privatisation across countries and over time are difficult. It is necessary for such conclusions to be influenced by case examinations of events before, during, and after Privatisation, in the context of the political and economic environment in which events unfolded. With that being said, there is evidence that Privatisation in developing countries can often both increase efficiency and equity, depending on how effectively post-Privatisation considerations such as regulation and competition are addressed.

Unfortunately, due to its frequent placement as a conditionality for aid funding disbursement, Privatisation is often rushed in developing countries. Competitive processes such as bidding are often flouted, and the formation of a robust regulatory environment in a timely manner, neglected. Emphasis is placed on ‘securing the deal’ vis a vis ensuring the interests of all stakeholders are protected (Bayliss, 2002).

Privatisation and poverty

Bayliss (2002) argues that Privatisation may adversely affect the poor because of the profit motivation of private investors. This may result in investors ‘cherry picking’ which aspects of a utility service to invest in, and which customers to serve. For instance, high value customers may be readily served, but expansion of service to poorer communities could either be lethargic or non-existent altogether. Hence, improvement of the living standards of the poor may be stymied by private profit interests.

Also, donor funded Privatisation is often accompanied by subsidy removals, since the goal is to engender fiscal sustainability. These subsidies may have been serving the purpose of keeping prices low. Hence, from a utility service perspective, removal may mean a hike in tariffs so that the entity may be economically viable for private investors (Bayliss, 2002). In addition, poor residential areas may not have the necessary network infrastructure to facilitate utility service delivery. Further, the installation of such networks can be prohibitively costly. Thus, the poor face continuous exclusion because of their inability to afford the set-up/connection tariffs. (Bayliss, 2002).

Birdsall and Nellis (2003) have a more optimistic disposition on Privatisation’s impact on access. They posit that Privatisation of utilities often leads to a rapid increase in access, especially for the urban poor; the rural poor usually face continued exclusion even after Privatisation. This increase in access results from the strategic decision of private interest to expand market reach, in order to boost revenues. Another potential reason for post-Privatisation expansion is the inclusion of service and network expansion clauses in the sale contracts to private investors. From a Latin American perspective, Privatisation in all of Peru, Mexico, Argentina, and Bolivia, resulted in increased access to the poor (Birdsall and Nellis, 2003). In cases where an increase in access isn’t followed by steep increases in price, Privatisation has a positive distributional impact.

However, Birdsall and Nellis (2003) agree with Bayliss (2002), in acknowledging the potentially hazardous effects of Privatisation-related price increases on the poorest. Such increases usually result either because it is imperative for the private owner to hike tariffs to levels that allow cost recovery, or because of poor and ineffective regulation. Steep price increases worsen distribution in the society, and increase inequity, as was the case in Peru (Birdsall and Nellis, 2003). In addition, post-Privatisation crack downs on illegal connections represent a significant welfare loss to society’s poorest, assuming they used the majority of the illegal connections. This was evident in the Case of Argentina, where 436,000 of the 481,000 new electricity subscribers were from those who held illegal connections prior (Delfino and Casarin, 2001, p. 23).

Most empirical evidence suggests that Privatisation very often results in labour retrenchment and an increase in unemployment, at least in the short run. The tendency is for private investors to maintain the same level of output with less staff, in an environment sans trade unions (Bayliss, 2002).  

As it pertains to employment, Birdsall and Nellis (2003) noted a study of 308 privatized firms, in which 78.4% of them saw post-Privatisation reductions in their staff complement, with only 21.6% of them recording either no job losses or job gains. It was concluded that in a general sense, the net effect of Privatisation on distribution of income is negative, at least in the short run, thereby affirming the submission of Bayliss (2002). Birdsall and Nellis (2003) also note that Privatisation is usually accompanied by an increase in working hours, reduction in fringe benefits, and vitiation of the security of tenure.

Lower skilled, lesser paid employees may likelier be retrenched than higher paid, more skilled workers. Even in the event that higher paid employees are retrenched, they may find it easier to secure alternative, high paying employment, than their lesser skilled counterparts. In the event that the aforementioned occurs, poverty and inequality may increase.

