Policy

Competition: the missing link in Australia’s privatisation program.1 Stephen P. King. Economics Program RSSS The Australian National University

During the last decade, privatisation has revolutionised government activity throughout the world. This revolution has seen telecommunication companies, airlines, public utilities, banks, oil companies, car manufacturers and numerous other government business enterprises (GBEs) in a wide variety of countries move to the private sector. While Britain, under the Thatcher government, was the undoubted leader in this revolution, privatisation policies have been implemented by governments around the world, including countries such as France and New Zealand where active government involvement in industry had previously been the norm. Privatisation programs have not been limited to developed Western economies but have played a crucial role in transforming the economic fortunes of, among others, Mexico, Chile, and Argentina. Some of the most vehement (and successful) advocates of privatisation have been the former communist countries of Eastern Europe, such as the Czech republic, and privatisation is part of China’s economic agenda. The privatisation revolution extends beyond government asset sales to other modes of introducing private involvement into the public sector. In Australia, privatisation has included the extensive use of contracting out to improve the delivery of services that were previously produced in-house by government. Contracting out has been embraced most widely at the State and local government levels, and encompasses a vast range of services from refuse collection and office cleaning to maintenance, warehousing and welfare services.2 1 2

From Agenda v10, summer 1994-95. See Domberger 1994.

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Despite the political rhetoric, progress in Australia on privatisation has been slow. The sales of the Commonwealth bank, GIO Australia, and Qantas, have been the exception rather than the norm and in some cases, for example Qantas, are still awaiting completion. There has been considerable reluctance by the Federal government to complete the deregulation process in telecommunications by following the lead of nations such as New Zealand and the UK and selling Telecom Australia. Despite moves towards a national electricity grid, the extent to which electricity generation will be moved to private hands is unclear. After a decade of rhetoric and debate, Australia has relatively little to show from the privatisation revolution. Why Privatise? There are two main reasons why privatisation is an essential ingredient in reforming sectors currently dominated by GBEs. First, privatisation is a way of improving the incentives that face the owners, managers and workers in an enterprise to ensure efficient, cost-minimising production. Secondly, privatisation places the enterprise at arms length from government and makes it both more costly for the government to interfere in the operations of the company and makes any interference more transparent. A privatised firm usually faces the removal of the (either explicit or implicit) government support that exists for a GBE. A government enterprise is immune from the day-to-day judgment of the financial markets and is free from the ultimate forms of private sector corporate discipline — takeovers and bankruptcy. These pressures mean that private sector owners have strong incentives to ensure that their companies operate efficiently, producing a product range that satisfies the desires of consumers at the minimum possible cost. Unlike a government owned monopolist who faces few negative consequences if their products inadequately address the needs of the public, a private firm which does not pay close attention to its consumers opens the door for an innovative competitor to steal both market share and profits. Even those who are highly critical of privatisation tend to concede that private firms out perform their public counterparts when it comes to innovation and response to changing market conditions (for example, see 2

Quiggin 1994:16). While there is a gulf between the desires of owners and the actions of managers in both the public and private sector, this gap is likely to be smaller in the private sector. Private sector owners have three related benefits in comparison to their public sector counterparts when setting the incentives for their managers and workers. First, private sector owners often have access to better information by which to judge and reward their managers particularly if the owner is able to compare their firm’s performance to that of close rivals. While there have been attempts to mimic these sources of information in the public sector, through yardstick competition, requirements on “dividend payments” and corporatisation, the information generated by artificial attempts to replicate aspects of the private sector will inevitably be second-best relative to a comparison between private firms competing in the same market at the same time. Second, it is not only owners but also managers who face market discipline. A manager who performs poorly in their current position may find it extremely difficult to move to another company at a later date. While similar penalties for under performance exist in the public sector, the traditional rules of public sector firing, promotion and transfer have tended to dampen these penalties. In the extreme there is no public sector equivalent to the loss of reputation to a manager associated with bankruptcy. Third, it is easier to set correct incentives for a manager if the aim of the firm is as simple and clear-cut as profit maximisation. In contrast, the bottom line for a public sector manager will alter with government policy and will change as political incentives change. Privatisation has the additional advantage that it sets the firm at arms length from government interference. While a GBE is always at the beck and call of its political masters who may intervene in ways which satisfy political necessities at the cost of economic and social efficiencies, it is harder for a politician or government to interfere directly in the operations of a private firm. While such interference can and does happen, either overtly through political interference in a regulatory regime, or covertly through political pressures applied to the firm, privatisation makes it harder for govern-

