Who Should Provide Infrastructure? On Regulation, Privatization, and State-Owned Enterprises
Competition among providers of infrastructure is often limited, because the investments required to build and maintain infrastructure are so extensive, durable, and immobile that the cheapest way to serve a given market is often with a single firm. This phenomenon is known as natural monopoly in economics jargon. How best to protect consumers from this lack of competition has been a topic of intense debate in infrastructure circles, and it’s one that is summarized in the recently published Lincoln Institute book Infrastructure Economics and Policy: International Perspectives.
In the 19th century, virtually all modern infrastructure—including canals, railroads, steamships, electric power, streetcars and subways, telegraph and telephone systems, and local water supplies—was built and operated by private companies. Most of these systems were nationalized or municipalized only after the turn of the century, and often not until the 1960s and 1970s in those developing countries that declared their independence around that time.
These new state-owned enterprises (SOEs) sometimes performed well at first, but often grew less efficient, provoking consumer complaints of high prices and poor service as well as government concerns about the burden of funding large SOE deficits. These concerns helped provoke the most recent round of privatization reform, starting in the 1990s and 2000s. Privatizations were relabeled as Public-Private Partnerships (PPPs) to emphasize the hoped-for cooperative nature of the reforms. Greater emphasis was placed on developing the means to regulate prices that would be accepted as fair by both investors and their customers.
Antonio Estache, a professor at the Universite Libre de Bruxelles, summarizes research on this recent round of privatizations in chapter 11 of the book. Estache’s findings will leave both critics and supporters of privatization disappointed. For example, he estimates that private finance accounts for only 17 percent of total finance for the typical PPP project, with the bulk of the remainder still to be raised through government bonds and loans or by grants or loans from international financial institutions. By sector, privatization is much more common in ports and electricity generation and relatively rarer in electricity distribution, roads, water, or sanitation.
Particularly troubling are Estache’s interpretations of research on the effects of private ownership on performance. Ownership alone does not appear to significantly improve infrastructure access and affordability for the poor. Ownership may have an effect on costs, but that influence may weaken once the “easy” measures to increase labor force productivity have been exploited. Estache blames this disappointing performance on the failure to address major governance issues including “corruption, lack of technical skills, lack of commitment to allocate the resources needed to get the regulatory job done, and lack of accountability for failing on any or all of the previous issues.”
Given that controversy over monopoly played an important role in the nationalization of private infrastructure companies in the first half of the 20th century, it is not surprising that a great deal of energy has been devoted to devising price-setting schemes for PPPs that would be accepted as fair by both consumers and investors. The most popular approach has been to use competitive bidding, to award a contract to build and operate an infrastructure facility for a fixed term, say 10 or 30 years. However, this approach works well only if the contract is relatively complete, in that it anticipates all important future developments and provides workable contingencies for them. Contracts that prove to be incomplete typically require politically controversial renegotiation. Furthermore, the risk that a contract will prove to be incomplete increases greatly with the duration of the contract, and infrastructure investments typically require long contracts.
In chapter 12, Sock Yong Phang, professor at Singapore Management University, uses several case studies to examine two alternative strategies to competitive contracting: cost-of-service regulation and price-cap regulation. The former allows the regulated firm to charge prices sufficient to recover specified accounting costs; the latter specifies the maximum increase in prices allowed in a set period, usually five years, but allows the firm to keep the difference as profit if the actual price increases are less than the increases allowed under the cap.
Phang argues that the evaluation of these two approaches depends on the priorities and objectives of the regulator. The use of cost-of-service regulation implies concern about the financial health of the regulated firm, and especially its ability to raise capital, while the use of price-cap regulation suggests concern about the firm’s technical efficiency and record of innovation. Other possible goals include access and affordability for the poor or protection from monopoly abuse.
In chapter 13, Sir Ian Byatt—a pioneer in the practice of price-cap regulation as the regulator of Britain’s water industry during the first two decades after its privatization—describes the challenges faced and the lessons learned during his tenure. Two themes emerge: first, the importance of the regulator being politically sensitive and proactive, and second, how many other critical decisions a regulator faces besides periodically setting the allowed caps on prices. These decisions include the firm’s capital structure, quality of service, treatment of ancillary activities, and the possibility of competitively contracting for major stand-alone facilities. The combined lessons of Phang’s cases and Byatt’s tenure illustrate the practically irresistible pressures for, and potential pitfalls of, regulatory mission creep.
SOEs were considered a key to economic growth by many developing countries in the post-colonial period of the 1950s and 1960s. The private sector often consisted of small traders and enterprises without the resources or appetite for the heavy investment that was generally thought to be needed at the time for development. The attraction of SOEs faded in the face of their disappointing performance, leading to various reform efforts in the 1970s and 1980s and ultimately to the privatization of many in the 1990s and 2000s. However, SOEs remain significant players in the infrastructure sector, especially in China and India.
In chapter 14, O. P. Agarwal, who has worked on transportation and energy policy for the government of India, the World Bank, and the World Resources Institute, and Rohit Chandra, an assistant professor at Indian Institute of Technology Delhi, examine the changing roles of SOEs.
Agarwal and Chandra map the global landscape of SOEs and compare the performance of SOEs versus the private sector. Despite their less efficient performance, SOEs still have plausible reasons to exist; for example, the inability of the market to supply classic public goods such as local road networks. Most important, Agarwal and Chandra recognize the evolving role of SOEs over the last decade as they have become more versatile through innovations in organizational form, financial management, PPPs, and private contracting.
In the end, no single solution has emerged to the competition problems caused by infrastructure’s reliance on costly, durable, and immobile investments. Private ownership is common in many developed countries, particularly in certain sectors such as telecommunications and electricity generation. SOEs are very important as well, however, and dominate infrastructure in China and India, the world’s most populous countries. A great deal of effort has gone into the design of regulatory schemes to replace the standard approach of long-term contracts awarded by competitive bidding processes. While there have been notable advances, particularly with price-cap regulation, so far every scheme has its limitations.
José A. Gómez-Ibáñez is the Derek C. Bok Professor Emeritus of Urban Planning and Public Policy at Harvard University. Zhi Liu is senior fellow and director of the China Program at the Lincoln Institute of Land Policy. They are the editors of Infrastructure Economics and Policy: International Perspectives.
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