Notwithstanding, Privatisation advocates argue that restructuring and the resultant job losses are a temporary cost, which would be repaid handsomely in the likely event that Privatisation and economic reform lead to increased efficiency, output, investment, job expansion and economic growth. Previously unemployed, low skilled workers may then regain employment, at better rates. The long term socioeconomic effect would be reduced unemployment and poverty, developments that would be especially beneficial for the poorest in society (Birdsall and Nellis, 2003)

Developing country governments often have inadequate social safety nets. As a result, de facto measures such as allowing of illegal connections, and having an inflated public sector staff complement are common. These are practices stridently criticized by aid funding agencies such as the World Bank and the IMF. However, the eschewing of such practices through Privatisation and other structural adjustment initiatives, represents a significant welfare loss to the poor (Bayliss, 2002).  

According to Birdsall and Nellis (2003), if the assumption that private ownership results in increased efficiency holds, then Privatisation can increase the returns to physical capital, or profits. This increase can serve as a powerful incentive to engender greater entrepreneurship, and the attendant benefits of increased employment, higher incomes and innovation. However, if private interest focuses more on ‘asset stripping’ than efficiency and innovation, the effects could be negative, due to reduced profitability and firm closures. Megginson and Netter (2001), in a review of 65 empirical studies that ranged across many sectors and countries, asserted that privately owned firms are more profitable and efficient than their state owned counterparts.

In the short run, Privatisation effects government revenues through the receipt of funds from the sale of assets. However, it is in the longer term that more substantial, lasting benefits are accrued, such as increased tax revenues, and savings from no longer having to subsidize state owned firms. Given that public expenditure in developing countries is usually progressive, the savings and revenues that result should lead to some amount of spending that benefits the poor.

 From a Fiscal standpoint, Privatisation may affect the level of income in an economy through a differential reduction in the society’s tax burden, and increase differential benefits through greater expenditure on services such as education and healthcare, with funds previously allocated to subsidies. The additional funds to education and healthcare could also have been accumulated through tax revenues from now private enterprises. These benefits would likely benefit the poor on a greater scale than the rest of society (Birdsall and Nellis, 2003).

Privatisation and Regulation: Case Studies

Regulation is a critical element of Privatisation. According to Bayliss (2002), a weak regulatory environment, or the absence of regulation altogether, debilitates to the government’s ability to sanction private sector excesses, and creates a pathway for market abuses.

Bayliss (2002) asserts that “it is not privatisation that will develop the private sector; rather it is the government, through effective regulation”. Birdsall and Nellis (2003) conform to the above assertion and claim that “The better the regulatory regime, the better has been the distributional outcome from Privatisation of electric power, telephones, water and sanitation”.

Cook (1999) notes that Privatisation does not necessarily lead to competition, because new entrants may not be able to achieve the economies of scale necessary for successful integrated service provision, such as for telecommunication and power generation services. Hence, regulation plays a critical role in preventing exploitation of consumers by monopolies, while simultaneously encouraging efficiency of those entities.

Types of regulation include price caps, which stipulate a maximum price that a service provider can charge. Other types of regulation include rates of return and profit caps (Cook, 1999). According to the World Bank (1995), price cap mechanism have been instituted in the telecommunication industries of Argentina, Mexico, Venezuela and Malaysia, while Chile adopted profit benchmark regulation. Jamaica adopted a rate-of-return approach to the industry’s regulation.

Newbery (1994) establishes two criteria for judging the effectiveness of a regulatory regime; the extent to which it allows a utility to raise finance for investment at an acceptable cost, and the extent to which it provides incentives for efficiency in operation, pricing, investment and innovation.

Cook (1999) notes that it is an uphill task for developing countries to implement regulation which effectively governs prices, service quality and competition. Conversely, the Privatisation aspect is usually much easier, as monopolies and anti-competitive practices are commonplace in developing countries.

The three case studies below, concerning Privatisation in Venezuela, Argentina and Chile, were referenced from Cook (1999), to investigate the extent to which these countries’ paths to Privatisation conformed to theoretical prescriptions.

Venezuela – Telecommunications

In the Case of Venezuela, State-Owned CANTV provided telecommunications services from the early 1950s, when it was nationalized. During the 1980s, there was a halt in service expansion despite increasing demand, and a reduction in service quality. Despite spiraling costs during the 1980s, tariffs remained stagnant. The result was a decline in financial performance, and a state of affairs whereby only 47% of the demand for new connections was met. There was also a waiting period of 8 years for applications for new connections, 50% of public phones were non-functioning and 19% of international calls succeeded.

The telecommunications company underwent Privatisation through a process of competitive international bidding, and was bought by an international consortium comprising both local and international investors. A 40% stake was purchased for $1.885 billion, which came with the rights to appoint 5 of the 9 board members. In a bid to make the sale more palatable, the government of Venezuela agreed to assume 500 million dollars in Long term debt and interest fees.

