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‘Privatization’ is defined here as the transfer from government to private parties of the ownership of firms. This definition is not so broad as to embrace, for example, the sale of publicly owned housing and natural resources, contracting out the supply of publicly financed services, or the introduction of user charges for services previously provided at public expense. However, some of the economic principles for privatizing firms apply more generally.

This article is in two parts. The first part addresses some economic and financial principles of privatization, beginning with the basic question: how does ownership matter for economic efficiency? It is concluded that, at least for firms with significant market power, this question must be addressed in conjunction with the framework of regulation and competition that accompanies public or private ownership. The second part examines some aspects of privatization in practice, particularly in Britain, the leading exponent of the policy in the 1980s.

Privatization: Principles

Ownership and Economic Efficiency

If privatization is defined as the transfer of ownership, the first question is: what is ownership? According to the incomplete contracts view of the firm (see Hart 1995), ownership of an asset is to be identified with residual rights of control – rights to make decisions in the domain not already subject to contractual obligations. No such rights would exist in a world of complete contracts, where ownership, and hence privatization, would therefore be irrelevant.

The ultimate owners of sizable firms typically delegate the exercise of residual control rights to professional managers (whose identity may or may not be affected by privatization). Privatization affects principal–agent relationships between owners and managers by changing (a) the principals and hence their objectives, (b) the means of monitoring and giving incentives to the agents, and (c) the scope and incentives for action by the former public principals.

As to (a), a limitation to the economic theory of privatization is that there is no definitive theory of the firm under public ownership. In some sense the ultimate owners are the general public, but, even if their preferences could satisfactorily be aggregated into a welfare measure, it would be pious to suppose that government ministers or bureaucrats would necessarily exercise their authority over public firms to maximize welfare, avoiding distraction by political considerations, influence by well-organized vested interests, and so on. With private firms the usual assumption that owners seek to maximize profit or share value seems a tolerable approximation for present purposes, except perhaps if workers or consumers have large ownership stakes.

Since private, unlike public, ownership claims are generally tradable, privatization can alter the monitoring and incentives of managers by changing information conditions. For example, managers’ rewards can be related to share price performance. In so far as share prices reflect the value of the firm, managers can thereby be given incentives to enhance firm value. Stock market investment analysts become a new source of managerial monitoring. However, free-rider considerations imply that monitoring by private owners might be limited, especially if share ownership is diffuse.

The tradability of ownership claims also means that privatized firms, unless they are given special protection, are potentially open to takeover threats, whereas publicly owned firms obviously are not. It is a matter for debate whether such threats from the market for corporate control are effective in disciplining managers of private firms to act in shareholder interests. Private firms also face the possibility of bankruptcy, in which case residual control rights shift to debt-holders.

Privatization changes the relationship between government and the firm. Thus public officials may lose power to intervene in the running of the firm. Moreover, and perhaps most important, the credibility of government commitment not to intervene may be enhanced by privatization so that, for example, managers face harder budget constraints and hence stronger incentives (see Schmidt 1996).

Nevertheless, privatization might not make government commitment not to intervene completely credible, especially if the firm remains subject to regulation or dependent on public subsidy. In any event, the government retains powers of taxation, and ultimately there is the possibility that privatization might be reversed, possibly on terms disadvantageous to private owners. To the extent that these factors give rise to risk of more or less subtle expropriation by government, private investment incentives may be adversely affected.

From the considerations above it follows that the consequences of privatization are likely to be influenced by the extent of market power enjoyed by the firm in question. For a firm that operates in competitive conditions, the shift from ‘public’ to profit objectives raises no concerns about the exercise of market power, and, since no special apparatus to regulate market power is required, opportunities for expropriation are limited. In these circumstances one may expect private ownership to be superior to public ownership in terms of economic efficiency, and indeed that is what the empirical evidence shows.

For a firm with market power, however, it may be desirable for reasons of allocative efficiency, and inevitable for political reasons, for privatization to be accompanied by monopoly regulation. But regulation risks blunting the very incentives – for example, for cost reduction and efficient investment – that privatization is usually intended to sharpen.