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ments to unduly intervene in the functioning of the firm. Willig (1993:155) argues that it is this “insulation” from “arbitrary political and self-serving influences” which is the key gain from privatisation. Corporatisation. If the arguments for privatisation are so clear, then why has both the progress on privatisation and the payoff from existing reform been so slow? One reason for Australia’s slow progress is that the above arguments do not apply equally to all GBEs. In particular, there may be little if any advantage in privatising a GBE in an industry that is characterised by natural monopoly technology and has high barriers to entry and exit so that privatisation will merely lead to the exchange of a government monopolist for a regulated private sector monopolist. As the industry commission notes (1992:115) “it can be argued that private ownership would be preferred to public ownership even under monopoly conditions. However, in reality there are clear trade-offs between the efficiency of private ownership and regulation to curb expected monopoly behaviour”. A regulated private sector monopolist is unlikely to face the pressures and incentives that exist in competitive markets, and will have the additional problems that arise through political manipulation of the regulatory regime. In particular, the regulated firm may face the significant risk of ex post expropriation, not through nationalisation, but through the government setting a regulatory regime that does not allow the firm to earn a reasonable return on its investments. As an alternative to privatisation both state and federal governments have attempted to gain the best of both the private and public sector by reforming GBEs without changing ownership. Such reform, called “corporatisation” involves a deliberate attempt by governments to set in place an incentive regime that is similar to that imposed on a private firm including setting cost-minimisation and efficient pricing as goals for the GBE’s managers. Few GBEs, particularly in Victoria and New South Wales, have not been influenced to some degree by corporatisation policies. The State Owned Enterprise Act 1992 in Victoria, for example, establishes an umbrella framework of reform for that state’s government business sector including corporati4

sation. These reforms have shown some success. For example the industry commission (1993:25) reports that, since its corporatisation “Pacific Power’s overall productivity” has risen “by over 30% from 1987-88 to 1991-92”. There are, however, good reasons why corporatisation will often be an inadequate response to public sector inefficiencies in the short-run and is doomed to failure over the longer run. The pressures for efficiency that exist in the private sector arise, not simply from private ownership or the business practices that are associated with this ownership, but the competition which exists in that sector. Any attempt to duplicate the results of this competitive pressure without actually introducing competition, will lead to a series of static measures which, while better than nothing, will often be inadequate at attaining more than a cosmetic improvement in performance. For example, requiring a GBE to remit a certain dividend to the government each year may simply deprive the GBE of funds that it could have better employed for internal investment. Similarly, setting targets based on short-term performance may simply lead to an inefficient trade-off to current returns at the expense of long term development. Corporatisation does not remove the GBE from the shackles of political interference and the reforms are likely to be watered down over time as it suits the GBE’s political masters. Evidence from the UK suggests that corporatisation, by itself, is an inadequate policy response to public sector inefficiency (see Hartley, et. al., 1991). Competition — the missing ingredient. The key missing ingredient in reform through corporatisation is competition. In fact it can be argued that any attempt to reform GBEs, including privatisation, is likely to be of marginal benefit unless it is associated with a market regime that allows for competition. This is not a new argument. For example it was forcefully argued by Kay and Thompson (1986) in the context of the British privatisation program. However, it is an argument that appears to have been overlooked in the Australian debate. If the government privatises a GBE without first considering the market in which that enterprise is going to operate and the possibilities for competition within that market then the gain from privatisation may be small or negative. Further, 5

it can be argued that there are substantial gains to be reaped from introducing competition into a sector previously dominated by a government owned monopolist even if the relevant GBE remains in government hands. While it can be argued that these gains will be muted compared to those which can be reaped through full privatisation (see for example Industry Commission, 1991:15) the improved performance of Telecom Australia in both the lead up to Optus’s entry and in the period since that entry, indicates that a little bit of competition can have a significant effect on the performance of GBEs.

