Privatesector P U B L I C P O L I C Y F O R T H E Note No. 207 April 2000 The Costs of Corruption for the Poor-- The Energy Sector Laszlo Lovei In recent years the fight against corruption has assumed a key place in development policy, as a and Alastair way of strengthening economic growth and helping civil society and democracy to function. McKechnie Corruption not only stifles growth. It also perpetuates or deepens inequality, as the few amass power and wealth at the expense of the many. The energy sector lends itself to corrupt practices. This is a result both of its traditional institutional arrangements--dominated by state monopolies controlling oil, gas, or electricity--and of the sheer amount of cash it can generate. Corruption in energy takes many forms, from petty corruption in meter reading and billing to grand corruption in the allocation of lucrative monopolies. These practices differ in scale but contribute to the same results--weak operational and financial performance and, for the poor in particular, declining service quality or reduced chances of ever accessing network services. The answer to corruption is continuing reform, to reduce the incentive and potential to capture monopoly rents and to increase the transparency of public and private transactions, regulatory structures, and decisionmaking processes. The energy sector, with its complex mix of pub- dence from case studies suggests that illegal pay- lic and private actors and often enshrined cen- offs can lower the quality of public works pro- ters of monopoly power, is prone to corruption. jects, and increase their costs by as much as This sector generates substantial cash transac- 30­50 percent (Rose-Ackerman 1996). And there tions compared with other infrastructure sectors, is reason to believe that the costs of corruption not only in both small and large capital-intensive are disproportionately borne by the poor--that investments but also in revenues, which tend to corruption is not only inefficient, but also be higher than those for such services as water inequitable. Understanding how corruption and sanitation or use of roads. With considerable manifests itself in the energy sector--and how monopoly rents at stake (from meter reading up this affects the poor--can thus make a valuable to project award) and, in many countries, long contribution to the identification and design of histories of weak monitoring, low transparency, sector programs aimed at improving the well- and inadequate civil service pay, opportunities being of the poor. and incentives for illicit gain are rife. This Note looks at some common manifestations While there is little hard evidence on the inci- of corruption in developing country energy sec- dence and costs of corruption within or across tors, drawing examples from Europe and Central countries or sectors, there is little disagreement Asia and from South Asia. (The choice of these that these costs can be high. For example, evi- regions as sources of examples is not intended T h e W o r l d B a n k G r o u p P r i v a t e S e c t o r a n d I n f r a s t r u c t u r e N e t w o r k 2 The Costs of Corruption for the Poor--The Energy Sector to imply that corruption of these forms is unique brings rewards, elections have become costlier to these regions or more prevalent there than as information channels proliferate through new elsewhere.) It looks at why the presence of technologies (satellite television). These trends corruption should matter to policymakers con- have resulted in election finance scandals in cerned with improving the lot of the poor--and industrial countries, and anecdotal evidence then discusses steps that governments might suggests that politicians in new democracies are take to reduce the incidence of corruption and also pressed to acquire illicit sources of cam- its costs to the poor. paign funding. Common forms of corruption Petty corruption For ease of discussion, some common forms of Petty corruption is most prevalent at the interface corruption can be grouped into categories with customers and is one of the reasons for the according to the level of the public officials low payment collection rates reported by many involved: gas, electricity, and district heating companies in Petty corruption, such as bribes paid to or de- developing countries. For example, the state- manded by meter readers or safety inspectors. owned Baku Electricity Company in Azerbaijan Corruption by company managers and mid- reported a household payment collection rate of level bureaucrats, such as side payments asso- 12 percent in the second half of 1999, despite ciated with energy purchase or sale contracts employing 1,000 meter readers and payment col- or debt instruments. lectors. Only part of the payments collected were Grand corruption, such as lucrative monopo- officially recorded, but consumers did not seem lies granted in return for political campaign to mind, since the meter readers in return reduced contributions and the personal enrichment of their reported consumption by 50 percent. The political leaders. indifference of the consumers was replaced by anger, however, when the low payment collec- Corruption characterizes both traditional and tion rate repeatedly led to electricity blackouts modern society