Central European University
Department of economics
‘Economics of regulation’ course paper
How ownership structure of
electric utilities effects their
efficiency?
Professor: Andrzej Baniak
Student: Willen Lipatov
Budapest, 2001
CONTENT
INTRODUCTION ............................................................................................................. 3
HISTORICAL OUTLINE.................................................................................................... 3
THEORIES OF PRIVATE VERSUS PUBLIC ENTERPRISE ..................................................... 5
EMPIRICAL STUDIES OF DIFFERENCES IN PERFORMANCE OF PUBLIC AND PRIVATE
ELECTRIC UTILITIES ....................................................................................................... 8
Illustrations for pricing behavior, allocative and productive efficiency................... 8
Other studies of efficiency of private and public electric utilities ............................ 9
A closer look at empirical studies: different approaches ........................................ 11
CONCLUSION ............................................................................................................... 14
2
Introduction
The problem of efficient functioning of natural monopolies in general, and electric
industry in particular has been an object of great interest for economists already
centuries ago. The importance of this problem is difficult to overestimate, since
distortions caused by monopolies lead to substantial economic inefficiencies and
consequently to the undermining of economic development. This paper considers one
aspect of the problem, namely how efficiency of electric utilities is effected by
ownership structure. Recently interest to the ownership structure of natural monopolies
has been given a new impetus, especially after the series of successful privatizations in
Great Britain.
Firstly, we will look at how views on ownership structure of utilities in general
changed in the historical context. Secondly, some theories of enterprise that shaped
opinions about natural monopolies will be surveyed. Next we’ll turn to empirical
studies of electric utilities, which aim at comparing performance of private versus
public utilities. Conclusion will stress the importance of regulatory methods in
interpreting results of these comparative studies.
Historical outline
In what follows in this section we follow Newberry (2000, chapter 3). Firstly,
one must admit that public ownership is not rare among the network utilities nowadays.
But its existence depends mostly on how widely it is spread geographically, as well as
on whether property owners or mass interests are more influential in the government.
The other factor is importance of a particular utility on local or national level.
Historically utilities started to develop on local level, and already at that time
there was a choice whether to own them privately or publicly. The decision depended
3
on cost-benefit relation of introducing certain kind of ownership. This relation included
price of service, its quality, and possible dividends of municipal companies. These
factors, in turn, were determined by how large a municipality was and how many areas
of economic activity were covered by it. Successful experience of other municipalities
also mattered, as well as availability of utility managers. And certainly ability of utility
customers as opposed to owners to influence local politics played an important role.
One common way to deal with local natural monopolies was offer of limited life
franchises. A private firm could get a right to operate as a natural monopoly if it
proposed the best (among rivals) conditions of operating a utility. Advantages of
franchises are usually considered to be ability of a firm to return its investment and of
municipality to reduce costs meanwhile. At the same time, high likelihood of being
denied prolongation of franchise makes incentive for the firms to reduce quality or
supply of services at some point of time before the expiration of the contract.
Nationwide network utilities first emerged only as private firms. Great Britain
failed to regulate such enterprises, relying only on franchise competition. As a result, it
experienced big difficulties caused by duplication of services, lack of coordination
between companies, and cartelization of industries. The United States were more
successful in accommodation of new trends, but here performance of network utilities
largely depended on industry and even macroeconomic dynamics. Apart from it, firms
had large profits, ownership was mixed, and the government had to implement profit
regulation.
In 60s there could be observed a shift in attaining higher weight to consumers’
surplus as opposed to profits. In 70s utilitarian approach prevailed. Both paradigms
pointed on ability of public capital to generate faster economic growth, inspired by
Soviet capital accumulation. But 80s brought a lot of doubts on this matter. The point
was that government has objectives that differ from those of the voters. As a
consequence public sector does not generate adequate investment, lowering savings
rate instead. Current situation is characterized by the fact that only a very limited
number of countries has sound system of regulation of privately-owned natural
4
monopolies. A wider circle of states has some mixture of private and public property in
network utilities. Finally, less developed countries have no other option except for
public ownership because of loosely-defined private property rights.