Competition is the necessary ingredient to achieve both allocative and productive efficiency in the market place. In its absence a firm, either privately or publicly owned, will have little incentive to set prices at an efficient level. Both the private and the public monopolist will also face severe organisational constraints on their ability to ensure cost-efficient production. In the absence of a competitive benchmark, provided by existing or potential competitors, neither public nor private sector owners may be able to ensure that their management is acting efficiently. In the Australian reform process, however, competition has been relegated to a minor position. This is clear, for example, from the emphasis on cosmetic reforms such as corporatisation. Such internal reform of GBEs has little or nothing to do with competition. Even in those sectors where governments have claimed to introduce competition through deregulation, that competition has often been subject to government “management”. For example, in telecommunications, the government has restricted competition in the pre 1997 period to a single chosen competitor. While the government claimed that such managed entry would ensure “effective, broadly-based viable competition” (see Maddock 1992), the real effect has been to limit price competition and product innovation. Similarly, while the deregulation of domestic air services in Australia has led to periodic price wars, particularly when the incumbent duopolists have been faced by a new competitor, the Federal government recently signaled is intention to prevent true competition in this market by reneging on its agreement to allow Air New Zealand

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to fly domestic passengers in Australia from November 1, 1994. While the reluctance of governments, particularly at the Federal level, to introduce competition into their privatisation programs is distressing, it is also predictable. The forces which have moved governments towards privatisation have had little to do with the arguments of economists or advocates of the free-market, but have more to do with political expediency. This is amply illustrated by ANL. The proposed privatisation of the national shipping line is not the result of well argued economics but is the result of an agreement between the Federal Government and striking maritime workers. Rather than encouraging competition, the aim of the agreement is to ensure ANL’s future through generous tax concessions and the continuation of restrictions on shipping in Australia. Privatisation has also become an acceptable way for governments to raise revenue. The most recent example of this is the proposed sale/long-termlease of the Commonwealth Airports Corporation — a policy which the Federal government has justified on the grounds of providing funds for a variety of short-term labour market programs. However, given a public accounting regime where the returns from asset sales enter as current revenue, the sale of Australia’s airports is only one of the more obvious attempts by a government to use privatisation as a way to lower the budget deficit without curbing its expenditure. The former labor government of Victoria appears to have used similar tactics to avoid explicitly issuing government debt when it raised revenue by selling government buildings and other assets on “leaseback” arrangements. Despite protestations to the contrary, the sale of the Loy Yang B power station may also be best explained by the need of the former labor government to raise funds rather than the desire for a yard-stick competitor. If efficient privatisation was simply a desirable side-effect of political dealing and government accounting, then there may be little room for complaint. For example many of the privatisations to date, such as the Commonwealth bank and GIO Australia, have occurred in industries that were already subject to reasonably high levels of competition. In such situations the gov7

ernment is able to raise revenue while freeing the GBE from the shackles of government ownership. However, as privatisation proceeds, if the main aim is to either raise government revenue or placate vested interests, then competition becomes an anathema to the process. It does not require sophisticated analysis to realise that a monopoly is usually worth considerably more than a large firm subject to the rigors of competition. The conflict between revenue raising and economic efficiency can lead to a privatisation program which attempts to simply transfer public sector monopolies to private hands. Revenue raising objectives may distort the privatisation process away from alternatives such as contracting-out and short term leases towards asset sales, even where the former are more likely to enhance economic efficiency. For example, if the federal government is dissatisfied with the current performance of its airport management then there is a good case to contract out this management to the private sector. It is, however, far from obvious that selling the airports to the private sector is the optimal privatisation strategy.3 In most cities their are relatively few substitution possibilities for passengers so that the private ownership of local airports will in general either require government intervention through a regulatory regime or lead to monopoly pricing. Sale of the airports will lead to substantial revenue, with this revenue increasing the more the government commits not to apply restrictions on airport pricing. It is, however, unlikely to provide a significant impetus to economic efficiency when compared to other privatisation possibilities. Where to from here? There are still considerable benefits that can be reaped from a well thought out privatisation program in Australia. Progress has been slow in many areas including the reform of public utilities and the provision of government services such as those in health and social welfare. While Victoria is leading the way in the reform and privatisation of electricity generation, other governments are lagging well behind. Reform and privatisation by themselves are, however, insufficient to achieve long term economic gains. The key to 3

Leasing the airports for 50 year periods is effectively identical to selling them.

