Privatising Network Utilities

Make sure it has a competitor. Or a regulator There is no doubt that the prices and availability of services provided by some privatised utilities have become much more convenient. There is equally little doubt that some privatised utilities have failed to deliver the improvements promised at the time of their going private. Is it possible to generalise regarding the success of privatisation? Which kinds of utilities are more likely to provide good returns for investors while maintaining quality and affordable prices?

David Newbery, of the University of Cambridge, examined this question in depth in a recent CESifo Working Paper. To get to the core of the matter, he explains, one must first examine the economic problem lying at the bottom of every utility. In order to reach its customers, the utility must first make a sizable investment in a rail, phone or power line network. That is a huge fixed cost. In contrast, the services provided through such network can be delivered with comparably low variable costs. This fact means that the higher the number of end users, the lower the average unit cost for the provider, something economists refer to as economies of scale. In order to capture the maximum possible economies of scale, utilities undercut their competitors until they remain the sole provider, giving a whole new meaning to the term "natural monopoly”.

From an economic point of view, some utilities are natural monopolies in the sense that it may be desirable to have only one utility provider in order to offer the service at its lowest possible cost. On the other hand, natural or not, a monopoly is a monopoly: without a bit of prompting from the state, it will be less inclined to offer its services either cheaply or more abundantly to its customers once competitors are out of the scene.

The key to utility privatisation is, then, the establishment of a regulatory system that makes sure that, on the one hand, the end user receives a good service and, on the other, the provider receives a good return on the investment it made in setting up the network. This suggests that not all utilities are equally suited to a successful privatisation. Recognising this, Newbery ranks utilities according to their potential for success and the size of the potential gains to be reaped from privatising and restructuring them: top of the list are telecoms, followed by gas, electricity, water and last, rail. There are doubts, he says, whether privatising rail can deliver sustainable improvements.

It has been 25 years since Margaret Thatcher, then the UK's Prime Minister, started her crusade against state companies. She initiated an unprecedented wave of privatisation covering public companies not only in the British Isles, but in many other countries as well. Many greeted this as a chance for efficiency improvements and better services. Others warned of deterioration in the quality of life and insufficient supply, in particular for poorer households. Did these misgivings prove to be correct, or was Margaret Thatcher right in her claim that privatisation was a cornerstone of Britain's economic success?

According to David Parker, of Cranfield University School of Management, privatisation of itself is no guarantee for economic success. As he shows in a recent CESifo Working Paper, there must also be competition between the privatised utilities. When a privatised utility enjoys a dominant market position, the State must regulate the services provided by such a company in order to keep prices low and quality high.

The lessons were there for all to see, but it still took a considerable time to apply them. In the early days of privatisation, it was mostly private investors who made large gains from the privatised utilities. Neither competition nor regulation were effective, leaving the new proprietors free to take advantage of their dominant position in the market and skim some fat profits. Only gradually did new competitors appear in certain markets. And where this was not the case, it took a long time for the relevant authorities to put effective regulatory policies in place. In this regard, utility privatisation redefined the role of the state: away from the state producers and into that of market regulator.

How have other countries done with privatising their utilities? A glance towards the US can at first be rather unsettling: in August 2003, the history's largest blackout made people loose all confidence in the liberalised American electricity market. What can we learn from the US experience?

That is the question Ingo Vogelsang, of Boston University, seeks to shed light on in his paper Network Utilities in the U.S. — Sector Reforms without Privatisation. In his view, in the early days of deregulation of the electricity market, in many US states too much attention was paid to the short-term advantages for the providers, and too little to the problems of long-term supply and fluctuations in demand. The electricity supply crises, particularly in California, focused minds onto better thought-out strategies: improvement of the coordination between electricity producers and network operators, furthering of competition between producers, and more link-ups with the electricity networks in other states and in Canada.

Note: This text is the responsibility of the writer and does not necessarily reflect the opinion of either the CESifo Working Paper author(s) or the CESifo Group Munich.