Evidence in support of one or other theory is difficult to rely on, as the data
(gathered by the World Bank in 1978-91) includes not only natural monopolies, but all
state-owned enterprises. However, absence of correlation between per cent of public
enterprises in GDP and real GDP per head points on lack of convincing argument for
private enterprises to be superior in terms of efficiency to the public ones. On the other
hand, larger share of public enterprises in Africa and Asia than that in Latin America is
consistent with the view that less developed countries often simply have no other
choice than public ownership.
Another interesting observation is that public enterprises have larger share in
investment than in GDP, but not only because they are more capital intensive, also
because of underpricing of output. Electricity, in particular, had a very poor
performance in middle-income countries. Prices were set below long-run marginal
costs despite existing excess demand, so that only 60% of costs were covered by
revenue. Investments were financed out of taxes that led to huge inefficiencies. In
general, public utilities earned low return and required high transfers. In order to
improve situations some steps were made, but mostly by lowering investment rather
than raising prices and revenues.
Theories of private versus public enterprise
As historical outlook does not provide non-arbitrary conclusions about relative
performance of public and private network utilities, although it serves as a useful tool
to become familiar with the problem, let’s switch our attention to some theoretical
models. Our speculations will follow Viscusi, Vernon and Harrington (1995, chapter
14) in this section.
5
The basic idea of modeling behavior of a firm-natural monopoly is how to
induce this firm to price its output efficiently (first, second-best or close to it). Two
ways to do it are establishment of a regulatory agency and franchise auction. First one
is not ideal, since such an agency does not have full information about the firm’s
actions, that leads, for example, to Averch-Johnson effect in case of rate-of return
regulation. Second has the same disadvantages, although maybe to less extent.
Such imperfections give room to existence of public enterprise. The striking
difference of it as compared with a private one is that the public enterprise does not
have to maximize profit. Instead, it is supposed to maximize social welfare. However,
because of the agent-principal problem, the public firm maximizes manager’s utility
subject to constraints imposed by government.
Similar problems certainly arise in a private enterprise. Usual methods to solve
them are to reward manager with shares of the company and to pay bonuses based on
performance of the enterprise. Reputation of the manager on the labor market also
plays an important role, but the most effective incentive for the manager is considered
to be a possibility to be fired. This threat becomes credible only with existence of the
capital market. Unfortunately, it is absent in case of public enterprise.
Moreover, social welfare is much more difficult to measure than profit. This
gives the manager of public company undesirable from the point of view of society
freedom. Indicators used in assessing performance of the enterprise always cause some
distortions, since managers achieve high values of these indicators undermining other
characteristics of production.
Sam Peltzman (quoted in Viscusi et al 1995, p. 460) suggested another approach
to modeling behavior of managers of public firms. According to him, manager
maximizes political support. Two ways through which it can be influenced are price
(the lower - the better) and tax burden (or subsidy necessary to run the business with
given price). As subsidy is equal to profit with negative sign the problem of manager
consists in maximizing profit with given price or minimizing price with given profit
6
(zero). If price is set to the level of average costs these problems are equivalent and
bring about the second-best solution.
This setup implies at least three results. First, public enterprise will set prices
below those that maximize profit, unless manager attaches no importance to
minimization of price, possibility that we are ruling out. Second, with possibility of
discrimination price for non-voters will be set on profit-maximizing level, and for
voters it will be minimized. Third, discrimination among customers-voters will be less
than in case of private enterprise, since discrimination alienates voters who are worseoff with its introduction.
The problem of higher degree of discretion possessed by manager of public in
comparison with that of private enterprise still stays. It has its deepest roots in nontransferability of public ownership and hence impossibility to impose the restrictions
on the manager that otherwise would be provided by the capital market and threat of
owner change. And all kinds of difficulties, as inefficiently high wages, more simple
pricing schemes and overcapitalization, stem from this problem.
All in all, theory predicts that public enterprise will be less efficient than
unregulated private enterprise, since it maximizes political support rather than profit,
does not have the capital market constraint. Moreover, even regulated private
enterprise (that has A-J inefficiency) is likely to be more efficient than a public
enterprise, because behavior of managers leads to the similar overcapitalization, but
also causes other inefficiencies.
