Viewpoint The World Bank Group October 1996 Note No.93 Privatizing Infrastructure-Capital Market Pressures and Management Incentives Timothy Ibwin One of the arguments for privatizing infrastruc- The problem anId Ian ture is that private ownership gives the man- Alexandeer agers of infrastructure firms better incentives In a competitive industry, managers come un- to manage well: the new, private sector own- der pressure from four groups: customers, ers put stronger pressure on management to workers, owners, and lenders (figure 1). Cus- operate efficiently and profitably, and those tomers want good prodticts at loW prices. Work- who lend money to the firms monitor manage- ers want competitive salaries. Owners want ment more carefully. But privatization does not high profits. Lenders want their loans repaid. ineluctably improve management. The devil is And if these groups don't get satisfaction, they in the details. The rules accompanying priva- can turn to other firms, run by other manag- tization determine how well new capital mar- ers. The combined pressure means that man- ket pressures are brought to bear. agers must run their firms reasonably well. This Note examines how owners and lenders The traditional infrastructure firm, however, has encourage managers to run private firms well been run as a publicly owned monopoly, radi- and proposes some privatization rules for in- cally changing the balance of these forces. Cus- frastructure companies. While it draws mostly tomers exert less pressure, because they cannot on the experience of the United Kingdom and choose among sellers, and governments typi- the United States, two countries in which pri- cally don't demand the same financial return vately owned infrastructure has an established on their investments as private owners do. In track record. the lessons are just as relevant to the absence of pressure from consumers and developing countries. In particular, the Note owners, the demands of employees and lend- concludes that privatizing governments should: ers do not create good managerial incentives, * Seek, where possible, to have several differ- for the easiest way for managers to satisfy these ent firms operating in industries that are local demands is to sacrifice the interests of custom- natural monopolies, such as water distribu- ers and owners-rather than increasing their tion, so that bankrupt firms can more easily firm's efficiency. A bank's demand for loan re- be replaced by others. payments, for example, may be met at the ex- * Allow concentrated share ownership, because pense of customer services or dividends paid large shareholders have the best incentives to the owner. to monitor management. * Allow foreign ownership and hostile take- The solution has two parts. First, governments overs, to increase new owners leverage over should subject infrastructure providers to com- managers by providing for a wide range of petition wherever possible, to strengthen cus- potential subsequent buyers for their firms. tomer pressure. And second, they should * Regulate privatized firms in ways that strengthen lender and owner pressure through don't guarantee owners their profits, so own- privatization. Here we consider the second- ers have financial incentives to monitor the first is the subject of other Notes in this managers. series. Private Sector Development Department. Vice Presidency for Finance and Private Sector Development LU1 Privatizing Infrastructure-Capital Market Pressures and Management Incentives FIGURE 1 THE SOJURCES OF PRESSURE ON MANAGERS a firm disappears along with its products-they can switch to another brand. But what hap- pens when a water monopoly goes bankrupt? A new firm must somehow take over the as- sets of the old business without unduly dis- rupting ser-vice. In a country with only one 4 ~~~~~water company. that may be difficult. Nevertheless, regulated infrastructure firms can go bankrupt-and in the United States, they have. The Public Service Company of New Hampshire, an electric utility, fied fr bank- ruptcy in 1988, and El Paso Electric in January 1992. Both had sufferedl unexpected increases in the cost of constructing nuclear power plants, and the regulatory authorities declined to al- low them to pass on all the cost overruns to consumers in the form of price increases. The Pressure from lenders New Hampshire utility mergedl with Northeast Utilities; El Paso was taken over by the Central Although priv atization doesn't always introduce and South W,est utility company. Bankruptcy new lenders, it does change the way lenders was an option in these cases partly because behave. Without implicit or explicit government there were many utilities operating in similar guarantees of loan repayments, lendlers worry circumstances in the United States, so other more about a firm's becoming insolvent. Thus, firms could take the place of their failed coun- they have more to gain from monitoring the terparts. (Also important was the fact that U.S. behavior of managers. They'll take more care law, allows companies to continue to operate specifying, in the debt covenants that accom- while bankruipt.) When privatizing, then, there panv loans, what the firm can and cannot do are advantages in not selling all the local edec- (what debt-equity ratio it must keep below, tricity or water monopolies to one buyer. Ar- for