A complementary approach to the problem of privatized (and in principle also nationalized) market power is liberalization – the removal of legal and other barriers to competition, and accompanying measures to contain anti-competitive behaviour by the incumbent firm. Among other things, liberalization may expose and undermine patterns of cross-subsidy practised under public monopoly.

Therefore, in contrast to the competitive market case, it would appear that no general claim can be made as to the economic desirability of privatizing firms with market power. The accompanying regimes of regulation and competition policy are crucial determinants of the consequences of their privatization.

Privatization and Public Finance

In addition to microeconomic efficiency, considerations of public finance have motivated privatization policies in a number of countries, including Britain. By raising government revenue, privatization reduces the immediate need for public sector borrowing. It may also release firms from financial constraints resulting from government macroeconomic policy commitments. But the economic, as distinct from public accounting, significance of these points is unclear.

Selling public firms indeed raises government revenue, but the same is true of selling government bonds: in both cases the public sector receives a lump sum in return for a stream of future profit or interest payments. The deeper question is how privatization differs from government bond issue in terms of its effect on the net worth of the public sector.

If privatization leads to economic efficiency gains (which would not otherwise have been achieved) – or to greater exercise of monopoly power, which is akin to a tax increase in public finance terms – then the firm’s profits are greater with privatization than in the public sector. If the firm is sold at a fair price, then the public sector captures the net present value of the profit gain (less the transactions costs of privatization, which are likely to exceed those of bonds). If, however, the firm is underpriced, then any gain to the net worth of the public sector is reduced by the extent of underpricing. Competition among potential buyers and a pre-existing market for the firm’s shares are factors likely to assist more accurate pricing of privatization share issues.

Privatization can also affect the net worth of the public sector, compared with selling government bonds, if risk-adjusted discount rates differ. For example, a government with poor inflationary credibility may have to cede a large interest rate premium when selling bonds. Shares in privatized firms are not so vulnerable to expropriation via inflation (neither are index-linked bonds). However, as discussed above in relation to regulatory credibility, some privatized firms, especially those with monopoly power, may face serious risks of expropriation via regulation or even renationalization. The relative sizes of these risks of default on debt and of ‘default on equity’ are likely to vary by industry as well as by country. The nature of the private shareholders – for example, their nationality or whether they are small individual investors – might also be an influence upon the probability of expropriation.

Self-imposed public finance constraints by government can provide efficiency rationales for privatization if they prevent publicly owned firms from making desirable investments. In macroeconomic terms, it ought to matter little whether a firm is in public or private ownership when it does a given amount of borrowing; it appears, however, that governments seeking to adhere to public borrowing commitments may view matters differently.

Privatization and Distribution

Privatization, and the financial and industrial policies that accompany it, can have large distributional consequences. First, if public firms are sold to private investors for less than their market value – for example as part of a plan to promote ‘wider share ownership’ – then, relative to the situation with more accurate pricing, wealth is redistributed away from the general taxpayer to the investors who succeed in getting shares. Employees and managers of privatized firms gain from such redistribution if, as has often happened, they are allocated shares on favourable terms. Managers may benefit also from share option schemes and from being released from public sector pay constraints.

Second, if privatization hardens the firm’s budget constraint, then it may diminish rents enjoyed by those within the firm to the benefit of the general taxpayer. Third, widespread cross-subsidy – for example, of small customers by large customers, and/or of suppliers of certain inputs – is a common feature of publicly owned monopoly. Privatization entails redistribution in so far as it undoes such cross-subsidies, but, here as elsewhere, the accompanying regime of regulation and competition is likely to be more important. Thus liberalization tends to be a more potent enemy of cross-subsidy than privatization itself, and, in the case of privatized monopoly, regulation can be a major determinant of the extent of redistribution among consumer groups as well as between consumers and shareholders.

Finally, it has been suggested (see Biais and Perotti 2002) that privatization policies may be designed in part so that their distributional consequences alter political preferences – in particular by giving voters a stake in the avoidance of political parties whose policies would undermine the value of shares in privatized firms.