7
Empirical studies of differences in performance of public and private
electric utilities
Illustrations for pricing behavior, allocative and productive efficiency
To begin with we give examples which illustrate previous theoretical
speculations, and also due to Viscusi at al (1995, pp. 463-67). In study using data from
1912-37, George Stigler and Claire Friedland looked for differences in prices of
regulated versus unregulated private electric utilities. So, the null hypothesis was
actually that regulatory constraint is not binding. The hypothesis was not rejected, and
explanation for this was high information advantage of a regulated firm, so the
regulatory agency sometimes could only accept a proposed tariff.
A study by Thomas Moore using data from 1962 supports the hypothesis that
public enterprises charge lower price than private electric utilities. It claims that
regulation had an effect of 5-6% reduction of price, whereas public ownership – 1022% reduction. Similar results were got by Peltzman in 1971. But he explained it by
special status of public utilities that allowed them not to pay taxes. He also found
support for the view that public enterprises discriminate less. Namely, private utilities
had 8391 rate schedules, whereas public ones – only 5290.
The fact that public enterprises charge lower prices does not necessarily mean
that they reach higher allocative efficiency. The thing is that due to finer price
discrimination private utilities may achieve lower amounts of deadweight loss.
Peltzman’s evidence shows that private utilities were selling more electricity per
customer on average, so it is possible that they did not bring about lower allocative
efficiency.
Productive efficiency was studied in 1970 study by Moore. He tested for
overcapitalization by looking at the ratio of capacity to peak demand. As public electric
utilities had larger capacity for a given peak demand, the view that public utilities tend
to overcapitalize more seems to be consistent. Thomas Dilorenzo and Ralph Robinson
8
1982 study considered labor productivity as a measure of technical efficiency. They
found that difference between publicly and privately owned electric utilities is
statistically insignificant. Donn Pescatrice and John Trapani, however, estimated
average costs for 33 private and 23 public utilities and found that they were higher for
public utilities 23,5% in 1965 and 32,9% in 1970.
Other studies of efficiency of private and public electric utilities
The next set of evidences comprises a larger number of studies. All of them are
taken from Newbery (2000, chapter 3). To make things clear from the very beginning,
Newbery gives a definition of the tern ‘owner’ in a sense it is used with respect to
natural monopolies: ‘Owner – the authority with the residual rights, that is those rights
that are not subject to contract or control’. Choosing between regulating privately
owned network utility and directly controlling publicly owned utility, the government
faces trade-off between lowering transaction costs and lowering incentives to work.
The major difference in relations of government with public and private
enterprises is the degree of commitment to its obligations. In case of private utility it is
normally well specified regulation setup, that is regularly revised. With public utilities,
to the opposite, any action can be negotiated and obligations can be changed virtually
at any time. The other things that is supposed to make public enterprises less efficient
is less pressure to set right prices. This pattern appeared in phenomena of underpricing
of capital and rent dissipation. The first one is possible because of access of utilities to
debt financing or tax exemptions, the other is caused by average pricing when average
costs are below long-run marginal costs. In hydroelectric industry, for example, both
phenomena were present.
There is a difficulty in empirical evaluation of ownership changes, since usually
such changes go in line with a broader set of reform, e.g. change of regulation method.
Intercountry comparisons are also difficult because technology varies from country to
country, and so does quality of regulation, as well as management. Assessments within
9
a single country are not promising, since co-existence of two forms of ownership
means that they yield approximately the same social benefits. Still, empirical studies of
all kinds can be helpful if one does not forget about the limitations of their
implications. Further there are summarized some of them.
In the United States regulation was and still is rate-of-return, so comparisons are
drown between publicly owned and regulated according to the rate of return
enterprises. Backer in 1913-15 considered 300 private and municipal electric firms, and
found that municipal ones sold at lower price in 1910-11, and also had lower capital
and operating costs. They also had 40% higher sales. Partly it can be explained by the
fact that they were better placed, got free managerial services and successfully used
economy of scale. These explanations seem to be plausible, since by 1925-26 both
sectors were getting the same average revenue.