example). And thev'll take more care en- gentina, to take just one example, followed this suring that managers comply with the coy- approach in privatizing its electricity sector: enants. Further, if the firm defaults on its three private distribution companies now sup- repayments, the lenders have to consider the ply electricity in greater Buenos Aires. possibility of taking control of it themselves, introducing new management, or even selling Pressure from owners the assets and closing the business. Private ow ners put pressure on managers in But getting the threat of bankruptcy to spur three ways: better management is tricky in infrastructure. u By monitoring them. The first problem is that regulated monopo- * By linking their pay to their firm's profitability. lists tend to he allowed to charge prices high * By being willing to sell the firm to new enough to keep them in business. In the United owners. Kingdom, for example, regulators are legally required to ensure that companies can finance Monitoring management their functions. The second problem is that infrastructure firms are monopolies supply 'ing The most direct w'ay in which owners look af- services that consumers cannot easily do with- ter their interests is by appointing and then out, such as water and electricity. In competi- monitoring their firm's top managers. In big tive markets, it may not matter to consumers if companies, they usually do this through the board of directors. which they appoint and Linking pay to performance which then appoints and monitors the man- agement. But at annual or extraordinary gen- Besides directly monitoring management, share- eral meetings, the shareholders may review and, holders, through the board of directors, can give if they want, overrule the directors' proposals managers performance-based pay packages. to, say, pay dividends or make major acquisi- Consumers are sometimes angered by large bo- tions. (The precise powers of shareholders vary nuses paid to the managers of infrastructure according to such things as company law, the firms, but well-designed performance pay can founding documents of the company, and the strengthen managers' incentives to increase their requirements imposed by stock exchanges.) firm's efficiency-not only increasing share- holder returns but in the long run giving con- If a firm is owned by thousands of sharehold- sumers lower prices or better quality. ers, each holding only a tiny proportioni of the firm's shares, no shareholder has a strong in- Privatization, of course, is not a prerequisite for centive to do the research and other work that's performance-related bonuses. The managers of necessary to monitor and influence managers. publiclv owned infrastructure companies can re- For small shareholders unhappy with a firm, it ceive bonuses linked to, say, operating profits. is easier to sell their shares than to take delib- But privatization permits a new type of bonus erate steps to improve the firm's management. because it allows managers' pay to be linked to Selling can in itself be helpful-as the discus- their firm's share price. As long as the firm's shares sion of performance pay below suggests-but are traded frequently, the link is useful because it is large shareholders who are most likely to the share price will reflect better than any other put direct pressure on managers. They have indicator the firm's value-which is what own- an important financial interest in management's ers want managers to focus on. Basing a performance-and the resources and voting manager's bonus solely on profit in the current power to influence managemnent. Privatizations year could, for example, encourage the manager that permit concentrated ownership therefore to sacrifice the firm's value for the sake of short- tend to be good for efficiency. term profits. Share-price-based schemes can cir- cumvent this problem, because well-infornmed In the United Kingdom, utility firms were privat- shareholders will be on the lookout for manage- ized under a rule that, initially, no one share- rial decisions that jeopardize future profitability. holder could own inore than 15 percent of a firm, to shelter management from takeover bids The simplest share price scheme gives manag- while it "adjusted to privatization." This rule ers shares in their firm. If they manage well has probably weakened the incentives for man- and increase the firm's expected profitability, agers to improve their firm's performance. in their wealth increases. The incentives can be electricity, the rule is in force until the year further sharpened by giving the managers op- 2000-although it has been possible for a ma- tions rather than shares. Suppose, for example, jority of shareholders to overturn the rule since that a firm's shares are trading at $10. The own- 1995. In water, it applied only until the end of ers could give the managers the right to pur- 1994. Since then, two water companies have chase shares in the company in three years at been taken over, one by a subsidiary of a a price of, say, $12 a share. if the share price is French water company, the other by a British lower than S12 in three years, these options electricity company. More takeovers are being are worth nothing: there's no point in buying discussed. The interest in takeovers shows that shares at $12 when they can be bought