and governance. Traditional due to the lack of fuel at power stations. society in some regions is characterized by patron-client relationships, complex interrela- In Bangladesh revenues are collected for only 55 tions of patronage and protection that require percent of the power generated. By one esti- financial resources for the exercise of power and mate, about half the total system losses of the impose financial burdens for protection. In Bangladesh Power Development Board (BPDB) South Asia, for example, these relationships are and Dhaka Electricity Supply Authority (DESA) reinforced by the vestiges of traditional social are accounted for by mismanagement and petty stratification, hierarchy, and deference. corruption surrounding electricity metering. Hard facts are difficult to come by, but anecdo- This is not to suggest that certain cultures are tal evidence from electricity consumers and inherently corrupt, but that the old social orga- articles in the local press suggest pervasive cor- nization provides incentives for rent seeking. ruption by some power sector employees. A Development involves the transformation of recent survey by the Bangladesh chapter of such societies so as to empower the poor and Transparency International revealed that public provide legal constraints on the exercise of utility employees were regarded as the most cor- power. In countries where governments change rupt officials after the police and lower judiciary. through elections, the political ideologies of par- Meter readers frequently delegate the actual task ties have converged since the end of the cold of meter reading to informal operators and focus war and government is being seen more as their own efforts on developing a business in acquisition of the spoils of office. If government illegal connections. The World Bank Group 3 In Pakistan nontechnical losses arising from A third example is from the coal industry in electricity theft were reduced significantly when Russia and Ukraine. Anecdotal evidence sug- the army took over electricity distribution in gests that unrecorded coal production illegally 1999. While there were many illegal connections sold for the benefit of individual mine managers by low-income households, the Pakistani army is a widespread phenomenon, involving local found that significant quantities of electricity industrial customers, the rail transport system, were stolen by high-income households, indus- and port authorities. try, and large commercial establishments such as shopping malls. In India surveys sponsored by All these practices may result in an increase of the World Bank as part of load management and 20­30 percent in costs and a reduction of simi- agricultural electricity studies have shown that lar size in revenues for gas, coal, and electricity 20­30 percent of electricity attributed to companies, aggravating their already precarious unmetered agricultural consumption is stolen by financial positions. users in other sectors. Certain government regulations in the former The aggregate impact of "petty corruption" may Soviet Union create particularly strong incen- be far from petty. In Bangladesh the losses of the tives for collusion between public officials and BPDB and DESA amount to more than US$100 private company managers. The allocation of oil million each year. Petty corruption in South Asia export pipeline capacity in Russia, where part of is often well organized. Trade unions protect the capacity is reserved to be allocated on a dis- corrupt workers, politicians protect the unions, cretionary basis, seems to be a typical example. and accompanying this protection is a stream of The difference between the domestic and export stolen revenues from the meter readers to prices of crude oil is US$80 a ton, so access to unions to politicians. export capacity translates into large economic benefits. Therefore, the limits imposed on petro- Corrupt management practices leum product exports--ostensibly to ensure adequate domestic supplies--coupled with the Corrupt management practices may involve both discretionary exemptions, provide an opportu- cash and noncash transactions. Noncash trans- nity to generate significant private (and per- actions, a key feature of the Soviet economic sys- sonal) gains. tem, have remained widespread and provide fertile ground for such practices in the former In the South Asian power sector cash transac- Soviet Union. Exchanging electricity (for fuel) tions, some paid overseas in foreign currency, and gas and coal (for electricity and industrial appear to be a more common manifestation of production) at artificially inflated rates is one corruption at the managerial level than noncash method of generating private gains. transactions. Corruption appears more common in unsolicited bids, supplier's credits, and crash Another practice is the issuance of promissory program­type procurement initiatives where notes by electricity companies with restrictions there is little or no competition among suppli- on circulation, duration, and eligibility. These ers, the definition of what is being procured is notes are immediately discounted heavily on the negotiable, and reputable firms may be reluctant market and can be purchased for a fraction of to participate. Even where competitive