In 1969 Wallace and Junk assessed performance of 900 US generating plants in
1964-65. According to this study, municipals had 74% higher average operating costs,
because of smaller size and spare capacity. Emmons in1991 considered 145 firms in
1930 and 153 firms in 1942. In 1930 public utilities charged 28% less, half of this
difference was due to the subsidies, but 14-17% remained as monopoly profit for
private utilities. In areas where competition was present, it eliminated profit driving
price s down 13%. In 1942 there was already only 5% difference between public and
private firms pricing, and all due to the subsidies.
Dihorenro and Robinson in 1982, Atkinson and Halvorsen in 1986 showed that
electric utilities with different ownership structure are equally cost efficient for given
prices. But public utilities face lower price of capital that serves as a misleading signal
and undermines efficiency. Fare in 1985 found insignificant advantage in the efficiency
of public utilities. Hjalmarson and Veiderpass in 1992 also didn’t find any ownership
effect among 290 Swedish electric utilities.
Politt in 1993 considered utilities from 9 countries in 1986, didn’t find any
differences in technical efficiency, but private enterprises performed better in sense of
cost efficiency. He also compared 760 power plants from 14 countries in 1989 and
10
found no difference for subsamples according to load factor. Pooled data, however,
revealed small, but significant difference of 1-3% in technical efficiency in favor of
private utilities. In the same study cost efficiency of public firms was 5% lower and
highly statistically significant. But it was explained by poor technology choice, for
example in Great Britain public utilities were obliged to buy expensive domestic coal
that undermined their cost efficiency.
Kwoka in 1989 compared 543 US electric utilities, 147 of which were privately
owned. He discovered that MC curve is rising for generators, U-shaped for distributors,
and that scale economies are present in transmission. Pubic utilities had 2,3% lower
costs and 1,9% lower prices. The use of quadratic cost function with presence of
different scales s questionable in this study. Another conclusion from this work is that
competition lowered prices by 8% (there were 22 towns with competition and 46
without it). In general public utilities performed better, especially if there was a need
for innovations.
In 1988 Frantz studied X-inefficiency in electric industry and came to the
conclusion that competition is more important for elimination of it than ownership
structure. Primeaux in 1977 compared public monopoly and private duopoly and found
that the latter lowered costs.
A closer look at empirical studies: different approaches
In this subsection we’ll thoroughly consider two empirical studies that reached
in a sense opposite conclusions. The first is due to Hausman and Neufeld (1991), the
second – to Arocena and Price (1999). Hausman and Neufeld used the data from the
Fourteenth Annual Report of the US Commisioner of Labor in 1899. Only power
plants that exclusively used bituminous coal as input were considered. Also plants that
did not provide full information about their production and financial variables were not
taken into account. The resulting sample consisted of 218 private plants and 97
municipal plants.
11
Outputs used included incandescent lighting, arc lighting and stationary motor
service. Almost two thirds of total revenue was attributed to the first one, and it was
price according to the number of lights installed. The second output was possible to
calculate in kilowatt-hours. The third one was measured by total power of motors in the
system. Inputs were capital, labor and fuel. The first was calculated as capacity of
generators, the second as average salary, and the third as amount of coal used.
Depreciation was calculated according to a straight-line formula and gave the average
of 6%. Interest rate was assumed to be 5%, so that cost of capital was 11% of installed
capacity.
The measure of efficiency used required no specific assumption about the
functional form of production. Overall productive efficiency can be written as product
of allocative, technical and scale efficiencies. The maximum value of any of the
efficiency indices is 1, and a firm with overall efficiency one reached minimum level
of costs given the output produced. Only allocative inefficiency means that the firm is
in a point on Pareto set of output, but does not minimize costs. Only scale inefficiency
means that the plant could raise its output-input ratio by reducing or expanding all its
inputs in the same proportion. Finally, technical inefficiency means that the firm is not
on its Pareto set of inputs. The actual efficiency ratio was ideal plant’s (with overall
efficiency 1) costs of inputs to the evaluated plant’s costs of inputs.
The results obtained in the study are non-arbitrary. Public plants revealed higher
efficiency than private plants for every measure used. All differences are statistically
significant. An average municipal plant was 21% more efficient than an average
private plant according to the overall measure. In terms of technical efficiency public
plants were 9% superior. Scale economies didn’t work in favor of private plants either,
although they were larger on average.