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reform is competition and if reform is carried out without consideration of increasing competition where ever feasible then many of the benefits from privatisation will be lost. Given the incentives that face governments at the State and Federal level, it is likely that competition will often be ignored in the race either to raise short term revenue or to satisfy political expediencies.

Where then does the reform process go from here? Without doubt the brightest part of the privatisation revolution for Australia has been the rapid increase in the use of contracting-out. The use of private sector provision and competitive tendering has freed numerous services from monopoly inhouse government provision paving the way for both increased innovation and substantial cost savings. While contracting out needs to be approached carefully, and is not a panacea for every inefficiency in government production, it has and will continue to provide some substantial gains.4 This said, contracting out by its very nature ensures the long term involvement of the government in the production process and, as such, can continue to be at the mercy of government intervention. This intervention may involve explicit or implicit bribery, with the latter involving paybacks for contracts through, for example, campaign contributions or may simply involve interfering in the tendering process to satisfy the whims of a particular political lobby. In the extreme, contracting out procedures are often easily reversed over time with the government resuming in-house production of services if this is viewed as politically desirable. The best hope for successful long term reform must rest with changing the incentives of the government. We cannot expect a government to embark upon an efficient privatisation program if it faces incentives that mitigate against the introduction of competition. Efficient privatisation needs to be preceded by an efficient system of government incentives. At a minimum, the government must not face incentives to maximise either sales revenue or political payoffs from privatisation but rather to maximise economic effi4 See King 1994 and the articles which follow for a review of the progress of contracting out in Australia.

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ciency by allowing open competition where ever possible. If such a reform in incentives does not occur, then it is likely that few of the potential gains from reform will be achieved in the short term, and in the longer term we are likely to see significant policy reversals as the gains that have been achieved in the past decade are diluted or destroyed by changing political requirements. If the incentives for government are to be changed then the pressure for such change must come from the electorate at large. It is the average consumer who will be the main beneficiary of sensible privatisation with competition. It is also the average consumers (and voters) who are the “forgotten people” of the Australian reform process. To see this, one need look no further than the arguments presented by the government to exclude Air New Zealand from the domestic aviation market. The claims that the benefits will all flow to the foreign carrier show that the government holds the benefits to consumers — lower prices and improved service — at naught. If the reform process, including privatisation, is to continue in Australia with long term success, then the pressure for competitive reform must be maintained. This will require strong opposition parties and a vigilant public. Without these ingredients, we are likely to see a privatisation agenda run increasingly for short term revenue and political gains. The outcome could be disastrous, with monopoly power simply shifting from the public to the private sector, inefficient rent seeking replacing bureacratic ineptitude, and higher prices for business and consumers with no efficiency gain. References. Domberger S. (1994) “Public sector contracting: Does it work?” The Australian Economic Review, 91-96. Hartley K, Parker D and Martin S. (1991) “Organisational status, ownership and productivity”, Fiscal Studies, v.12. Industry Commission. (1991) Annual Report 1990-91, AGPS Fyshwick ACT. 10

Industry Commission. (1992) Annual Report 1991-92, AGPS Fyshwick ACT. Industry Commission. (1993) Government trading enterprises performance indicators 1987-88 to 1991-92, Belconnen ACT. Kay J. and Thompson D. (1986) “Privatisation: A policy in search of a rationale”, The Economic Journal v96, 18-32. King S. (1994) “Competitive tendering and contracting out: An introduction”, The Australian Economic Review 75-78. Maddock R. (1992) “Microeconomic reform of telecommunications: The long march from duopoly to duopoly”, in P. Forsyth (ed) Microeconomic reform in Australia, Allen and Unwin, Sydney. Quiggin J. (1994) “Does privatisation pay?” Discussion paper number 2, The Australia Institute. Willig R. (1994) “Public versus regulated private enterprise”, Proceedings of the world bank conference on development economics 1993, 155-170.

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