bidding their face value. The electricity company officials processes are used, side payments may be made who certify that the circulation of the note fol- to ensure favorable bid specifications, terms, and lowed a permissible path and that the holder of conditions, and favorable bid evaluations or the note is entitled to redeem it in full for elec- endorsements. Side payments may also facilitate tricity or fuel are able to use their position to the issuance of work orders, the opening of extract bribes. letters of credit, and all stages of project 4 The Costs of Corruption for the Poor--The Energy Sector implementation carried out by contractors and An example of an environment that creates consultants, such as processing payments and opportunity for the abuse of high office comes obtaining permits. from the Russian coal sector. One of the most heavily subsidized industries in Russia, coal min- Jobs where rents can be collected are themselves ing continues to command a particularly high subject to corrupt processes. Patrons in govern- degree of political influence. As recently as 1994 ment or management award such jobs to their the drain of coal subsidies on the federal budget clients, who are expected to transfer back some was enormous. In that year almost US$2.8 billion of their illicit gains. Such jobs may even require was spent on direct subsidies to the sector, rep- up-front payments by the new employee. Being resenting more than 1 percent of GDP. Until late able to "transfer" employees from low-paid jobs 1997 control of these subsidies was the prerog- without potential for illicit gain to low-paid jobs ative of RosUgol, the national coal monopoly (in that benefit from corruption bestows power on fact, operating as a ministry of coal mining). the manager or politician. It is also common for Allocation, distribution, and use of these budget politicians to reward their supporters or cronies funds were highly nontransparent, with no effec- by using their influence to award rent-collecting tive monitoring arrangements. Audits of 1996­97 jobs in public enterprises. coal subsidies ordered by the first deputy prime minister and the Duma found that significant Grand corruption sums of money had either been disbursed to the wrong recipients or used for the wrong pur- Grand corruption is seldom as visible as its two poses. The Russian government responded with lesser cousins. A notable exception occurred in a series of far-reaching measures to improve the Ukraine, where a former prime minister per- transparency of and accountability for subsidies sonally granted exclusive rights to a gas trader to the coal sector. that was reportedly controlled by him and his associates. The trader imported gas from Russia Corruption and the poor at a price of US$50 per thousand cubic meters and sold it to captive industrial consumers for The kinds of corrupt activity described above dif- US$80. When the prime minister, who used the fer in the nature and magnitude of their impli- financial wealth generated by this lucrative cations for the poor. monopoly to establish a political party, was fired, the wholesale gas market was liberalized. In petty corruption in electricity or gas systems, both parties (the meter reader and the house- The gas trader quickly lost most of its customers, hold) may benefit from striking a "deal." In the but remained the holder of several hundred mil- short run--especially in the countries of the for- lion dollars of debt to the Russian gas company mer Soviet Union, where almost all households RAO Gazprom for gas received but not paid for. are connected--there is nothing particularly RAO Gazprom, arguing that the private trader's antipoor in this. But in countries in South Asia privileges were granted by a cabinet resolution, the poor may be too vulnerable to resist the has reportedly succeeded in transferring the lia- rapacity of the coalition of corrupt utility employ- bility for unpaid gas bills to the Ukraine gov- ees and their protectors, who may use physical ernment. Following the temporary liberalization force to enforce their regime. In such countries of the gas market, the owner of another private poor consumers may not benefit much from the gas trading company was appointed to head a diversion of utility revenues. newly created vertically integrated national oil and gas company (Naftogaz) and given exclu- In the long run, however, inadequate revenue sive rights to sell gas imported from Russia to collection and other corrupt practices tend to the 300 largest industrial companies in Ukraine. lead to deteriorating service. This hurts the poor The World Bank Group 5 more than others since less politically influential Similarly, in Bangladesh subsidies from the gov- (typically less affluent) neighborhoods suffer ernment budget amount to more than US$100 more blackouts and supply interruptions. In million a year, more than expenditure on health. Azerbaijan, for example, gas supply has been The beneficiaries of the subsidies are the rela- permanently suspended except on the peninsula tively affluent 16 percent of households that have where Baku, the capital city, is located. Many electricity service. The poor lose from the budget households and district heating systems in the subsidies to the power