To check the soundness of the results, the authors change some of the
assumptions, for example using reported depreciation instead of the straight-line or
eliminating all the observations that showed extreme values of efficiency. The results
did not significantly change. The problem of selection bias could work only in favor, of
12
private enterprises. It is also unlikely that higher efficiency of municipal plants was due
to higher competition among them. Also adverse effect of efficiency on ownership was
observed, in a sense that efficient private plants were less likely to be taken over by
municipal firms.
The study concludes that its results going against the theory are quite
explainable in a different framework. It states that except for self-interest and profit
motives an individual is driven by other motivations such as altruism or ‘public spirit’.
It is also assumed that such ‘public’ motives can be encouraged successfully only
within public firms (Taussig and James quoted in Hausman and Neufeld 1991).
Arocena and Price considered Spanish electric industry in 1984-97 (before and
after the introduction of price cap regulation in 1988). Inputs were traditional: capital
was measured in MW of capacity, labor in employees per plant, and fuel in millions of
terms. However, outputs included not only annual net power produced in MWh, but
also declared availability in MWh ready to be provided at any time and three
pollutants: sulphur dioxide (SO2), nitrogen oxide (NOx) and particulates in tons. Last
three outputs, of course, were undesirable. Only physical units were used for
measuring.
Efficiency is understood in a sense to what extent plants under consideration
moved closer to the most efficient plants. Overall efficiency was decomposed similarly
to the study considered above. More precisely, Malmquist index approach was used.
Three components of efficiency were technical change between future and present
efficiency in movement to production possibility frontier, change of the frontier itself,
and change in technical efficiency. Each indicator could take values less or greater than
one, where one would indicate absence of any change.
Results showed that public sector generators were more efficient than private
ones before introduction of the price cap. After that the relation was reversed.
Efficiency of private enterprises was growing faster than that of public, especially
during the first years of the cap. Especially rapid growth of productivity was observed
13
for the least efficient private generators. Scale efficiency changes were approximately
the same for the two sectors.
The study also shows that the move towards the price-cap regulation from the
cost-of-service regulation increased productivity in private sector, but not in public
sector. This results supports the idea of ‘public spirit’ that was not strengthened by new
regulation, which provided only conventional additional incentives relevant for private
enterprise to the bigger extent than for public one. The important feature of the study is
environmental consideration, and the regulation in this area was binding throughout the
period under consideration.
Conclusion
In this paper we showed that both historical evidence, theoretical considerations
and empirical studies do not provide overwhelming support to the use of public or
private ownership. History of the development of natural monopolistic industries
reveals cyclical pattern, and ownership structure seems to be determined by more
general macroeconomic tendencies. Theoretical models provide explanations of better
performance of either of ownership forms, depending on their assumptions about the
determinants of economic agents behavior. Finally, empirical studies find evidence in
support of higher efficiency of private or public electric utilities, or no difference in
their performance, depending on other variables.
The main lesson we can extract from these speculations is that ownership
structure is not so important per se. Competition and quality of regulation are of much
greater importance in their influence on efficiency of electric utilities. Thus, the main
task of the government is probably not to privatize or nationalize an industry, but to
stimulate competition where it is possible, and provide regulation that creates
incentives for agents involved to raise efficiency. The decision whether to privatize or
14
nationalize electric utilities should be made after careful consideration of costs and
benefits for every particular case, but this issue is beyond the scopes of our paper.
15
REFERENCES
Arocena, Pablo and Catherine Waddams Price, “Generating Efficiency: Economic
and Environmental Regulation of Public and Private Electricity Generators in Spain”,
July 1999.
Hausman, William J. and John L. Neufeld, “Property Rights versus Public Spirit:
Ownership and Efficiency of U.S. Electric Utilities Prior to Rate-of-Return
Regulation”, The Review of Economics and Statistics, 1991, 73 (3), 414-423.
Newberry, David M., Privatization, Restructuring and Regulation of Network
Utilities, Cambridge, Mass.: MIT Press, 2000.
Viscusi, V. Kip, John M. Vernon and Josef E. Harrington, Economics of Regulation
and Antitrust, Cambridge, Mass.: MIT Press, 1995.
16