Privatization in Practice

Privatization Worldwide

Principally since the mid-1980s, privatization policies have been pursued, to varying degrees, around the world – for example in Argentina, Brazil, Chile, France, Germany, Jamaica, Japan, Malaysia, Mexico, the Philippines, Singapore, Spain, the formerly Communist countries of central and eastern Europe and the former Soviet Union. Privatization sales proceeds worldwide are estimated to have exceeded a trillion dollars. The extensive survey by Megginson and Netter (2001) concludes that the state-owned enterprise share of global output fell from more than ten per cent in 1979 to below six per cent by 2000.

The following account concentrates on Britain, which was a leader of the worldwide privatization movement in terms of both the scale of its programme and its embrace of monopoly industries. Further details may be found in Vickers and Yarrow (1988) and Newbery (2000).

Privatization in Britain

Nationalization by the post-war Labour government and subsequently had led to a situation in 1979 where the public sector in Britain dominated the supply of energy (gas, electricity, coal and some oil), transport (air, rail and bus), communications (post and telecommunications) and water, and also had substantial interests in manufacturing (for example, in aircraft, shipbuilding, steel and cars).

In the 18 years of Conservative government from 1979 to 1997, the proportion of GDP accounted for by state-owned firms fell from 11 per cent to below two per cent. At the peak of the privatization programme, between the mid-1980s and the early 1990s, sales proceeds typically exceeded one per cent of GDP and were sometimes of the order of three per cent of public expenditure.

The watershed in the British privatization programme was the sale of British Telecom (BT) in 1984, an event motivated in good part by a desire to free BT from macro-economic policy restrictions on public sector borrowing. Before that, privatization policies were relatively modest in scale and confined to firms in more or less competitive industries such as oil and manufacturing. By extending the programme to utility monopolies, the sale of BT marked a key shift in the nature, as well as the scale, of the British privatization programme. In particular, it required the development of a system for regulating private monopoly.

Privatization – with accompanying regulation – was subsequently extended to gas (1986), airports (1987), water in England and Wales (1989), electricity (1990–91) and the railways (1996). By 1997, when the Labour Party returned to power (having abandoned its traditional commitment to public ownership), the main activities remaining in the public sector were the Royal Mail, the BBC, London Underground, British Nuclear Fuels, Air Traffic Control, and the water industry in Scotland. In 2001 National Air Traffic Services was partly privatized as a public–private partnership (PPP). London Underground remains in public ownership but since 2003 infrastructure renewal and maintenance has been procured under long-term PPP contracts.

Methods of Sale

The main ways of privatizing a firm are (a) offer for sale of shares to the general public, (b) sale to another firm, and (c) management/employee buyout. The third method was used in parts of the transport sector, including road haulage, some bus companies, and rail rolling stock leasing companies. The Rover car group was an example of privatization by sale to another firm (British Aerospace, which later sold Rover to BMW). However, by far the most important method used in Britain was offer for sale to the general public.

With this method, questions include (a) whether to sell the firm in two or more stages, or all at once; (b) whether the share price is set administratively or by competitive tendering among prospective purchasers of the shares; and (c) whether incentives and bonus schemes are created to encourage small investors to buy (and hold) privatization shares. Before the BT sale, privatizations were mostly in stages (as was BT’s), use was often made of competitive tendering, and no great inducements to wider share ownership were given. These methods are conducive to reasonably accurate share pricing. Thus selling a firm’s shares in stages enables accurate pricing after the first stage because the market value of the shares is known.

In the latter part of the 1980s, however, some large firms (such as British Gas) were sold in one go, tendering methods were eschewed, and there were strong incentives for small investors to buy shares. This pattern suggests that wider share ownership was a primary objective of privatization policy. In the 1990s tendering methods came back into use, albeit with discounts for small investors, thus combining the objectives of revenue maximization and wider share ownership to some extent. However, Railtrack, the railway infrastructure company, was floated on the stock market in one go in 1996.