sector in two ways: lower country, dependent on gas, found themselves rates of economic growth and less social expen- (literally) in the cold. The recent residential elec- diture from which they would benefit directly. tricity blackouts have been scheduled for the peak morning and evening hours outside the Corrupt management practices typically lead to capital city, while curtailments in Baku have increases in supply costs, which in turn result in been scheduled for the hours when people are increased tariffs or, alternatively, mounting finan- typically at work or asleep. cial losses leading to reduced service. Increased tariffs badly hurt the less affluent (but still con- In Bangladesh, where voltage in distribution net- nected) households, since their budgets are works is unstable, observers in rural villages tighter and they may have to give up other essen- have noticed lightbulbs lasting only a few days tials (such as health care or education), while because of voltage surges. A low-income rural middle- and high-income families may just sacri- household might spend as much on lightbulbs fice luxuries. In other words, the problem is not as on electricity. (A Bank-funded survey revealed that there is an antipoor bias in the tariff increase, that power outages in Bangladesh cost about but that the tariff increase may hurt the poor more US$1 billion a year and reduce GDP growth by than others. For the poor who are not connected, about half a percentage point.) Diversion of util- the higher tariffs (plus higher connection costs) ity revenues had become such a problem in resulting from corrupt management practices Pakistan that in 1999 the government mobilized may create a higher barrier to access to the ser- the army to supervise meter reading and billing. vice than for the nonpoor. The alternative The scale of theft surprised the authorities, espe- scenario--unchanged tariffs but mounting finan- cially the extent to which the affluent benefited; cial losses leading to service reductions--has a industries, shopping centers, and large resi- clear antipoor bias when service reductions are dences accounted for a large share of the stolen spread unevenly across the country, as illustrated electricity. above. Where the great majority of poor households lack Grand corruption typically has the least direct connections--as is the case in most developing impact on the poor. It leads to higher energy costs countries--the costs of petty corruption are likely for industrial entities or reduced budgetary rev- to fall disproportionately on the poor. Large enues from export and natural resource taxes. power sector losses due to theft have been a major Most of the money paid in bribes is in foreign cur- cause of the bankruptcy of Indian state electricity rency that never crosses the border. Excess costs boards--negative equity is not uncommon. These of projects and concessions are funded by the losses mean that little funding is left for expansion country through electricity tariffs and foreign bor- of networks to improve access--in South Asia less rowing, and the illicit funds flow to the foreign than half of households have electricity service. accounts of government officials. The diversion of Losses also put a strain on state budgets, through these funds harms economic growth, reducing major expenditures on subsidies for electricity employment opportunities, and also tends to boards. This fiscal drag lowers the growth of state reduce the resources for social programs, includ- GDP and crowds out other expenditures, partic- ing assistance to the poor. The diversion of coal ularly for education and health. industry subsidies in Russia could have had a 6 The Costs of Corruption for the Poor--The Energy Sector more direct impact on some poor families, since and Russia. In South Asia the Bank has supported it might have contributed to the delays in the pay- the privatization of four distribution companies in ment of disability and unemployment benefits. the Indian state of Orissa, achieved in 1999 after an earlier attempt at a management contract Reducing the costs of corruption failed. Other Indian states--Andhra Pradesh, Haryana, Karnataka, Rajasthan, and Uttar Governments can take various steps to reduce Pradesh--have sought Bank assistance in utility the scope for corruption--most involving priva- restructuring and privatization, as have Pakistan tization, competition, more transparent rules, and Sri Lanka. and more disclosure. Corrupt management practices Petty corruption Corrupt practices involving noncash transactions In the utility sector an interim solution to petty can be targeted through an economywide reduc- corruption in bill collection is to hire a private tion of the share of barters, offsets, and other collection agency or to sign a management con- noncash payment mechanisms. In addition, they tract with a private party to run part or all of the can be reduced by reforms in the energy sector distribution company. Contracts of this kind nor- that include: mally include collection targets and stipulate Adoption of transparent market rules. sanctions for failure to meet these targets, includ- Reduction in the scope and applicability of ing contract termination. The few management emergency provisions. contracts