Two steep increase in tariffs just before Privatisation meant that the rate per line increased from $275 in 1990 to $500 in 1992. Clear performance targets were established in the sale contract, and a regulatory body (CONATEL) set up to monitor the achievement of objectives.

CANTV’s early post-Privatisation performance was deemed successful. There was an expansion target from 1.6 million lines in 1991 to 4.4 million by 2000. A preliminary target on the way to that ultimate goal was achieved in 1993. During the 1992-1993 period, 413,000 new digital lines were installed and 210,000 new customers were recruited. 18,400 new lines were installed, and the amount of lines out of service fell by 70%.

Chile – Electricity

Before Privatisation, electricity generation in Chile was done by a vertically integrated monopolistic company. High transmission and distribution losses, and power outages were commonplace. There was regulatory agency, but it was not politically independent. Government was required to provide enormous subsidies to the sector to ensure its continued existence. This figure reached levels of approximately US 200 million, at about the 1970s.

Chile astutely undertook regulatory reforms prior to electricity Privatisation, so that when it came on-stream between the 1986-1989 period, there was already the institutional framework in place to govern generation, transmission and distribution of electricity. These oversight duties were to be performed by a special regulatory body called the CNE. In addition, competition was encouraged by breaking up the vertically integrated monopoly into smaller service providers along the value chain. This entailed having separate companies for generation, transmission and distribution.

Post-Privatisation, electricity prices in Chile were regulated based on customer size. Distributors were allowed to freely negotiate prices with large consumers, with demand of more than 2 megawatts. Prices for smaller users were regulated by the CNE, as a means of protecting the welfare of those without tremendous economic clout. Electricity Privatisation in Chile led to efficiency gains, improved service quality and reduced prices. The cost to consumers in 1981 was more than the level at 1989, suggesting that efficiency gains were passed onto consumers. The electrification drive gained momentum with the advent of Privatisation, such that, by 1989, 97.9% of Urban Households and 62% of rural ones had access to electricity. It was concluded that the benefits accruing to all stakeholders in the electricity sector of Chile were attributable to regulatory reforms, as opposed to Privatisation itself.

Argentina – Water

As at 1947, coverage for water distribution in Buenos Aires (Argentina) stood at an impressive 97% of households. However, the state owned enterprise responsible for water at the time, found it difficult to meet increasing demand as time progressed. By 1980, less than 60% of households had a water connection, and water quality was spiraling downwards.

The government of Argentina decided to privatize as a means of increasing efficiency, and to pursue the expansion necessary to fulfill burgeoning demand.

However, before this was undertaken, the necessary regulations were formulated, to protect the interests of both the investors and consumers.  These regulatory undertakings came at a cost of US$4 million dollars, and took more than two years to complete. Finally, in 1993 the government auctioned the water service delivery.

The winning investor agreed to reduce prices by 27% from levels under public ownership, while investing US200 million annually over the first 5 years. This figure represented an astronomical increase from the levels under public ownership, which ranged between US20 million to 40 million. Stipulations regarding expansion targets were included in the service contract. After taking over the reigns, the private investor embarked on a process to streamline operations and reduce costs, which saw a 45% reduction in staff.

Discussion

In each of the aforementioned cases, trying economic circumstances preceded Privatisation. The circumstances bore implications on access to, and quality of service in all three cases, as well as fiscal implications, as seen with the enormous subsidies in the case of Chile. In all three cases, the governments’ rationale for Privatisation centred around increasing efficiency, reducing fiscal burden, and pursuing the needed investment capital for expansion.  

All three countries were prudent in ensuring regulatory infrastructure was in place before embarking on Privatisation, so that there would always be a watchdog to ensure equity prevailed, and incentives for efficiency and performance were provided. This regulatory step was in line with the recommendation of both Birdsall and Nellis (2003) and Bayliss (2002). The implementation of these regulatory regimes wasn’t a costless task; in the case of Argentina, it came at a price of US4 million and two years. However, it was a small price to pay in the grand scheme of things.

The state’s intention to optimize revenues from the divestitures was evident in all three cases; each country undertook a competitive process to effect the sale.

As it pertains to access, again each country ensured that the interest of the poorest wasn’t subordinated to private ownership’s profit interests, through the use of sale contracts. These contracts stipulated specific expansion targets, so as to ensure increased access, moreso to poorer communities. However, the concern of continued rural exclusion to access, as outlined by Birdsall and Nellis (2003), was evident in the Chilean experience.