Even judged relative to the discounts that are typical with private initial public offerings, the government revenue forgone in pursuit of the objective of wider share ownership appears to have been very large. The number of British individuals directly owning shares rose sharply but the proportion of the stock market owned directly by individuals has continued its long-run decline. If it is thought to be an appropriate policy goal, wider share ownership might be better pursued by reforms to the taxation of saving and investment generally rather than by privatization policies.

Regulation

The regulatory framework for the privatized BT was established by the Telecommunications Act 1984. A similar framework was subsequently adopted for gas, electricity, water and railways. Regulatory powers and duties were divided between the government minister, who granted licences containing regulatory provisions; an industry-specific regulator (for example, the Director General for Telecommunications), who enforced and reviewed licence conditions; and the Monopolies and Mergers Commission, which considered disputes about licence modification.

This regulatory model developed over time. Powers were transferred from individual directors general to boards, and some regulatory bodies were combined. Thus the Utilities Act 2000 created the Gas and Electricity Markets Authority, and under the Communications Act 2003 a new body, Ofcom, took over the roles of several regulators including the Director General for Telecommunications. The regulators gained powers under new UK competition law (see below). And the wider European context grew in importance, with EC directives for the liberalization of network industries such as telecommunications and energy.

For firms with market power, perhaps the most important aspect of regulation concerns price control. When it embarked on the privatization of BT the British government was anxious to avoid perceived deficiencies of rate-of-return regulation. Instead, following the report of Professor Stephen Littlechild (1983), it adopted the form of price cap regulation known as ‘RPI minus X’, which requires an index of the firm’s regulated prices to fall by X per cent per annum in real terms (that is, relative to the retail price index) for a period of years. This was intended to be ‘regulation with a light hand’ and to wither away over time. However, price regulation in several industries at first became tighter and more detailed, and rate-of-return considerations were soon seen to be of prime importance at points of regulatory review. Nevertheless, even if RPI minus X price cap regulation is akin to rate-of-return regulation with long lags, this may well have substantial advantages over rate-of-return regulation as traditionally practised. After a time, as competition took hold after liberalization, some price controls were lifted, notably from domestic energy retail prices in 2002 (though transmission and distribution remain regulated) and from BT’s retail prices in 2006.

Industry Restructuring

Restructuring is an important instrument of competition policy when firms with market power are privatized. (Forced restructuring after privatization may seriously jeopardize regulatory credibility.) Both BT and British Gas were privatized without restructuring as vertically integrated firms with nationwide dominance. However, after a decade of competition problems arising from the vertical integration of British Gas, and, in view of accelerated liberalization of retail supply, the company divided itself into separate pipeline and supply companies in 1997.

By contrast, the government radically restructured the electricity and railway industries before privatization. In 1990 the Central Electricity Generating Board in England and Wales was divided into a transmission company (National Grid) and three generators (National Power and PowerGen; and Nuclear Electric, which was eventually privatized as British Energy in 1996). Vertical separation meant that a new mechanism had to be devised to coordinate transmission and generation, and a wholesale auction market, the Pool, was established (and later reformed by the introduction of New Electricity Trading Arrangements in 2001). In all, 12 Regional Electricity Companies (RECs) were privatized with responsibility for distribution and retail supply, which was progressively liberalized in the late 1990s and finally deregulated in 2002.

Major restructuring and ownership changes have occurred in the energy sector since privatization. The generators, National Power and PowerGen, had to divest substantial generation capacity following concerns about their market power, which was largely due to the concentrated structure for generation chosen by government in an unsuccessful effort to privatize nuclear power at the outset. Initially National Grid was jointly owned by the RECs but it became an independent company in 1995, and in 2002 merged with the gas pipeline company. After the lifting of takeover protections in the mid-1990s, most RECs were acquired, and ten years later six companies, supplying both gas and electricity (often in combined deals), accounted for nearly all energy supply – British Gas and five electricity suppliers, of which one is French- and two are German-owned. Thus, depending on merger policy, industry structure and ownership can alter substantially after privatization.