implemented so far in Europe and Establishment of independent system opera- Central Asia have led to noticeable improve- tors with a multilevel governance structure to ments in collection rates, but have still fallen reduce the influence of any single individual. short of producing a cash flow that would ensure Establishment of independent regulatory bod- the long-term financial viability of the energy ies to oversee market operations. companies. Contracting out billing and collec- tions has been less successful in South Asia, The track record so far is mixed. It appears that where powerful vested interests such as trade these safeguards work less effectively in envi- unions have undermined private participation ronments where the bulk of the sector is still that does not give the private sector full control publicly owned. The recommended sale of gas of the utility. and electricity distributors, producers, and gen- erators to strategic investors is expected to fur- The final solution is to sell the distribution com- ther reduce the possibility for "foul play" by pany to strategic investors with a proven track public officials and politically motivated employ- record and a long-term interest in the business. ment policies that support corruption. Doing this, however, requires considerable time, technical expertise, and political commitment. In the oil sector in Russia the World Bank has pro- Assisting clients with the privatization of their dis- posed transparent procedures for allocating crude tribution companies is probably the single most oil pipeline capacity that would include a market- important building block of the World Bank's based component such as an auction, an audit of strategy to promote reforms in the energy sector. Transneft (the pipeline operator), and the elimi- In Europe and Central Asia the Bank is actively nation of product export restrictions (except for engaged in the privatization process in Armenia, delinquent taxpayers). However, the government Georgia, Moldova, Poland, and Ukraine and is has so far resisted these proposals. In the coal sec- also promoting privatization and management tor the Bank made progress in privatizing coal contracts in Albania, Azerbaijan, Bulgaria, mines a condition for releasing a slice of financ- Estonia, Kazakhstan, Latvia, Lithuania, Romania, ing in its sectoral adjustment operation. The World Bank Group 7 To the extent that privatization exposes produc- For the gas sector in Ukraine recommendations ers to the incentives and discipline of the market, have included the following: it serves as a natural counterbalance to corrup- Gas imports and marketing to industrial con- tion among company managers, who for the first sumers should be liberalized. time are answerable to private owners with an The government should not guarantee pay- interest in protecting and increasing the value of ments to RAO Gazprom. their assets. This aspect of the restructuring pro- Regular gas auctions should be held to pro- gram tends to encounter resistance at all levels of duce a transparent (cash) price signal. government and from the labor unions. The functions of the electricity regulator should be expanded to include the down- Bangladesh has been able to minimize corrupt stream gas industry as well. practices in the rural electrification sector The operation of gas transmission and dis- through a combination of public participation patch should be transferred to a strategic from below and financial discipline from above. investor through outright privatization or a The sector is organized into cooperatives with concession or management contract. boards of directors elected by their customers. A well-managed rural electrification board chan- Progress with the first three items has been nels donor funds to the cooperatives conditional mixed, the fourth item has been implemented, upon their performance and has the right to dis- but no progress has been made so far in priva- miss incompetent or corrupt managers. tizing or concessioning transmission. Rural cooperatives charge higher tariffs than In the Russian coal sector several remedial mea- BPDB and DESA and have succeeded in recov- sures have been taken: ering revenues for about 95 percent of electric- Dissolving RosUgol. ity billed, a much higher level than for BPDB and Transferring all subsidy management func- DESA. When rural cooperatives have taken over tions to the appropriate agencies. towns previously supplied by BPDB and Establishing earmarked federal treasury ac- replaced BPDB workers with their own staff, counts for all subsidy categories and recipients. they have achieved huge reductions in losses Putting in place mechanisms that ensure that and increases in collections. Cooperatives have individual entitlements go directly to individ- developed management practices to reduce uals, and not through coal companies, as theft, such as not allowing staff to be meter read- previously. ers for more than three years and staffing billing Setting clear priorities for subsidy disbursements departments with women, who have a better to mitigate the social impact of restructuring. reputation for integrity in these jobs than men do. Empowering the poor to demand better ser- Experience with the new system shows a vice has seldom been