for less market participants believe they can increase on the stock market. But if the share price ex- efficiency now that they are permitted to own ceeds $12, the options are valuable. controlling interests in the firms. Any efficiency improvements they do make will benefit share- There are many variations on the options ap- holders and, over time, consumers. proach. British Gas, for example, introduced a Privatizing Infrastructure-Capital Market Pressures and Management Incentives more complex scheme, partly in response to quently buy the firm. In particular, they can public criticism that management pay was high ensure that they haven't placed any obstacles and not clearly linked to performance. Under in the way of hostile takeovers or foreign own- this scheme, British Gas awards its managers ership. Note, however, that takeovers are not bonuses in the form of long-term share op- always desirable, especially when they are tions. The market value of the options-at the friendly rather than hostile. If one firm buys time they are created-is between 33 percent out another so that the two no longer compete and 125 percent of the managers' base pay. with each other, this takeover (or merger) re- But the managers do not immediately receive duces the intensity of customer pressure. In the options; instead, the company holds the these cases, governments need to weigh the options for three years. At the end of the three- advantages of permitting takeovers against the year period, the increase in the share price for benefits of competition. British Gas is compared with those for the 100 biggest listed companies in the United King- Regulation dom, and the managers are given a proportion of the options based on British Gas's ranking Regulation affects private investors' interest in among these 100 companies. This ranking, or pressuring their managers to manage well. In "benchmarking," helps to separate the effect particular, the more that regulation determines of the managers' performance from other in- a firm s profit, the less need owners have to The Note series is an fluences on the share price, such as the strength supervise, cajole, and threaten managers. Regu- open forum intended to encourage dissemina- of the British economy. lation should therefore let firms benefit from tion of and debate on good management decisions and suffer the con- ideas, innovations, and Selling the shares sequences of bad ones. Pure rate-of-return best practices for expanding the private regulation sets the price a firm can charge and sector. The views Another action owners can take to look after increases or decreases that price so as to keep published are those of their interests is to sell their shares to someone the firm's rate of return constant. If the regu- the authors and should not be attributed to the else. When owners jointly sell a controlling lator's price reviews are too frequent (for ex- World Bank or any of its interest in a firm to another group against the ample, every year), rate-of-return regulation affiliated organizations. wishes of managers. the sale is called a hostile takes the risk out of the business and weakens Nor do any of the con- clusions represent takeover. The incentive effect on managers is the incentives of managers. At worst, when official policy of the encapsulated in the term hostile: the incum- private owners receive guai-anteed profits, they World Bank or of its bent managers feel hostile because the take- may do no more to encourage efficiency than Executive Directors or the countries they over can result in their being fired. If managers public owners. Indeed, studies of water and represent. are doing their job poorly and the current own- electricity utilities in the United States, where ers cannot remedy the problem, the sagging rate-of-return regulation is used, have often To order additional copies please call the share price provides an opportunity for other found private companies to be no more effi- FPD Note line to leave a groups to buy the firm, fire the management, cient than their public counterparts. The solu- message (202-458-1111) change the firm's strategy. and improve its prof- tion is to rely on competition, not regulation, or contact Suzanne Smith, editor, Room itability and thus its share price. If managers wherever possible. Where competition isn't G8105, The World Bank, are doing their job well, the firm's assets should possible, the rate reviews in rate-of-return regu- 1818 H Street, NW, not be undervalued and no such opportunities lation can be made less frequent or price cap Washington, D.C. 20433, orWsntern,t .ddress should arise. The chance of a takeover bid regulation can be introduced instead. ssmith7@worldbank.org. arousing the hostility of management is smaller. Previous issues are also Thus. owners' abilitv to sell their shares is one Timothy Irvin, Private Sector Development available on-line (http:// www.worldbank.org/ source of pressure on managers. Departmnent (tirwingworldbank.orgJ, and Ian htmllfpdlnotes/ Alexander (ian@londecon.co. uk)., London notelist.html). Governments can therefore help new private Economics, England (This N\ote is based on ®Printed an recycled owners to improve the efficiency of their firms work by MIr Alexander at Oxford Economic paper. by not putting restrictions on who can subse- Research Associates.)