British Rail was restructured before privatization to separate network infrastructure from train operation. Railtrack, which took over network infrastructure, including track and stations, was privatized in 1996. The company went into administration in 2001 and its assets were acquired by Network Rail, a company limited by guarantee that has no shareholders. Three rolling stock leasing companies were also privatized in 1996 (and soon resold at a profit). Private train operating companies run train services under franchises. Large public subsidy to rail services continues in the privatized regime.

Liberalization of Competition

Statutory monopoly typically accompanied public ownership in the utility industries. Among other things this served to facilitate extensive cross-subsidy between groups of customers, and sometimes of input suppliers – for example, the nationalized electricity industry effectively subsidized British Coal. The removal of statutory barriers to entry in telecommunications, gas and electricity began in the early 1980s, before privatization policies were adopted, but then had little competitive effect. Liberalization has generally gone further since privatization – as illustrated above by the energy sector – and over time more attention has been given to economic, as well as legal, barriers to entry.

In telecommunications, liberalization of apparatus supply and value-added services began in 1981, when BT was split from the Post Office, and in 1982 Mercury was licensed as a competing network operator. However, for the rest of the decade the government adopted a ‘duopoly policy’ of allowing no further entry into fixed-link network operation. A parallel duopoly policy applied to mobile telecommunications.

When the duopoly policy was ended in 1991, the interconnection question – on what terms can rivals gain access to BT’s local network? – became and has remained a focus of controversy. On the one hand it was argued that rivals could inefficiently ‘cream-skim’ BT’s more profitable business while BT remained restricted by controls on its tariff structure and universal service obligations. On the other hand, it was argued that rivals faced entry barriers. These tensions eased somewhat over time as tariff rebalancing diminished cross-subsidies in BT’s pricing structure, and as entry barriers (such as the lack of number portability) were tackled directly by the regulator. But the advent of broadband, with BT still an integrated incumbent operator, brought the inter-connection question back into sharp focus. Faced with the prospect of an investigation under competition law, BT agreed in 2005, 20 years after privatization, to operational separation of its local access infrastructure.

A major weakness of UK policy towards privatized firms with market power had been the absence of effective competition law against anti-competitive agreements and abuse of dominance. However, that gap was filled in March 2000 when the Competition Act 1998 – which mirrors Articles 81 and 82 of the EC Treaty – came into force and was followed by the Enterprise Act 2002. The regulators can now apply (non-merger) competition law in their sectors. Over time, then, following the shift from state monopoly to regulated private monopoly, there has been increasing availability of competition policy instruments to address market power in historically monopolized industries such as energy and telecommunications in Britain. Nevertheless, the regulatory regimes have remained the principal means of controlling market power.

The Performance of Privatization

Privatization policies have undoubtedly had major economic and financial effects. Have they generally been positive? Answering this question properly requires the specification of evaluation criteria, performance measures, statistical methods and the counterfactual: what would have happened without privatization?

Megginson and Netter (2001, section 5) review 38 empirical studies of privatization covering both developed market economies and transition economies. Privatized firms are generally found to become more efficient and profitable, and to invest more. There are mixed results on employment effects, though job cuts appear to be associated with corresponding productivity gains. Direct evidence on effects on consumers is limited. In their survey of studies of transition economies, Djankov and Murrell (2002) conclude that privatization, especially to outside investors as distinct from managers and workers, is robustly associated with enterprise restructuring and growth, and that competition has a significant positive effect on enterprise performance.

In competitive industries, improvements in the corporate performance of privatized firms imply overall economic gain, and there is ample evidence that privatization has been a success. For firms with market power, however, corporate performance can improve at the expense of the public as well as by enhanced efficiency. Moreover, it is hard to isolate the effects of privatization in hitherto monopolized industries from those of accompanying regulatory and competitive reforms. In Britain, methods of privatization and regulatory reform have at times been seriously flawed. But privatization was probably necessary for liberalization and for the creation of a system of independent economic regulation, augmented in time by effective competition policy. Though far from perfect, these are major improvements upon the nationalized monopoly of old.

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