tried in the power sector, marked improvement in the management of coal yet holds promise for the future. sector subsidies. Flows of funds through the ear- marked accounts are strictly monitored by the Grand corruption treasury, whose local offices release funds only upon presentation of documentary evidence tes- As with lesser forms of corruption, grand cor- tifying to the completion of the works for which ruption is likely to be tackled most effectively by the funds have been transferred. In addition, highly transparent reform programs that involve social surveys of laidoff miners have confirmed disaggregating and divesting former state that subsidies disbursed for their social protec- monopolies and creating independent and rea- tion have been delivered to the intended recip- sonably transparent regulatory and monitoring ients. Present efforts to further strengthen the mechanisms. multifaceted subsidy management system focus 8 The Costs of Corruption for the Poor--The Energy Sector on discouraging the widespread practice of non- revenues, rent collecting by corrupt employees, competitive procurement of goods (such as the and large-scale graft related to the award of expensive equipment needed for environmental major contracts. Many industrial countries that mitigation works at and around closed mines), today preach against the sins of corruption were which leads to wasteful use of public funds and themselves noted for corrupt administration dur- is rife with potential for corruption. ing the past two centuries. Better-educated citi- zens are likely to demand higher standards of Bangladesh has been successful in awarding governance. It was instructive in January 2000 to independent power producer contracts through see a workers' strike against power reforms in transparent international competitive bidding the Indian state of Uttar Pradesh fail after the based on the price of electricity supplied. This public, frustrated by poor service and abuse by has resulted in prices of less than US$0.03 a kilo- employees, refused to support the strikers. The watt-hour, roughly half the price of directly social transformation that underlies develop- negotiated deals in such countries as Indonesia ment will create pressures for better governance. and Pakistan. But the imperative of attacking poverty requires that the World Bank Group and others that sup- Conclusion port energy development assist countries in eliminating corruption in the energy sector. Corruption in the energy sector is antipoor. It slows economic growth and diverts public References funds away from social expenditures that would Lovei, Laszlo. 1998. "Gas Reform in Ukraine." Viewpoint 169. World Viewpoint is an open Bank, Finance, Private Sector, and Infrastructure Network, forum intended to directly benefit the poor. Corrupt utilities are Washington, D.C. encourage inevitably bankrupt utilities unable to extend Rose-Ackerman, Susan. 1996. "The Political Economy of dissemination of and service to those without it, usually the poorer Corruption--Causes and Consequences." Viewpoint 74. World debate on ideas, Bank, Finance, Private Sector, and Infrastructure Network, innovations, and best segments of society. Washington, D.C. practices for expanding the private sector. The Transparency in the energy sector can be views published in this series are those of the improved by first privatizing electricity distribu- Laszlo Lovei (llovei@worldbank.org), World authors and should not tion, where most theft takes place. In some Bank, Europe and Central Asia Region, Energy be attributed to the social and political settings other forms of pri- Sector Unit, and Alastair McKechnie World Bank or any of its affiliated organizations. vate participation might work, such as contract- (amckechnie@worldbank.org), World Bank, Nor do any of the con- ing out meter reading and billing, leasing South Asia Region, Energy Sector Unit clusions represent distribution utilities, or offering concessions. official policy of the World Bank or of its Encouraging electricity customers and those This Note originally appeared as a chapter in Executive Directors or without supply to find a voice and articulate their Energy Sector Management Assistance the countries they frustration with inadequate service merits more Programme (ESMAP), Energy and represent. attention by reformers. Ideas that could be Development Report 2000: Energy Services for To order additional piloted include surveying public opinion, orga- the World's Poor (Washington, D.C.: World copies please call nizing focus groups, using the mass media, Bank, 2000). For more 202 458 1111 or contact Suzanne Smith, editor, forming partnerships with nongovernmental information on ESMAP go to Room F11K-208, The organizations, and giving customers a say www.esmap.org. World Bank, 1818 H through cooperatives, reconstruction of utility Street, NW, Washington, D.C. 20433, or Internet boards, and participation in regulatory hearings. address ssmith7@ worldbank.org. The series is also available As countries become more concerned about on-line (www.worldbank. governance, they are likely to direct attention to org/html/fpd/notes/). reducing corruption in the energy sector, where Printed on recycled there is huge potential for diversion of public paper.