With respect to prices, in Venezuela’s case, the common practice of effecting a price increase just prior to Privatisation, was employed. The likelihood of such an outcome was addressed by both Bayliss (2002) and Birdsall and Nellis (2003). This was probably done as an inducement to potential buyers. In the other two cases, consumers saw a price reduction after Privatisation. One instance was due to increased efficiency, and the other through Privatisation negotiations.

Overall, in the three cases presented, Privatisation attained the objectives set out. The attainment of these objectives was directly attributable to the prior creation of regulatory environments, which promoted equity and, wherever possible, competition. However, there were costs to be borne, such as the cost of regulatory establishment, and job losses. In the case of the latter, standard operating procedures of Privatisation suggest it wasn’t an altogether surprising outcome. The extent to which these short term costs will be indemnified depends the long term performance of the now private enterprises, and the ability of the retrenched to find alternative employment of comparable or superior compensation. In addition, government may have a role to play in providing assistance to the now unemployed, until they manage to secure another job.

Recommendations and Conclusion

In conclusion, there is no straightforward proclamation one can make, as to whether or not Privatisation is bad for the poorest in society. Whether or not it is, depends on the initial conditions prior to Privatisation, how the process of Privatisation was undertaken, and the political and economic environment that prevailed post-Privatisation.

Regulation and competition, rather than Privatisation, lead to private sector development and an environment in which equity prevails. There are cases where natural monopolies result from Privatisation, because of significant barriers to market entry, such as economies of scale. In such instances, it is even more important to ensure that robust and autonomous regulatory institutions are forged prior to Privatisation. This way, the price and expansion decisions of the investor will align with the social goals of increased access to the poor, and ensuring prices are not beyond their reach. In order to yield optimum benefits from Privatisation, the following recommendations are suggested:

• The transfer of assets from state entities to private hands should be a transparent exercise, undertaken through a process of competitive bidding. This way, the state will get the best deal possible.
• Effective regulatory bodies should be established before the Privatisation sale, to ensure prices and service quality of private firms are fair, and to promote competition where possible. A regulatory authority may also serve to ensure tax compliance of the newly privatized firm. The tax revenues from the now private entities could greatly aid government’s ability to fund anti-poverty social programs. Such programs may even be of benefit to victims of Privatisation, who lost their jobs as newly privatized entities restructured.
• Additionally, sale contracts for utilities should ideally contain service expansion and price control clauses, so as to ensure increased access and affordable pricing for the poorest in society. In addition to protecting the interest of the poorest, price controls may serve as an incentive for the now private firm to be as efficient as possible, thereby maximizing their profitability. Profit maximization of these firms is likely to result in business expansion, thereby having a positive impact on utility services access to the poor, and tax revenues which government can use to fund anti-poverty initiatives.

References

1. Bayliss, K. (2002). Privatisation and poverty: The distributional impact of utility privatisation. St. Louis: Federal Reserve Bank of St Louis. Retrieved from https://manchester.idm.oclc.org/login?url=https://search.proquest.com/docview/1697510149?accountid=12253
2. Birdsall & Nellis (2003). Winners and Losers: Assessing the Distributional Impact of Privatisation. World Development, 31(10), pp.1617–1633.
3. Cook, P. (1999). Privatisation and Utility Regulation in Developing Countries: the Lessons So Far. Annals of Public and Cooperative Economics, 70(4), pp.549–587.
4. Delfino, J. A., & Casarin, A. A. (2001). The reform of the utilities sector in Argentina. UN University WIDER Discussion Paper No. 2001/74, June.
5. Megginson, W. L., & Netter, J. M. (2001). From state to market: a survey of empirical studies on Privatisation. Journal of Economic Literature, 39(2), 321– 389
6. NEWBERY D. (1994). Regulatory Policies and Reforms in the Electricity
7. Supply Industry’. DAE Working Paper No. 9421, Cambridge.
8. Department of Applied Economics. University of Cambridge.
9. World Bank, (1995) Bureaucrats in Business: The Economics and Politics of Government Ownership, Washington DC, World Bank and Oxford University Press.
10. World Bank (2000) Can Africa Claim the 21st Century World Bank, Washington D.C.

Appendix

Figure 1 depicting the position of developing countries (C) and developed countries (D), based proximity to the production frontier.

Source: Birdsall and Nellis (2003)

Figure 2 depicting the ability of developing countries to simultaneously pursue efficiency and equity goals, because of a further proximity away from the production frontier.

Source: Birdsall and Nellis (2003)